By Turgut Kisinbay, Senior Analyst
On June 23, the United Kingdom (U.K.) will hold a dramatic referendum to determine whether it should withdraw from the European Union (EU). Essentially, the British electorate will be responding to the following question: "Should the U.K. remain a member of the EU-or leave it?"
A British departure from the EU-known as a "Brexit"-could have major political and financial consequences. Here we answer some of the most important questions concerning this prospect and its investment implications.What are the chances and general consequences of a Brexit?
Our base-case outlook calls for the U.K. to vote to remain a member of the EU. Still, the possibility of a Brexit is real, and we believe the financial markets are underestimating it-and thus underpricing the uncertainty leading up to the referendum.
The consequences of a vote to leave the EU would be significant for the U.K. economy, but even they would pale in comparison with the threat it would pose to the European integration project. And the EU's fate is of far greater significance to the financial markets.
We strongly believe that a Brexit would result in the EU taking more concrete steps towards greater integration among its member countries-but that financial markets would be volatile in the interim following the U.K.'s withdrawal.Why is a referendum on a Brexit being held now?
Prime Minister David Cameron is fulfilling his promise to hold the referendum if he won the 2015 general election. Cameron's promise was the result of growing calls for independence from his own conservative members of parliament and the U.K. Independence Party, but he is a strong advocate for remaining in the EU.What are the arguments for a U.K. withdrawal from the EU?
The driving force behind the campaign to withdraw is the belief that the costs of an EU membership are now outweighing the benefits.
Proponents of withdrawal, or the "Leave Camp," want the U.K. to maintain control over its own affairs in the following respects:
- Trade: The Leave Camp expects an autonomous U.K. to be able to secure beneficial trade deals with other important countries such as China, India and the United States.
- Regulation: The Leave Camp laments what it perceives as the burdensome cost of EU regulations to U.K. business operations. The costliest regulations include the renewable energy directive (which requires the EU to meet at least 20% of its total energy needs using renewables by 2020) and the working time directive (which requires EU companies to limit weekly working hours of employees).
- Immigration: The Leave Camp believes that the arrival in recent years of hundreds of thousands of legal immigrants from eastern Europe has led to lost jobs for Britons and a larger portion of government benefits going to migrants.
In addition, concerns over the prospects of an "ever closer European Union" has the Leave Camp fearful over the costs of future bailouts and the potential for greater wealth transfers from wealthier member states to poorer countries.
Of course, the strong counterarguments to the Leave Camp is that there is no guarantee that the U.K. will be able to negotiate better trade deals, and that the net effect of immigration is bad for the U.K.'s economy.What do the polls show about the possibility of a Brexit?
As of May 5, 2016, an aggregation of multiple U.K. polls by The Financial Times shows a minor lead of 3% for those in favor of remaining within the EU (or the "Stay Camp"). This is far less than the share of undecided voters, estimated at 11% (Exhibit 1).
The polling may not be completely accurate, and there is a wide discrepancy between online and phone polls. The latter show the Stay Camp consistently ahead, whereas the former suggest a much closer outcome. The likely reason for this discrepancy is that online polls require proactive participation and are likely attracting the more passionate members of the Leave Camp, who could skew the results. Indeed, phone polls proved to be more reliable in the 2015 U.K. general election, but we caution against using that outcome to make generalizations.
Exhibit 1: Polls show a slim majority of votes in favor of remaining within the EU
If the base case is for the U.K. to remain in the EU, what is the biggest risk to that outcome?
No one knows what voter turnout will be, though it's widely expected that members of the U.K. Independence Party will be highly motivated to vote, and that support for the Leave Camp is highest among older age groups, who are most likely to vote.
Additionally, the British Conservative Party is split on the issue. The Labor Party is clearly more in favor of remaining with the EU, but its leader, Jeremy Corbyn, was a skeptic about EU membership in the past and ambivalent about the EU during his campaign for Labor Party Leadership. It remains to be seen if he will energize his base to actually vote.What are the potential outcomes of a leave vote and their effect on the U.K. economy?
There are two potential leave outcomes:
- An amicable exit
In the event of an amicable exit from the EU, the U.K. may explore other existing models that provide access to the single market but still enable the country to maintain its national sovereignty and democratic rights.
France and Germany are unlikely to allow the U.K. to withdraw from the EU amicably, because such a smooth and low cost exit may encourage other member countries contemplating a withdrawal. A complicated exit is in France's and Germany's interest, to say the least. A lack of clarity over what would replace an EU membership for the U.K. would persist for a long time and probably trigger volatility in the financial markets.
- A full exit
The impact of a full exit is hard to quantify. The result of a Brexit, on the basis of some estimates, could be a 2%-3% loss (if not greater) in permanent gross domestic product. A full 52% of U.K. trade, worth £400 billion per year, is with other EU countries.What would be the potential impact of a leave vote on the EU?
The biggest risk of a Brexit is not a permanent loss in U.K. GDP, but rather the threat it poses to the EU integration project. An exit of one of the most important members of the EU may lead to other EU members that are not part of the common currency (including Poland, Sweden, Romania and Hungary) to question the benefits of their membership.
Ipsos, a global market-research company, conducted a recent poll in nine leading EU states-including Spain and Italy-that showed certain select countries being enthusiastic about holding their own referendums, though the polling also suggests that the likelihood of actually voting to leave is below 50%. Still, it is conceivable that a U.K. exit would signal the end of deeper European integration and lead to more member states demanding their own terms for EU membership or voting for independence.
To reiterate, we believe that a Brexit will result in the EU taking more concrete steps towards greater integration among its member countries.What would a Brexit mean for the European financial markets?
Despite our base-case scenario of a victory for the Stay Camp, we believe that the market is underestimating the uncertainty of a U.K. exit. The U.K.'s markets have not priced in much of a risk premium, except for their currency (the British pound). The credit spreads of government bonds of peripheral European countries have widened in recent weeks, but we do not believe that the risk premiums sufficiently reflect the probability of an exit.
If the vote were to go against our base-case view, we believe that the first month would be particularly volatile for the financial markets. Our expectation would be for peripheral European financial markets to once again come under stress and for the British pound to depreciate against the euro. In light of this possibility, we have cut our exposure to the British pound.
While equity markets may also come under pressure, we believe that multinational large-cap U.K. companies are still in a strong position: They generate 75% of their sales outside of the U.K. and 57% outside of Europe. Valuations today are relatively attractive given the uncertainty around the vote, and these companies would likely benefit from the increased competitiveness resulting from a devalued pound. We also note that only 7% of EU exports go to the U.K., which means that a Brexit may not have a material impact on the actual sales results of non-UK, multinational companies, though we suspect that it could hurt investor sentiment in the near term.
Foreign investments may be volatile and involve additional expenses and special risks, including currency fluctuations, foreign taxes, regulatory and geopolitical risks. Eurozone investments may be subject to volatility and liquidity issues.
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