UK votes for Brexit

The outcome of the EU referendum in the UK shows a majority in favour of a Leave. In this document we assess the economic and market impact and outline our investment strategy.

What’s next?

Article 50 of the Lisbon Treaty, signed in 2007 and ratified in 2009, has defined a roadmap for exiting the EU. The steps are now the following:

• The UK government notifies the European Council of its intention (effectively triggering Article 50 of the Lisbon Treaty). Note that the UK parliament might first have to approve the decision to withdraw from the EU.
• The European Council (without the UK) provides guidelines for negotiations with the UK;
• Negotiations between the Union and the UK can start and could last for a maximum period of 2 years (in between, EU laws will continue to apply to the UK);
• The Council then needs to obtain EU parliament consent (by a simple majority);
• The European Council finally has to accept the agreement with a “super qualified majority” (i.e. 20 out of the 27 remaining member States, comprising at least 65% of the EU27 population).

Although the Lisbon Treaty has clarified the process, what will happen from now on is far from straightforward. The referendum is indeed only an “advisory” referendum. Cameron has already explained that his government would promptly trigger Article 50, but there could be a period of at least a few weeks or months before formal approval by the UK parliament. 

Going into a long and complex negotiation process

• If Article 50 is triggered, the EU and UK will enter a lengthy negotiation process. For instance, when Greenland decided to leave the European Community in 1982, it took 3 years to reach a deal. The UK has 65 million inhabitants, it exports a myriad of goods and services to the EU (40% of its exports) and is financially deeply integrated with the EU (UK external assets on the euro area amounted to around €4,600 billion in 2013 while its liabilities to the euro area ran to € 4,800 billion).
• The negotiation process between the EU and the UK is thus bound to be lengthy and complex and legal, with numerous political hurdles along the way.

How does this affect the economy?

The economic impacts are difficult to assess. Given the relatively low euro area trade exposure to the UK (3 % of euro GDP), one might also be tempted to conclude that whatever happens in the UK will only have a modest effect on the euro area. This is nevertheless highly misleading. The main risk is a confidence shock with political deadlocks, preventing governments from providing a prompt and joint answer.

Short-term economic impact

We believe that, over one-to two-year horizon, three scenarios could unfold:

• 1. The favourable scenario (10%)

Governments show their immediate clear commitment to minimizing the economic consequences and draw up a clear roadmap. Central banks react in a coordinated way to dampen financial tensions. The ECB could, if needed, use the OMT to prevent peripheral countries’ spreads widening, while the Fed postpones any rate increase, and the BoE even lowers its policy rate and, if needed, launches a new QE.

• In the UK, activity slows even further, as firms facing uncertainty on the coming trade agreements continue to postpone their investment projects. However, thanks to the GBP-decline and a postponement of fiscal rebalancing, fiscal policy remains neutral or even turns supportive – activity rebounds. After a weak H2 2016, GDP growth recovers.
• For the euro area, the consequences are mild as the direct trade impacts are modest: a 1% slowdown of UK growth will subtract a modest 0.2% from euro- area growth.

• 2. The muddle-through scenario (60%)

While central banks intervene to limit the negative impact of the Brexit (the ECB remains committed to keep maintaining an expansionary monetary policy for an extended period of time), the response of governments is deemed insufficient. Markets test “who’s next” and contagion affects states where the euro membership could, in one way or another, be called into question.

• Growth weakens in the euro area as investment decisions are, here too, postponed. Faced with a deteriorating environment, the EU however avoids a full confrontation with the UK.
• To prevent a sharper slowdown, the euro countries agree to relax the fiscal rules. After a soft patch, returns and, thanks also to a weaker euro, activity reaccelerates.

• 3. The European recession scenario (30%)

After a couple of months, it becomes clear that European governments are unable to find an agreement in their negotiations with the UK and to agree on the need to support activity. Confidence is lastingly affected both in the UK and in the euro area. Stock markets remain depressed and wealth effects add to the UK slowdown. While central banks continue to do whatever they can, the response to lower rates remains muted.

