Brexit update: markets begin to price some risk around a “leave” vote

Jean-Philippe Bry's picture

We are one week from the Brexit vote and since writing on the subject two weeks ago, the “leave” campaign has gained momentum and appears to be ahead of the “remain” camp in most opinion polls. The accuracy of these polls is suspect and as such, the best pollsters are left saying the outcome on June 23 is a coin toss. 

What we do know is that there are many undecided voters, and one would expect most would lean towards favouring the certainty of remaining to the unknown risk of leaving. But even that is questionable when western politics is literally being turned upside down with emotion seemingly trumping (no pun intended) rational argument.

And herein resides the problem for markets. While sterling initially was the vector for the risks around the Brexit vote, global equity markets carried on serenely. That is no longer the case as both equity and bond markets are starting to price a possible “leave” vote. While markets have sold off, especially in Europe, it remains tame in contrast to what might be a market reaction post a “leave” vote.

The tail risks to a “leave” vote are almost impossible to quantify, and difficult to fully appreciate, and certainly have not been fully thought-out. Markets are likely to react rapidly and at times irrationally in a heightened period of uncertainty.

Here are some questions that investors might be concerned with after a “leave” vote:

  1. How will financial conditions unfold? U.K. banks rely on foreign currency for half of their wholesale funding. Will banks be able to source foreign exchange funding? The fact that both the Bank of England and the European Central Bank have recommitted to open swap lines provides some reassurance.
  1. Debts of U.K.-based entities due over the next 12 months amount to 755% of external receipts, the highest of 131 rated sovereign states. Will this matter?
  1. Britain has a 7% current account deficit, meaning that it relies on the kindness of foreigners for inflow of capital. Will foreigners have the confidence to continue financing Britain?
  1. Who will govern the U.K. out of the EU, when conceivably David Cameron would have to resign, leaving the Conservative party split and in disarray. Labour is not an alternative. Conceivably prominent “leave” campaigners would take over, probably led by Boris Johnson. But, they would not have the votes to continue as the government with their very slim majority unless they can unify the party, which seems highly unlikely. It means general elections could ensue.
  1. How will markets react to the inevitable copy cats in Europe who will insist on a referendum of their own? Would it be the beginning of the end for the European project? This is not inconceivable, given the rise in populist parties and the continued failure to deal convincingly with the migrant crisis that poses an existential threat to the EU. 

In addition to these “known unknowns”, there are certainly “unknown unknowns” that we have yet to appreciate.

We have maintained at Signature that the fragility of the world economy with slow growth, and by extension the capital markets, makes for periods of heightened volatility brought upon by events like the Brexit vote. 

Signature’s positioning ahead of the vote:

We have generally increased our exposure to the U.S. dollar through our currency hedging.

A vote to leave would see a very sharp fall in sterling. The extent of the fall will depend on the markets interpretation of questions one through three above. A 10% fall is likely; a 20% fall is possible. The euro would likely follow, on account of question four, all to the benefit of the U.S. dollar.

We have increased our gold exposure. This is not only related to the Brexit vote but the notion that gold will act as a safe haven in times of heightened volatility. In addition, we believe that authorities will react to counter any large market moves that will be to the benefit of gold. It is increasingly acting as an uncorrelated asset class and we believe will continue to do so.

If the “remain” campaign wins there will be a relief rally in both sterling (5% is likely) and equity markets. The size of the rally is likely to be proportional to the decline preceding the vote. 

Still we would expect the market rally to resume globally. The European economic recovery is in place, continuing to fuel a recovery in corporate profits where valuations are more reasonable than the U.S. 

The Fed meeting yesterday confirmed the Fed’s very prudent approach to raising rates, where expectations are for one rate hike in 2016, possibly two. This is down from four, at the beginning of the year. Importantly, the Fed has dramatically reduced its expected pace of tightening, reflecting the fragility and sensitivity of markets to higher rates. This provides further support to equity investors.

Nevertheless, risks will not evaporate in the medium to long term as the rise of populism, xenophobia and anti-EU manifestos continue to rise throughout the continent and threaten the European project. Globally, sentiments being expressed by the “leave” camp are not going to go away anywhere in the world anytime soon.

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