The UK referendum on EU membership is the big ‘known unknown’ for UK assets. It could be called for as early as June or as late as October 2016, with disincentives to carry it over to 2017.
Our base case remains Brexit is avoided, averting a destabilising hit to most UK assets. Logic suggests the unlikelihood of the UK wanting to risk weaker ties with its main trading partner (46% of export value, 53% of imports), FDI forgone, and a diluted relationship with the US. But, the uncertainty could soon erode the UK’s relative safe-haven status.
Logic suggests the unlikelihood of wanting to risk weaker trade, FDI & US relations…
Should Brexit go ahead (risk case), the mark-down in assets would surely be greatest in the case of a ‘hard exit’ (acrimonious departure, lower trade, lower migration, recession), than the more probable (if there is a Brexit) ‘softer version’. This version may be akin to Norway and Switzerland’s associate membership, with trade relationships and freedom of movement maintained.
This is just as well. We consider the benefits and costs of EU membership.
First, as a small open economy, the removal of trade barriers has probably benefited the UK. Despite being in the G5, it’s a relatively small, open economy. Its 2.5% share of world GDP compares with 4% of world exports. Its total trade (exports plus imports) is 59% of GDP, versus the euro-zone’s extra-regional 37%, and US’s 31%. This infers an interest in keeping down trade barriers and maximising its clout by negotiating as part of a like-minded group.
Second, regulation negotiations in services will remain important to the UK (services accounting for a hefty 78% of UK value added). The UK’s 43% services-export share dwarfs the 27% EU average, the euro-zone’s 25%, and Germany’s 16%. Admittedly, within that, the benefit to London’s financial centre from third-party access to EU markets may not be lost on a Brexit.
Yet, Brexit risks: extra legal/administrative costs of UK institutions then complying with two sets of regulations; the likely need for separate, bilateral third-party trade agreements (e.g. with the US); the risk of ‘regulation without representation’ (e.g. as with Norway); and thus EBA decisions on banking union becoming, via the ECB, weighted toward euro members.
Third, labour migration. The direct macro advantages are clear: the efficient allocation of labour to lower cost, higher unemployment areas, raising participation rates, creating tax revenue, soothing wage pressure, averting inflation, and promoting stability. The EU’s enlargement in 2004 to include central/eastern European countries accelerated significantly the UK’s net intake from the EU. The average 1.6%yoy unit wage-cost growth since 2004 compares with 2% for the 10 years before.
Fourth, foreign direct investment (FDI). The UK has been a magnet for FDI. In 2014 (latest data), the stock of inward FDI at £1trn was 57% of GDP, with Europe accounting for the lion’s share of this stock (see chart below).While factors other than the EU are doubtless at play, such as a flexible labour market and international language, threatening the UK’s free access to EU markets would surely risk reducing this inflow and divesting some of the stock.
Then there’s the market impact of Brexit, whether ‘soft’ or ‘hard’. Given the perceived threat to growth and the current account deficit (4.3% of GDP), there would probably be downward pressure on equities and the pound. With rate hikes deferred, short-term conventional gilts may initially benefit, especially on a hard exit. But, this could be short lived, given about one third of the £1.3trn gilts outstanding is backed by international investors sensitive to currency and ratings risk. And, especially if Brexit reignites the risk of Scotland breaking from the Union.
Greenland’s exit in 1985 is the only real precedent we have. That took three years…
In which case, it’s possible that dealing with Brexit and a hit to growth may need the BoE to again be the biggest sponsor of gilts, via QE. Bank rate is unlikely to have been raised by then (we expect nothing till November), and may not be cut if the pound is vulnerable. QT would also be deferred. Which leaves Governor Carney’s latest clarification – that the QE stock will be maintained around £375bn until Bank rate is about 2% – looking like a way of extending his options in case Brexit occurs.
And, despite saving the annual £8-10bn net contribution to the EU budget, the OBR’s GDP/tax-revenue projections would have to be revised down, and their gilt-yield assumptions raised. This would eat into the fiscal saving.
The only real precedent we have is Greenland, whose ‘soft’ exit in 1985 left it as an associate member still subject to EU treaties. For what it’s worth, their negotiating process between referendum (sparked by home-rule and fishing rights) and departure took three years. So, a risk with the UK – much larger and, after 43 years, far more entwined in the European project – is it would need even longer than this.
Neil Williams is group chief economist at Hermes Investment Management
