With just a few weeks to go until the UK’s referendum on its membership of the EU, opinion polls still suggest that the outcome will be close. The impact of Brexit on the UK economy could be very significant, but it will also have knock-on effects across the rest of the EU and eventually some of these effects may also be felt in other regions as well, including here in the Gulf.
The possibility that the UK could leave the biggest single market in the world raises considerable questions about UK growth, interest rates, currency movements, trade, capital flows and foreign direct investment, as well as about security and numerous other political issues and risks.
The most significant and immediate impact of Brexit for those outside of the UK will be felt through the impact on financial markets, and in particular the effect on sterling. The Bank of England, IMF and other prominent global central banks such as the Federal Reserve in the United States even thought to be considering delaying a further interest rate hike in June partly because of the risks.
Sterling the first casualty
The pound has already been the weakest performer among the major currencies so far in 2016, falling around 2.0 per cnet against the dollar, and at one point reaching 1.3834 after the referendum was announced in February. It has also fallen by almost 8 per cent from this time a year ago. However, there is potential for it to be much weaker in the event that the UK actually decides to leave the EU on the 23rd June, declines which would be accompanied by significant amounts of volatility.
FDI delays
Sterling has a structural challenge as the UK continues to run a sizeable current account deficit that requires funding with capital inflows to keep sterling from falling precipitously against other currencies. The current deficit is one of the largest in history. A decision to leave the EU could lead to delays in foreign direct investment flows into the UK as industrialists wait to see how the UK’s negotiations with the EU play out over access to the single European markets for goods and services.
Europe Pandora's Box
It is not only sterling that stands to be negatively affected by Brexit. No country has ever left the 28-member EU, so should the UK decide to leave it would set a precedent which others might also be tempted to follow, opening up a Pandora’s Box of potential consequences. After all, the current condition of the EU is hardly strong with economic growth weak and the political splits over issues like immigration and the Greek crisis still very raw. For the 19-member euro zone in particular there would be clear downside risks, with the likelihood that some of its members might flirt with the possibility of pulling out.
But even if the rest of the EU and the euro zone did manage to stick together, there could also be negative consequences for European growth, trade, investment and fiscal policy from the UK’s departure. If anything Britain is an even more important trading partners for many European countries, than Europe is for the UK, as Britain is a net importer from the EU by quite a large margin. So any weakness in sterling could see reverberations into these countries as well. At a time when the US Fed is likely to be considering a second rate hike of its tightening cycle, Brexit could be the issue that consigns both sterling and the euro to much lower levels.
UK economy
The Bank of England Governor has recently warned about the possibility of a ‘technical’ recession following a decision to leave the EU, and recent economic data has tended to support this likelihood as UK economic growth appears to have been slowing since the referendum was announced in late February. Growth in Q1 fell to 0.4 per cent q/q and both manufacturing and service sector PMI’s were much weaker than expected in April. This weakness has already been sufficient for the Bank to lower its Q2 and whole year growth forecast for the UK economy, to 0.3 per cent q/q and 2.0 per cent y/y respectively, and we are also lowering our own 2.3 per cent forecast to the same level. As our working assumption is that the UK will remain in the EU, there should be a recovery in the second half of 2016 as the uncertainty fades. However, in the event that the Leave camp wins short-term expectations for growth will be downgraded further and the possibility of a BOE rate cut will increase which would be one of the factors likely to weigh on sterling.
UK bonds
UK bonds could sell off quite aggressively should the UK decide to leave the EU. Rating agencies have already signalled that they could take the UK credit ratings down by a notch or two. Much will depend on how the rating agencies see the ability of the UK to keep its trading relationships intact and whether or not there could be damage to the country’s ability to attract capital. The country is running a record high current account deficit that requires funding through capital inflows – notably FDI from Europe.
International investors remain significant holders of UK gilts with a market share of 26 per cent. Back in 1995-2000 for example the holding was lower at 19 per cent of the total market. Concerns about sterling weakness, and possible credit downgrades suggests that the risks are that foreigners would be minded to reducing their holdings.
A decision to leave could leave investors facing a steepening yield curve with the move up in long dated yields coming at a time when the Bank of England feels compelled to cut rates to support the economy through the angstof shock of the UK voting to leave.
Stay – Flattening yield curve
Should the UK decide to stay the bond market would likely rally at the long end of the curve as the threat of credit downgrade would abate and international investors would no longer be concerned with unwinding their holdings. At the short end of the curve the sense of relief and with it a likely pick-up in economic activity might bring forward a rise in UK interest rates. Hence the two year yield could rise from its recent lows.
UK equities
There are a number of mixed factors that could impact the UK equity market should the vote be for UK exit.
Higher corporate profits
The uncertainty over the process of how the UK leaves is expected to take domestic growth down and negatively impact the profitability of domestic businesses. However on the other hand the likely marked fall in sterling on a trade-weighted basis would improve the international competitiveness of UK businesses and lead to overseas earnings of UK businesses translating back into higher sterling profits. Deutsche Bank estimates that combining the reduction of domestic profits with the higher international earnings of UK businesses would lift profits by 6.5 percentage points from current assumed level of 2016 profits.
The UK exiting from the EU is expected to lead to wider credit spreads, lower GDP growth and greater uncertainty about the future to lead to a de-rating of UK equities. For international investors the uncertainty would make the UK a relatively less attractive place to invest hence the UK could suffer significant outflows from the equity market further depressing valuations.
In aggregate UK equities could be down as much as 10-15 per cent on Brexit.
Remain in the EU
There would be a collective sigh of relief in the equity market if there was a decision to stay in the EU. If the result remains in the balance, the initial reaction from the market for a ‘remain’ will probably be to rebound from any setbacks that may have been experienced in the last few days prior to the vote. A good template for what may happen is the Scottish referendum where the vote appeared to be in the balance in the final few weeks. Global equity markets were dragged down by the UK as risk aversion rose. There was relief rally when the Scottish voters pulled back from independence but the shock of coming close to a break up in the UK meant that the risk aversion continued for a few weeks beyond the vote held on September 18th 2014.
- Gary Dugan is the Chief Investment Officer, Wealth Management at Emirates NBD and Tim Fox is the Chief Economist & Head of Research at the Dubai-based bank
