In just over three weeks time the UK electorate will vote on whether to remain in the EU or not. The Prime Minister has called this ‘more important than a general election.’ Does this vote matter for investment markets? And if so, how should you be positioned ahead of the vote? In what follows I am trying not to make any political points, but probably fail; the aim is to analyse the facts (in reality more often forecasts) as much as possible, to determine any likely effect on investment markets.
The uncertainty principle
The starting point is the effect on the economy. One view is that the economy and business thrive, or not, more or less independent of political noise, and all that matters to markets is the removal of the uncertainty surrounding the outcome of the Referendum. This view was argued powerfully by Ken Fisher (of Fisher Investments) writing his reasonably regular column in the Weekend FT (27.05.16), entitled ‘Brexit uncertainty is a buy signal for investors’. He writes: ‘How bad would Brexit be? No one can know, but we know when we’ll know (June 24). Here too, don’t wait. Fear of the worst is baked in, and it’s unlikely a Brexit will go even worse than that. Hence a non-disaster is likely. Whether things go a bit or a lot better than disaster, better than expected is bullish’.
This view has some merit (and it is difficult to know how much Brexit is already discounted in market prices), but putting aside the fact that whenever I have read Mr. Fisher’s column over a number of years, he has been relentlessly bullish, whatever is going on in the world (I am sure this is not because he runs a retail investment business), I do have a problem with it. I don’t think the uncertainty does go away on June 24 – except in the event of a Remain vote. In fact the more one looks at this issue, from an economic perspective at least, the more questions there are about what a post Brexit landscape would look like.
The rights and wrongs
What would Brexit really mean for the UK economy? We have looked at a number of models, but of course they are just models, and hence subject to the criticism that the assumptions determine the outcome; studies from the Treasury, NIESR and large international institutions (IMF, OECD etc.) are reasonably consistent in their predictions of doom and gloom in the event of Brexit. A useful summary of positions has been made by the Institute of Fiscal Studies (IFS), whose goal is stated to be ‘to promote effective economic and social policies by better understanding how policies affect individuals, families, businesses and the government’s finances.’
In a study titled ‘Brexit and the UK’s public finances’, they state: ‘The mechanical effect of leaving the EU would be to improve the UK’s public finances by in the order of £8 billion (ie. the saving on net contributions) – assuming the UK did not subsequently sign up to EEA or an alternative EU trade deal that involved contributions to the EU budget. However, there is an overwhelming consensus among those who have made estimates of the consequences of Brexit for national income that it would reduce national income in both the short and long runs. The economic reasons for this – increased uncertainty, higher costs of trade and reduced business investment from abroad (Foreign Direct Investment or FDI) – are clear. The only significant exception to this consensus is ‘Economists for Brexit’.’
It’s all in the assumptions
Why do the ‘Economists for Brexit’, dominated by the strongly monetarist economist Patrick Minford, come to a different conclusion from the vast majority of other studies? The IFS has analysed this. Essentially, the important economic variables affecting national income in all the studies, aside from uncertainty, are trade, FDI, regulation and migration; it is assumptions on these that determine the outcome. Even the Economists for Brexit concede on initial uncertainty: the IFS quotes: ‘(They) (and specifically Minford and Hodge’s forecasts) note that short-term uncertainty exists and agree that sterling will depreciate, with a rise in inflation in the short term and slightly higher interest rates in the long term. Little detail is available, but they suggest that these effects will be significantly more than offset by longer-term gains beginning to be felt, and suggest GDP would be 1.7 percentage points higher in 2020 under a Brexit scenario.’
Where do these longer term gains come from? Two inputs are key: firstly assumptions about trade. Minford suggests that if the UK removes all tariffs and barriers to imports ‘it is able to access goods on the world market at lower cost. These cheaper imports in agriculture and manufacturing bring the relevant UK prices down to the world level and move significant land and labour resources into the more productive services sector, leading to large economic gains.’ (IFS). This is code for saying that the UK will no longer have much of a farming or manufacturing industry. Not wholly desirable perhaps?
