European Union referendum implications for UK and European Markets

UK voters will decide on June 23 whether or not Britain will remain part of the European Union – a unique economic and political partnership between 28 European countries. As a major contributor to the EU — and the EU’s status as the third-largest economy in the world – a UK vote to leave – or Brexit – certainly has significant implications for Europe, financial markets and investors worldwide

The upcoming UK referendum on EU membership appears to be a knife’s edge contest. Although financial markets have already felt some impact, if the vote produces an “out” result, global markets face additional turbulence this summer.

There are (at least) two challenges markets face around potential Brexit. The first: financial markets are not terribly good at pricing political risks. Many market participants have more training and experience in pricing common financial risks such as credit, maturity or inflation risk, compared to their abilities to price political risk.

The second: the usefulness of UK polls is in question. The polls were proven far off base in last May’s general election. The last polls ahead of that vote suggested that the Conservatives and Labour were essentially tied, with neither likely to win enough seats to govern without a coalition partner. The actual result produced a 6 percentage point victory for the Conservatives, and a large enough majority that they could govern alone
Given these challenges, here are some of my observations::

• We expect some sharp movements in global financial markets in the event of an “out” vote
• We also anticipate credit ratings agencies will likely penalize the UK after an “out” vote
• We have seen sustained depreciation pressure on the British pound thus far in 2016, some of which is likely related to “Brexit” risks, and some related to weakening interest rate support for sterling as markets priced out expectations for the Bank of England’s first rate hike
• We’ve also observed underperformance of UK bank assets relative to peers, as many expect the financial sector to be negatively impacted by a potential “out” vote
• The UK financial services industry would likely face increased transaction costs across the EU compared to the current status under the European Single Market

We agree with market expectations that post Brexit negotiations will be both noisy and prolonged (over at least 1-2 years), which creates fertile ground for tumultuous swings in financial markets.

In the end, we would expect the negotiations to produce a new working relationship between the UK and Europe (some analysts have examined the EU’s relationship with Norway or Switzerland as potential models.) We would expect the result to include continued trade and financial links, although quite possibly with somewhat higher transaction costs. We would also expect that beyond the noise, the UK will remain a solid sovereign credit with a sound policymaking framework supporting a dynamic economy that is competitive on the global stage.

Laura Sarlo, CFA® – Senior Sovereign Analyst – Loomis, Sayles & Company