Investment Clock insights

Brexit won't be the end of political risk for investors


Trevor Greetham

22 June 2016

First published in the FT on 22 June 2016. Click here to view.

A late resurgence in support for the remain camp in the UK’s referendum on its future relationship with the European Union has been greeted positively by markets.
We expect undecided voters to prove decisive in favour of the status quo, as they were in the vote on Scottish independence two years ago. We are overweight sterling in the multi asset funds we manage and underweight gilts.

A more pronounced sell-off on a vote to leave would create a buying opportunity for global stocks, especially if turmoil in Europe stays the US Federal Reserve’s hand in hiking interest rates this year. Whatever the UK decides, the world economy is expanding, monetary policy is loose and this is a positive backdrop.

Those in favour of leaving the EU argue that it is the only way to restore sovereignty and to control immigration. Those against argue that leaving the world’s largest trading block would be a serious self-inflicted wound. The UK referendum is a political choice with economic consequences.

Markets like what they know and they don’t like Brexit.

The UK has a long history as an open free trading nation before the European Union was ever thought of, but a vote to leave could mean years of uncertainty while exit strategies were debated and negotiated.

Meanwhile, lack of clarity over the future regulatory and trading landscape would act as a headwind for the economy, deterring foreign direct investment, trade, capital spending and hiring.

Policy makers would respond to a downturn but not necessarily in the way investors would like to see. Under the current fiscal framework a drop in government revenues if deemed structural would trigger a further round of austerity.

The Bank of England has little room to lower mortgage rates to boost the housing market as it would have done in prior years when faced with weakness in the productive economy and quantitative easing has had mixed results.

Sterling would need to weaken enough to attract business and capital back to the UK without inflation getting out of control, a risky strategy given the size of the current account deficit and efforts being made by other central banks to depreciate their own currencies.

From a purely financial point of view the costs of full market access within the EU are modest. Net of Margaret Thatcher’s rebate the UK contributes less than one percent of GDP to central EU funds – a similar amount to the overseas aid budget – and some of this comes back through grants.

For this cost, the UK benefits from unfettered access to the common market but, given its enviable position of being in the EU but not in the euro, it retains the flexibility of an independent monetary and fiscal policy. Loss of sovereignty is largely limited to an adherence to common trading standards, environmental safeguards and social protections.

Free movement of labour acts as a release valve, easing skill shortages when the economy is strong. The associated increase in the working age population creates an expanding tax base to pay down government debt and support the growing ranks of pensioners. You need only look to Japan to see what can happen when an ageing population starts to shrink and there are no new workers coming in to share the burden.

In the final analysis, we think a desire for economic growth and stability will swing undecided voters in favour of the status quo – and the closeness of the polls as we approach 23 June may lead to a surprisingly high turnout.

A decision to remain in the EU would lift uncertainty with immediate effect, boosting global stock markets and the pound. We’d expect UK business confidence and the property market to bounce back. In this scenario, we would probably see a rise in base rates towards the end of the year which would be bad news for gilts.

If the UK votes to leave then stock markets will drop further. We went into the summer positive on equities but only lightly positioned as thin markets are prone to shocks. A deeper sell-off could present a buying opportunity, especially if problems in Europe mean US interest rates remain on hold. Dollar weakness could result in continued strong performance for commodities and the emerging markets.

Whatever the outcome of the UK referendum, the fundamentals for stocks are positive with the world economy expanding and monetary policy loose. It would be nice to think political risk will soon be behind us. More likely, attention will shift to America and the pros and cons of a Donald Trump presidency.

The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. The views expressed are the author’s own and do not constitute investment advice