As a UK referendum on whether or not to leave the EU approaches, the major banks have been analysing the possible impact of a ‘no’ vote on the financial markets – and the bottom line seems to be that sterling would be hit hard, while the reaction in stocks and bonds would be more nuanced.
A vote on ‘Brexit’ – or British exit – is now seen as most likely to take place in late June and while many polls see the British public as likely to vote for the status quo, the chances of a vote to exit are seen as far from negligible.
“The referendum is likely to be near term, probably in late June (23rd or 30th), [and] the outcome is uncertain. We continue to put the probability of Brexit at around 20-30%, so it is not our base case but by no means a trivial risk,” write Michael Saunders, head of West European economic research, and his colleagues at Citi.
READ: Brexit could see sterling shed 20%: Goldman Sachs
“The effects of Brexit, if it happens, are likely to be large and painful in economic and political terms, both for the UK and the EU as a whole. The possible effects of Brexit are inevitably uncertain, but we suspect it would trigger significant economic weakness for the UK, with a 15-20% depreciation of sterling in trade-weighted terms, resultant return to import-driven inflation and a major policy dilemma for the MPC. It would also likely prompt a wider wave of referendums and embolden other separatist movements within the EU,” they add.
Opinion polls suggest the referendum result is too close to call
So what should investors do? “FX markets probably offer the most straightforward means to hedge Brexit risk, but other markets also provide possible sanctuary for those seeking protection during what may well be a turbulent period for UK markets,” the Citi team argues.
The bank’s economists write that although sterling has depreciated by about 1% this year and is now the second worst performer in the G10 list of major currencies, they think that Brexit is nowhere near priced yet.
“Firstly, GBP doesn’t look cheap. A glance at the BIS [Bank for International Settlements] real effective exchange rate for GBP shows that it’s just below its historical average, and 20% from its historical low,” they write.
“Furthermore, during shock events, historically, GBP has depreciated rapidly and to a larger magnitude than it has done so in the past several months,” they add, noting that the pound’s exit from the European exchange-rate mechanism in the early 1990s saw a depreciation of about 30% in the space of six months.
READ: UK rates could rise soon after early Brexit vote: Citi’s Englander
As for other asset classes, in bonds they reckon the short end may benefit from a flight to quality while the long end is likely to suffer. Long term, though, some of the drivers may flip.
In credit, they expect generic spreads on investment-grade-rated, UK-domiciled corporates to rise by 20-40 basis points in the immediate aftermath of a Brexit vote – or indeed if it became the central scenario before the actual vote.
In stocks and shares, they suggest four Brexit hedges for investors: 1) Overweight energy/Underweight financials, 2) Overweight tobacco, mobile telecoms, pharma and household goods vs Underweight food retail and non-life insurance, 3) Overweight FTSE 100 vs Underweight FTSE 250, and 4) Own US exposed strong balance sheet stocks with surplus free cash flow.
Over at HSBC, Simon Wells, the bank’s chief UK economist, writes that the UK will need to get beyond Brexit fears before sterling can strengthen, but, once it does, he argues that the rally is set to be sizeable. “Our base case scenario is that the UK remains in the EU, and hence we see GBP/USD hitting 1.60 by year-end,” he reports.
In credit, HSBC recommends selling UK corporates in euros into UK corporates in sterling, staying Underweight Scottish credit to reflect uncertainty over a possible second independence vote and reducing exposure to UK banks in the run-up to the referendum as it believes they will see a widening in spreads.
In bonds, working on the premise that uncertainty is not good for investment and the deployment of capital, HSBC argues that this translates into a positive for gilts. Also, at the very least, it implies that the Band of England will keep interest rates on hold pending the resolution of the event risk.
Finally, in equities, it finds the continued optimism on the UK surprising given the political uncertainty created by the referendum on EU membership and also by the weakness in UK fundamentals.
Meanwhile, knowing precisely when the referendum will take place could be positive for sterling, according to Adam Chester, head of economics, commercial banking, at Lloyds Bank.
UK Prime Minister David Cameron “is due to travel to Hamburg on Friday to continue the negotiations ahead of the key EU Summit on February 18-19,” he writes. German Chancellor Angela Merkel’s support will be crucial. “If all goes smoothly, the referendum could take place as soon as June 23 – a welcome prospect as uncertainty in the meantime risks putting the pound under renewed pressure,” Chester adds.