Brexit and the UK Equity Market
James Mee looks at the potential impact a vote for British withdrawal from the European Union could have on the UK economy and financial markets.
A couple of weeks ago, European President Donald Tusk published a letter addressed to the Members of the European Council outlining his proposal for the UK’s membership of the EU. The announcement was largely seen as not going far enough to meet even Mr. Cameron’s own “watered down” targets.
Ahead of this week’s EU summit, where the reform deal will be discussed, we look at the potential impact of a vote for Brexit on the UK economy and financial markets.
A Vote for Brexit: The UK Economy
The economic effect of Brexit is virtually impossible to know ahead of time: complexity lies at every turn. For example, there are various options on the table for an “independent” UK, including the Norwegian model of being an EEA but not EU member, the Swiss model of negotiating treaties on a case-by-case basis, or even entering into Free trade Agreements with Europe, to name a few. Each of these will take the UK down economically distinct paths. Furthermore, whichever path is chosen, the negotiation process will be extremely complex and inherently unpredictable, making any outcome very difficult to predict.
What we can (perhaps) predict, however, is that the uncertainty itself, both in the run-up to and following a Brexit vote, will be bad for the economy: businesses may be unwilling to invest, consumers unwilling to spend, and the government will be reticent to plug the gap, as George Osborne races to reach his self-imposed budget surplus target date of 2020.
While we would not like to put a number on GDP following an “out” vote, it seems plausible that the currency will be weaker for some of the reasons mentioned above.
A Vote for Brexit: Financial Markets
Continuing with the currency theme, it seems likely that Sterling (GBP) will suffer the first bouts of market attack. Indeed, we have already seen weakness in recent months; since the election of the Conservative Party in May 2015, Sterling has weakened by 2.5% on a Trade-Weighted basis, with the most dramatic move coming around the turn of the year as markets turned their attention to the referendum negotiations.
Trade Weighted GBP: 1 Year View
However, a weaker currency is generally good for equity markets generating significant portions of their income overseas, as the repatriation of earnings to the home country with a lower currency drives up earnings in said local currency. In the case of the UK, the FTSE 100 generates 74% of its sales overseas, and as such ought to benefit from weaker Sterling. While less good for the FTSE 250, which earns 46% of sales overseas, a weaker exchange rate does make exports more competitive, which ought to benefit the companies within the 250 index.
Turning to fixed income, a worst case scenario might be a loss of confidence in the government’s ability to meet its debt obligations (the UK’s debt to GDP is currently c.90%) which in turn can create a negative feedback loop of bond sell-offs resulting in higher yields resulting in lower confidence resulting in more sell-offs. However, this would not be our base case. Confidence in the Bank of England (the UK’s independent central bank) is high, and the economy is resilient, notwithstanding uncertainties surrounding renegotiation with Europe.
A Brexit is not our expectation, however we are aware of the risks and considering all means of diversifying away from these as appropriate.
The views and opinions expressed are the views of Waverton Investment Management Limited and are subject to change based on market and other conditions. The information provided does not constitute investment advice and it should not be relied on as such. All material(s) have been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy of, nor liability for, decisions based on such information.
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