Counting the cost of ‘Brexit’ from the EU

Guy Huntrods, Head of Investment Counsellors, RBC Wealth Management

The UK election is too close to call, which could unnerve markets but create opportunities for investors 

For the first time in UK electoral history, five political parties began the campaign with polls pointing to support of more than 5 per cent of voting intentions. With Labour and the Conservatives currently tied, the odds of a hung parliament, a coalition, or minority government are extremely high. Getting to grips with this new ambiguity could explain why markets have yet to focus fully. But as 7 May looms large they are likely to do so, impacting equity, fixed income and currency prices.

Labour has committed not to hold a referendum on Britain’s place in the European Union in the next Parliament. While a Labour-led government may dent the UK’s reputation as a relatively low tax and business friendly economy, the markets would like the certainty of not having an in/out referendum in 2017. A Conservative-led government on the other hand, which would hold a referendum, would raise the possibility of ‘Brexit’. 

The prospect of a referendum may weigh on households and businesses directly, impacting economic momentum, putting pressure on asset prices and the currency. Even with polls suggesting a lead in favour of remaining in the EU, they are close enough to raise concerns, especially with the Scottish referendum fresh in the mind.

These pre- and post-election moods are likely to increase the volatility of the FTSE 100 and the sectors that are likely targets of political parties. Energy price freezes announced by Labour last year and the Coalition’s signals to decrease pressure of higher bills on households, explain why we remain cautious on the energy sector. Real estate could be impacted and banking remains susceptible to government targeting. Food retail and services may see costs increased by revisions to minimum wages.

However, in the event of a hung or weak coalition parliament, other sectors and stocks with global exposure, that have lower operational and sales exposure to the UK, are likely to be less impacted by domestic political uncertainties and may offer attractive entry points following market corrections. The media, healthcare and industrial sectors could all represent interesting opportunities. 

Even before the election, uncertainty is likely to ensure sterling might come under pressure, even if the result is a continued Conservative-led government, due to Brexit concerns. Notwithstanding such dips, the strength of sterling in recent months against the euro may present an opportunity for investors to diversify through the purchase of selective European equities. We have long advocated a stronger dollar and many clients have already invested a suitable allocation into US assets.

As most clients diversify their portfolios towards more balanced risk profiles, fixed income is also a relevant asset class.  Volatility can be expected. But with the main parties advocating fiscal responsibility, anticipated lower bond issuance due to the sale of some one-time items, a more dovish Bank of England and lower inflation expectations, there are reasons that may offer support to gilt prices. Corporate issuance has been heavy this year, widening spreads. This too provides opportunities, with corporate bond fundamentals in some sectors becoming more constructive.   

Michael Emerson, Associate Senior Research Fellow, Centre for European Policy Studies  

A Conservative victory could be the first step towards a decade of uncertainty

Uncertainty is bad for business, with the possible exception of hedge funds. It increases the risk premium for new investment. And now there is more uncertainty over a forthcoming UK election than at any time in post-war history. 

But the choice of the next government may be only the beginning of a complex cascade of uncertainties that could hang over Britain for much of the next decade, notably if there has to be an in/out referendum on the EU. 

The sequence of the cascade can be described as a decision tree with up to 10 successive steps. Step one is of course the election on 7 May. If Labour could form the government, the referendum will be called off. End of story, at least for the time being. 

But supposing a Tory-led government is returned to power, step two would be legislation to fix a date for the referendum. A consequence of great importance is that this would trigger conditional demands for a new Scottish referendum if the UK voted to secede from the EU. 

In step three, the government would have at last to set out in operational terms what its demands were for what David Cameron calls a ‘new settlement’ with the EU. Step four would then be the negotiation around these demands with the EU and its member states, leading maybe to an agreed outcome that the government could recommend as basis for a positive vote to stay in.

Step five would be the referendum itself. Opinion polls suggest that if the government declared victory in its negotiations with the EU and recommended a vote to say in, there would be a clear majority in favour. If so, the story then ends here. But if there were no agreement, or one lacking in credibility for Tory eurosceptics, there might be a majority vote to quit the EU. This is a non-negligible risk, since the government’s own Balance of Competence Review produced no case for repatriation of competences from the EU to member states, to the dismay of the eurosceptics.

