Breaking Bad

On June 23, the United Kingdom will vote on whether to remain in the European Union. The vast majority of economists are projecting dire consequences for the U.K. economy if voters decide to leave, with some likely spillover to the rest of the world. Until a few weeks ago, polls had pointed to an easy victory for the “remain” campaign. However, many polls now show the “leave” side ahead. Polls are widely regarded as unreliable, following the inaccuracies ahead of last year’s general election. Betting odds (to date) still favor “remain,” but it may be a photo finish.

The European Union allows for the free flow (or mostly free flow) of goods, services, capital, and people across the borders of member countries. Hence, in leaving the EU, the U.K. would face restraints in foreign trade, global finance, and immigration. The vast majority of economists believe that leaving the EU will have a significant negative impact on the U.K. economy. HM Treasury estimates that a Brexit will shave 3.6% from the country’s Gross Domestic Product over two years, and the hit could be a lot more.

In its recent policy statement, the Bank of England’s Monetary Policy Committee noted that the outcome of the referendum is “the largest immediate risk facing U.K. financial markets, and possibly also the global financial markets.” Brexit would weaken the currency (10-20% by some estimates) and present a major challenge for the central bank. Facing a lower growth path and a higher inflation path, the BoE would have to weigh stabilizing prices against stabilizing output and jobs, and it’s unclear currently which would require the greater response.

The uncertainty of a Brexit has already had on impact on the U.K. economy by paralyzing capital investment. The BoE sited evidence of delays to major economic decisions that are hard to reverse, such as commercial and residential real estate transactions, car purchases, and business investment. That comes on top of a scenario of capital spending in the global economy in general.

Some analysts are minimizing the likely risks for the markets. After all, a “leave” victory would set in motion negotiations with the rest of the EU, which could take up to three years. However, an exit from the EU is analogous to a divorce and every other country would be expected to ask for some form of alimony. The uncertainty of a long, a competitive negotiation process by itself would be a negative for economic growth.

Why then, would U.K. voters want to leave? Some want more autonomy, to be free of European regulations no matter what the cost to the economy (and many “leave” voters recognize that there will be a large negative impact on growth). It also turns out that a significant portion of U.K. voters distrust the government, dislike immigrants, and are dismissive of expert opinion (it’s a good thing that we don’t have any of that in the U.S.).

The U.K. is very much integrated with the rest of Europe and a Brexit would also have significant impacts on other European countries. Consider Ireland and Northern Ireland (which is part of the U.K.). Movement between the two would become a little more difficult and trade would likely be whipsawed. Many U.K. retirees have settled in Spain, Italy, and Southern France. Who will cover their healthcare? Will they have to move home? Following a Brexit, who might be next? Will nationalistic tendencies spread, leading to a broader collapse of the EU?

London is a major financial hub. Some big global banks have already begun to retreat. Presumably, Frankfurt would gain a stronger foothold in global finance, or Dublin could become a financial center, or some business would likely go to New York. However, that’s one more negative for the U.K. economy.

Those arguing for an exit have suggested that the U.K. shouldn’t really care about losing trade with the rest of Europe. Global growth is going to come mostly from China and the other emerging economies. However, the U.K.’s trade with all the BRIC countries is currently less than its trade with Ireland.

A couple of weeks ago, many polls began to show the “leave” vote in the lead, but betting odds (Ladbrokes, for example) show a comfortable lead for “remain.” The horrific murder of Jo Cox, an MP and “remain” proponent, has led to some speculation (by the markets) that the “remain” vote will benefit from a sympathy vote. That’s speculation. However, the campaign has been contentious and should heat up significantly in the next few days.

On Thursday, polls will close at 10 p.m. local time (5 p.m. EDT) with results anticipated four to seven hours later (9 p.m. to midnight EDT). A “remain” victory would likely be well received by global stock markets and we should see some unwinding of the flight to safety (that is higher bond yields). A “leave” victory would not be taken well (weaker stock market, weaker sterling, and lower bond yields).

© Raymond James

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