Archived News 11/04/2016
Brexit - the Cornelian view
We believe it is more likely than not that the United Kingdom will elect to remain in the European Union. However there are several factors that may derail this view, and we outline the background to the debate, possible departure options and the potential impact on financial markets.
The electorate is being asked to consider whether the United Kingdom should remain in or leave the 28 member European Union (and, therefore, the Single Market) on the 23rd June. The Single Market seeks to guarantee the free movement of goods, capital, services and people within the EU. Four non-EU states (Iceland, Liechtenstein, Norway and Switzerland) are Single Market participants. The only two countries within the Single Market that have opt outs from the Schengen Agreement (no border controls) are the UK and Ireland. The population of the Single Market is over 500 million and accounts for over 20% of global GDP. Roughly 50% of UK exports are sold into the EU (Source: Deutsche Bank).
The population of the Single Market is over 500 million and accounts for over 20% of global GDP.
The UK Government has negotiated some treaty changes ahead of the referendum. The most relevant points from a financial markets perspective are (i) the establishment of non-Eurozone EU member protections against having to participate in future Eurozone country bailouts, and (ii) an agreement that financial regulation may be applied differently to non-Eurozone members and that this will be a matter for the domestic authorities of non-Eurozone states. This latter point could prove to be the most significant concession achieved by the UK government.
Possible Departure options:
Should the electorate vote to leave the European Union, a crucial question then becomes whether the departure is ‘soft’ or ‘hard’.
Under a ‘soft’ leave, the UK would seek to re-join the Single Market as a non-EU member either by joining the European Economic Area or through bilateral deals. Under this scenario, the UK would still contribute to the EU’s budget but the quantum would fall and the UK may be able to exit the Common Agricultural Policy. However, the commitment to unrestricted EU immigration would remain and the UK would have no say in the development of the Single Market’s rules and regulations.
Under a 'soft' leave....the UK would have no say in the development of the Single Market’s rules and regulations.
Under a ‘hard’ leave, a customs union with the EU (cf. Turkey) would need to be agreed and the UK would trade with the Single Market under World Trade Organisation rules. This negotiation would be a lengthy process. The UK would be able to restrict EU migration and there would be a substantial saving in the UK’s net contribution to the EU budget (circa £10bn pa).
Under a 'hard' leave...the UK would be able to restrict EU migration and there would be a substantial saving in the UK’s net contribution to the EU budget (circa £10bn pa).
The economic impacts of a ‘hard’ leave would be more fundamental that those of a ‘soft’ leave. Whilst political power would be returned to the UK, there would be a significant negative economic impact (eg. a collapse of inward investment), at least, in the short term. The outlook for the UK financial service industry would be dependent on whether the sector could transform itself into a successful ‘offshore’ financial centre for the Single Market.
Regardless of whether a ‘soft’ or ‘hard’ leave is enacted, over time a deliberate policy to marginalise the UK’s financial services sector could be introduced. The UK would have little leverage to influence such policy making. The Scottish independence question could also re-emerge as a source of domestic uncertainty. Furthermore, if the UK left the EU and then years later asked to re-join, it is unlikely that the existing opt outs would be offered. Finally, the pace of European Union integration may well accelerate without the UK’s presence.
Impact on financial markets:
- Brexit would have little impact on global economic growth, unless it was interpreted as a precursor for the break-up of the European Union/Eurozone.
- There would be a near term negative impact on UK economic growth, the scale of which would be dependent upon whether a ‘soft’ or ‘hard’ leave was enacted.
- Sterling would weaken further. This would boost UK based global companies’ competitiveness and ensure currency translation derived earnings upgrades.
- Gilts would probably underperform, given the economic uncertainties and the imported inflation risk arising from Sterling weakness.
- UK retailers would struggle as they tend to buy in stock from overseas. Imported inflation could eat into consumers’ real disposable income and this could impact the performance of retail banks as well.
- There would be negative implications for the outlook of the central London commercial real estate market.
- Some asset prices would be impacted by speculation that another Scottish ‘independence’ referendum might be forthcoming.
We believe it is more likely than not that the United Kingdom will elect to remain in the European Union, although an economic crisis within the Eurozone, an accelerating migrant crisis or further terrorist outrages may derail this view. Our global, multi asset portfolios should not be significantly impacted by Brexit. However, if risks of Brexit rise appreciably we will need to consider reducing exposure to domestically focussed UK equity holdings.
Chief Investment Officer