Sterling fall could hit 12.5% post-Brexit vote, says Rathbones
Edward Smith, asset allocation strategist at Rathbones, has pointed to data suggesting sterling could fall up to 12.5% in the wake of a UK referendum vote to leave the EU – the so-called Brexit.
This would come on top of some 8% already shed in the value of the UK currency on a trade-weighted basis in the past six months.
Data supporting the outlook comes from sources such as the GBP/USD option. Costs of protection have risen sharply for those currency traders who are seeking to mitigate the impact of any spike in volatility following a Brexit vote.
Even if there is a vote to remain in the EU, it is likely that there will be volatility in currency markets, the data suggests.
For investors in UK equities there is a slightly more positive storey, Smith argues.
The FTSE 100 overall is described as “immune” to any immediate market impact of a Brexit vote – by virtue of the fact most of the earnings of its constituent members are not driven by the UK economy or its performance. Some FTSE 100 constituents have been suffering relative poor performance recently, but this is arguably down to other factors than Brexit fears, Smith adds.
More immediate impact is expected in the UK small and mid-caps space. However, the price falls already seen in the FTSE 250 relative to the FTSE 100 suggests that there may be a buying opportunity, purely on price/earnings differentials. One reason that fears are greater around small and mid-cap stocks is that they are more sensitive to the performance of the UK economy. Rathbones suggests the impact in the short term could be a cut of 0.5%-1% off UK GDP in the wake of a Brexit. But again, investors also need to distinguish between the levels of sensitivity as they would affect different sectors.
Smith disagrees with the view that has been put out by the UK chancellor, George Osborne, of a range of shock defined as a 3.6% to 6% cut to GDP in the wake of a ‘Leave’ vote. For example, the ejection of the UK from the Exchange Rate Mechanism caused an estimated 1%-2% hit to GDP. One of the reasons is that the more extreme forecasts are based on trying to understand levels of uncertainty around Brexit and how this would impact behaviour in the markets.
But nobody can agree currently on just how much uncertainty there is. Additionally, if there is a Brexit, then markets will be immediately looking for a strong government response from the UK. This is likely to include immediate action by the Bank of England, which may be forced to take the lead on any response, as current UK prime minister David Cameron would be expected to resign if he loses the vote to remain in the EU. But markets will also be looking to the potential shock to the eurozone and broader EU economy of the UK leaving – given that it is not only one of the largest EU economies, but also because it is growing better than a number of others.
David Coombs, head of Multi-Asset Investing at Rathbones, pointed to another reaction already taking hold among portfolio managers: they may be seeking to maximise their cash holdings, in readiness to made investment decisions once they know the outcome of the referendum.
He argued that the “real action” would be in the UK gilt market. International investors would be in no hurry to buy gilts on 24 June, the day after the referendum, if it is for an exit. At that point markets would want a signal about continued strong governance of the UK.
Yields could rise dramatically in response – Coombs said the 10-year gilt could to to “3%, quite quickly” – meaning the government would have to contemplate cuting taxes to attract investors, just as the cost of borrowing went up. In effect the Bank of England might be pushed into having to buy gilts in order to keep yields low. Should the market reaction be so bad, it might lead to the shut-down of the gilts market entirely for a few days, he suggested.
The risk to investors is not volatility of asset classes, however: Coombs stressed that the real challenge from a Brexit vote would be the sheer drop in markets. Hence, there is a need to be liquid. He has upped his cash holdings recently, and sait that it was the more logical thing to do rather than try to take bets for or against Brexit. Overseas investors were also more likely to just sit on their hands until they know the outcome, he added.