Voters in Britain will be deciding next Thursday, “Should we stay, or should we leave?” – that is, should Britain exit the European Union (the option known as Brexit) or remain a member? Early polls indicated a sizable majority for remaining in the EU, leading global markets to be rather relaxed about the matter. However, as June 23rd draws near, the “Leave” campaign appears to have gathered momentum and closed the gap, with some of the latest polls suggesting that support has shifted in favor of departing the EU. The shocking assassination of Jo Cox, a UK parliament member, put the campaigns on both sides on hold for several days. This tragic, cathartic event may lead some to decide against “a leap in the dark,” that is, a decision to go it alone outside the EU.
It is particularly difficult to predict the outcome of the Brexit vote. Opinion polls have not proven accurate in the past. According to most economists, the UK Treasury, leading international institutions, present and past prime ministers, and major businesses and business organizations, the likely economic costs and benefits Britain that will occur if it leaves the European Union are very heavily negative, on balance. The leaders of the Leave campaign, which include long-time euro-sceptics, argue that the main issue is not economic but rather a desire to “take back control” from Brussels, to restore Britain’s sovereignty. The Financial Times aptly notes that “Real sovereignty is the capacity to advance the security and prosperity of the nation. Britain has been sharing it for centuries.… It has signed more than 13,000 treaties and international conventions.” This debate is an old one in Britain, and alone it would not likely result in a close vote on Brexit. However, it is the highly emotional issue of increased immigration that tops the list of motivations for many Leave supporters, fueled by the rise of populist anti-establishment and anti-globalization sentiment that has grown in Europe. Few in the Leave campaign appear to be aware that immigration is the main reason the UK has one of the most favorable demographic outlooks in Europe. In this note we summarize the reasons that make this vote important, not only for the UK and Europe, but also for the United States and US investors.
The uncertainty that global markets confront about the outcome of the June 23rd vote has many dimensions. While the voters are faced with a binary decision, to stay or to leave, the effects of a majority vote for Britain to leave the EU are many and highly uncertain. It is important to understand, however, that the referendum is merely advisory – the UK parliament would have to vote to withdraw from the EU. If a Leave victory turns out to be narrow, it is not certain that the House of Commons will agree to start Leave negotiations with the EU. A narrow victory for Remain also could lead to political uncertainty, as the Conservative Party has been seriously split by the referendum. A further political uncertainty involves Scotland. Scottish voters are said to be strongly in favor of remaining in the EU. Should Britain vote to Leave, Scotland could hold another referendum to leave the UK.
A decisive victory for Leave presumably would force Prime Minister Cameron to notify Brussels that Britain wishes to enter negotiations under Article 50 of the Lisbon Treaty, which governs the right to leave the EU. That action would begin a two-year negotiation on the terms of the exit. Reportedly, some Leave campaigners have suggested not invoking Article 50 at all, thus unilaterally rolling back common EU laws and seeking informal talks on new trade agreements instead. The EU would very likely strongly oppose such an approach.
Should Britain vote to leave the EU and begin the exit negotiations, the UK would be excluded from the European Council. European treaties would continue to apply in the UK, which means common EU laws would still be in effect. The UK’s future trade relations with both the nations in the EU and the rest of the world are central to the uncertainty now affecting global markets. Negotiations with the EU would very likely be difficult: the EU would not wish to have exiting the Union appear to be an attractive option for other member countries. The UK’s access to European markets is critical because the EU accounts for 43% of the UK’s exports. Yet the UK could not realistically expect a deal that gives Britain continued full access to the single market without EU rules, free movement of people across EU country borders, and contributions to the EU budget.
One possibility would be for the UK to seek a position similar to Norway’s in the European Economic Area. That would keep the UK in the single market, but exports would be subject to costly checks for rules of origin. The UK would have to make large payments into the EU budget that could be close to its present fees and would have to continue to accept the free movement of people and almost all of the EU’s regulations while having no say. Alternatively, Britain could seek a bilateral treaty with the EU similar to the two that Switzerland has. These do not include most financial services. Note that the EU accounts for 40% or so of the UK’s financial exports.
Finally, the UK could fall back on its membership in the World Trade Organization. That would mean tariffs on UK exports to the EU and no free access for services, which account for 80% of the UK’s GDP and 45% of its global exports.. Moreover, the UK then would have to negotiate with each of the 53 countries that have free-trade agreements with the EU. Is it any wonder that markets are concerned about the trade implications of the Brexit vote?
Along with the uncertainties about the UK’s future trade relations, markets are concerned about implications for investment and the banking sector. Withdrawal from the EU would likely have a negative effect on the attractiveness of the UK for foreign direct investment (FDI), both because of reduced access to EU markets and an increase in uncertainty. The UK’s current account deficit is largely financed by FDI flows. FDI also plays an important role in the UK’s economic growth. Domestic investment is already being negatively affected by heightened uncertainty.
The banking sectors in both the UK and Europe would be hit by a British vote to leave the EU. Banks would face a prolonged period of regulatory uncertainty. Earnings would suffer from weaker economic growth. European banks on both sides of the Channel have yet to resolve their problem loan burdens that resulted from the 2008 financial crisis and have recently been suffering from significant share selloffs. Banks in London doing cross-border investments and euro transactions may feel compelled to move to EU financial hubs. Should the UK vote in favor of leaving the EU, the currency market’s likely reaction would be a sharp drop in the pound sterling, perhaps as much as 10% on a trade-weighted basis over the following six months. The UK Treasury has warned that “a shock to sterling might cause a sudden contraction in foreign currency lending to UK banks.”
Investors must also be concerned about further risks that relate to the Brexit referendum. Should the UK decide to leave the EU, its exit could be the beginning of an unraveling of the Union should other nations decide to withdraw, too. The EU will make every effort to prevent this outcome. Also, an EU deprived of its second-largest economy will be weaker economically and less likely to follow liberal, market-friendly policies. A post-Brexit EU would be a weaker counterforce to a resurgent Russia. (Recall the strong role the UK has had in demanding sanctions against Russian aggression.) The June 18th issue of The Economist summarized that ”A vote to leave the European Union would diminish both Britain and Europe.” President Obama has stressed how it is very much in the US interest to have a strong European Union with the United Kingdom as a member, participating in its decisions.
One sure thing is that markets do not like uncertainty. A strong vote to remain in the EU would put an end to most of the uncertainties cited above; and a relief rally would very likely follow, boosting both the pound sterling and the euro, along with UK and European equity markets. Global markets would also breathe more easily. A vote to leave, on the other hand, would very likely precipitate a recession in the UK, weaker growth in Europe, and years of uncertainty for UK and European markets, with high volatility.
The vote looks to us too close to call. We are maintaining cash reserves in our US and International equity ETF portfolios, and we are ready to deploy that cash as opportunities arise.