In late February, David Cameron, the Prime Minister of the United Kingdom (UK) announced June 23rd as the date for a referendum on the country’s membership of the European Union (EU).
This followed a lengthy attempt to renegotiate the conditions of the UK’s membership and growing calls from MP’s who asserted that the UK had not had a vote since the 1975 referendum when it voted to stay in the EU.
The referendum will allow the British people to have a say regarding the question ‘Should the United Kingdom remain a member of the European Union or leave the European Union?’ More specifically, Cameron’s four objectives for the UK will be addressed including economic governance, competitiveness, sovereignty and social benefits and free movement.
Campaign Arguments For and Against
The official Brexit campaign, Vote Leave, believes that being bound by EU law is restricting trade deals and relationships with nations outside the EU such as China and Brazil. Vote Leave campaigners also argue that the UK contributes €350m to the EU per week, which could be spent on national priorities such as education, national health services and housing. A leave result would allow the UK to control immigration and adopt a ‘fairer system’ when it comes to welcoming immigrants based on skill and doing so would be an important security gain.
Conversely, the campaign to stay in, Stronger In, believes that being able to trade freely across the EU, which contributes 3 million UK jobs, provides the UK better job prospects and security. Economically, the UK receives more value than the amount it pays to be a member of the EU single market. Furthermore, the campaign states that Brexit would create an economic shock that would cause public spending cuts, job losses and financial insecurity. Regardless of the dubious facts being thrown around by both campaigns, it is evident that the consequences of the UK leaving the EU are leaving many voters confused. This is particularly evident in the high number of undecided voters.
How will Britain vote?
In early January, voting polls were skewed towards Remain at 44%, with Leave lagging at 38%. Over the course of the year the margin has narrowed and the Leave campaign has increased momentum, with current polls indicating Remain at 42% and Leave at 44%.
The uncertainty regarding the decision has added pressure to already volatile markets, which can be seen in the Volatility Index (VIX) spiking in the week prior to the referendum. Despite the close polls, the implied probability of a UK exit is only approximately 40%. Additionally, Remain is the conservative vote, the status quo, and it is likely that majority of Undecided voters (currently 10%) will support the status quo.
Economic and Investment Implications
The possibility of a UK exit from the EU is a significant risk facing the global economy. The EU referendum skews risks to the downside in both European and global markets, particularly if Brexit were to materialise. The issue is that an EU exit will impact the UK economy through trade barriers with the EU and a fall in foreign direct investment as a result of higher trade costs. This will impact growth in the region and force the European Central Bank to undertake further monetary policy easing, and it will also likely see the Bank of England delay monetary policy tightening.
Long term risks of an EU exit would depend on the post-exit relationship between the UK and EU. Global markets will be negatively impacted if the relationship is one that restricts trade between non EU and EU members. A free trade agreement would most likely be implemented but the trade benefits of staying in the EU outweigh current free trade agreement models.
UK growth would be further impacted if the free movement of labour was obstructed, particularly for lower skilled workers. Majority of the risk would be associated with the impact on market sentiment.
Whilst we don’t believe that the UK will fall into a recession if it leaves the EU, the uncertainty caused by a leave vote would initially create a rally to safe haven assets such as gold and bonds. There will likely be a ‘flight to quality’ in bond markets as investors seek shelter in perceived higher quality bond markets such as Germany, France and the US. This could drive yields in these markets to new lows, whether that be zero or negative rates.
The implication of this would push UK equities lower, and in particular companies with higher revenue exposure to the UK. The FTSE 250 would be impacted to a greater extent than the FTSE 100 because it is less economically diverse with approximately 40% of revenue derived externally to the UK. Additionally, small and mid-cap stocks are more vulnerable due to their higher valuations and earnings risks.
Conversely, the FTSE 100 is more economically diverse with approximately 75% of revenue derived externally to the UK and would weather the storm better. This is predominantly due to the likes of large caps such as Rio Tinto, BHP Billion and AstraZeneca deriving majority of their revenue internationally.
Whilst the main concern is the material impact on the UK economy, ASX listed companies with revenue exposure to the UK are at risk. Companies in the financial sector within this group will experience the greatest impact to returns and drawdowns. This is already evident in the current outflows from UK funds because investors are not comfortable engaging the UK equity market.
This sector is also heavily reliant on the free movement of labour within the EU, and furthermore banking within the EU is possible by EU legislation which takes into account investment services, deposit taking and payment services.
