To Brexit or not to Brexit, that’s the question

Some shocks will always come out of the blue and can only be absorbed first and responded to afterwards. These are what Nassim Taleb calls “Black Swans”

Some events, though, can probably be better described as “Grey Swans”. These are vaguely visible on the horizon, but it is extremely hard to identify in which direction they will swim. Yet it is possible to qualitatively assess the probability of potential moves and to anticipate their market impact.

The most important Grey Swan to assess currently is the Brexit referendum on June 23, as timing, likelihood and potential impact makes it urgent to form an opinion. However, disentangling what markets are exactly pricing in terms of Brexit risk is not easy, because so many other factors are at play. Did the currency weaken so much since late last year because of increased Brexit risk or because of euro strength and a dovish shift in the policy outlook for the Bank of England? And what role played wild gyrations in commodity and EM markets in the UK growth outlook and the attractiveness of UK assets (especially equities)? Acknowledging the complexity of economic systems and taking the dragonfly perspective make it hard to find easy answers to these questions.

At minimum, however, it seems fair to say that UK risk premiums have increased in recent months and probably part of the rise was driven by higher Brexit risk. Therefore, rather than providing a clean indication on the level of Brexit risk, the evolution of UK assets does suggest that risks have increased in recent months. A somewhat “cleaner” insight on the likelihood of Brexit can be distilled from opinion polls, betting markets, bookmakers. From these sources, a range of between 25% and 45% probability of Brexit can be observed, with betting markets on the low end and opinion polls on the high end.

Shortly put, the probability of Brexit seems to have gone up recently, but probably “only” to somewhere around 35%.
Despite this uncertainty, our base case is that the British will vote to stay “in”. After all, the British may be euro-sceptic by nature but they are also pretty pragmatic.
The debate between the “ins” and the “outs” evolves very much along these two lines. The “ins” emphasise the pragmatic side which to a considerable extent boils down to the fact that remaining in the EU best serves UK economic welfare, but also preserves the benefits from cooperation in the areas of security, counter-terrorism and crime fighting. Meanwhile, the “outs” are by definition prone to sound very euro-sceptic and emphasise the perceived benefits of more national sovereignty. To some extent this boils down to the perception that the UK will be able to adapt to a changing world more flexibly and quickly if it is not held back by cumbersome procedures and rules from Brussels. One should not underestimate how deep-seated this desire for more UK sovereignty is.

Ultimately, we believe these perceptions are not grounded in reality and that the UK would have a much harder time outside the EU with not all that much too show for it in terms of increased sovereignty. What would happen in case of Brexit is extremely difficult to answer with any degree of precision, as it would very much depend on the “terms of divorce”. It is likely that the EU will want to make these terms as disadvantageous for the UK as possible, as they would want to set an example: an exit should be as costly as possible to deter other nations from doing the same. After all, Brexit could not only lead to further political disintegration within the UK, but political uncertainty may also blow across the Channel and encourage other regions within the EU to seek independence.

Brexit would in our view be much more negative for the UK than for the rest of the EU. UK exports to the rest of the EU are typically around 12% of GDP while rest-of-EU exports to the UK are 2-3% of GDP. Brexit would thus entail a one-time hit to the export level and could bring the UK dangerously close to a recession. In addition, there could also be a substantial loss of inward foreign direct investments for the UK, while international investors may require a larger risk premium on UK assets and the pound sterling would likely depreciate further.

Emotion and sentiment play a big role
All in all, the actual question on the table is whether or not the British public wants to cross the line and regain full national sovereignty. If this were a matter of a rational cost/benefit analysis it is absolutely clear that they should not cross that line. However, in politics (as well as in markets and the economy) it is very often not about rationality, but about emotion and sentiment. As a result of that, the calculation may well be rather different in the end.

Valentijn van Nieuwenhuijzen – Chief Strategist and Head of Multi Asset – NN Investment Partners