Brexit not impossible, but unlikely

With us just one month away from the June 23rd EU referendum in the United Kingdom, the latest polls put the ‘Remain’ camp ahead. Candriam’s central scenario is based on a continuation of Britain’s EU membership.

Current status

The latest opinion polls point in favour of Britain remaining in the European Union. According to an ORB survey commissioned by The Daily Telegraph, 55% of voters would prefer to stay in the EU. These ‘Remain’ voters look mainly worried about the economy, which is currently trying to tackle the impact of the political uncertainties.

The latest Q1 2016 GDP release shows that the UK economy lost momentum at the start of the year, with a growth rate at its lowest level since 2013 (0.4% QoQ, 2.1% YoY) and a sharp downturn in both recent business and consumer confidence surveys.

Assessing the Brexit market risk

At Candriam, we believe a Brexit will be avoided. Not only are the opinion polls in favour of a ‘Remain’, but also the risk priced by the financial markets is relatively low.

When taking into account the recent evolution of both the British pound (against the euro) and the UK’s CDS spread against Germany, we estimate the probability of an exit of Britain out of the EU at less than 20%, as shown by the graph to the right.

This justifies our overweight in euro-zone equities. The removal of this political uncertainty could unlock the potential in European equities.

Nevertheless, even if a ‘Remain’ in the EU is our central scenario, we have assessed the possible market risks in the case of a Brexit. In a worst-case scenario, a Brexit could potentially lead to a strong market correction, such as we saw during the euro crisis, with European equities dropping 15% to 20%. For bonds, this time things are different, as the European Central Bank is ready to act by buying peripheral bonds in order to prevent strong spread-widening and to preserve the future of the European Union.

Additionally, although we believe in an immediate, massive and coordinated central bank response that could limit the downside market risks, negotiations between the EU and the UK would take time and could result in a higher market volatility that could persist some for time. If the voters decide Britain should leave the EU, the UK would have two years to figure out the exact terms of its departure, and even after Great Britain had formally left the EU, it would take years to determine a new long-term relationship with the changed EU.

We are positioned for a ‘Remain’

Our base scenario is a ‘Remain’ of Britain in the EU. As a consequence, our asset allocation funds and mandates are positioned for a ‘Remain’. In this scenario, expected returns of risky assets, such as equities, high yield and emerging markets, are attractive.

• We prefer to maintain a slight overweight in equities and a risk diversification through high yield and emerging markets (both equities and bonds).
• From a regional point of view, we have lowered our conviction in euro-zone equities since the beginning of the year, on the back of mounting political risks, such as Brexit.
• As a consequence, we still have an overweight in euro-zone equities, while slightly underweighting the UK. Our base case is that the UK remains in the EU and that the removal of this uncertainty could unlock some potential in European equities.

Nevertheless, we remain cautious for the time being, as recent surveys reveal risk appetite as below its average. The scheduling of the EU referendum in the UK for June 23rd has already guided our relative cautiousness in the recent months. Therefore, our slight overweight in risky assets is coupled with a tail risk hedge.