On trade, Minford also assumes that Brexit will have no adverse effect on UK exports, which seems unlikely to be the case. Any loss in exports to the EU would apparently be made up by gains in exports to the rest of the world. From IFS: ‘this conclusion appears to arise from the model structure and assumptions where goods are homogeneous and, under perfect competition, therefore find a new overseas market even when new tariffs are imposed in one country.’ Surely even A level economics students are taught that perfect competition does not exist in the real world.
The IFS concludes on the Brexit case for improved trade: ‘In summary, whilst Minford’s theoretical argument – that low import prices would drive competition and efficiency improvements – is sound, the empirical estimates appear to overstate the import price falls the UK would enjoy as well as their knock-on to UK output. The approach also ignores what would be substantial adjustment costs and the likely loss of trade with the EU’.
If not trade, what about regulation?
The other big source of gain in the Brexit case is regulation – or more precisely escaping from the straightjacket of EU imposed regulation. What might this involve: there are a number of areas where the UK might ‘set business free’ such as labour laws, health and safety, climate change and consumer protection. The IFS examines the regulations which might go: ‘Suggestions include scrapping the Agency Workers Directive and much of the Working Time Directive. Since the first of these in particular was opposed by the UK government, such a change is certainly possible post Brexit and official estimates suggest modest economic gains from abolishing it. More radical scenarios suggest that greater savings might be feasible, though these estimates include the assumption that the UK would back away from, for example, most climate change legislation. Since our current domestic legislation is more constraining than EU legislation, such a change is unlikely – or at least would require a reversal of policy at least some of which would be possible even within the EU.’
But the big gains in the Economists for Brexit model appear to come from assuming that it is inevitable that EU regulation becomes more business unfriendly in the future. Hence ‘The scale of (Minford’s) estimates appear to derive from a combination of assuming a starting point in which there is a considerable increase in EU regulation, a modelling strategy that imposes these regulations on what is otherwise effectively a perfectly functioning competitive economy, and some somewhat ad-hoc methods of taking account of these regulations in the model’ (IFS). In other words the model has been fixed to achieve the desired result.
All an establishment conspiracy?
Could all the dire economic predictions from large institutions be the result of some sort of elite or establishment conspiracy? Such a charge seems to have been laid by the old Etonian, ex Oxford and Ex mayor of London Conservative MP leading the ‘Leave’ campaign. In attempting to avoid such bias we have tried to find as independent a source as we can; of course no source exists in a vacuum and everyone has some axe to grind. But one of the most even handed assessments of the economic effects of Brexit, comes from Oxford Economics (OE), an independent commercial organisation which exists to advise clients on economic outcomes. ‘This research presents a comprehensive, rigorous and impartial assessment of the scale and nature of the impact of Brexit on the UK economy.’ (Assessing the Economic Implications of Brexit, Oxford Economics March 2016).
In its summary OE notes: ‘The UK is the (EU’s) second largest economy and almost half of all its overseas investment comes from the EU, as does a similar proportion of its export revenues. As such, business and investment decisions will be affected over both the short and long term.’ It concludes: ‘The results of the research suggest that the economic risks and opportunities presented by EU withdrawal are asymmetric. Any upside effects appear to be limited and the worst-case scenarios are far from disastrous. However, most scenarios would impose a significant long-term cost on the UK economy. The worst-case scenario that we model is associated with a decline of almost four percent in real GDP compared to a baseline of continued EU membership.’
Back to uncertainty
OE seem to have bent over backwards to be fair to the Brexit case and, delving into the detail, there are several places where it is noted that their assumptions may be overoptimistic in terms of a Brexit scenario. Nonetheless, what is striking about the research is the sheer number of options that their model has to cater for in the case of Brexit. In a section entitled ‘What might the UK look like after Brexit’ they say: ‘The range of outcomes is vast but for the purposes of this report we have modelled Nine scenarios from a much wider range’. The point here is that the range of potential outcomes is so big because the economic outturn depends on political responses that cannot be known. For example, the least worst case outcome under Brexit assumes that the UK adopts very pro-business policies and lowers taxation. One has to ask how likely this is in the event of Mr. Corbyn becoming prime minister.
And the markets?
Whatever the impact of Brexit on the UK economy might actually be, markets are pretty convinced it is not going to be good. This is most obviously seen in the exchange rate, as we show in the chart below.
