Brexit or Bremain… the lesser of two evils
Philippe Ithurbide is global head of Research, Strategy and Analysis at Amundi.
It would not make much sense to decide on an asset allocation according to future electoral results. On the other hand, scenarios and risks do have to be assessed, especially when it comes to an important electoral deadline, as the British referendum may be.
The latest polls seem to argue in favour of a Bremain (even if the Brexit camp has gained ground), and it is fairly common to see the Brexit/Bremain debate reduced to two conclusions:
1. A risk for the financial markets with the Brexit, an appeasement with the Bremain;
2. An economic risk for the UK and a political risk for the European Union.
Unfortunetely, it is not that simple. Here is our take on the issue.
What is the risk for the UK?
A clearly-defined economic risk: 50% of UK exports go to the European Union and, in terms of GDP, trade volumes with the European Union account for 65% of GDP (compared to 20% in the 1960s).
If the UK does leave the EU, trade volume and costs would be affected, and some segments that are highly integrated in the European Union, such as financial services, chemicals, or automobiles, would be affected.
A depreciation of the pound would certainly give British trade a boost but, according to estimates, due to the end of the European passport and the disappearance of trade agreements with the EU, the impact on GDP would be significantly negative.
The London Stock Exchange is in no danger, but there is no reason not to think that the EU could (should) take advantage of this new situation to promote the opening of a financial marketplace in Continental Europe.
For example, with regard to economic growth, the OECD considers that the UK would lose 3%-8% of its GDP while British employers announce that the EU by itself contributes 4%-5% of GDP, or about £70bn.
These numbers should be refined according to the different scenarios relating to “treatment” of the UK:
• If the UK stays in the European Economic Area (which currently has 31 countries), like Norway, the cost would be €3,345 per household per year (a reduction of 3.8% of its GDP over 15 years);
• If the UK signs bilateral agreements with the EU, as Switzerland has done in past years, the cost would be €5,528 per household per year (a 6.3% loss in GDP over 15 years)… Remember, though, that the negotiation of trade agreements takes between seven and 10 years on average!
• If the UK were to decide not to renegotiate with the EU, then the cost would be much higher at €6,689 per household per year in this case, i.e. a 7.4% decline in GDP over 15 years.
In light of the foregoing, we understand better why business leaders, the Bank of England, and the British Treasury, to name just a few, are warning UK voters about the consequences of a Brexit.
A not-insignificant political risk: By leaving the EU, the UK would regain its independence – and some seats – in the major international organisations, but it should be reiterated that the Brexit camp is not uniform – far from it.
Some (extremists) are demanding total independence, even the closing of borders (protectionism, stopping immigration), while others, liberals, want to ease the regulatory constraints imposed by the EU and be able to renegotiate all relations (including trade relations).
How can these two camps be reconciled if the Brexit wins? In addition, the risk of seeing Scotland demand a new referendum for its independence is high, since the Scots have never hidden their close ties with Europe.
And let’s not forget that the bulk of British oil is located in Scottish territory.
If it is a Bremain, what will David Cameron’s position be? Bolstered by a wide victory, weakened by a narrow one? Will it lead to new elections? Nothing is less certain.
What is the risk for the European Union?
A moderate economic risk: by all appearances, the United Kingdom’s withdrawal would have no serious direct economic consequences for European Union countries.
The hardest-hit countries would be those with close ties to the United Kingdom, especially Ireland, but also Luxembourg, Belgium, Sweden, Malta, and Cyprus.
A not-insignificant political risk: EU countries have just recently made some concessions to the UK (on immigration, sovereignty, and governance), to avoid the Brexit scenario.
The lack of solidarity within the EU has been demonstrated with every one of these concessions, with some countries expressing their interest in this or that measure.
The UK’s withdrawal would mean several things: i) first, that it is possible to leave the EU, and nothing is irrevocable; ii) that it is possible to get concessions at any time; and iii) that Europe à la carte isn’t just a fantasy.
Without going so far as the risk of dislocation, we can clearly visualise, via the referendum, the “spanner in the works” thrown by the British into EU governance.
Will Europeans be able to mobilise (simplified governance, budget and tax integration, stronger leadership, improved job market, etc.) and move the institutions forward?
A critical question, one which is being raised regardless of the outcome of the UK referendum, because it is as valid if there is a Brexit as it is if there is a Bremain.
The rise of extremists and populists (to the right, in Europe’s core countries, and to the left in the peripheral countries) goes hand in hand with the worsening economic situation and governance deficit in the EU.
Will the referendum be what gets things moving, or gets them stuck? That is the EU’s problem in a nutshell.
What will the consequences be for the market?
It is indisputable that a Bremain is preferable for the financial markets. This will, of course, not change a complex game, but that game is known and has been part of the day-to-day for several years.
Conversely, a Brexit is a door to the unknown: not everything will be decided quickly (it will take two years before the UK officially withdraws), but no one knows how the issues raised above will be resolved.
So we can bet on the possibility of sanguine reactions leading to wider credit spreads, and a weaker GBP – and euro.
It seems reasonable not to count on British market capitalisations appreciating: this is the battle between the weak GBP (favourable) and the end of trade agreements, and the (negative) impact on certain major segments.
Faced with these uncertainties, we should instead be counting on capital outfl ows from both the UK and the EU. If needed, the ECB could take advantage of it to accelerate its asset purchases, which makes the EMU’s fixed income markets a relatively protected zone.
