Uncertainty reigns as the U.K. electorate prepares for a June 23 referendum vote on continued inclusion in the European Union (EU), pithily nicknamed Brexit. Polls have remained tight since David Cameron’s February return from Brussels with negotiated EU concessions, which triggered the announcement of the referendum vote date. The most recent YouGov survey indicates a tight race: as of June 10, 42% of respondents intend to remain in the EU, 43% intend to leave, and 15% are undecided. Yet betting markets and investors are less convinced of a Brexit: betting markets imply a 30%–35% probability of a Leave vote, while 7% of investors expect a Leave vote, according to a recent broker poll. Brexit is a moderate-probability near-term risk that would affect nearly all asset classes, though U.K. and pound-denominated equities would bear the brunt of the pain. The most vulnerable instruments — U.K. equities and the British pound — both sit in negative territory on the year, though U.K. equities have surprisingly outperformed broader European equities. Given these expectations and this positioning, a potential win for the Leave camp has the potential to cause a jolt in U.K. and broader markets.
*The expected standard deviation of the pound as implied by the pricing on three-month currency options.
We have a modest overweight toward international developed market equities — including the U.K. — and thus a vote to leave would cause pain in the near term. U.K. and European equities would likely underperform and a risk-off stance would envelop the market. The near-term impact to the U.K. economy of a Leave vote is highly debatable with the U.K. Treasury predicting a small recession in 2017. Overall, a Leave vote would be an unwelcome development to start the summer.
Over the longer term, we believe a Brexit Leave vote would be an opportunity for patient investors as the political process would slowly lead to renegotiated trade and immigration pacts, cushioning the overall impact. EU countries account for 45% of U.K. exports, so Parliament has every incentive to stem the political damage of the vote and maintain open trade with the EU as far as possible. Central bank policy would remain accommodative, a benefit for our bias toward equities over fixed income. The true downside would be a domino effect: should EU countries in turn hold their own referendums, it could threaten the very fabric of the EU and the eurozone.
While we stand ready to act in the event of a Leave vote, we agree with the market that a Remain vote is more likely. Despite the enticing populist rhetoric, voters tend to make the safer decision when in the voting booth, as witnessed most recently during the Scottish Referendum. In financial markets, a small relief rally would likely ensue, and with the vote in the rearview mirror Europe could continue its plodding recovery, to the benefit of our European equity positions. Despite the specific Brexit risk, we remain comfortable with the modest tilts we are taking on our strategies: overweight risk assets (equities and high yield bonds) with a slight overweight to developed international equities.
