Brexit – the wider picture

With the outcome of the approaching EU referendum still the ‘known unknown’ for UK assets, Head of Hermes’ Investment Office, Eoin Murray, and Group Chief Economist, Neil Williams discuss the implications of Brexit-risk for the economy and financial services. They argue the risk could extend beyond the June vote, and also beyond the UK.

A long, drawn-out ‘can of worms’

Neil Williams said: “Our base-case remains that Brexit can be avoided, given the unlikelihood of wanting to risk weaker ties with our main trading partner, FDI foregone, and a diluted relationship both with the US and other third-parties that use the UK to access the Single Market.

“Inertia (‘better the devil you know’) could also play a part - as it did in 1975 when the UK survived its first in-out referendum. Turnout was 65%, with 67% voting ‘in’. The turnout this June could be just as high, given emotively charged issues such as fiscal profligacy and immigration. Yet bookmakers’ predictions of a similar two-thirds/one-third vote look complacent against polls suggesting the 14-17% ‘don’t knows’ will swing it on 23 June.”

The UK’s renegotiation could take several years, just to end up close to ‘square one’

Neil Williams said: “Should Brexit occur, getting to the next stage would be a long, drawn-out ‘can of worms’. Even a ‘soft exit’ – where trade relationships and freedom of movement are broadly maintained - would probably need several years just to end up close to ‘square one’. Greenland’s (EEC) departure in 1985 took three years; the UK - much larger and, after 43 years, more entwined in the European project - would need even longer than this.

“Brexit would then risk a spill-over into the remainder of the EU. A ‘trap door’ opened by the UK could well be approached by others. This questions the EU as a relative haven should Brexit occur. In which case - given the second-round effects and the ECB’s ongoing QE - Brexit would probably benefit the US dollar and Japanese yen.

“With 2017 general elections due in France (April/May), Germany (by late October), and potentially Italy and The Netherlands, it’s doubtful the UK will be shown much sympathy by its former peers should it try to secure a ‘no-strings’ exit deal.”

More QE?

Neil Williams said: “The pound would probably fall on a Brexit. As a guide, our inflation simulations suggest a fall in the pound to £/$1.20 from June would push the CPI back above the BoE’s +2% target by New Year. In our ‘base case’ (i.e. no Brexit), the CPI does not breach 2% till 2018. Further sterling weakness, to £/$ parity, would bring this 2% forward to November 2016, leading to 2.5% before next spring. But we doubt it would trigger a BoE rate hike, given Brexit’s feared hit to growth.

“With rate hikes deferred, short-term conventional gilts may benefit initially, especially on a hard exit. But this could be short-lived, given about one third of the £1.3trn gilts outstanding is backed by international investors sensitive to currency and ratings risk, particularly if Brexit reignites the risk of Scotland breaking from the Union.

“In which case, it’s possible that dealing with Brexit and a hit to growth may need the BoE to again be a sponsor of gilts, via QE - potentially intensifying the pressure from ‘lower for longer’ yields on pension schemes.”

Brexit would throw up macro, passporting, & regulatory challenges to financial services

Eoin Murray said: “The impact on financial services would be critical, with Brexit offering macro, ‘passporting’ and regulation risks.

“Measured properly, services in the UK accounts for about 80% of what we produce, and has, more than any other sector, been the driver of the UK’s recovery from the 2008-09 crisis. Within that, financial services is about 8% of the UK’s gross value added. While this may appear modest, financial services has been the heartbeat of this growth, providing disproportionately large trade benefits, employment, and tax revenue. The UK has a trade surplus in financial services of over £16bn, out of a total services surplus of some £17bn. This surplus is equivalent to about 1% of GDP, with 40% of our financial services exported to the EU.

“Then there’s the EU’s ‘passporting’ system that currently allows financial services businesses to operate in other member states without setting up a local branch. If the UK loses the ability to provide cross-border financial services, the industry will be faced with significant additional costs such as establishing local branches in European centres, maintaining local capital, and the compliance costs of seeking approval from multiple local regulators.”

UK financial services have more to lose than most other sectors from a Brexit

Eoin Murray said: “London’s status as a global financial centre and gateway to the EU would be threatened if it’s no longer the dominant force in clearing European financial markets. London enjoys ‘king status’ as the centre for clearing foreign exchange trades (over three quarters of EU trading) and bond futures.

“Critically, London has benefitted from the privileged position bestowed upon it by the European Court of Justice that ruled out the ECB’s requirement that clearing houses of euro-denominated business between European banks be based in the euro-zone, and regulated by the ECB. A Brexit could forego this special status.

“And there’s the regulatory challenges Brexit would throw up.  A large amount (43 years worth) of EU regulations have been fully or partially implemented into UK law. Many of these rules apply directly to member states; they would ultimately fall away on a Brexit, and have to be passed as new UK law. Even outside the EU, regulation would of course still be needed - but replicating the EU’s would be no easy matter, and could not happen overnight.

“Overall then, financial services has more than most other sectors to lose from a Brexit. Given the City’s strong starting point, Brexit may not short term be a complete ‘disaster’, as the City maintains, at least initially, much of its comparative advantage. But, is it all worth risking?”