If the referendum called for the UK to quit the EU, step six would see activation of legal procedures for negotiating terms of secession. In particular the government would have to decide whether it wanted to remain within the EU’s single market, like Norway. But Mr Cameron has already said he would not want that. At this point mobile international investors would be getting really worried about the UK as an investment location, if they had not got there already from step two onwards.  

This uncertainty would be enhanced by the fact that, in step seven, on the day of secession, all of the EU’s international agreements and treaties with third countries (828 bilateral and 255 multilateral agreements) would cease to apply for the UK. These include all the EU’s preferential trade agreements, which cover much of the world economy. The UK would have to renegotiate these, and also to stand aside from important agreements currently under negotiation such as the TTIP with the US, and free trade agreements with India and others. All that is certain is that it would take years for these uncertainties to be sorted out.

Step eight would be the new Scottish referendum, which could well yield the double result of quitting the UK and joining the EU. If that were the result step nine would see negotiation of the terms of Scottish secession from the UK, but a further uncertainty would be how this would go alongside and be compatible with Scottish accession to the EU, and the UK’s new relationship with the EU.

This hypothesis for Scotland is such that we hear already serious Irish commentators from Dublin fearing de-stabilisation of the Northern Irish status quo, which would be our final step ten. 

Most people contemplating this logical and legally founded decision tree would see it to be such a horrific nightmare that cool rationality should cut it short fast, and see the UK settle for sustained efforts to improve the EU through policy reform and development, alongside continued membership. 

But the question that remains entirely open is at what point that might happen, with or without the hazards of a referendum. It could be on 7 May, but if not, there could be a long uncertainty period for business strategists to keep on monitoring.  

François Savary, Chief Strategist and Head of Asset Services, Reyl & CIE

With a clear majority unlikely, it is hard to see a positive outcome from the UK election

With the pound reaching its lowest level against the dollar in five years, the FTSE index underperforming its European counterparts quite significantly year to date and some tension on the Gilt yield curve since 1 January, one could come to the conclusion that a lot has been priced in by financial assets when it comes to the looming UK election results.

As a matter of fact, it had been known for quite a long period of time that David Cameron would face a difficult re-election campaign and some pre-election polls put Labour in the lead. The recent acceleration in the downward trend on the pound could be seen as the best evidence that the investment community is getting quite worried by the prospects of a Labour-led government. 

In fact, the problem with the 2015 UK elections is that one cannot foresee any positive outcome as there seems to be no probability of a clear majority emerging on the day itself. At best, the UK will be run by a coalition which could be far less stable than the current one. 

A weak coalition government is not a good prospect, considering that important issues need to be tackled quite powerfully. In this regard, whatever coalition government emerges on 7 May will have to deal with the question of the place the UK intends to hold in Europe. In other words, the Brexit debate will have to be dealt with. 

Depending on how quickly a government is able to get a clear answer to the UK position on the matter, the potential risk to both the economy and status of London as a financial centre could be different. As a matter of fact, the Brexit question could become poisonous for the future government, as investors’ sentiment towards the UK will be significantly impacted first by the resolve of the government to quickly address it and second by the final choice that will be made.

A decision to leave the EU would not bode well for the UK economy or London as a financial centre. Obviously the strong connection between the British and continental economies under the EU treaties would have to be reconsidered under a different institutional framework, which would have to be clearly defined. Related uncertainties to the setting of such a framework would have side effects on UK activity and therefore on financial assets. 

Regarding London, a Brexit would certainly reinforce the arguments of those Europeans who wish to develop an alternative to the British capital as a financial centre. The debate about the need to make Frankfurt a real substitute would gain ground, as it did during the 1990s, when the UK opted out of the common currency. 

Undoubtedly, it is much easier said than done when it comes to establishing a leading financial centre, optimists about London’s supremacy could argue. But a Brexit would certainly accelerate the development of an alternative financial centre within the EU.