Into the unknown
Investors fear Brexit, but don’t think it’s likely
IN A month’s time, on June 23rd, Britain will vote on whether to leave the European Union.
For many voters, polling day will be a blessed relief after a campaign that will have dominated the news for four months. Mind you, if they vote to leave, they will suffer many years of further debate about the exit negotiations.
Financial markets have been bemused observers of the campaign. Most investors, like most economists, think Britain would be worse off outside the EU. A recent survey of global fund managers by Bank of America Merrill Lynch (BofA) found that Brexit was the biggest market risk, ahead of a Chinese devaluation; however, 71% of those managers thought it unlikely that Britons would vote to leave. Despite the closeness of most opinion polls, gambling markets have consistently favoured a Remain vote; the odds on Leave are down to 25%.
If Britain does vote to leave, the nature of the subsequent trade relationship with the EU will be all-important. Fitch, a credit-rating agency, says a quick deal guaranteeing free trade with the EU would be only mildly negative. But that would probably require Britain to accept free movement of labour and a contribution to the EU budget—the very things that Brexit campaigners want to stop. At the other end of the scale, a scenario that involved protracted negotiations and Scottish independence would put Britain’s credit rating under great pressure.
So it is a difficult trade for investors: an event which they think is unlikely, but which could have grim consequences. The pound would probably be the biggest casualty of a Brexit vote; indeed, it took a hit on the day the referendum was announced. Since then it has recovered against the dollar, which has dropped against most currencies as the Federal Reserve has sounded more dovish on further rate increases. But the pound has still weakened against the euro during the campaign (see chart).
The problem for currency traders is that the risks go both ways: a vote to remain in the EU would probably push the pound up, making life hard for those who had gambled on Brexit.
This uncertainty shows up in the options market, where traders can hedge against currency swings. The premium they must pay to insure against lurches by the pound (known in the jargon as implied volatility) has risen sharply.
Fund managers polled by BofA are already less enthusiastic about British equities than they have been for more than seven years. But the impact of Brexit on individual stocks will vary.
More than 78% of the revenues of FTSE 100 companies come from outside Britain, according to BlackRock, a fund-management group. Such companies will see the value of their foreign earnings rise if sterling declines. But companies in the FTSE 250 index (medium-sided groups) generate nearly 60% of their revenues at home. So the performance of the FTSE 250 has lagged the large-cap index so far this year.
On the surface it might seem that British government bonds, or gilts, should be suffering in the run-up to the poll. International investors who hold gilts would lose out if a Leave vote led to a fall in sterling; they might be expected to demand a higher yield to compensate for that risk. In fact, the yield on the ten-year bond is close to its level on the day the poll was announced. In part, that is because the British bond market is part of a global bond market, where yields have remained low. Also, a Brexit vote would have an adverse effect on confidence and economic activity, so it would probably be followed by an interest-rate cut from the Bank of England, or even an expansion of its bond-buying programme (quantitative easing). Both events would be good for gilts, driving yields down, not up.
Investors’ confidence that the Remain side will win means that the markets’ reaction in the event of a Leave vote is likely to be dramatic. Erik Nielsen, chief economist at UniCredit, an Italian bank, thinks the pound could fall 10-15% in trade-weighted terms. The news would probably drag down the euro against the dollar, too, since the long-term stability of the EU would be in doubt. Indeed, even Federal Reserve governors have said that the British poll might affect their policy decisions, because of the potential impact on confidence. Many fingers will be crossed on the night of June 23rd.