Brexit: Boost or Bust?
February 29, 2016
by Leigh Harrison
of Columbia Threadneedle Investments
- A post-Brexit U.K. would arguably find trade with Europe harder and more costly, resulting in reduced economic growth.
- Given that 75% of the U.K. market’s earnings base is outside the U.K. a weak currency may substantially offset the impact on investment and business confidence.
- Brexit is likely to have the biggest impact on banks, retailing, domestic earnings, other financials, insurance and property.
The campaign for the U.K. to leave or stay in the EU has barely started and the outcome of any vote remains uncertain. Most commentators are sticking with the 50/50 in/out position taken by the press, although betting companies are currently showing a bias toward 65% in favor of staying in. While little money has flowed into these bets so far, as we move forward bookmakers’ prices are likely to be a more meaningful reflection of sentiment in the country.
While the government would like to hold the vote as soon as possible, there are logistical complications, not the least of which is that David Cameron’s current negotiations with the EU need to be finalized before he can put a proposition to the country. While the prime minister appears to have agreed to a draft deal on proposed new terms of Britain’s EU membership, it has yet to be agreed upon by the European Council (EC).
Subsequent to the ratification of any proposals by the EC, it is expected that at least three months is required to put a referendum in place in the U.K. The European Council meets monthly so the earliest any agreement could be finalized is late February, allowing a June vote. This is the government’s preferred option.
However, failure to finalize discussions in February would mean a vote would occur in July, in which case the concurrence with school holidays means that any vote could end up being pushed back into September or October. The expectation that it could be later than that is low because of emerging conflicts with other votes in Europe and year-end holidays. A vote in 2017 is a possibility, but is clearly a poor option for the government, prolonging uncertainty and yet again overlapping with other EU elections.
Forecasters currently expect the uncertainty ahead of any vote to have a negative effect on economic activity, with the most cautious suggesting this could subtract 1-1.5% from annualized GDP growth during the middle quarters of 2016 and 1% in 2017. Clearly, this is a non-trivial number in the context of the low-inflation, low-growth environment we are experiencing and is another reason for the government to want to remove the uncertainty as soon as possible so it can focus on positioning the economy for the next election.
How Brexit would affect the wider economy
EU membership has undoubtedly been positive for the U.K. economy, both in terms of boosting growth and increasing the flow of foreign direct investment (FDI). A study from the Centre for European Reform (CER)1 suggests that, “the U.K’s trade with the other EU members is 55% higher than one would expect, given the size of the countries’ economies.” The EU is also the U.K’s largest trading partner (with around 50% of U.K. trade as of year-end 2015). Moreover, it is estimated that almost half of FDI in the U.K. is from Europe and almost half of outbound U.K. investment is into Europe.
It is likely that the U.K. outside the EU would find trade with Europe both harder and more costly, resulting in reduced economic growth. Further, the reduction of the attractiveness of the U.K. as a gateway to Europe would clearly impact FDI originating from outside the EU, leading to the possibility of it being redirected to investment and jobs inside the EU.
It goes without saying that one of the biggest areas of growth within the U.K. economy in the last 15 years has been that of the financial services industry as London has increased its dominance of European financial markets. While the many advantages enjoyed by the U.K. may well limit the impact, there is no doubt that business would drift to within the EU as regulatory requirements and legal practicalities favor Europe over the U.K. for future investment.
Sterling has been weak in recent weeks, which may be due in part to an increasing reluctance of international investors to hold the currency while the uncertainty of Brexit continues. The issue here is that the negative impact on growth could keep policy loose for some time and weakness in the currency would be encouraged to stimulate exports, given the economic importance of international trade to the U.K. Additionally, sterling may be less attractive in a global context if the U.K. is merely an island on the edge of Europe rather than a key part of one of the largest markets in the world. Consequently, it is possible that the cost of funding the deficit may rise, pushing long-term interest rates up.
There are consequences to an out vote for the U.K. as a whole, with the Scottish National Party likely to call for a renewed referendum on Scotland separating from the U.K. and trying to enter the EU as an independent nation.
The impact of Brexit on U.K. equities
There is no doubt that a vote for Brexit would be negative for the equity market as weak sterling and lower growth expectations would reduce earnings forecasts for the market as a whole. However, given that 75% of the U.K. market’s earnings base is outside the U.K. a weak currency may substantially offset the impact on investment and business confidence (although the longer term unwind of the benefits of being in Europe would undoubtedly be a headwind to longer term growth). The impact, however, would not be uniform. Companies with overseas earnings may well benefit, in reported earnings terms, from a weaker pound, while investors would be likely to reduce focus on the domestic earnings (mid-cap) companies, which have led the market for the last 18 months.
At an industry level, Brexit is likely to have the biggest impact in the following areas:
Banks: Lower domestic growth in the near term, but possibly less competition; international investment banking could migrate some functions to Europe, depending on discussions over the “passport”; other questions include: U.K. domestic banking to become more parochial? A bigger role for the domestic regulator? Potential restructuring required to maintain European exposure for some?
Retailing: An impact on staffing given the significance of migrant labor in the workforce (leading to potentially higher costs?); potential change in sourcing and spending patterns, especially in the food sector where EU regulation is a key driver of practices; potential impact from uncertainty post a Brexit vote until Brexit actually happens (for up to two years?).
Domestic earnings: Clear impact from lower GDP forecasts and consequential lower growth in consumer incomes, plus a period of reduced job creation as the adjustment takes place; impacts on housing and construction, industrials.
Other financials and insurance: Regulatory impact on insurance and impact on market-related stocks.
Property: Would Brexit lead to a loss of foreign buyers? The impact from bond yields is perhaps more significant, but a weaker pound might also be an incentive for foreign buyers; also offset by the limited effect on U.K.’s "safe haven" status.
Brexit might also have a limited impact on utilities (except, perhaps, if a Scottish independence vote were to follow) and large international companies (oil, mining, international industrials, pharmaceuticals, tobacco, staples) along with some international business services, e.g., media, telecoms.
A vote to leave the EU would be seen as a negative
In our view, the current uncertainty affecting world markets is more significant for investors than Brexit. Having said that, there is no doubt that a vote to leave the EU would be seen as a negative by the market. Nervousness about the possibility is already driving the current valuation of the U.K. stock market and of sterling. This is only likely to increase ahead of a vote.
If the vote is to stay in, then we can assume there would be some return to business as usual and the market may stage a recovery relative to other markets, with those areas most pressured ahead of the vote leading the way. If the vote is to exit, then the issues mentioned above are likely to come sharply into focus and the overall market is likely to remain depressed as adjustment to the new reality takes place.
On a brighter note, there is no currently obvious leader for the Brexit campaign, so Brexit is more a focus for generalized discontent than a coordinated body with a clear set of objectives. This may change as campaigning starts. Finally, a perhaps surprising fact is that many voters attach considerable weight to David Cameron's stance on this issue, and have expressed to pollsters that their voting will be guided by the position of the prime minister.
1 CER, The economic consequences of leaving the EU, June 2014