Brexit Threat - Repeated Political Failures Damage The Euro And Sterling

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Includes: DRR, ERO, EUFX, EUO, FXB, FXE, GBB, ULE, URR
by: Tim Clayton

Summary

Sterling will remain vulnerable over Brexit concerns; 1.35 for GBP/USD remains in reach.

The EU Summit has further damaged wider confidence in the political process.

Failure to resolve the migrant crisis will intensify internal EU tensions.

The Euro will also be vulnerable ahead of the June 23 UK referendum as confidence slides.

The stage-managed and 'politics of illusion' deal on revised EU membership terms for the UK illustrated yet another failure of European decision making. The charade convinced nobody and the much more urgent and pressing migration crisis was virtually ignored. The UK referendum campaign now threatens to generate further instability with both Sterling and the Euro suffering from a lack of economic and political confidence while the ECB will again be called to the rescue.

Prime Minister Cameron's promise to hold an in/out EU referendum might have seemed like the best plan to contain internal party dissent, but the decision is now threatening to become an even more destabilising influence. Far from cementing the UK in a reformed Europe, there is now an important risk that the UK will be outside a politically divided and weakened EU with an increased risk that the Union will be broken by Scottish independence. There is a serious long-term cost of short-term political decisions taken for the wrong reasons.

Sterling's fundamentals mean the currency is not well placed to cope with the threat of Brexit and potential capital outflows. Unless there is evidence of a decisive lead for the stay campaign, Sterling will remain vulnerable to further net selling. There will also be wider fears that Europe in general and the Euro-zone in particular will suffer collateral damage, especially with very serious political tensions liable to escalate.

Looking from a UK perspective, the first important risk to Sterling is the fact that the referendum is still more than four months away. It's a fairly worn cliché that markets hate uncertainty, but there will certainly be important concerns over the length of campaign which has not officially even started yet.

There is a high risk that investment inflows will be delayed as overseas investors wait for the outcome. Even if companies are still optimistic surrounding a project's long-term future, there will inevitably be pressure for decisions to be postponed as boardrooms and shareholders ponder the uncertainty. It is also the case that some potential capital flows will be diverted elsewhere. The mechanics of any EU exit is highly uncertain, but companies will inevitably be wary of potential adverse impacts on market access.

There has already been an increase in capital outflows from the UK due to the slump in oil prices. Sovereign wealth funds and individual investors from oil-producing countries are forced to repatriate funds to prop-up domestic economies and fund spending commitments.

Although this will continue to be an international feature, given the openness of the economy and capital markets, it is likely to be much easier to withdraw funds from the UK which will tend to leave the financial account more vulnerable.

The UK is still running a substantial current account deficit at around 4% of GDP for 2015 while there is still high leverage in the financial sector. In this context, Sterling will inevitably be much more vulnerable if there is a sustained outflow of capital.

There is an important risk that opinion polls will overstate the potential for a Brexit in the run up to the vote. Those campaigning for an exit are likely to be more vocal and committed in their views while there will be a high proportion of don't knows, at least in the early stages of the campaign. There is liable to be only a very late swing in favour of staying in and, until then, poll leads for those advocating withdrawal will undermine Sterling.

It is easy to overlook the fact that the referendum campaign and outcome will have a pivotal impact not just on the UK, but also on the wider EU. Both the domestic and international ramifications will be extremely important with potentially far-reaching consequences.

From the UK perspective, there is an important risk that there will be a negative impact on the UK government given that Ministers will be in opposing camps. The party has previously been torn part by internal splits over Europe and the referendum will once again intensify the divisions.

Any vote to leave the EU would certainly result in the resignation of Prime Minister Cameron, triggering a further round of divisive party in-fighting. Markets will also be looking at the possibility of a general election which would trigger further uncertainty and could force investors to consider the unthinkable - a government led by Labour Leader Corbyn.

There will be increased speculation that there would need to be a second Scottish independence referendum, indeed it would be inevitable if the UK as a whole voted to leave the EU while Scotland recorded a strong majority to stay in.

There has been some speculation that the EU would look to impose punitive exit costs on the UK. This would be seen to act as a deterrent for any other country looking to execute an exit strategy in the future. This would look to be an extremely dangerous tactic, especially as the use of such unsophisticated tactics would likely harden UK attitudes against the EU.

Although there is something of a 'love-hate' relationship between the UK and rest of the EU, UK membership is seen as a crucial economic and political counter-balance. Any UK vote to leave, would increase concerns over an even more dominant German position with political cohesion liable to be damaged further.

There are already major simmering political stresses with Portugal's government battling against imposed EU austerity while there is still no government in Spain following December's election . Amid the dominance of the UK negotiations at last week's Summit, there was a depressing lack of progress on the migration crisis and tensions have increased further after Macedonia's decision to restrict border crossings. German Chancellor Merkel faces increased opposition from within her own party ahead of crucial state elections in March and could face a no-confidence vote.

With the lack of political leadership further undermining confidence, German business confidence for example fell sharply in February, the heavy lifting will again be left to the ECB with further pressure to cut interest rates again in March.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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