Brexit: A Summer of Uncertainty
Understanding the Panic Surrounding the Pound Going Into the EU Referendum
- Both outcomes of a Brexit vote are likely to cause a prolonged period of unpredictability as investors watch the markets closely.
- Britain has a history of market shocks. What can we learn from them? What was their previous impact on the FTSE?
- BoE concerned with an increasing deficit and decreasing GBP post vote.
The Summer of 2016 has the potential to provide quite a bit of uncertainty to traders and investors with any financial exposure to the United Kingdom. On 23rd June, voters will have their say in what is according to Bloomberg “the most important referendum in modern British history.”
While politicians are stating whether or not voters should favour ‘Leave’ or ‘Remain,’ investors are wondering whether they should ‘Buy’ or ‘Sell.’
The Only Thing We Have To Fear…
Every election large and small seems to play on a fear of the unknown, and the European Referendum vote is no different. From the ‘Bremain’ Camp, we’ve heard the preferred choice of businesses to delay or decease investment following the uncertainty that ‘Brexit’ would bring. Across the aisle, the ‘Brexit’ group will continue to make the analogy that a divorce is necessary given the troubled family relations within the Eurozone from members such as Greece. While both views have credibility, the many unique aspects of a potential UK divorce from the EU leave investors wondering how this might play out given either outcome.
Lessons From Past Times of Uncertainty
Like any developed Financial Market that is a hub of global capital flows, Britain is not without system shocks. The ERM breakup of 1992 & the Great Financial Crisis are two examples of such occurring.
On September 16, 1992, Britain felt it best that the United Kingdom should leave the Exchange Rate Mechanism (the predecessor to the Euro as we know it today), after failing to support the falling pound against a strong Deutsche Mark. Almost immediately, the pain was taken in stride before investors started to look forward to opportunities that the sharp GBP devaluation created. The market outcome was that the FTSE 100 & 250 entered into a bull-market less than one year after the ERM Exit. At the time, the United Kingdom was already in a recessionary state, but the ERM breakup caused a 14% devaluation in Sterling vs. the Deutsche Mark from 2.81 down to 2.14, making UK assets cheaper for Non-UK investors.
In 2008, as a financial hub for global capital markets, London was caught square in the fear of investors pulling money from anything exposed to credit. Given the force of the move, Sterling fell by ~20% between summer 2008 and spring 2009 and the current account was severely strained from a pre-crisis deficit level of 3.4% of GDP (H1 2016 at ~3.7%). The similarities make this a helpful comparison.
The Bank of England’s Primary Concern
Presently, Britain is running a current account deficit of 3.7% of GDP showing a reliance on foreign investment. A Brexit vote, which remains an outlier of an outcome with polls split nearly 40/40/20, 20% being undecided, would threaten to increase this deficit.
Upon a Brexit, the UK current account deficit would be vulnerable to increase significantly because of the slowdown or possible near immediate stop of capital flow or foreign direct investment that has so far remained at current levels. In January, Bank of England governor Mark Carney noted that a ‘Brexit’ outcome would leave the UK relying on the “kindness of strangers” to fund its hefty current account deficit. Such an outcome is likely to send Sterling much lower.
Increasing signs of a ‘Brexit’ risk have increased hedging and whilst, buying downside for protection exits, we likely have not seen the full extent of the volatility that a Brexit would bring. A sharp decline in current account investment could result in an environment similar to that of the Great Financial Crisis of 2008 as mentioned above.
Questions for investors
One of the great promises of our technological age is that location is becoming less important. Therefore, while the cost of money could increase for companies within the United Kingdom should a Brexit outcome surface, many of the larger companies would likely not be plagued by a negative shock to the UK Business Climate. Therefore, we could see an environment where money flowing out of Britain’s Gilt Market weakens the Sterling, and ironically sets up a strong buying argument for companies within the FTSE100 whose business activity is ~80% outside of the United Kingdom.
In 1992, the more international companies saw a rise, but that was pale in comparison to the FTSE 250, which rose ~60% in the 12 months following the ERM exit. Therefore, a situation in which there is weak sterling making UK equities cheap to foreign investors may be the welcome sign that UK business has not seen in quite a while.
Given the size of the UK equity market relative to other European counterparts (twice the size of the German and equal to a combination of Spanish, Italian, Swedish, Dutch, Danish, Belgian & Finnish), money would likely be reallocated to the most promising sectors within the UK as opposed to exiting entirely.
In other words, a weaker pound could bring a flood of foreign investors which has been a beacon for economies around the world after the financial crisis of 2008.
Challenges and opportunities
The 1992 sterling fall from the ERM exit was a good entry for investing in UK equities 3 months after the event. The FTSE 250 fell ~23% leading up to the ERM exit, but what many investors today will likely wonder is if we will see the same wave of buying we saw in the early 1990s. The following 12 months after ‘Black Wednesday’ saw the FTSE 100 rise by 23% and the FTSE 250 by ~60%.
The opportunities brought by a weaker sterling would however not be without its challenges as well. Falling 20% from the Great Financial Crisis, the FTSE has not risen by the same magnitude as other global markets like the SPX500. Many understandably blame this on a few high-momentum names within the SPX500 like Facebook, Amazon, Google & other darlings of the Tech-Boom. Also, the 1992 turnaround was aligned with the UK coming out of a recession.
Overall, it is clear that whichever way the British public votes, there will be a certain amount of uncertainty created over the summer period. However, it is this uncertainty that could provide traders and investors with opportunities both in the run up to, and the fallout from, the ballot on 23rd June.
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