Investment Strategy Bulletin
A SWISS PERSPECTIVE ON BREXIT
On 23 June 2016, the UK will hold an historic referendum on whether or not to remain part of the European Union (EU). With the vote date approaching and polls indicating a close outcome, investors are expressing concern about the potential consequences of a Brexit – the UK leaving the EU.
Although Switzerland is proof that there can be a life outside the EU under the right conditions, such concerns are legitimate given not only the extended period of uncertainty that would follow a Brexit vote, but also UK economic fundamentals. Indeed, the country’s recent solid cyclical performance within the EU has helped mask structural weaknesses.
A look at UK fiscal and economic fundamentals
Fiscal fundamentals are poor
The UK lacks domestic savings – as evidenced by a current account deficit over 5% of gross domestic product (GDP). To cover this shortfall the country has relied mainly on inherently volatile foreign portfolio inflows, which could be reversed on Brexit fears.
Underlying growth drivers are imbalanced
The country’s industrial base has declined over the past 20 years to less than 15% of GDP while services now make up almost 80% of the economy, a quarter of which are financial activities and real estate – both dependent on foreign investment and easy monetary policy. Not only would a Brexit weaken the banking sector through increased uncertainty and possible regulatory changes, but a burst of the London property bubble could also not be excluded.
The consumer is vulnerable
Although the country is close to full employment with only 5% of the labour force unemployed, job quality remains unsatisfactory with a high share of part-time workers (27%). In addition, the household saving rate has declined significantly, below 4%, down from a peak of nearly 12% in 2010, leaving very little margin of safety in the event of a shock to – admittedly growing – wages. A Brexit would most certainly weaken the GBP, in turn driving inflation up and disposable income down.
What could be the potential implications of Brexit?
A vote to leave the EU would lead to a period of at least two years during which the terms of the exit would be negotiated – and the UK continue to be governed by EU rules. While definite conclusions on the ramifications of a Brexit are obviously impossible to draw today, given the numerous unknowns, a few points can already be raised.
A Brexit could question UK sovereign solvency
The period of uncertainty inevitably linked to a pending Brexit would likely delay most investment decisions and hamper foreign inflows, in turn weakening the currency – in a context where the UK has one of the largest “twin deficits” in the world, i.e. a lack of domestic savings combined with a large budget shortfall. While we would not expect the UK to default, this could nonetheless create concerns as to the country’s ability to finance its debt. Moody’s has already cautioned that it may put the UK’s rating on “negative outlook” should British voters decide to exit the EU.
Terms of trade may come under pressure
The UK is an open economy, with 45% of its exports going to the EU. Any deterioration in the terms of trade with the EU would thus stand to offset some of the (weaker) currency-driven incremental competitive advantage. In addition, the trade balance is skewed, with a large goods deficit partially matched by a services surplus. A weaker GBP would make imported goods (which are not necessarily substitutable domestically) more expensive, hurting consumers’ purchasing power.
The EU should not be immune
The EU would not come out unscathed from a Brexit, not least because such an event could question the political integrity of the Union, which has already been weakened over the past year by the Greek situation, the migrant crisis or the rise of nationalist parties. As such, the EU may not make exit negotiations easy for the UK, even if that were to go against its own economic interests.
Beyond the EU, a possible channel of transmission of a Brexit to the world economy would be the banking sector. Indeed, global financial companies use London as a hub for providing operations across Europe. The UK shelters almost 70% of foreign institutions that would be threatened to lose their rights to deploy activity in the EU, following a lengthy period of uncertainty.
All told, while we cannot assess the implications of a Brexit today, they should not be underestimated, first and foremost for the UK itself, but also for the EU and the rest of the world. Portfolio-wise, the resulting period of uncertainty would not be welcomed by investors. We would expect a significant fall in the GBP, some de-rating of most UK assets, and a near- to medium-term risk-off period globally, the intensity and length of which will depend on the tone of the exit negotiations.
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