The UK potentially faces the biggest economic upheaval in several generations should voters mandate a Brexit in the national referendum on the UK’s future membership of the European Union, according to David Page, senior economist at AXA Investment Managers, the effect on financial markets profound.
While there is no set date or even month for the national vote, many are now anticipating that a referendum could in fact come in the first half of this year.
The base case is that people will vote to stay in the EU, Page says, but a narrowing margin is making the spectre of an exit for Britain more likely and ramping up the threat to financial markets and hence investors.
“The potential cost of Brexit is likely to be in the order of magnitude of 2-6 per cent of gross domestic product [GDP], although we readily accept that any such estimates have a high degree of uncertainty,” he said.
“As such, even a relatively small perceived chance of exit is likely to affect market perceptions of mean growth rates in the economy,” he added.
A ramp up in uncertainty could also hurt the domestic economy with businesses looking to hold back investment and other economic activity, he adds.
“The uncertainty created by the EU referendum is likely to weigh on the economy. Domestic business looks likely to hold back on investment faced with the uncertainty the referendum brings.”
This could hit smaller listed stocks in the FTSE 250 and FTSE Small Cap spaces which tend to have more domestically focused firms.
Until recently smaller cap focused funds have been the saving grace for equity markets, with these holding up nicely against the China-induced volatility thanks to an improving UK economy and a business-friendly government.
Performance of sector and index over 1yr
Source: FE Analytics
Page says, however, that a glummer outlook for domestic firms was evident around the time of the Scottish referendum. A parallel he draws between the pending Brexit vote.
“In 2014, business investment had averaged 2.3 per cent in the four quarters to the first quarter of 2014. It then slowed to 1.4 per cent per quarter in the second and third quarters and fell by 0.5% in the fourth quarter,” he said.
“Reduced investment by companies that would have been adversely affected by a division of the Union is likely to have played some role in this slowdown. We forecast a more material slowdown in the pace of investment than suggested by a projected deceleration in corporate earnings growth alone in 2016.”
SVM’S Colin McLean, who manages the £140m SVM UK Growth fund, thinks the vote could also potentially trigger sell off UK government bonds by unnerving international investors, while a vote for Brexit has the potential for severe short-term disruption.
“We may see a sell-off in gilts and Sterling in the lead up to the referendum, an unsettling prospect for investors. But the whole of Europe could benefit if British negotiations and vote are a catalyst for EU structural reform. The removal of uncertainty could allow the UK market to catch up to the eurozone,” he said.
Gilts have rallied hard for many years and currently sit on very high valuations. As a result, many have become too concerned to holding anything but a small amount of exposure.
Performance of index over 10yrs
Source: FE Analytics
James Foster, manager of the Artemis Strategic Bond fund, says the Brexit worries add to many other things for bond investors to pay attention to.
“There is plenty for bond markets to worry about. On the one hand, interest rates in the US are rising. On the other, while the ECB has just lowered rates its enthusiasm for further quantitative easing may be waning. The Bank of England, meanwhile, is likely to raise rates – but perhaps not until the autumn. The confusing backdrop this creates is unsettling bond markets.”
“Politics will be a big factor in the year ahead. The impending US election could leave the country in limbo until November. Meanwhile, there was no clear outcome from recent elections in Spain. This, combined with the rise of anti-EU parties across the continent – and a potential referendum on a Brexit – mean there is the potential for some instability in Europe too.”
However, Ian Kernohan, economist at Royal London Asset Management, says there is some solace in the fact that a UK interest rate hike is unlikely until at least sometime after the vote.
“Looking ahead, lower sterling should lead to rising import cost inflation, while the bulk of the labour market data is still relatively strong. There will be no interest rate hike ahead of the Brexit referendum however, given the uncertainties which the vote is already creating.”
