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Brexit: cutting through the noise

IC writers push propaganda to one side to examine how the results of the vote on EU membership could affect your investments
May 20, 2016

We’re a month shy of a vote that Prime Minister David Cameron says goes to the “heart of what country we want to be” – presumably he didn’t countenance ‘sovereign’ as the preferred option. But perhaps he understands what motivates us better than we care to admit. It’s rather curious, but as we approach the June referendum on our continued membership of the European Union (EU), it seems that for many Britons, perhaps even a majority, the primary attachment to these shores seems to be essentially pecuniary in nature.

 

Prosperity trumps sovereignty

The ‘Yes’ (or ‘in’) campaign, or at least the bright young things framing its strategy, certainly appear to share this view. Admittedly, we’ve had a few inflammatory warnings on the security front, culminating in David Cameron’s claim that Europe might drift towards war without the calming influence of John Bull. In reality, the spectre of the Wehrmacht crashing through the Ardenne is unlikely to unsettle many nerves outside No 10. But whichever way you cut it, the main focus remains on the potential economic pitfalls – or perhaps uncertainties – of a ‘Brexit’ vote. Immigration is another key battleground, but come 23 June the likelihood is that most people will vote with their wallets.

Thus far, it appears that warnings on the economy, no matter how hyperbolic, are holding sway. Most people obviously wouldn’t subscribe to the view that Britain’s economy is set to descend to the level of Burkina Faso’s if cut adrift from the EU, but with discretionary incomes tightening and many mortgagees sailing close to the wind, it is perhaps unsurprising that family prosperity is likely to trump national sovereignty a month from now.

Maintaining the status quo

Indeed, since David Cameron first promised an in/out referendum in January 2013, most polls have shown a decisive lead for the ‘staying in’ vote, although the continued sluggish performance of the eurozone economies and a worsening refugee crisis have caused the gap to narrow. There was also a largely negative reaction to the EU reform deal the Prime Minister brokered in Brussels, which, for many, actually highlighted our political impotence in the face of the EU hierarchy. The deal, such as it was, was ridiculously short of the ‘full-on’ treaty change that David Cameron once trumpeted. Nevertheless, the fact remains that in referendum after referendum the undecided element almost invariably plump in favour of the status quo. And it’s also worth noting that ‘Yes’ votes hold a clear statistical advantage in this type of plebiscite.

 

Lies, damn lies and statistics

Regardless of which way you intend to vote, perhaps the most depressing aspect of the debate for anyone looking to make a reasoned assessment is that you would be hard pressed to recall a nuanced argument from either side of the divide over the past few months; a point brought home by HM Treasury’s farcically one-sided study into the potential economic implications of Brexit.

Those intent on severing our ties with Brussels have been no less disingenuous at times, or have simply engaged in tabloid-inspired trivia. Boris Johnson recently claimed that funds from the Common Agricultural Policy are still being used to prop up Spain’s bullfighting industry (in the event, MEPs voted for an amendment to the EU budget last October to ensure that agricultural payments should not be made to land being used for the rearing of bulls for bullfighting). Predictably, he has also highlighted previous attempts to impose political union on Europe via the Grande Armée and the Third Reich.

Doubtless, claims like this generate column inches, but they do little to illuminate the main issues in what many believe will be the most important vote in our lifetimes. But, often as not, the debate has descended into farce, or outright propaganda. Someone once said the English follow the principle that “when one lies, one should lie big... even at the risk of looking ridiculous”.

 

Agnosticism and a leap of faith

You will be unsurprised to learn that opinion in the offices of this magazine are as divided as those for the country as a whole, so for the purposes of this feature we’ve decided to remain agnostic in so far as possible. What we have tried to do is identify those areas that could have a direct bearing on the financial wellbeing of our readers. It’s an unwieldy subject, virtually impossible to cover in any detail within the confines of these pages, but we’ll touch upon the possible impact of a ‘No’ (or ‘out’) vote on the UK’s financial sector, our borrowing costs and the direction of gilts, together with notes on the real estate market and a niche area – the potential dangers to research funding. Helpful as ever, our stockpicking guru Simon Thompson has highlighted a number of UK plays that could actually benefit from a vote to leave the EU. And we’ve also included contrasting views from Malcolm Bracken, investment manager at Redmayne-Bentley, along with Conservative MP and Vote Leave campaigner John Redwood.

