This is a comment on the UK Referendum from an investment house.
With just under one week to go before Britain decides whether to remain inside or outside the European Union (EU), the country is divided and the outcome is in the balance. The debate has descended into hyperbole, with both sides exaggerating the economic arguments over a so-called Brexit, and led to violence with the death of Labour Party MP Jo Cox. Until recently, the “Remain” campaign led in the majority of polls; but over the last few days, the Brexit campaigners have managed to narrow the gap. A poll conducted by “What UK Thinks” between June 9 and June 15 revealed that the majority of those polled plan to cast a “Leave” vote — largely on growing concerns about immigration control efforts. This report spurred Prime Minister David Cameron into action; just one day later, he uncharacteristically scheduled an impromptu press conference — urging the general public to “ignore Brexit untruths about the economy and immigration,” as he seeks to keep the U.K. in the EU. SEI’s own EU-referendum poll, conducted during our recent pensions seminar at The Royal Albert Hall, found that 73% of attendees were in favour of remaining in the EU.
It is often said that financial markets hate uncertainty; and everything about a Brexit — from whether or not it will happen to what impact it will have — is shrouded in uncertainty. Accordingly, it is no surprise that concerned investors have pulled £65 billlon of cash out of the country or moved it into other currencies over the past two months — the largest outflow since the financial crisis in 2009.
There has been some currency hedging, as evidenced by the positioning of currency traders. Consequently, the value of sterling has declined relative to other major currencies, and the cost of hedging a Brexit event has been expensive. Long-term gilt yields have fallen, but it is hard to separate this from the overall global decline in the value of bond yields. European stock markets have pulled back notably, triggering pullbacks elsewhere. But just how likely is a Brexit? And how significant would its impact be on the U.K. economy?
Why a Brexit Could Happen
Scepticism about the value of EU membership has steadily increased over the past four months, as polls displayed a growing number of “Leave” campaign supporters — now representing the majority vote. This shift in public opinion is thought to be driven by growing concerns about regulation of U.K. immigration: Over 330,000 people moved to the U.K. in the year ending December 2015, which well exceeded Prime Minister Cameron’s target of 100,000 immigrants. Immigration is a political hot topic, as many believe this influx of residents has resulted in lower wages for British employees (despite unemployment having reached a 10- year low).
“Leave” campaign advocates propose addressing these issues by implementing a points-based immigration system upon Britain’s departure from the EU. Such a system would evaluate visa applicants based on age, English-language competency, job experience and skill sets.
Why a Brexit Probably Won’t Happen
Despite the recent anxiety on behalf of both the public (about immigration) and the Prime Minister (about departing the EU), pundits believe the 13% of undecided voters will likely prove a pivotal role in the referendum — with most expected to vote “Remain.” Yes, the view of the general public has slightly shifted in support of a Brexit — but political parties in the U.K. and throughout Europe strongly favor Britain’s continued EU membership. Many analysts believe that a Brexit would cause economic hardship as opposed to growth. It would certainly hinder Britain’s future trade relations, for example, given that the EU is the U.K.’s largest export market.
As a member state, the U.K. holds a significant competitive advantage over top financial centres around the world, as individuals can work and travel with ease between countries. A Brexit would not only make this harder, but could also result in the relocation of company offices and headquarters due to regulatory issues and trade policies.
SEI’s Strategies Largely Unchanged
The longer-term points of view expressed in the majority of our client portfolios have remained largely unchanged. We believe that there is a limit to which portfolios can be positioned for such fluid political events. For instance, the costs associated with buying protection against a falling pound may be high. In addition, any form of risk- off behavior would be tempered by the substantial costs of moving into less-risky assets (particularly as fixed- income yields are hovering at historic lows). Yields on more-stable, lower-volatility stocks in equity markets are also low — indeed, by more than they were at the tail- end of the financial crisis in the spring of 2009.
We believe the outcome of the vote is too close to call. In the event that it does happen, we expect only a temporary shock to the European economy — with a weakening British pound, decreased confidence among investors and consumers, and an increased likelihood of another Scottish referendum.
Our stress tests suggest that double-digit declines in U.K. equity markets could spill into Europe. Bond markets would likely see continued investor preference for quality, which has already pushed German bund yields into negative territory as many seek the relative safety of high-quality government bonds. The U.S. dollar and the Japanese yen would probably strengthen as the pound weakens further.
Possible long-term repercussions include increased regulation, reduced economic growth (from new immigration policies) and deteriorating trade performance. In this uncertain environment, we feel an investor’s best source of protection from risk is, as always, diversification — and the ability to look past today in order to focus on long-term goals.
James Mashiter, U.K. fixed-income portfolio manager at SEI advises, “A vote to leave should, in the short term, lead to further depreciation in the pound and spread widening in sterling (and euro) credit markets. We could also see the gilt curve steepen as an uber-dovish Bank of England anchors the front end; but higher-term premium is priced in further out along the curve.”
On the equity side, Jim Solloway, CFA, senior portfolio manager at SEI, believes that the initial impact of a Brexit on the financial markets could be counter-intuitive. “A fair amount of hedging has already taken place, and traders typically buy on the rumour and sell on the news. For these reasons, the short-term market impact may be a little muted. However, should the U.K. elect to remain in the EU, the markets are likely to view this favourably and adopt a more-pronounced risk-on approach. We would expect to see a stronger pound and a lift in the stock markets.”