Brexit: Is it in the price?

Credit Suisse Global Equity Research believes that two hedges on the potential knock-on impact of a UK EU exit are: buying Bonos relative to BTPs (Spanish relative to Italian bonds) or euro volatility (which has, unlike sterling volatility, remained range bound)

Markets remain relatively more sanguine than polls: Opinion polls show a 44% chance of a Brexit, while betting agency implied odds are lower at 28%; just 13% of the respondents in our most recent client survey believed the UK will leave the EU. Opinion polls can be misleading (as in the UK general election) and change significantly in the four weeks prior to a vote (as in the Scottish referendum, where there was a 15-point swing).

The referendum has already weighed on domestic activity: There has been a slowdown in domestic activity, reflected in service sector PMIs and vacancy growth, which have fallen to levels consistent with zero GDP growth.
Some of this is likely related to investment and employment decisions being postponed until after the vote (44% of corporates said they had postponed decisions, according to the Credit Suisse Executive Panel survey, 16 May).

A vote to leave could reduce trend GDP growth: The OECD believe the UK’s potential growth rate could nearly halve up to 2020 compared to the status quo.

There is also a risk of political contagion: A Brexit could generate a Conservative leadership election, or at least party disunity. We would also expect the effects of a Brexit to spill over into the euro area, leading to increased European political risks, especially when the Netherlands and Italy have anti-EU parties that are the most or second-most popular domestically.
There are also a host of other political challenges facing the euro area, including immigration, Spanish elections, and no final agreement on Greece.

We remain mild sterling bears: We think sterling is pricing in a c.25% probability of exit. Sterling does not appear cheap (it is only mid-range on PPP against the euro and dollar), but fundamentals are challenging with the largest twin deficit in the OECD. So far, sterling has just reacted to rate differentials (and thus, to some degree, reduced expectations of BoE rate rises).

FTSE 100 – we stay benchmark: GEM, sterling and commodities are the key drivers. Valuations are not particularly attractive, but weaker sterling and high exposure to GEM offset this. Positioning has generally been mildly cautious.
Our year-end FTSE 100 target remains 6,600.

UK sectors – upgrade retailing to benchmark from underweight: We upgrade principally on valuation grounds, but also note that retail sales and earnings momentum look to have troughed, while the oil price is close to a peak.
We reduce our underweight of UK REITs (the most sterling-sensitive UK sector) and stay underweight regulated utilities. We don’t like the market fundamentals for Berkeley Group or the UK office REITs (Derwent London, Great Portland Estates, British Land and Land Securities), and consider these as areas that would be negatively impacted in a Brexit scenario.

Potential hedges: Long FTSE 100 versus FTSE 250, owing to better largecap fundamentals and their greater international exposure. Into a Brexit, we think that Italian bond yields would rise above Spanish yields. EUR/USD volatility has not risen much but it would, we think, on a vote to leave.

Global Equity Research – Credit Suisse