Q&A: Is 'Brexit' likely? And then what?

04-05-2016

On June 23, British citizens will vote in a referendum to decide if that country will remain a member of the European Union. We asked Portfolio Manager Brian Holland for his take on the likelihood of a British exit, i.e., "Brexit," potential consequences if it did and considerations for investors.

What would a U.K. exit from the EU entail? Each member state can withdraw from the EU in accordance with their own constitutional guidelines. In the case of the U.K., a majority of voters need to approve the withdrawal through a referendum. If a majority of the electorate approve of leaving the EU, then the U.K. government would announce such intent to the European Council. All agreements and treaties made while a member state of the EU will be declared null and void. The U.K. has two years to negotiate its exit and its treaties with member states after which the separation is considered final. Given that no formal exit agreement or framework exists, it could conceivably take the U.K. more than two years to extricate itself from the EU.

Is a Brexit likely to occur? At this point, it’s a coin toss. That said, the risk of the U.K. leaving the European Union (EU) has definitely increased from a year ago. Britain’s economy is on a much stronger footing than it was when it joined the EU and, as we know, peoples’ memories can be short.

What impact would it have on the U.K.? In analyzing the impact, one has to look at near- and long-term effects, both tangible and intangible, on the U.K. economy and markets. Britain would have less economic and political clout acting on its own than as a member of the EU. Initially, there would be a high degree of investor uncertainty, which would negatively affect the equity, currency and fixed-income markets and this negative sentiment could possibly leak into the broader U.K. economy, thereby slowing growth. 12.6% of the U.K. economic output is a direct result of trade with the EU member states, so any reduction in U.K. exports to the EU will negatively impact the economy. 

Depending on the outcome of negotiations with the EU and how the U.K. government positions the exit, longer-term effects are less clear. The U.K. economy’s long-term potential output will most clearly fall, negatively impacted by reduced trade with the EU, less foreign direct investment, fewer immigrants. However, the result of national sovereignty will be less regulation and bureaucracy which may help offset some of the reduction in growth

More specifically, an exit would have negative implications for the financial services sector, one of the key economic drivers of the U.K. economy. An exit by the U.K. from the EU would result in higher cost of capital, lower returns on equity and a less supportive business atmosphere than these companies have enjoyed over the past several decades. A number of financial companies have or are exploring alternative locations from which to operate given the potential for a vote in favor of a Brexit.

What about for the EU? In the near term, uncertainty would negatively impact markets. The economic impact would be small as only 2.6% of EU GDP is a result of trade with the U.K. We believe market reaction would be similar to what occurred prior to the Greek vote to remain in the EU last year. Certainly, the U.K. is a more stable and substantial economy. But the biggest negative impact on the EU and investors isn’t so much about the size and stature of the country leaving the union; rather, it is the resulting uncertainty about the long-term viability of a monetary union that was created to serve as an economic and geopolitical entity. The lingering question would remain …”Who’s next?”

Could it lead to a domino effect? In the short term, it is unlikely. But it opens the door for disgruntled nations to take the same action. For example, the anger over Germany’s imposition of stringent austerity measures during the sovereign debt crisis almost resulted in Greece leaving the EU. The key threat isn’t that this would happen immediately; it’s the uncertainty that it could happen. In the current political environment, given the rise of fringe political parties with anti-euro platforms that have gained traction in many European countries over the past year, any uncertainty with regard to the stability of the EU increases investor risk aversion.

Would a Brexit have a lasting impact on international markets? We believe there would be a substantial short-term impact for investors with government and central banks working in tandem to calm markets and investors. Initially, the stock market would react severely to the uncertainty as it did during the 2011 European debt crisis. Longer term, governments would have to intervene to mitigate the economic repercussions to limit any damage to the broader real economy.

In sum, our view is that a U.K. exit poses a risk to our positive outlook for European equities and the broader economic recovery. We still believe that the U.K. will remain a member of the EU and that this recent increase in anti-EU sentiment is really a response to the refugee crisis and immigration.

Thank you, Brian.