Alasdair Macdonald, UK head of Advisory Portfolio Management at Towers Watson, comments on the impact on exchange rates, gilt yields and UK asset volatility.
The fundamental economic changes and associated uncertainty arising from a ‘Yes’ result in the Scottish referendum poses medium-term fiscal and sovereign risk for the UK, according to Towers Watson. Based on our assessment of the UK’s fundamentals and looking at similar historical episodes, we think the main impacts will be felt around exchange rates, gilt yields and UK asset volatility. Other market effects, for example on UK equity prices, are more ambiguous.
Towers Watson believes that Sterling could weaken materially (for example 5-10% over a few days seems plausible as a central expectation), primarily against the US dollar, but suggests the potential move could be greater than this.
There are two important drivers: First, without Scottish oil revenues the current account deficit of rUK would increase because rUK would be spending proportionately more on imports and earning less from exports. This would increase the rUK current account deficit from 4% of GDP to around 6-7% of GDP (ex Scotland) – the worst in the G10 set of major developed economies – and lower the short-term value of Sterling. Second, the greater the uncertainties around currency union, integration of future rUK and Scottish government spending and banking union the greater the risk of capital flight, not only from Scotland to rUK but from rUK to the rest of the world. The latter is a relatively low probability event but, if it occurred, could see Sterling fall by more than our expected range.
If a high proportion of an institutional investor’s overseas assets are currency hedged into sterling, then a weakening sterling would cause short-term losses on these foreign exchange hedges. It recommends that institutional investors should check they have sufficient liquidity and capital to be able to maintain their foreign exchange hedging positions, suggesting they examine their available liquidity in the event of a possible 5%, 10% or 15% fall in sterling over a few days.
In the event of Scottish independence, the UK government has already stated that it will honour all of the debt previously issued. While some risks remain, this should limit the extent of any movement in gilt yields according to Towers Watson.
With an equitable distribution of assets and liabilities, Scotland would be liable for around 8-9% of the UK’s current debt burden. It is likely that the UK government would continue to service all debt, with Scottish repayments being made directly from Scotland to rUK. Thus, post-independence the rUK government would be partially reliant on on-going debt repayment from the Scottish government, exposing it to the credit risk of Scotland, or would have to make the debt repayments itself supported by a smaller residual economy. These factors might be expected to increase the credit risk of gilts from current levels and push up yields. This could actually be viewed as favourable for most pension funds, as the liabilities would fall in value when assessed on a gilts basis.
However, an alternative argument could also be considered. If independence were anticipated to lead to more difficult economic conditions – for example a protracted period of elevated uncertainty might itself reduce investment and growth – in the rUK, a low interest rate environment might be expected to persist for longer. Lower future interest rate expectations could act to lower gilt yields, perhaps offsetting the impact of the increased credit risk.
It is not clear which effect would dominate in the short-term, but again institutional investors with large liability-hedging programmes could usefully think through the implications of a ‘Yes’ vote for large gilt and swap yield moves either way, collateral quality, and counterpart risk to Scottish banks directly or through liquidity management vehicles.”
UK asset volatility
The implications of Scottish independence are already likely to be priced in to markets to some extent, especially in Sterling. However,once the outcome is known there would be an increase in daily volatility in Sterling and gilt markets.
The implications for UK equities and credit are similarly uncertain. On the one hand a fall in the value of Sterling would might be a boon to the earnings of large UK companies – and hence their equity and debt – as the predominantly overseas sales of large companies are worth more, boosting profits*. However, the impact of greater uncertainty, a possibly weaker growth outlook and capital flight could more than offset this.
UK corporate bond portfolios may have significant exposure to Scottish bank paper, which would probably come under particular focus following a ‘Yes’. Like gilts, it suggests the obvious thing to expect from UK equity and credit pricing following a ‘Yes’ vote is higher volatility, implying that investors should avoid asset transitions in the three-day period around the election.
Opinion polls have been showing a consistent improvement in net support for independence over the last month. The latest polls indicate that the result is too close to call. However, with this caveat in mind we still think that a ‘No’ result is most likely. An important reason for this is the historic evidence from previous constitutional referenda. One of the relatively common trends has been that ‘Yes’ votes tend to be lower than in pre-voting polls due to a tendency for undecided voters to opt for the status-quo.