Brexit: Big Risk, Little Reward

UK voters in June will decide if the country will stay in the European Union (EU) or exit the bloc. A vote to leave could bring great economic and political uncertainty, principally to the UK, but also to the rest of Europe. What are the key risks of a British exit or ‘Brexit?’ Our main conclusions:

• A newly independent UK would likely have reduced leverage to fashion trade deals for the crucial services sector and less clout to negotiate regulatory standards for unimpeded EU market access. Both would be lengthy and painful processes, and we see the UK as worse off in the end.
• The EU, for its part, would lose a major budget contributor, a leading voice for free markets and easy access to a world-class financial centre. A Brexit could spur separatist calls and embolden populist parties across the continent, but we do not see a EU breakup as a result.
• We see volatility in UK and European assets rising ahead of the referendum. Global markets are already reeling from a deflationary scare driven by the oil price crash and a slowdown in China. An actual Brexit would hit global risk assets, we believe, whereas a vote to stay would reassure markets.
• The Bank of England (BoE) has said it is following its normal policy of not prejudging the vote’s outcome and assuming the status quo continues. Yet we see the central bank closely monitoring business confidence and market volatility. Uncertainty about the vote’s outcome provides yet another reason not to raise market expectations for any interest rate increases.
• Sterling is most vulnerable to Brexit fears as it is the most liquid UK capital market. A Brexit could pressure the UK’s budget and current account deficits, hurting the currency and potentially triggering credit downgrades. Conversely, we see depressed sterling bouncing back if the UK votes to stay.
• A leave vote would likely increase gilt yields. Portfolio inflows could falter, pressuring domestic sources of funding for the budget deficit. We could see bank funding costs rise and credit spreads widen. The BoE would likely cut rates in such a scenario (or revive quantitative easing), looking past any temporary rise in inflation caused by a weaker currency, we believe.
• We could see a Brexit dealing a blow to domestically focused UK equities, especially to shares of small and medium-sized companies.  We would expect large cap overseas earners to outperform as sterling falls.
• A Brexit poses risks to the London property market as at least some corporate demand is based on access to the EU’s single market. Overseas pension demand is strong, but any financial industry pullback could exacerbate an oversupply of office space set to hit as early as 2017.
• A Brexit would cut into the financial industry’s outsized contributions to the UK economy, tax revenues and trade balance, we believe, and offset apparent fiscal gains from leaving the EU. We could see the EU pushing hard to harmonise standards for financial services and capital markets – to the detriment of a UK financial industry dependent on single market access.
• Leaving the EU would lead to lower growth and investment, and higher unemployment and inflation in the UK, we believe. Any offsetting benefits are more amorphous and less certain, in our view. In other words,  a Brexit offers a lot of risk with little obvious reward.