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Brexit or Bremain?

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“Brexit would see the UK return to its status as a cake-filled misery-laden grey old island.” - Emma Thompson, actress

The world is rapidly shifting into a realm of less social cohesion and integration. As evident by the rise in popularity of polarising political figures such as Donald Trump, Marine Le Pen, Bernie Sanders and various other extreme political groups around the world.

The status quo and established political doctrines of our recent history are being contested more and more. Many ordinary voters have become disgusted and weary of political correctness. Nowhere is this more evident than the upcoming Brexit vote in Britain which is set for June 23. Brexit refers to the act of Britain leaving the European Economic Union. Britain is not a member of the euro currency union and has retained the pound but it is linked in many ways to the European Union. I won't offer an opinion on Brexit or Bremain, but I will summarise some aspects to consider with a focus, more so, on the economic and investing implications.

Ties that bind

How interrelated is the UK with Europe? Here are some facts from the October 2015 report on EU Membership and the Bank of England:

• The EU is the UK's biggest trading partner. Some 44 per cent of UK exports and 53 per cent of UK imports are with the eurozone. In fact, seven of the ten largest import and export markets are EU countries.

• The EU is the UK's biggest investment partner. The EU is either the source or destination for over two fifths of the UK's cross-border investments. Foreign investors own £10.6 trillion in UK assets.

• The UK is the second largest economy in the EU (£1.8 trillion versus Germany at £2.4 trillion).

• The UK accounts for one eighth of the EU's population, the second most populous country. EU countries account for five of the top ten most favoured countries for those emigrating from the UK, and three of the top ten sources of migrants living in the UK.

• The UK is the largest financial centre in the EU and accounts for 24 per cent of EU financial services activity. Eighty of the 358 banks operating in the UK are headquartered elsewhere in Europe.

Needless to say the integration with Europe is extensive and meaningful.

Investment implications

First, it's important to categorically admit that no one really knows what would happen upon a Brexit. There has been no precedent for a country leaving the EU so there is virtually nothing to pull from on a historical contextual basis in order to come to some sort of parallel conclusion.

There have been various attempts to calculate the ultimate effect but the range of outcomes are extensive. Putting aside the fact that accurate outcomes are nearly impossible to come by, the economic and financial implications of Brexit could be enormous in scope.

If Bremain prevails we are likely to see somewhat of a relief rally in UK assets. Sterling and UK equities would be expected to bounce and perform well in the near term. Sterling has lost 10 per cent of its value over the past year largely due to investor concerns. The FTSE 100 Index has underperformed the S&P 500 Index by more than 15 per cent over that same period when measured in dollars. Areas of the markets, such as UK banks, which have performed poorly should perform even better in the bounce.

A vote to leave would be associated, generally, with the withdrawal of foreign capital, the possible relocation of certain businesses and the almost certainty of a delay in various investment and hiring decisions. Mark Carney, Governor of the Bank of England, has warned that Brexit consequences could possibly include a “technical recession”, defined as two consecutive quarters of falling economic output.

The IMF suggested that an” … exit vote would precipitate a protracted period of heightened uncertainty, leading to financial market volatility and a hit to output.”

The OECD has forecasted that the UK economy would be 5.1 per cent smaller in 2030 if voters elect to leave than what is initially expected. Pro-exit economists, on the other hand, suggest the economy would actually be 2 per cent greater by 2020 if the UK opts to leave. The views among other private-market prognosticators varies. I have seen estimates that suggest the cost could be as high as 20 per cent of GDP or as much as a gain of 10 per cent. Since growth is impacted by consumer and business confidence, a quantifiable outcome is difficult to measure.

Foreign direct investment and portfolio flows into the UK would almost assuredly slow dramatically if Britain would leave, sending the pound lower in the medium term. Assuming inflation expectation remain anchored, Gilts would likely rally as the market would anticipate the BOE to maintain lower rates for longer or even lower them further to stimulate the economy. Since the FTSE 100 is largely a collection of global multinational companies the fall in stocks may not be as large as anticipated. Secondary implications

It's not the more obvious economic fallout that may follow a Brexit that is my major concern, however. Rather, the risk would be the future of the EU — a trading block that has a combined GDP higher than that of the United States. If one member can exit, what is to prevent others from doing the same? The odds of one of the euro-area's floundering members leaving the fold likely increases. The risk of a fracturing Europe could put pressure on euro-area equities and peripheral bond prices — leading to weakness in euro stock markets and spiking yields among the highly indebted peripheral countries.

When I look at the bond market in Europe and its ever shrinking yields, I can't help but wonder if some of the buyers appreciate the risk a Brexit would have on the weaker nations. Buying Italian bonds, for example, with the intent of hedging downside risk of a Brexit may blow up in your face. The euro itself would likely also weaken considerably against the dollar.

But will it happen?

First, let's access the odds. If you take the recent polls as measured by the Bloomberg Composite EU Referendum Poll Tracker, it is very close with the “Leave” at 42 per cent, the “Remain” at 43 per cent and the undecided at 15 per cent.

But for those with money on the line, the betting house odds, the chance of a Brexit is much lower and sits at most at about 29 per cent.

Personally, I would weigh the money crowd much higher given their actual “skin in the game” compared to the polling results at this point, especially considering the accuracy of past UK political pols. Due to the incumbency effect it's also most likely that people will vote for the relative safety of the known and to remain in the EU. But this is not assured by any stretch and at this point in time especially given the overall political discontent. A surprise could happen.

The referendum in Britain is likely not to be the last of its kind over the next few years. Macro investors will continue to need to assess political uncertainties and the shift to polarised politics and the effect they will surely have on investment allocations and returns. In the world of the “New Normal”, nothing is normal in the political sphere.

Nathan Kowalski CPA, CA, CFA, CIM is the chief financial officer of Anchor Investment Management Ltd and can be reached at nkowalski@anchor.bm.

Disclaimer: This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by the author to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. Investment involves risks. Readers should consult their financial advisers prior to any investment decision. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.

Tight race: the graph suggests the 'leave' and 'remain' campaigns are virtually neck and neck going into the home strait (Source: Bloomberg)
Status quo favoured: the betting odds reflect a feeling that the 'remain' camp will prevail (Source: Bloomberg)

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Published June 13, 2016 at 9:00 am (Updated June 13, 2016 at 1:42 am)

Brexit or Bremain?

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