Investment Strategy Bulletin  

18/04/2016

A SWISS PERSPECTIVE ON BREXIT: PART II

As a follow-up to our publication discussing the macroeconomic implications of a Brexit, this bulletin looks at the potential financial market impacts of the UK voting to leave the European Union (EU) on June 23, 2016.

While UK risky assets would be an obvious victim – at least in the short term – one of our main conclusions is that European assets would not come out unscathed. A Brexit would revive concerns regarding the political sustainability of the European Union and/or Eurozone and, more broadly, could kindle latent aspirations for independence. Financial market impacts can thus not be ignored, with Brexit joining the list of potential sources of risk.

Sterling on the front line
As the most liquid UK financial asset, the pound sterling is also the most vulnerable to Brexit fears. The currency has already fallen more than 8% year-to-date but continues, in our view, to bear downside risk. Given the uncertainty as to the outcome of the vote, we expect volatility to prevail up to the referendum date, with sterling’s path being largely poll-dependent.This will likely be followed by a period of depreciation if Brexit becomes a reality. We would expect most of this depreciation to be against the US dollar and Swiss franc, on safe-haven flows, with the euro likely to be affected by fears regarding future EU cohesion. Indeed, even though a Brexit would not cause a sudden economic shock to the EU, it would definitely renew investor concerns as to political sustainability. We see another Sterling downside against the USD and CHF, while GBP should thus depreciate somewhat more less against the Euro. Conversely, should UK voters decide to remain part of the EU, a sharp bounce back of the depressed sterling would not be surprising – particularly given the significant short positions. That said, the UK’s poor economic fundamentals, exposed by the current turmoil (see prior bulletin for more detail), would eventually weigh on the currency.

Limited impact on Gilts
A Brexit could deepen the UK’s budget and current account deficits, potentially triggering credit downgrades, while the associated currency weakness would fuel inflation expectations. In theory, this should result in a marked sell-off of UK gilts, especially against US treasuries. However, the very low level of overseas gilts holdings (25% currently, as compared to over 50% for US treasuries and to some 60% for French government paper) makes them much more sensitive to domestic regulation than to market conditions. Meanwhile, more active domestic managers could be tempted to switch from equities to bonds during such a risk-off episode. All told, these opposite forces point to a rather balanced outlook for gilts in the event of a Brexit, although their spreads versus safe havens such as US treasuries or German bunds should widen.

Will the FTSE 100 index remain immune?
To date, large caps have been cushioned from Brexit concerns by currency depreciation and other external factors, notably rebounding oil and metal prices. Indeed, FTSE 100 companies derive most of their revenue from outside the UK (hence the negative correlation versus sterling), while the energy and materials sectors are far more represented in the FTSE 100 index than in its Eurozone counterparts. But as uncertainty drives up risk premia, the positive impact on earnings from currency depreciation and rising commodity prices might no longer be sufficient to offset negative sentiment and foreign outflows, particularly in the short term. One should also bear in mind that the financial sector accounts for almost 20% of the FTSE 100 index and could face significant pressure from i/ slower loan demand in the UK due to uncertainty and ii/ risks to business conducted by UK banks in EU markets in the event of a Brexit. As such, sector positioning might prove crucial: the dispersion in performance is likely to intensify with a weakening of the currency and domestic economic momentum.

What to expect outside of the UK?
Although the rise in risk premia has so far mainly been confined to UK assets, we anticipate that volatility will increase across both UK and European assets ahead of the referendum. Peripheral spreads might come under pressure because of the institutional issues, although ECB purchases are likely to limit their widening.  At some point, the rise in political risk should also affect European equity indices. Noteworthy is the fact that UK and European equity market volatility is currently lower than in both 2011 and 2012, contrasting with what has occurred in the forex market. This suggests that a deterioration in polls, signalling greater odds of a Brexit vote, would likely drive up equity volatility. Turning to the US, another bout of volatility would certainly dissuade the Fed from adopting a more hawkish stance in coming months. US assets thus appear rather disconnected from the Brexit issue and should outperform their European peers. Finally, albeit they would obviously be impacted – like any other asset – by a rise in global risk aversion, emerging market (EM) assets should not post significant underperformance. The main driver of the EM recovery is currency undervaluation and the oil price rebound, which would appear to have no direct linkage to a Brexit.

Main investment implications
At this stage, sterling hedge remains the most obvious means to protect portfolios from a Brexit – mainly against the US dollar and Swiss franc (the single European currency being likely to also come under pressure in a Brexit scenario). We have implemented such a hedge, bearing in mind that, by a mirror effect, a bounce back of the depressed UK currency would be probable if voters decide to remain part of the EU. In the event of a Brexit, we would also envisage a near- to medium-term risk-off period, focused on UK but impacting Eurozone risky assets as well, the intensity and length of which will depend on the tone of the exit negotiations.

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