“Should the United Kingdom remain a member of the European Union?” A simple enough question on the face of it, but one which will almost certainly result in severe political fallout regardless of the result, particularly in the ruling Conservative party. Indeed, it’s not inconceivable that we could be faced with another national vote in fairly short order. For investors, there are innumerable issues to take on board. And though we haven’t been able to provide a comprehensive overview, we do hope that the advice and views contained over the following pages will help our readers to either exploit the situation, or come to an informed decision. Perhaps the last word should rest with Charlemagne, founder of the Holy Roman Empire, who believed that “right action is better than knowledge; but in order to do what is right, we must know what is right”. MR

 

Brexit and the City

■ Existential? - no; corrosive? - yes

First, let’s grasp the importance of the ‘City’ – really just shorthand for the UK’s financial services industry – to the country’s economy. Based on the latest figures, the City accounted for 8.5 per cent of the UK’s gross value added. That doesn’t make it the UK’s biggest industry. Professional and business services – a mish-mash including both the highly lucrative and trog work – accounts for almost 12 per cent and transport and distribution for 10 per cent. Yet no industry comes close to matching the productivity of financial services. It generates its share of output while employing just 3.6 per cent of the nation’s workforce. By contrast, the biggest employer of labour, health and social care generates less than 8 per cent of value added while employing 13 per cent of workers.

In addition, without the help of financial services, the UK’s ailing balance of payments would look even sicker. In 2015, the balance of payments was in deficit by £96bn despite a £56bn credit delivered by a combination of financial services (£41bn) and insurance and pension services (£15bn).

How much would be put at risk if there were a Brexit? True, if the City had its way, the question wouldn’t even arise since its workers are strongly in favour of staying in. That was the finding when the Centre for the Study of Financial Innovation, a think-tank, polled City folk early last year. Of the 408 replies to the centre’s detailed questionnaire, 49 per cent said ‘definitely’ and 24 per cent said ‘probably’ that they would vote to stay in the EU.

Yet even this endorsement came with little enthusiasm for the EU and the reasons to stay were grudging and familiar – they revolved around the need to defend London’s position as the EU’s dominant financial centre and the worry that Brexit would also undermine the City’s global standing.

Granted, Brexit is unlikely to pose an existential risk. As the Centre for European Reform, a pro-EU think-tank, said in a big report last month: "Advocates of a British exit believe that it would not be a disaster for the City. This is probably true." That's because some of the City's core strengths don't depend on the UK being in the EU:

■ A strong legal system and markets with a reputation for integrity.

■ The global status of the English language.

■ Established infrastructure for financial markets combined with lots of expertise.

Within the EU, these strengths help give the City genuine barriers against its European competitors. Outside the EU, they may not be strong enough, especially as specific factors would erode the City's position:

■ The so-called Mifid II directives would mean British and UK-based financial services firms would only be able to do business in the EU if the European Commission decided the UK's legal and supervisory regime was broadly the same as the EU's. At the very least that would mean British firms would need a base in the EU, adding to costs. Some UK-based firms would decide to quit the country.

■ The European Central Bank would get its longstanding wish to force London's clearing houses that settle euro-denominated trades to relocate to a eurozone country. Currently, this runs contrary to a ruling by the European Court of Justice - but the law could change.

■ Hedge funds and private-equity funds would come under similar pressures to comply or leave London.

■ Swiss financial institutions would scale down their London operations or leave completely. That's because they must have subsidiaries within the EU in order to trade yet could no longer use the City as their chosen location.

From these specific points, two general ones arise. First, that the EU's financial directives could well be changed, thus undermining the City and benefiting Paris and Frankfurt. Second, that the pool of skilled-yet-mobile labour that plays a vital role in the City's success could drift to the continent.

