The UK and Europe — in or out?
The starting gun has been fired for the UK’s referendum on EU membership. While the British press has certainly played its part in stirring up public opinion on whether the UK should stay in the EU, the vast majority of the electorate has been slow to wake up to the issue and markets have been equally complacent about the risk of ‘Brexit’ – the risk of Britain exiting the European Union.
The wheels are now in motion, with both the ‘ins’ and ‘outs’ starting their referendum campaigns in earnest ahead of the 23 June 2016 vote.
What did the prime minister seek to achieve at the recent EU Summit?
Prime Minister David Cameron believes that the UK’s best position lies within a reformed EU. His four key objectives at the recent EU Summit were:
- Integration and sovereignty: Opting out of an ‘ever closer union’, power for Parliament to block EU legislation and a ‘red card’ allowing scrapping of unwanted directives.
- Competiveness: An extension of the single market and a reduction in regulation.
- Immigration: Restricting access to in-work and out-of-work benefits to EU migrants, unless a migrant has been a resident for four years.
- Economic governance: Setting out an explicit recognition that the euro is not the only currency of the EU. The UK is asking for safeguards that steps towards further financial union cannot be imposed on
non-euro-zone members and the UK will not have to contribute to euro-zone bailouts.
What did the prime minister achieve?
While the Summit was always unlikely to see a wholesale reordering of the UK’s position within the EU, the prime minister managed to achieve some changes. However, it could be argued that these changes were never going to be enough to satisfy the ‘outs.’
On sovereignty, there was recognition that the UK is not committed to an ‘ever closer union’.
As the UK’s objective on competiveness was not particularly contentious, there was widespread agreement with the prime minister’s stance. Whether this results in action, of course, remains to be seen.
Immigration was the toughest part of the UK’s EU reform agenda and David Cameron had to make significant concessions to his original demands. EU members rejected a ban to prevent UK resident EU nationals sending child benefit home, and there was a compromise on how soon after arriving in the UK new EU migrants can claim in-work benefit payments.
Finally, in respect of governance, and the relationship between those countries using the euro and those who have opted-out of the currency union, there were guarantees that the UK will not have to fund euro-zone bailouts and recognition that the EU has more than one currency. However, in respect of regulating the financial sector, the EU’s laws prevailed.
Is Brexit a real threat?
The referendum will use a binary in or out question “Should the United Kingdom remain a member of the European Union or leave the European Union?” As with the Scottish independence referendum in September 2014, a majority will be enough. Once considered to be little more than a tail risk, the risk of Brexit is on the rise. While the probability of Brexit is still 20-30% (source Citi, January 2016), opinion polls have narrowed since mid-2015 and suggest the outcome could be far closer. As there is considerable variation between polls, particularly whether conducted online or by telephone, we would caution against reading too much into individual poll results.
What could influence the swing voters?
Polls suggest that 20-30% of the electorate are definitely for ‘out’ and a similar percentage are for ‘in’, leaving the rest either undecided or liable to change their mind. However, history shows that people tend to vote for the status quo. The arguments for staying in the EU are largely economic and political, hinged on the current benefits enjoyed by being a member. It is worth pointing out that the UK economy is among the least regulated of all EU members. By contrast, the ‘out’ campaign plays to the anti-establishment sentiment, appealing to the ‘man on the street'. This, of course, can have a powerful mobilising force.
Even so, the ‘out’ side won’t say what the alternatives are, touting either the EU-Norway or EU-Switzerland models as a blueprint for Brexit – both of which have their issues. For example, Norway has to pay in order to trade with the EU and must accept all the rules and regulations without any say in how they are made. In addition, both Norway and Switzerland must accept free movement of labour for EU nationals.
Arguably, immigration is the number one concern among the electorate. The refugee crisis in Europe is already having an impact on the climate around the UK EU referendum, and if the vote is delayed beyond June, then there is the risk that another influx of migrants in the summer (as we saw in 2015) could feed public anxiety about immigration. If this is pushed to the top of the political agenda, then this could help the ‘out’ campaign. Certainly, any terrorist activity in Europe that can be linked to recent immigration has the potential to aggravate the situation further in the run-up to the June referendum.
What are the possible scenarios?
If ‘in’ wins, we are likely to see some form of relief rally in markets. If ‘out’ wins, we believe there is likely to be a sharp sell-off in markets, potentially to the point of official intervention. The medium-to-longer term effects of an out vote will be harder to quantify, given that it could lead to years of uncertainty. The effects are, however, likely to be large and painful in economic, fiscal and political terms for both the UK and the EU as a whole. The risks to economic growth are palpable – 44% of UK exports go to the EU (versus 17% to the US) and bilateral trade deals will need to be arranged which will take some time.
If a Brexit transpires, it would likely prompt a wider unravelling within Europe. In the case of Scotland, the SNP-led government has indicated it would hold a second referendum on independence. Scotland is likely to re-apply for EU membership (Scotland is more pro-EU than the rest of the UK), rather than stay out with the UK. If successful, Catalonia could pursue independence from Spain with more gusto.
Are Brexit risks priced into markets?
Few in the market believe that Brexit is the base case scenario. While businesses are already mapping out their contingency plans and hedging strategies are being put in place, Brexit risks have yet to be fully priced-in by markets. The more recent falls in sterling have been largely attributed to a shift in rhetoric by Mark Carney, the governor of the Bank of England (BoE), together with growth concerns and the risk of a “greater persistence of low inflation” in the near term, which has seen markets price out the chance of a UK rate rise until mid-2019. In our view, uncertainty around Brexit merely adds to the view that the BoE will not be in a hurry to hike rates.
Now that the date has been announced, we are beginning to see greater positioning ahead of the referendum. Sterling has fallen sharply against all major currencies but interest rate markets are holding up better. However, with 25% of the UK gilt market held by overseas investors, it is not clear what will happen to government bond yields over the coming weeks. As any prudent business, we are running scenario analysis to map out practical courses of action we may have to take, but we would reiterate that this remains only a risk scenario.