Brexit

June 2016

The build up to the UK referendum is driving headlines and financial markets. As recent polls suggest the outcome will be close, investors are moving into havens assets and volatility is increasing.In Asia, we will know the result during the day of Friday June 24. While bookmakers in the UK predict that the decision will be to remain, investors are concerned about the impact that a vote to leave could have. In this Perspective, we answer some of the key concerns.

How will a “leave” vote impact my investments?

The truth is that nobody really knows how a vote to leave will impact investments overseas or in Australia. We can more safely predict that the short-term impact will be increased volatility and a significant hit in terms of investor sentiment towards the UK and Europe. We are already seeing this, with growing demand for haven assets and increased volatility in equity markets not just in Europe but in many other regions including Australia. There has also been a significant decrease in demand for the UK pound. 

In the longer term, the implications for investors will depend largely on what sort of arrangements the UK comes to with Europe on how it will leave, and the types of trade agreements that it can arrange with the EU and non-EU trading partners, as the UK will no longer be covered by EU trade arrangements with the outside world. This is all uncertain and is expected to take several years to be worked out. In addition, the political repercussions of a Brexit vote in the UK and across Europe could cloud the outlook for markets and economies for some time, as the continent considers what shape its future cooperation should take.

In short, investors should be prepared for a period of volatility if the vote is to leave. You can do this by making sure portfolios are diversified across assets and geographies, and not over-exposed to any one industry.

What will the impact be on the UK if it votes to leave?

Overall, the impact on the domestic UK economy in the short- to medium term would likely be negative due to slowing investment and trade as new trade and other agreements were forged; a process that could be protracted and create an unwelcome distraction from the day-to-day running of businesses and public institutions. 

It’s important to note though that there would be opposing forces determining the short- to medium term outlook for the UK and a vote to leave is not all bad news. A weakening pound, for example, could cushion any blow to the domestic economy as 67% of the revenues of unlisted UK firms are generated in foreign currencies. Of those companies listed on the FTSE 100, 80% of sales are made overseas. These companies would benefit from any material depreciation in the pound when translated back to the UK and would, in turn, potentially drive earnings upgrades for the firms that generate them. On the other hand, small cap indices, which contain a higher proportion of firms with high earnings exposure to UK sterling, would likely underperform.  

The credit impact will also be name-specific. Generally, multi-nationals are better placed given their diversified revenues. In the short term, export-oriented, UK-based issuers could benefit from a weaker currency, although that may be eroded over time if inflation picks up. Bond investors have already discounted much of this and we believe a sharp reversal of recent moves is likely if the UK votes to stay. On the other hand, a Brexit would likely see an acceleration of existing trends. It is likely that the Bank of England would attempt to counteract some of the potential pressure on credit markets and long-term government bonds by maintaining a more accommodative policy for longer.

What will the impact be on the rest of Europe?

It’s quite reasonable for investors to be cautious about investing in Europe at a time of uncertainty in the UK because Britain is a very important market for European companies. For example, about 9% of sales made by companies listed in Germany’s DAX index are directly to Britain. That is pretty much in line with the 10% that goes to China. French companies have a smaller exposure to the UK but, again, Britain is almost as important as China to France.

The consequences of a Brexit will again largely depend on the types or agreements the UK draws up with the EU in the months and years after the event. With trade between the UK and Europe important to both parties, it is in everyone’s interest to ensure reasonable agreements are made.

There is a risk that a Brexit could lead to other Eurosceptic countries holding similar referendums, but the likelihood of this is not easy to forecast or assess.

What about the impact on Australian markets?

Although the referendum is a regional issue, the uncertainty around it is already being felt worldwide, including in Australia. In reality though, the UK referendum is not the only issue to watch: the outlook for China and the pace of rate rises in the US are likely to be more pressing global concerns for Australian investors.

The biggest effect of a leave vote would likely be a continuation in the short-term of the volatility we are currently seeing.

What happens if the UK votes to “remain"?

Brexit fears have recently been fuelling a market rush to safety, with strong rallies in government bonds, especially in Germany and Japan. The UK currency and UK stocks have reached their lowest levels in months.

A vote to remain is likely to alleviate these fears and could lead to positive sentiment towards those assets that have been sold off. With the continuing China slowdown, the unclear outlook for US rate rises and the race to the White House heating up, a remain vote will remove a key area of concern for investors.

If volatility increases after a “leave” vote, how should investors respond?

As an investor, your mind-set is critical. When we are prepared at the outset for episodes of volatility on the investing journey, we are less likely to be surprised when they happen, and more likely to react rationally. By having the right mind-set that accepts that volatility is an integral part of investing and depending on your circumstances and appetite for risk, investors can prepare themselves to take a dispassionate view and remain focused on their long-term investment goals.