Brexit – A View From Brooks Macdonald

March 30th, 2016

With the upcoming vote on whether to UK should leave the EU, it’s always interesting to see the views from the Financial Services world. Brooks Macdonald, one of the Discretionary Fund Managers on the Radcliffe & Co panel, have the following to say:

“The ‘Brexit’ referendum on Britain’s European Union (EU) membership, which is due to take place on 23 June, represents one of the main investment risks of 2016 for both UK and global investors. Within this document, we focus on the economic and investment implications of the referendum, such as those regarding trade and financial regulation.

In order to predict how economies and investment markets might act in advance of and following the referendum, it is necessary to understand both Brexit’s potential consequences and how uncertainty affects markets more generally. What we can be fairly sure of is that a rise in Brexit-related uncertainty is likely to weigh on the UK economy and investment market in the period running up to the referendum, as long as the result is in question, while a vote to leave could extend this uncertainty for a number of years. Furthermore, Europe will not be immune to this impact and is also likely to suffer from short- and medium-term financial and political pressures. However, there is no precedent of any secession from the EU on this scale and it is impossible to say with confidence what the longer-term consequences of a Brexit might be.

Trade

Through its EU membership, the UK benefits from trade agreements with numerous countries around the world. These cover around four fifths of its import / export business. The EU is also the UK’s largest trading partner, by far, taking almost half of its exports and providing just over half of its imports. Since the UK maintains a significant trade deficit with the EU (of around £10bn a month), it is likely that other EU members will be keen to maintain UK trade links in the event of Brexit. However, the process of renegotiating trade agreements could still be long and complicated and during any renegotiation period both the UK and EU’s trade activity may come under pressure, weighing on economic activity.

A key area of negotiation will surround which EU rules the UK will have to comply with in order to maintain trade agreements. For example, Norway is not a member of the EU, but has had to contribute to its budget and comply with labour restrictions in order to be included in the European Economic Area, which allows free movement of persons, goods, services and capital between the EU’s 28 member states and certain other European countries. Trade negotiations surrounding service industries, which make up around four fifths of the UK economy, would likely be particularly complicated due their heterogeneous nature.

Financial services

A potential Brexit poses particular risk to the UK’s large financial industry. EU membership provides UK-based companies with the ability to ‘passport’ services throughout Europe and this has led to a high level of financial integration between the UK and other EU member states. It has also helped London become a gateway to Europe for the rest of the world, a fact demonstrated by the high level of global foreign direct investment in the UK financial sector.

Some argue that the UK would be able to establish a more favourable regulatory environment, but it is unlikely that the European Securities and Markets Authority (ESMA) would allow the UK to operate in Europe without adopting equivalent regulatory structures, such as the Markets in Financial Instrument Directive (MiFiD) II. While preserving the ability to passport services would very likely require regulatory equivalence, it is possible that the added risk accompanying non-EU status would lead to some repatriation of financial activity to both Europe and the world’s other financial centres in any case.

London could clearly no longer be seen as the European financial capital, however that does not mean that it would necessarily stop being the dominant financial centre in Europe. The incumbent position and network effects provided by London’s long history as a financial centre should ensure some insulation from any significant exodus of financial activity.

Investment implications

Before the event

We have already seen a decline in investor sentiment as a result of uncertainty surrounding the Brexit referendum and this has primarily manifested itself in the foreign exchange markets. Although the pound’s recent weakness can also be partly attributed to a weakening of UK economic data and a subsequent dovish shift in the Bank of England’s policy, it was telling that the currency’s sharpest losses of the year came in the week following Mayor Boris Johnson’s high-profile announcement supporting an exit from the EU. It could also be argued that the potential for a Brexit has weighed on the performance of the financial sector in 2016. However, this manifestation is less clear given the multitude of other headwinds the sector has faced.

As the event approaches, and as long as the result of the referendum remains in question, we see potential for economic data within the UK to weaken further. Uncertainty will lead corporate managers to delay investment and recruitment plans, putting downward pressure on demand and negatively affecting economic growth. This is likely to compound the declines in investor sentiment, potentially leading UK equities and credit to underperform broader global markets.

We are more optimistic on the outlook for UK government bonds ahead of the event, as increases in risk aversion should favour safe-haven assets. We are also cognisant of the fact that the Bank of England is likely to react to weakness in the economy by shifting to a more accommodative policy stance, potentially leading the pound to weaken further. What a weaker currency would do is boost the earnings of UK-based multinationals. It would also improve the global competitiveness of UK-based businesses, in the same way that the weakness of the euro and yen has helped the eurozone and Japanese export sectors in recent years, providing support to the UK’s economic growth over the medium term.

Outside of the UK, there is potential for contagion to spread into European economies and asset markets given their heavy integration with the UK. Likewise, there is scope for some impact on the supply of wholesale funding to UK financial institutions. However, we note that the Bank of England has already drawn up contingency plans to combat this issue.

If the UK votes to remain in the EU

A vote to remain within the EU would improve clarity on the economic and political outlook. As such, it could lead to a reversal of the effects of uncertainty seen prior to the referendum, i.e. the pound, UK equities and credit may rally. Over time, any pent up demand that had built up as a result of delays to investment programmes should flow through, potentially boosting UK economic growth in the second half of 2016. From this perspective, any Brexit-related weakness in asset prices may ultimately prove to be a buying opportunity.

If the UK votes to leave the EU

In the event that the UK decides to leave the EU, the economy is likely to undergo a period of significant uncertainty. Exit negotiations are likely to last for at least two years (per the terms of Article 50 of the Lisbon Treaty) and uncertainty surrounding the UK’s economic outlook is likely to be elevated during this period and beyond. It is somewhat unclear how markets would act in this period, although it is probable we could see an intensification of the effects evident in the build up to the event, in particular a weakening of sterling. Volatility would last for some time and news surrounding exit negotiations would likely become a key driver of asset markets and economic sentiment.

By leaving, the UK may call the EU’s longer-term sustainability into question if other countries choose to follow. However, the EU could also see itself strengthened if the UK is perceived to have weakened its own position by leaving. Furthermore, the event may lead to further questions over what Scotland will do in terms of its own relationship with the UK. In either case, the political fallout is likely to reverberate for some time.

Conclusion

The referendum is likely continue to provide a headwind to both the economy and asset prices as long as its result is in question, as uncertainty will weigh on investment activity, job creation and investor sentiment. Through this mechanism, it could potentially lead the Bank of England to respond with more accommodative policy. The longer-term investment implications of a Brexit are likely to be bad for London and the City but good for exporters. This divergence adds further weight to our argument that we are currently in a stock-picking environment. The wider economic and political implications also mean that this situation deserves significant consideration from a global asset allocation perspective, in particular the wider European impact.”

Please note this is a view from Brooks Macdonald and not Radcliffe & Co.