Increasing focus on Brexit risk

Among the rising political risks in Europe, concerns around the Brexit theme are likely to mount over the coming weeks. Since PM David Cameron’s announcement that the UK’s EU membership referendum will take place on June 23rd, political heavyweight London Mayor Boris Johnson has joined the “Leave” camp, along with six senior ministers. While PM Cameron pledges that Britain is “safer, stronger and better off in a reformed EU”, the arguments of the Leave camp include “taking back democratic control, increasing trade and saving money for the people”. As of the end of last week, opinion polls still showed a large number (15%) of undecided voters, with a small majority in favour of Britain remaining in the EU.

Among the Brexit risk factors we focus on a weaker pound (GBP), weaker growth and higher risk premiums attached to UK assets due to regulatory uncertainties.

• In assessing the weakness of the GBP, the key issue for the currency is the UK’s large external imbalance. The current account deficit has increased since 2009 and now stands at 4.7% of GDP (which is financed by portfolio and foreign direct investment flows). In a Brexit scenario, a reduction in the current account deficit would likely be brought about by a sharp decline in the exchange rate. Looking at the downside scenario, EUR/GBP parity seems a reasonable hypothesis to work on. In this context, a EUR/GBP level of 0.78 suggests that the forex market is currently assigning a 20% possibility of a Brexit. The export-oriented FTSE100 equity index (22% sales exposure to the UK, 78% to the RoW) is benefiting from the weaker pound but is likely to be affected by potential Brexit costs if the probability of a Brexit scenario arises.
• There is no consensus in assessing the impact of a Brexit on UK growth. Candriam expects a negative impact on growth which is likely to be mitigated by the expected fall in the exchange rate. We know that the EU is more important economically for the UK than it is the other way round: UK exports to the EU are worth about 13% of its GDP while EU exports to the UK are worth only 3% of the region’s GDP. Furthermore, increased political uncertainty and volatility in financial markets following a Brexit could negatively impact the UK GDP multiplier.
• Rising UK risk premiums due to increased political and regulatory uncertainties are also likely to impact the bond market through a flight of capital. We note that foreign investors have been the most significant investor in UK gilts after the BoE, increasing net holdings by GBP 268bn since 2007. Overall, there is a risk of upward pressure on Gilt yields, even though it is likely to be mitigated by subsequent weaker growth and potential BoE easing/buying.

The open question is the access to the European single market in a Brexit scenario. Switzerland and Norway represent examples of non-EU countries that have different degrees of access to the single market. Overall, however, their access appears inferior to the UK’s current access. Finally, full access to the European single market implies compliance with most of the EU’s rules (“non-tariff barriers”) without having a say over them. We expect the upcoming campaign to focus on this point in order to provide clarification on the trade issues.