Brexit: Ultimately unlikely

Edison has not taken any formal position on the desirability or otherwise of the UK leaving the EU. We are however pleased to provide the following summary of the key issues.

First, we believe any discussion on Brexit should be placed in the proper context. Based on current polling data it is significantly more likely than not that the UK will remain in the EU in the two years following the referendum on June 23rd. Online polls may indicate a nation split nearly 50:50 on the issue, but online polls also proved significantly less accurate than telephone surveys in the UK’s most recent election.

We would lend greater weight towards telephone polls which continue to point to a victory for “Remain” by a margin of 50% to 39% with 11% undecided. Recent bookmakers’ odds indicate only a 33% chance of vote for Brexit. Academic research at University College London on the behaviour of voters in referenda also suggests that undecided voters tend to migrate to the status quo as a referendum approaches. On this basis polls are likely to swing further towards the “Remain” camp in coming weeks.

The key uncertainty would appear to be in the turnout; Brexit is favoured by older voters who, if the the UK’s last general election is a guide, are significantly more likely to vote than the young who favour remaining in the EU. However on balance (and we emphasise again we have taken no position on the outcome) the data continues to point to a victory for “Remain”.

Should the electorate vote for Brexit in the referendum, although Prime Minister Cameron has indicated that Article 50 (to leave the EU) would be invoked immediately he would be under no legal obligation to do so. The UK’s EU Referendum Act 2015 only obliges the holding of a referendum and makes no legal obligation to take any action following the result.

Given the magnitude of any decision to leave the EU, the temptation for the UK’s incumbent political leaders to re-frame a marginal victory for “Leave” into another attempt at re-negotiating the UK’s relationship with the EU cannot be completely ruled out in our view. It is entirely possible in this scenario a second referendum could be called, again even if campaigners for “Remain” have emphatically ruled this out. Prior experience in Europe shows that referendum results which go against the wishes of EU policymakers are often not definitive. Academic studies also demonstrate that European governments have proved adept at winning a second referendum in these circumstances.

Therefore, taking into account that even after a vote to leave there is a significant likelihood of remaining in the EU the actual probability of Brexit is even lower than the referendum polls suggest. In addition, there is certainly merit in the argument that it is better to negotiate for better terms from within the EU rather than outside. For investment purposes we would suggest the Brexit probability in the next 5 years is currently 10-15% (33% chance of vote to leave and a 30-50% probability of Brexit if so). For comparison, we would put only marginally lower odds of the EU breaking apart for another reason over the same period.

While we may be more relaxed about the Brexit vote itself, we would caution against underestimating the medium-term risks from the EU’s low-growth economic trajectory, Exhibit 1. This low-growth trajectory is in our view the primary cause of the EU’s financial instability and voter disaffection. The ‘reformed EU’ scenario presented by the UK’s Treasury is perhaps not an optional extra but an absolute necessity over the medium-term. Otherwise electorates will continue to question the cost of centralising political power to achieve the benefit of only modest improvements in welfare.

Exhibit 1: US, UK , Switzerland and EU GDP growth

While global markets may therefore be over focused on the Brexit vote (is it a a real-time example of Kahneman and Tversky’s availability heuristic? Every soft data point for the UK’s economy seems attributed to the Brexit vote at present), even if Brexit is only a modest risk, we should consider the impact for investors. Here we have changed our views somewhat from February, as on closer examination an exit from the EU based on Article 50 would in itself give rise to significant uncertainties in the timing and terms of a Brexit. Uncertainty is the enemy of investment and, as the recipient of a 20% share of European foreign direct investment (FDI) the UK would quickly suffer, even if the reported slowdown in City hiring looks a little premature.

Should the referendum vote be in favour of remaining in the EU we would expect a short-term relief rally in sterling. But the Brexit vote is also highlighting the UK’s current account deficit, which reached over 7% of GDP in Q4 15, the widest deficit since 1985. We understand that changes in net foreign income have exacerbated the situation in recent years but the correlation between the deficit and the declining savings rate is striking, Exhibit 2. BOE Governor Mark Carney has highlighted the UK is reliant on the kindness of strangers; but such financing can prove fickle in the event of a shock. Both the savings rate and the current account deficit are uncomfortably close to the levels of 2008.

Exhibit 2: UK Current account and savings ratio

Apart from the obvious threat to sterling, the Brexit process becomes lost in a fog of media campaigns in respect of the longer-term position of a UK outside the EU. There are many different precedents – such as Switzerland, Norway or New Zealand. Even the Albanian model has been suggested. In our view it is illogical to expect that withdrawing from a free trade area with 450m inhabitants is likely to benefit trade, except possibly over the extremely long term if structural changes bring increased competitiveness. The biggest risk is to the UK’s financial services industry which represents the crown jewels of the UK’s service sector.

Unsurprisingly, many financial firms have already come out in support of the “Remain” campaign. While larger firms can establish subsidiaries within the EU as a short-term solution to the absence of “passporting”, Brexit could represent a renewed threat to London’s pre-eminence as the financial centre of Europe. The remaining members of the EU would naturally look towards the development of a new EU financial centre within the eurozone, although reaching a decision over its location would likely hamper progress.

Furthermore, while a significant draw we are not convinced the benefits of the English language and English law are sufficient to attract international corporate and individual investors to the UK in the absence of full access to the EU. Therefore, in the (unlikely) event of Brexit, the risk to London’s role as the financial centre for Europe appears real over the medium-term. It is also not at all clear whether the political appetite for UK tax incentives to keep London pre-eminent would exist in the circumstances.

Therefore, investors who wish to steer clear of Brexit risk would underweight the banks sector and the until recently very strongly performing London property market. But investors should also remember the UK’s stock market is only loosely linked to the fortunes of the UK itself. For example, we have recently highlighted the widening valuation discrepancy between US and UK industrials and suggested opportunistic M&A may see a resurgence. If sterling remains under pressure this would also be a strong tailwind for exporters who are focused on global rather than EU markets.

Quick conclusions:
1. Based on recent polls and analysis of polling trends in referenda, the likelihood of a vote for Brexit is in the region of 33%.
2. A vote in favour of Brexit does not mean Brexit will happen. The UK government is not obliged to act following the vote and we would estimate the current likelihood of actual Brexit at 10-15%.
3. In the event of Brexit there would be a significant degree of uncertainty until the new UK/EU relationship is established. Market prices of assets dependent on foreign inflows of capital and financial services would be likely to suffer (i.e. sterling, London real estate and related sectors and financial services firms).
4. In the event of Brexit, the decline in sterling would benefit exporters focused on international markets outside the EU. There is already a valuation gap in this segment of the stock market which may incentivise incoming M&A in the circumstances.