• A recession occurs both in the UK and the euro area, strengthening global deflationary pressures. In the UK in particular, large capital outflows or a halt in inflows could, given the UK's 7% GDP current account deficit, put strong upward pressure on domestic interest rates.
• Note that this scenario has a binary outcome in the longer run: either the euro will be able to re-launch a political project and strengthen its governance or it will be subject to increasing centrifugal forces.
• Of course, this scenario would become more than just a UK problem, as questions about the EU’s future (disintegration) could arise over time.

Candriam’s main assumptions for the euro area and the UK

In the favourable scenario, with the slowdown in the UK, euro area external demand weakens by 0.1% in H2 2016. In the muddle-through scenario, businesses postpone their investment plans (shock of -4% YoY in equipment investment in H2 2016 in the euro area), while the REER (real effective exchange rate) falls by 5% in the euro area and 10% in the UK. In the worst-case scenario, world growth slows. Business investment falls further, inventories are adjusted and hiring plans are postponed in both the euro area and the UK.

The scenarios depicted above are “extreme”: in the favourable as well as in the recession scenario, we assumed that both the UK and the euro area will react either in the most favourable or in the most negative way. Many intermediate cases could, however, unfold. Moreover, at any time, one could move from one scenario to another. As British and European authorities will be engaged in multi-year negotiations on trade agreements, treaties etc., they will have to compromise on many conflicting issues: even in a favourable scenario, disagreements can return to the front stage and lead to a less favourable outcome, all the more so since “Euro scepticism” is now almost everywhere on the rise and growing anti-EU sentiment is challenging the democratic legitimacy of the whole European project. In this regard, the recession scenario would, of course, be the most dangerous to the integrity of the EU.

Long term economic impact

While the many uncertainties surrounding Brexit make it difficult to quantify the longer term economic effects, recent studies made by international institutions before the vote (possibly with the purpose of influencing British voters) have produced converging results: even in the most optimistic scenario, the UK would be significantly worse off. As Christine Lagarde put it, the impact of a Brexit ranges “from pretty bad to very bad”.

• By 2020, UK GDP will be 2% to 5% lower than in a Bremain scenario and by 2030, it will be 2% to 10% lower (cf. OECD policy paper, April 2016, table 5). The range estimate of the size of the shock depends in particular on the future trade agreement with the EU after 2018. It will be significantly weaker if the UK manages to rapidly re-negotiate a free trade agreement with the EU, avoiding a reversion to WTO rules.
• A recent OECD study  envisions an “intermediate” scenario where the UK initially reverts to WTO rules before a new free trade agreement with the EU is reached: by 2030, GDP is 5% weaker. In many studies, FDI inflows in the UK are substantially reduced (in 2014, the UK was by far the largest recipient of FDI in the EU). The ending of the EU pass porting rights for UK- based financial firms and possible relocation of some clearing houses for Eurozone business (which are currently mostly based in London) are also frequently mentioned as curbing UK activity .
• The shock to growth would significantly raise the UK budget deficit, offsetting the net fiscal savings generating by ending EU membership. According to the IMF, “any output losses in excess of 1% of GDP would result in net fiscal losses for the UK, as reduced revenue due to lower output would more than offset any gains from eliminating the UK’s net EU budget contribution of 0.3% of GDP”.

How does this impact financial markets ?

• Risk assets suffered worldwide and safe-haven assets were well bid, at European market opening:
  • Asian equity markets are falling: the Japanese Nikkei closed -7.9% down. European equity markets tumbled -10% this morning. In the UK, the FTSE 100 has lost -9%.
  • On the fixed income side, peripheral bond spreads are rising  and high yield markets are suffering while the 10y German bund yield has fallen to a record low of –17bp.
  • Currency markets show huge discrepancies: against the USD, the GBP hast lost -8%, the EUR is losing -3% and the JPY is up by +3.5%.
• Even if the short-term impacts are rather straightforward, the medium-term consequences are more uncertain

Estimated market impact in our three scenario’s

The favourable scenario (10%) is close to the scenario envisaged for a ‘Bremain’, though rather unlikely. An equity market decline would be the first reaction. This could be a possible buying opportunity, as equity market stress could ease thanks to a swift reaction by governments and central banks. Another initial reaction would be a GBP decline, and corporate and high yield spreads would slightly widen.

