The British referendum on whether to remain a member of the European Union (EU) is likely to weigh on UK markets for months to come.
The possibility of Britain exiting the EU – or “Brexit” – has received considerable market focus over the last six weeks. In part, the narrative of heightened uncertainty over Britain’s relationship with the EU was always likely to gain more focus when markets were nervous about the possibility of a significant global slowdown. However, even if concerns over the global business cycle abate, the likelihood is that the “Brexit” referendum will continue to make headlines.
Having committed to hold a “Brexit” referendum in the course of this Parliament (2015 – 2020), Prime Minister David Cameron clearly wants to hold the vote as quickly as possible. He is hoping to gain agreement on new concessions with fellow European Premiers at the EU Council meeting on February 18 and 19. He aims to gain some flexibility on in-work welfare benefits for (non-British) EU workers, some repatriation of sovereignty to national parliaments, the maintenance of free markets to all EU members and, ideally, a reduction in red tape.
The challenge of obtaining these concessions in a universally acceptable fashion has been well-documented and become clear to all. Meanwhile, UK polls suggest a tight vote with a very high degree of uncertainty. We assume the UK will vote to remain in the EU. However, we assign a probability of up to 40% to a “Brexit”.
If the UK votes to leave, the market response will be guided by what kind of separation ensues. We see two alternatives:
- A co-operative separation accompanied by slow and good tempered negotiations. In this case, the macroeconomic impact should be smooth.
- A confrontational separation where the two sides act as if in an unpleasant divorce. In such a situation, the market response could be more long-lasting, with obvious pressure on the British pound and large UK listed companies with significant European activities. Contrary to some commentators, our sense is that this would be bullish for gilts as any hope of an interest rate rise is pushed yet further back. If there is any gilt market weakness, this should come through in longer-dated yields, where a higher risk premium may come into the real yield.
Cameron appears to intend to hold the referendum in June, or failing that, September. So irrespective of the twists and turns of the debate, uncertainty over the outcome is likely to weigh on UK markets for a good few months yet.