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BREXIT: WHAT INVESTORS NEED TO KNOW
Todd Mattina, Ph.D, Chief Economist and Strategist, Mackenzie Asset Allocation Team
Should the United Kingdom remain or exit as a member of the European Union? That is the question British citizens
will answer in a referendum on June 23rd. As the countdown continues to referendum day, public opinion has oscillated
between the “Exit” and “Remain” camps. Recent polls have given the edge to a British exit (Brexit) while online
bookmakers – which have been reliable at forecasting previous uncertain events – still point to Britain staying in the EU.
However, the market odds of Britain remaining in the EU have declined sharply in recent weeks from about 85% to under
65%.1 This increased uncertainty is one of the greatest near-term risks for global asset markets and has implications for
investors and the economic outlook and political future of the UK and Europe. This commentary summarizes the key issues
that investors need to know as Britain considers its membership in the EU.
Market Reaction to ‘Brexit’ Jitters
Investors have responded to increased uncertainty surrounding the risk of Brexit by demanding larger risk premiums for certain UK assets. The British
pound declined against most major currencies from November to June. In fact, on a trade-weighted basis the pound has weakened by almost 10% since
November 2015 (Chart 1). The Bank of England estimated that a substantial share of this decline has been due to Brexit fears.2
Chart 1. British Pound Underperforms as Investors Demand a Wider Risk Premium for Brexit
Britain’s Real Effective Exchange Rate (REER)
Relative Performance of British Pound
104
115
102
Pound Underperformed Major Currencies
Relative to the US Dollar
(all currencies indexed to 100 as of Nov. 2)
110
100
98
105
96
100
94
92
90
Britain's trade-weighted real effective
exchange rate depreciated by about 10%
since November 2015
95
90
88
86
2015-10-01
2015-12-01
2016-02-01
2016-04-01
85
15-11-02
16-01-04
JPY
16-02-02
16-03-02
GBP
16-04-01
16-05-02
16-06-02
EUR
Sources: The REER is based on a broad-based index calculated by the Bank for International Settlements. Relative currency returns provided via Bloomberg and author’s calculations.
1
2
Odds offered by online bookmakers provided via Bloomberg as of June 14, 2016.
See Inflation Report, May 2016, page 5, Bank of England. http://www.bankofengland.co.uk/publications/Documents/inflationreport/2016/may.pdf
CAD
Domestically-focused UK stocks have also underperformed the broader UK and European markets. Specifically, the valuation premium of small- and
medium-sized British companies with a greater exposure to the domestic UK economy has declined relative to the overall British and European stock
markets (Chart 2). These trends suggest that investors are demanding larger risk premiums for UK-oriented companies in part because of the potential
impact of Brexit on domestic economic activity. In contrast, more than two thirds of the overall corporate earnings of Britain’s benchmark equity market
index, the FTSE 100, originate from outside the UK. Despite Brexit worries, the FTSE 100 has been the best performing European market on a year-to-date
basis because of the weak pound, Chinese economic growth and resilient oil prices.
Chart 2. Domestically-Focused British Companies Have Underperformed
Internationally-Focused UK Stocks Have Outperformed…
…While Valuations of Domestic Stocks Are Depressed
0
1.12
-2
FTSE 250 / FTSE 100: Price Over Estimated Earnings
(6m moving average)
1.10
-4
1.08
-6
1.06
-8
-10
-12
Returns (year to date)
1.04
The value premium of small- and
medium-sized stocks (FTSE 250) compared
to internationally focused UK stocks
(FTSE 100) has declined sharply in 2016
1.02
FTSE 100
CAC 40
DAX
EUROST
15-09-01
15-11-01
16-01-01
16-03-01
16-05-01
Sources: Returns of small- and medium-sized UK companies are based on the FTSE 250 index and are used as a proxy for stocks with a relatively high exposure to the UK economy. The UK’s
benchmark FTSE 100 index is more internationally focused with over two thirds of total earnings originating from outside the UK. Data for the FTSE 250 and FTSE 100 in the left panel are
provided via Bloomberg. The price-to estimated-earnings next year for the FTSE 250 and FTSE 100 are provided via Bloomberg and expressed as a ratio to show how the value premium for FTSE
250 stocks has been declining.
Exit and Remain Scenarios
In the immediate aftermath of an exit decision, the largest impacts are likely to be felt in the currency and equity markets. The pound may tumble further
against major currencies as capital flows abroad. UK equity markets may also sell-off initially. However, losses are likely to be cushioned over time
by the favourable impact of a weaker pound, which should bolster competitiveness and boost the local currency value of foreign earnings. The impact
on UK government bonds is less clear. While the pound has weakened because of Brexit fears, 10-year Gilts have rallied with yields declining from over 2%
in November to about 1.1% as of June 14, as investors sought safe assets. The Bank of England may also need to ease monetary policy to cushion
the negative economic impact of Brexit.