It's not a happy prospect. As to which companies' shares would be especially hard hit by Brexit, take your pick from a big selection in the financial sectors, but it would be likely to include: London Stock Exchange (LSE), Schroders (SDR), ICAP (IAP), Man Group (EMG), Ashmore (ASHM), Barclays (BARC), Hiscox (HSX) and Beazley (BEZ). PR

 

Implications for gilts and yields

Brexit would create short-term uncertainty, which is bad for risky assets. But it might not raise gilt yields.

■ Uncertainty usually causes a shift out of riskier assets and into safer ones such as gilts.

Would Brexit mean higher gilt yields? The Bank of England fears it might. Its Financial Policy Committee has warned that "heightened and prolonged uncertainty has the potential to increase the risk premia investors require on a wider range of UK assets". This, it said, could "affect the cost and availability of financing for a broad range of UK borrowers".

The thinking here is straightforward. The UK has a record current account deficit, of 7 per cent of GDP in the fourth quarter. This means we need to attract big capital inflows. Anything that spooks global investors – such as uncertainty arising from Brexit – might reduce their willingness to buy UK assets such as gilts. This would cut their prices and raise yields.

Such unwillingness to buy UK assets would also depress sterling: Angus Armstrong and Jonathan Portes at The National Institute of Economic and Social Research (NIESR) say this could cause a "sharp fall" in the pound, which would raise inflation. This, too, would raise borrowing costs.

In fact, the impact on borrowing costs might be more direct than this. Some banks have been considering building ‘flexit’ conditions into corporate loans, which would automatically raise rates in the event of Brexit.

However, while almost all economists agree that Brexit would indeed increase short-term uncertainty and cut the prices of risky assets such as equities and lower-grade corporate bonds, it's not so clear that this would raise gilt yields. There are five offsetting mechanisms.

■ Uncertainty usually causes a shift out of riskier assets and into safer ones such as gilts.

■ If short-term uncertainty looks like harming growth - as even some Brexit supporters such as Andrew Lilico concede - the Bank of England might cut Bank Rate or resume quantitative easing to support the economy. That would reduce yields.

■ Brexit's opponents such as the OECD, Treasury, NIESR and economists at the LSE argue that Brexit would depress growth – in the long term by reducing trade with the EU and in the short term because uncertainty reduces capital spending. Lower economic growth should mean lower gilt yields.

■ Brexit might lead to lower prices in the long run if it allows the UK to cut tariffs. Patrick Minford at Cardiff University Business School says this could reduce consumer prices by 8 per cent. Lower inflation (than would otherwise be the case) should be good for nominal gilt yields.

■ If sterling falls sufficiently far, investors might hold on to gilts in the belief that there is no further exchange rate risk; if sterling's so cheap that investors expect it to rise, yields on gilts should actually be lower than those on overseas bonds.

In theory, therefore, the impact of Brexit on gilt yields is ambiguous. But we don’t just have theory. We also have facts. And these suggest that gilts wouldn’t suffer in the event of Brexit.

There’s a testable hypothesis here. If Brexit is bad for gilts, we should have seen the spread between five-year gilt yields and their German equivalents rise when expectations of Brexit rose, and to have fallen when those expectations receded. Three things tell us that this has not happened.

First, sterling fell sharply in late February, a move attributed to heightened expectations of Brexit. But the gilt-Bund spread was stable then at just over 1.2 percentage points. Secondly, between late March and late April, the chances of Brexit declined; the odds against it rose from 7/4 to 12/5 at Bet365. If Brexit is bad for gilts this should have narrowed the gilt-Bund spread. In fact, it widened.

Thirdly, since late April the odds on Brexit have narrowed, from 12/5 to 9/4. However, the gilt-Bund spread has also narrowed since then.

These facts don’t rule out the possibility that Brexit would raise gilt yields. But they do tell us that, if this happens, it would represent a marked change in investors’ behaviour from what we’ve seen recently. CD