Before going into our two alternative scenarios to the favourable one, it is worth mentioning that we will not have all the answers on the first day after the referendum and the markets could easily switch from one scenario to another. The first reaction of the market will be insufficient to determine the scenario we find ourselves.

The recession scenario (30%) is also rather clear-cut: a recession that could trigger a global shock and a strong rise in the European risk premium. Investors flee to safe-haven assets, exiting risky assets. To assess the potential impact on markets in the first weeks, we have taken recent historical shocks and crises as a reference (Euro Crisis, Lehman shock, September 11). Since the macroeconomic impact is closer to that of the Euro crisis, this would probably be the best reference, for the time being. However, we expect there to be less contagion to peripheral Europe, thanks to the measures in place at the ECB (QE, PSPP). US asset classes, too, will probably be less affected. The table below indicates the possible market impact in this scenario.

We believe the muddle-through scenario (60%) is most likely one. In this case, the political risk premium should remain at a higher level for a while and weigh on the performance of European assets. However it is worth noting that in this scenario the economic impact could be rather limited for the Eurozone (growth would fall to 1% at its lowest point). This would impact earnings growth but we could also find a floor on the market more rapidly (a fall of around 10% from the current level is expected). Peripheral spreads would widen somewhat but the ECB action should contain the risk aversion. We would nevertheless adopt a more cautious strategic allocation process, particularly on European assets, taking into account the higher political risk and economic uncertainty. 

How does this impact our investment strategy?

Asset allocation strategy

Measures in recent weeks

We had maintained a cautious approach even if we have been more constructive since February-March. While macroeconomic indicators have improved, especially in the US and emerging markets, we have not invested the entire risk budget we have at our disposal. 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”.

To hedge the “Brexit” risk:

• We had increased the optionality in the portfolio. We saw the outcome of the EU referendum in the UK as a binary event, which would have had a significant impact on equity markets either way. Hence, we replaced some futures exposure by options strategies offering a better risk-return profile.
• We have kept an underweight stance on UK equities.

Based on the outcome of today’s vote

• The announcement of a vote in favour of Brexit clearly has an important impact on risky assets. Therefore we have decided to reduce our equity exposure to an underweight. Also, we decided to reduce our short duration, as safe haven bonds will perform in this market context.
• Regarding our regional allocation, we have made some changes:
  • We maintain our underweight in UK equities.
  • We have decided to (temporarily) reduce our exposure in euro-zone equities to an underweight.
  • We have decided to implement a neutral stance in US equities. The US market is less impacted and is thus more resilient in the current market environment.
  • We have decided upon a neutral stance in emerging market equities: Although, the short-term evolution will depend on the evolution of the USD and the global context, we believe there is no reason to start underweighting the region.
• Regarding our fixed income exposure,  we have reduced our short duration.

Fixed Income strategy

• Today’s announcement clearly favours safe-haven bonds. We believe the US central bank will postpone its interest rate hike, while the Bank of England will intervene by cutting its interest rates, increasing its quantitative easing programme or even intervening on the Forex market. However, it won’t be easy for the Bank of England to manage its monetary policy, as the Brexit could result in an increased inflation risk and reduce confidence in the GBP.
• This context is supportive of government bonds, except UK government bonds, as there is reduced confidence on the survival of United Kingdom as a whole.
• In the coming months we shall be cautious on peripheral bonds.
• Regarding currencies, we are long on the USD, which is a safe haven currency. We are negative on the British pound and the euro.

Equity Strategy

• We currently hold a cash exposure.
• We are negative on UK banks and real estate.
• However, not all companies will be impacted by the Brexit vote. We continue to invest in companies that have structural growth and an international orientation.
• From a sectorial perspective, we favour defensive and globally exposed sectors, such as:
  • Healthcare
  • Consumer staples (Food, Beverage & Tobacco, Household Products)
  • Technology (structural growth)

Conclusion

The UK vote to leave the European Union is unprecedented. Brexit is another serious warning for the European project. Europe is now entering a period of uncertainty, as both the future of the United Kingdom in the European Union and the European project itself are being questioned. The upcoming negotiations between the UK and the EU will provoke an uncertain environment. Volatility will increase for some time on both UK and eurozone assets. We now face a period of strong political uncertainty, with even some disintegration risks in the UK. Central banks and government will have to manage this crisis.