A vote to leave the EU will create uncertainty regarding these issues. Furthermore, wholesale Australian bank funding costs will track increasing European spreads given Australian banks have a large dependence upon those markets, so it is possible that out of cycle bank rate hikes may occur even as the RBA eases monetary policy.
In regards to currencies, our view is that in the case of Brexit, the EUR would depreciate, but the GBP would depreciate to a greater extent. A recession in the UK is an unlikely result though because the UK’s fiscal position is improving and a weaker GBP would be beneficial to exporters and would improve the UK’s trade balance.
An appreciating USD will put downward pressure on commodity prices which may trigger further RBA rate cuts along with a tumbling AUD as global markets turn risk off. A leave vote could see the EUR/GBP go to parity but a vote to remain will see a rally in the GBP as fundamental strengths of the economy return to drive the currency.
A UK withdrawal from the EU will have a 2 year negotiation deadline under Article 50 of the Lisbon treaty with the possibility of extension. A vote to leave would not result in the UK leaving the EU immediately. Therefore, the greatest impact would be on short term market sentiment as opposed to the economic effects of an exit. UK economic fundamentals will likely remain strong and the period of negotiation following a leave outcome would allow for access to a common market to be negotiated without significant pain.
On the downside though, it would raise questions over the implementation of structural reforms and the possibility of an EU breakup. This is already evident in a number of other EU nations such as Sweden and the Netherlands expressing interest in holding similar referendums and so the pressure for the latter will heighten the strain in the Eurozone.
From a Stock Market/Equity perspective
There are two major implications for stocks with ties to the UK and could be negatively impacted by Brexit. Firstly there are the stocks which are dual listed like BHP and RIO which do not necessarily have exposure to the UK but are listed on the FTSE and therefore compared with UK businesses and alternatives within the FTSE. These companies are not necessarily impacted from an earnings perspective, should the UK enter recession but may be subject to a global slowdown.
The stocks with specific UK exposure are likely to be impacted from both a sentiment as well as earnings impact. It should be borne in mind that not all earnings would be UK/Euro based and therefore more likely to experience a lower earnings number and potential growth number than an absolute collapse in earnings. This is clearly dependent on the stock and the percentage of earnings exposed to the UK market. The likes of Ramsay healthcare would have 10%* of earnings exposed to the UK, whereas CYBG is 100% UK exposed and at far greater risk.
Certain stocks like HGG and CYB are exposed to both factors by being dual listed and deriving a percentage of earnings from the UK. In the case of HGG while the group is predominantly exposed to the risk of FUM (“Fund under Management”) outflow due to Brexit and a recession, HGG will benefit from their exposure to USD, EUR, AUD and translating their earnings back to a weaker GBP. Similarly BTT is also exposed to the UK market, both through FUM invested in the UK and a UK client base, but they have an added earnings risk of translating a weaker GBP into AUD.
Other stocks we would highlight which potentially face earnings risk should there be a recession in the UK are the likes of Lend Lease 10%* of earnings, Westfield 25%* of earnings but bear we should bear in mind earnings are made up of medium to long term leases which are more stable, Computershare (projected 600m GBP Revenue over 7 years – UKAR acquisition), QBE 15%* of earnings* but a higher percentage of Gross Written Premiums and Macquarie approximately 10%* of earnings.
In the case of BRG- the rest of world (includes UK business) is 25% of EBIT, but as ROW includes the distribution business we estimate actual exposure to UK at less than 10%* of earnings, though this is the growth driver going forward. Finally stocks with a global presence like Brambles, Amcor CSL etc. will be at risk of a general global or Macro slowdown, whereas domestic only stocks will be impacted by the macro slowdown and the potential negative impact of market sentiment.
Overall the impact of BREXIT we feel will be far larger driven by sentiment and the market performance rather than an actual direct earnings impact other than for a few very specific stocks.
* Approximate % of earnings
Source: IOOF. Information current as at 16 June 2016. Capstone Financial Planning Pty Ltd. ABN 24 093 733 969. AFSL / ACL No. 223135. Information contained in this document is of a general nature only. It does not constitute financial or taxation advice. The information does not take into account your objectives, needs and circumstances. We recommend that you obtain investment and taxation advice specific to your investment objectives, financial situation and particular needs before making any investment decision or acting on any of the information contained in this document. Subject to law, Capstone Financial Planning nor their directors or employees gives any representation or warranty as to the reliability, accuracy or completeness of the information; or accepts any responsibility for any person acting, or refraining from acting, on the basis of the information contained in this document.