Brexit: What You Don't Know Can Hurt You

Should I stay or should I go?

Today is the 90th birthday of Queen Elizabeth II, and Shakespeare’s 400th birthday is right around the corner, so it seems fitting to address a British-related investing topic. Unfortunately, the subject is not confined strictly to the UK, as it counts among the biggest global event risks for this year. I am referring of course to the dreaded ‘Brexit’ referendum.

‘Brexit’ refers to the potential outcome of a national referendum to be held in the UK on June 23, about two months away. In a binding poll, voters will be asked to decide if the UK should remain a member of the European Union (EU) or to exit (Britain + exit=Brexit, get it?). If voters choose to exit, the UK government would have two years in which to negotiate its departure from the EU.

Membership in the EU gives Britain unfettered access to its European trading partners and markets, the UKs largest export region. Perhaps more importantly, EU membership guarantees the free flow of capital and people, which has benefitted the UK greatly (especially London) as a destination of capital and corporations over the last few decades.

No Nation Is An Island

The fallout of a vote for Brexit would likely have a significant global impact far beyond either the UK or Europe, at least in the short-term. The EU is arguably an economic superpower, having generated nearly a quarter of nominal global GDP in 2014. Global markets would be rattled by the uncertainty generated by a leading member of the EU splitting off; no member state has ever left the EU before. At least in the short-run, investor sentiment would plunge, sending global stock markets lower and investors fleeing to safe havens, such as US Treasuries, JGBs, and possibly even gold.

More importantly, a Brexit vote would likely fuel anti-EU separatist movements simmering in other key EU states, such as France and Spain. The current wave of global economic nationalism and populism, seen from the US to Russia and beyond, would also likely receive a boost, unnerving investors who rely on stable trade and legal environments.

The UK would clearly feel the brunt of a Brexit vote. UK stocks would likely suffer a sharp hit as growth prospects for UK corporations would be undermined. Some key UK corporations, such a banking giant HSBC, have indicated they would be inclined to relocate in the event of a Brexit vote. The British pound (GBP) would also weaken sharply (economists are suggesting a 10-15% decline initially) as capital rushed out, generating a spike in UK inflation. The European single currency (EUR) would also likely not escape unscathed, as investors worried about the broader impact on EU unity and the stability of the euro. The US dollar (USD) and the Japanese yen (JPY) would be the safe-haven beneficiaries among major currencies.

What Are The Chances Of That?

Polls currently show an extremely close race, with the ‘remain’ vote (Bremain) just one point ahead of exit (Brexit) at 39 vs. 38, within one point of their average for the year, according to a YouGov survey from early April. Nearly a quarter of British voters are undecided (18% ‘don’t know’; 5% ‘wouldn’t vote’), also close to the average for the year, meaning the vote is still up for grabs.

My own expectation is that Brexit will not come to pass. The UK simply stands to lose more than it would gain by any measure, either economically or socially. An increasing number of leading UK economists and officials, past and present, are making that exact case with increasing volume, and UK voters will eventually catch on.

Still, keep an eye on those polls. Populist and nationalist fervor is still rising around the world, so we can’t completely ignore the possibility of Brexit. UK assets and markets are likely to become increasingly sensitive as the vote nears, with a skewed bias lower from negative shocks (Brexit leads in polls) in my view. Investors may want to double check their exposure to UK markets specifically, and European assets in general, in the run-up to the June 23 referendum. (Did you know that a leading European stock ETF is 27% allocated to the UK? The next biggest allocation is about 14 %.)

By the way, Happy Birthday Elizabeth and Will!