The threat of Brexit is a credible one, given that latest polls have shown both the Brexit and Bremain (staying in the EU) camps to be evenly tied, with the latest poll by The Financial Times revealing (as of 24 May 2016) 40% leaning towards the exiting the EU and 47% remaining within. Bloomberg's poll (as of 22 May 2016) has also shown a similar direction, albeit a larger proportion of respondents wanting to stay in the EU (50%) as compared to those wanting to leave (38%).
Is Brexit a legitimate worry? In this article, we take a look at the potential repercussions for investors should the referendum result in the UK exiting the EU.
The Brexit Argument Simplified
Given the influx of immigrants stemming from the Middle East, the arguments that have been made by the Brexit camp have been mainly centred on immigration and security issues, with a smatter of sovereignty coming into the picture. While some debate has been made on the potential economic benefits of leaving the EU, including lesser protectionist measures that would free up the UK's trade with other non-EU nations and in turn help to offset the expected dip in trade with the EU, it could be a far reach as the UK would have to negotiate/re-negotiate several trade agreements with many other nations and ensure they are of the same quality as the current set of trade agreements with the EU, not to mention negotiate their own trade agreement with the EU which could prove difficult.
Potential Economic Implications
One of the biggest impacts would be on the UK's trade with its largest partners given that the Eurozone accounts for 41% of all UK exports with the larger EU accounting for 46%. While each individual Eurozone or European Union member are not the largest trading partners by themselves (Chart 1), it is the collective size of their trade that is very significant. Thus, a departure from the EU is likely to deal a rather hefty blow to the UK's exports as trade tariffs will rise in the wake of a Brexit result, with Chart 2 showing the average amount of tariffs the EU would likely be imposing on the UK's exports.
Chart 1: Where Do The UK's Exports Go?
Chart 2: EU Tariffs & UK Exports To The EU
The above will hurt the economy directly through lower exports, while the producers of the goods, UK corporates, will be hurt by the rise in trade tariffs that will eat into their bottom line. The geographical revenue derivation of the UK's benchmark equity index (FTSE 100) in Chart 3 reveals that UK equities garner approximately 44% of their revenues from the UK and the EU, with approximately 21% from the domestic front and 22% from the EU. With the EU accounting for a rather hefty chunk of revenue, an increase in tariffs is likely to affect the bottom line of companies doing the bulk of their business with the EU. Domestically focused stocks are likely to see their revenues come under pressure as well, given that secondary knock-on effects from reduced exports (e.g. layoffs, reduced spending in times on economic uncertainty) are to be expected.
Chart 3: Where Does The FTSE 100 Derive Its Revenue From?
Although latest poll readings put the 'remain' camp in the lead, it is difficult to tell if Brexit will materialise or not as polls can be notoriously unreliable. In either case, investors should brace themselves for volatility, given that markets will begin to reprice the eventual outcome.
Brexit Outcome: Should Brexit materialise, investors are likely to witness a decline in the British Pound (GBP) against many other currencies, a sell-off in UK equities and a spike in the yields of both UK Government Gilts and corporate bonds as a result of investors demanding an additional risk premium to hold UK-related assets. UK equities that are focused on the domestic market as well as those heavily exposed to the European Union are likely to be worse off given that the former are likely to be hurt by a local economy that is expected to be negatively impacted while the former will be hurt by a cut in their margins due to the rise in trade tariffs. Internationally exposed stocks are likely to benefit from foreign currency effects from the anticipated weaker GBP, while European stocks (non-UK) are unlikely to be permanently impaired although there is the potential for assets to be repriced to factor in the potential for future departures.
Thus, while Brexit is a legitimate worry for the UK economy and its potential destabilising effects for the future of the European Union, we do not believe that it will spell the end of the world for investors as markets will likely eventually find their footing.
Bremain Outcome: Should Brexit not materialise and the 'remain' camp wins the poll, investors could expect the GBP to rise against many other currencies. UK equities and corporate bonds are likely to benefit from positive price appreciation as well given the aversion of a risk event.
Investors who have a view that Brexit will materialise, could consider utilising a Europe ex-UK fund for European equity exposure to reduce exposure to the British isles. Investors who believe that Brexit is not going to materialise could continue to keep their existing European exposure to the Europe including UK range of equity funds.
Regardless of the end result, we do not find European equities to be appealing or attractive at this juncture given current valuations that see the Stoxx 600 trade at 15.8X 2016's estimated earnings and 13.9X 2017's estimated earnings (as of 24 May 2016). As mentioned in Europe Downgrade: An Unhealthy Combination Is Brewing, investors today are paying a premium against our estimated fair value of 13.5X PE for European equities, making the region no longer as attractive as it once was earlier in the year to us given the run up in valuations.
Chart 4: Valuations Still Elevated
While the risk of a Brexit poses some short term risks (volatility) and a potential repricing to European equities, we believe that UK equities are at greater risk than Eurozone equities at large. We retain our 2.5 Star - Neutral rating on the region and caution investors to brace themselves for volatility for either result.
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