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Brexit, stage left

The United Kingdom will soon vote to either stay in, or leave the European Union. Pathfinder's John Berry looks at this important referendum and discusses what it means for markets and investors.

Monday, May 30th 2016, 6:04AM

by Pathfinder Asset Management

Concerns about Greece leaving the EU created market turbulence for three years (2012 - 2015).  Would Grexit bring down the Euro, the EU and the whole European project?  A year on and “Grexit” has become “Brexit” - the concern is now whether the UK leaves the EU.  All will be decided shortly with the referendum on 23 June.

Markets have only this year woken up to the potential disruption that Brexit can cause. There would be disruption for the UK itself, for the EU and for global markets generally. Polls tell us it will be close with “decided” voters generally split 50/50 between “Brexit” and “Bremain”.  A range of polls show 20% of voters are undecided – by voting they could determine the outcome.

Why the EU?
The EU’s origins are important.  After two devastating 20th Century wars the new thinking was that close economic ties and trade would bring peace to the continent.  Countries wouldn’t go to war when they are integrated with each other.  In 1950 a common market in coal and steel was set up by six European countries.  Germany and Italy had found a way to work with France and Belgium.  This developed into the common market which the UK (along with Denmark and Ireland) joined in 1973.

The goal of the EU was to create a single market for goods and services.  Free movement of people within the EU and a common currency were over-laid later.  The UK has since struggled with the EU’s drive for “ever closer union”. 

The EU has become a significant economic group.  With 7% of the world’s population, it generates 17% of world GDP.  But it is also a complicated political machine.  Its 28 commissioners (one from each country) oversee the civil service (the European Commission) and recommend laws to its 751-member parliament. Should the UK stay as part of this? 

Why exit?
In recent times there has been an inertia for Western democracies to vote in favour of separation from a larger grouping.  The UK voted to remain the EU (1975), Quebec voted to remain as part of Canada (1980, 1995) and Scotland decided to stick with the UK (2014).   This inertia favours Britain staying in the EU.

However, there are plenty of reasons for UK voters to favour Brexit.  They come under the umbrella of “sovereignty” – border control, immigration, costly EU membership fees and control of law making.  These arguments are powerful – and easier to grasp than complicated economic analysis.

Why stay?
From an investment perspective the question is “does the EU enhance or constrain UK growth?”  Most commentators believe the UK is better off inside the EU.  Outside could see growth slowing, with some arguing the shock could be similar to the GFC.  The result hinges on trade deals the UK can agree and how quickly it can implement them.  At stake is not only free trade in the EU (almost 50% of UK exports go to the EU) but also the range of deals that the EU has with the rest of the world.

Norway, Canada and Switzerland are all precedents for open market access to the EU.  But there are sticking points.  Firstly, while Canada has quite a clean trade deal, Norway pays for access to the EU and submits to free movement of people (i.e. two of the very reasons that Brexiteers want to leave the EU).  It would be a huge risk to assume the UK would get a more favourable deal than Norway.

Secondly, any new deal with the EU will not include financial services.  This would be troubling for the UK given London is the financial capital of Europe.  A UK banking licence would no longer be a passport to the rest of Europe. Paris and Frankfurt would enthusiastically try and step into this role. 

That would be a loss for the UK with the finance industry generating around 10% of GDP and 7% of employment.

Does Europe care?
Brexit could be painful for the UK but it will also hit the EU.  Ten percent of EU exports go to the UK. Losing the country with the largest military, the second largest economy and the third largest population will weaken Europe’s political clout.  Russia welcomes the idea, while the US, China and the rest of the world have a strong preference for the UK staying in the EU.  The UK is their gateway to Europe.

Europe will also be concerned that if the UK leaves and is successful, voters in other member countries could consider an exit.  For this reason, the EU is not incentivised to help the UK as it exits.  In fact the EU is incentivised to be tough and discourage other EU members from entertaining the idea of leaving.  They will want to be able to say “the UK left and look what happened to them.” This means a clean and quick UK / EU trade deal is unlikely if the UK exits.

How will Brexit impact markets?
Given the uncertainty in the polls, the outcome will likely be binary for markets – either a good outcome (UK stays) or a very bad outcome (UK leaves).  Sterling has drifted lower over the last six months as concerns about Brexit have grown.  There was a small taste of potential currency impact in late February when the date of the referendum was fixed – Sterling promptly lost 3% against the US dollar and 5% against the NZ dollar. 

A “stay” vote should see the weakness in Sterling promptly reverse.  A “leave” vote could, according to some estimates, see a 10%+ hit to Sterling.  Take your pick – Sterling will likely head straight up or straight down on the referendum result. 

For UK equities a “leave” vote could be ugly.  The FTSE100 fell 3% when the referendum date was set and has lost around 10% against global equity indexes (in Sterling terms) since mid-2015.  So how does an investor reduce the UK investment risk of a “leave” vote? Currency hedge Sterling?  Sell UK financial stocks?  Favour exporters to the US and Asia over exporters to Europe?  Buy defensive stocks like consumer staples?   Move into yielding stocks (property and utilities) on the basis that a “leave” vote will hold UK interest rates lower for even longer?  Or maybe just “hold” if you expect the UK will vote to stay? (It was best to be asking these questions in 2015...).

UK will vote to stay?
The market impact could be wider than just the UK.  A “leave” outcome could easily wash over into global equity markets.  It could provide the justification for a broad sell off in global equities like October 2015 and January 2016.

So where does this leave investors?
If the UK votes to leave the EU it is entering unchartered waters.  Sterling and UK equities would likely be hit.  Indeed, global markets generally could be hit.   “Brexit” is bad for markets, “Bremain” is good for markets.  The outcome is binary.  Brexit could prove to be the most significant geopolitical risk for investors in 2016.

John Berry is a founder of Pathfinder Asset Management Limited and is an independent director of Punakaiki Fund Limited. This commentary is not personalised investment advice - seek  investment advice from an Authorised Financial Adviser before making investment decisions.

Pathfinder is an independent boutique fund manager based in Auckland. We value transparency, social responsibility and aligning interests with our investors. We are also advocates of reducing the complexity of investment products for NZ investors.

Tags: Pathfinder Asset Management

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