Risks we see for asset classes on Brexit
Pointers to the impact of Brexit in respect of asset classes are already being seen, says Intelligent Pensions investment director Douglas Kearney
The vote on whether we remain or leave the EU is less than two months away and opinion is much divided as the polls reflect, although the bookmakers’ odds are heavily in favour of a “remain” vote. Both sides undoubtedly put forward compelling arguments about the reason for their stance. Not all the arguments are economic, but the possible impact of an exit on the UK economy and markets and indeed beyond is hugely significant.
The question is how significant but no one knows the answer. The only consensus from the many independent reports now circulating is that there is no obvious significant upside in leaving but there is significant downside. How significant the downside is, is where views differ but so far none is predicting anything other than a negative impact on our economy. We have already seen substantial weakness in sterling, reflecting investor worries around the uncertainty of the outcome. A vote to leave would see sterling fall further. Some predict that a 20% fall is highly possible. The weakness of the pound could push up inflation as imports become more expensive, which could bring forward the prospect of a rate rise.
It is the dreaded uncertainty of the result that will hang over the UK market until a result is known and if we vote to leave the uncertainty will be magnified as there are so many issues and outcomes to be resolved on leaving the EU to which no one knows the answer.
A vote to leave would reverberate around the EU and it could lead to other countries following suit and the breakup of the European project. It would be like taking a complicated engine apart in the dark, putting it back together and wanting it to perform more efficiently but using substantially the same components.
It does sound a bit like serendipity. It might work but it would be very tricky and there is no certainty that it could be done and very unlikely that it can be done quickly or without a few hiccups and bruises along the way. Few would argue that the current engine is perfect and couldn’t be improved but it does work and attracts substantial foreign investment.
Risk to investment inflows
Those that advocate an exit may be correct that all the parts can be made to work more efficiently but in the short term, and who knows how long short might be, foreign investors will have limited appetite to invest in an area that is riddled with uncertainty. They will look for alternative areas to invest and alternatives exist in abundance. There is no need to take the risk and they won’t. This could make it harder for EU Governments to fund their debt and the UK would not escape that. Bank of England governor Mark Carney said a Brexit vote is “the biggest domestic risk to financial stability” and also noted that Britain currently relies on “the kindness of strangers” to finance its twin current account and budget deficits.
This is not a Grexit but we all remember the turmoil that caused, particularly as no one could truly identify the potential domino effect if the country had been allowed to become bankrupt. There was so much interlinking and self-interest that the unravelling was truly unimaginable and caused great alarm to investors and European markets and the currency. It is a different scenario here, but we are not convinced that the consequences would be hugely different for markets and the resolution would take significantly longer to conclude.
How investors and fund managers are reacting
We are already seeing some of the concerns reflected in some asset classes. Property transactions have slowed and are unlikely to pick up at least until after the result is known. Equity fund managers, particularly UK and European fund managers, are reviewing every holding to consider the impact on the company of a leave vote and quietly repositioning if they view the company’s prospects unattractive in a “leave” environment. The preference is for global earnings rather than EU. Foreign investors are also quietly moving funds elsewhere, which coupled with the Middle East Sovereign Wealth funds repatriating cash to cope with the shortfalls caused by the decline in the oil price, is unwelcome but not hugely surprising and a mild harbinger of what eventually might be in store. The outlook for bonds is also mixed under Brexit. Credit could see wider spreads as investors demand a higher premium against the risk of lower growth and higher default risk.
The UK’s contribution to the EU’s budget does not represent a significant saving should the UK decide to leave the EU. At just 0.2% of gross national income, the saving would barely put a dent in the UK’s fiscal black hole. So it really is a struggle to find where the economic reward is for the risk.
So what in our view might Brexit mean for the various asset classes?