There are always other factors involved; but the Bank of England’s May quarterly inflation report notes sterling is 9% below its November peak and concludes ‘there is evidence to suggest that roughly half of that decline reflects perceived risks associated with the referendum’. The chart shows Sterling v. US dollar, Sterling v. Euro and the FTSE All Share over the last four months, roughly from the point when the EU debate started to take centre stage. The chart shows an initial period of uncertainty whilst we were waiting to see what deal David Cameron would emerge with from his negotiations; a big sell-off in sterling on 21 February when Boris Johnson announced his support for the Leave side; and since then as the various economic assessments have come out, generally a recovery as international investors in particular have become more convinced of a Remain win. It has to be said that, at least up until recently, this was not particularly reflected in the strength of the Remain lead in opinion polls. In terms of betting odds, however, the biggest odds you can get on a Leave result have moved out from 5/2 at the end of April to roughly 4/1 currently.
In a sea of uncertainty, one fairly safe conclusion is that the pound would drop precipitously in the event of a Leave vote, unless of course it had already done do if this was expected. The Treasury’s latest report suggests that the pound would be 12-15% lower in two years in the event of Brexit.
What about the impact on different sectors?
According to Oxford Economics: ‘How different business sectors are affected will be determined by both the trade settlement and the government’s policy response, but certain sectors are more at risk. In general, the industrial sector (excluding extraction) is at greatest risk, with manufacturing and construction suffering the largest average contraction in our analysis. Among service sectors, our modelling suggests the financial services industry is most at risk.’ So banks and housebuilders are likely to be in the firing line. How have these reacted so far?
The chart below looks at the price performance of Lloyds, Barratt Developments and the overall Household Goods and Home construction Sector over the same four months as the first chart.
Here it is less easy to see a trend, and other events, (for example) results reporting and the global market backdrop have perhaps more influence. But there has been a firming up in the prices of these sort of companies as investors perceive the risk of a Leave vote diminishing.
It is, however, particularly difficult to assess the sectoral impact of Brexit because whilst one would logically expect exporters to be badly hit; this might be offset to some extent by the weakening of sterling improving their competitive position. There must be some irony in the fact that the UK focused small cap stocks, the very ones that the Leave side say will be the major beneficiaries of removing regulation, are possibly most in the firing line. In the end one must conclude; avoid banks and housebuilders, stress larger cap stocks, and especially those with big international businesses.
Here again, the impact is difficult to predict. On the one hand, there is likely to be increased risk premia applied to all UK assets (ie. prices will fall); on the other hand Gilts may be perceived as a safe haven in a troubled world. It is most likely, however, that with the exchange rate under pressure, gilts would experience some sell off. As regards interest rates, according to Mark Carney, governor of the Bank of England: “The combination of the effects on demand and supply in the exchange rate . . . could result in either a lower or a higher bank rate. What is more likely, where I’m on surer ground, is there’s likely to be a risk premium on risky assets in UK sterling for a period of time, and so even in the case of a potentially lower bank rate the overall mortgage rate could be higher. It is not unreasonable to expect term premiums on UK assets to increase from the relatively low level and those are more relevant for mortgage rates.” (Carney in evidence to the Treasury Select Committee). In other words, in the event of a Brexit, in determining its interest rate the BOE will have to balance the pressure on inflation from a weakening sterling with the demand shock to the UK economy which would usually entail lowering rates. But whichever way it goes with the bank rate, it sees the interest rate that the ordinary consumer pays – particularly mortgage rates – as being higher. So rather bad news all round. On balance we would not add to gilt exposure.
The international investment community at least is convinced Brexit is bad for UK assets: how much of this is in the price? We think not as much as might be expected; or rather we think markets are being too complacent about the possibility of a Leave vote. On the one hand investors may be overestimating the rationality of British voters on this particular issue and underestimating their ability to be pig headedly stubborn apparently against their own interests. On the other, there is always the risk of some one-off event – a terrorist attack for example – which might swing opinion in a Leave direction.
Finally, in the analysis above, I have concentrated a lot on the economic impact of Brexit; there are of course other issues such as sovereignty, border controls, power and freedom. In the end I would submit, however, that it all comes back to economics. The stronger your economy is, the more sovereign you will be, whatever trading relationships you have.