Investors who are concerned about Brexit risk should think holistically about their global portfolio exposures. European stock markets may also underperform
in the immediate aftermath of a British Exit decision. The share of German and French corporate earnings originating from the UK are about 10% and 5%,
respectively, which are roughly comparable to their exposure to China.3 As elaborated below, a protracted negotiation between the EU and Britain about
exit terms would increase uncertainty, restraining business investment and foreign direct investment. Global risk sentiment may also deteriorate following
an exit decision, encouraging a global flight to safety that would benefit the U.S. dollar, Japanese yen and high-quality government bonds.
In contrast, a decision by voters to remain in the EU would likely calm markets, leading to a rally in the pound and domestically-focused UK stocks as risk
premiums are priced out. However, after the uncertainty surrounding Brexit has been resolved, the market’s attention could swing back to the underlying
fundamentals of UK assets. British stocks are attractively valued compared to other major stock markets. The dividend yield alone is about 4.5% compared
to about 2% for the S&P 500 and Nikkei and British corporate earnings have room for upside surprises. On a purchasing-power basis, the pound
is relatively expensive compared to other major currencies. Longer run macroeconomic headwinds could also weigh on the pound, such as Britain’s large
'twin deficits' (i.e., sizable current account and government budget deficits) that require significant external financing. For these reasons, Mackenzie’s
Asset Allocation Team remains overweight UK stocks and underweight the pound.
3
See Strategy Matters: Five Questions on Brexit and equities. Goldman Sachs. June 6, 2016.
Economic Impact of Brexit
There are a wide range of estimates regarding the economic impact of Brexit. The impact is likely to be felt primarily through trade channels, but financial
and investment channels may also be important. Six of the most comprehensive studies suggest the long-run impact of Brexit could range anywhere from
a 5.5-percentage point decline in GDP to a gain of 1.55 percentage points.4
Despite the high degree of uncertainty around these estimates, most economists agree that the key to a successful transition out of the EU would be
whether Britain can minimize trade disruptions with the EU and stem a decline in foreign direct investment. This could be a huge challenge for the UK,
especially since it has been estimated that Britain’s trade with the EU has grown to be as much as 55% greater than it would have been without membership.5
Political Uncertainty in an Brexit Scenario
An exit decision could trigger a prolonged period of political and regulatory uncertainty in the UK. This uncertainty may take several forms. At the political
level, Prime Minister David Cameron’s leadership could be questioned if British voters refute his pro-EU stance. Uncertainty about Britain’s leadership could
delay business investment, foreign direct investment and job creation.
The next steps and timetable following an exit vote are also unclear. The referendum outcome is not formal notification to withdraw from the EU under Article 50,
the formal legal mechanism for an EU country to exit. Once the UK government notifies the EU of its intention to withdraw, Article 50 obligates the EU to
negotiate a “withdrawal agreement” over a two-year period. EU laws would still apply to the UK during this time. At the end of the two-year negotiation
period, if an agreement cannot be made and there is no unanimous agreement to extend negotiations, all EU treaties would cease to apply to the UK.
Competing interest groups from both the UK and European financial, manufacturing and agricultural sectors are likely to make exit negotiations contentious.
Given the EU’s large market of 500 million people, Europe would have an incentive to use its leverage to extract concessions from the UK. Greenland was
the only member state to exit the EU. Following its exit in the early 1980s, negotiations took more than two years despite much simpler issues than those
facing the larger and more complex UK economy. The EU’s highest priorities would also likely remain its unfinished trade agreements with the U.S. and
the Pacific area. With no trade deals in place, the UK would be forced to trade with the rest of Europe under World Trade Organization rules. The British
government would also need to decide which of the 6,987 applicable EU regulations should be kept in UK law.6
In a Brexit scenario, the UK would face a prolonged period of uncertain trade, regulatory and legal structures.
The economic consequences. The Economist, April 9, 2016. http://www.economist.com/news/britain/21696517-most-estimates-lost-income-are-small-risk-bigger-losses-large-economic
The economic consequences. The Economist, April 9, 2016.
6
What happens next if Britain votes to leave the EU? Patrick Wintour and Jennifer Rankin,
The Guardian. May 31, 2016. http://www.theguardian.com/politics/2016/may/31/what-happens-next-if-britain-votes-to-leave-the-eu
4
5
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