Brexit: Can the UK afford to leave the EU?

Brexit: Can the UK afford to leave the EU?

After months of debate, the Brexit referendum is fast approaching. With less than two weeks to go, several contentious points have been made by both the Leave and Remain camps and the outcome hangs in the balance.

For investors, the focus should be on the main vulnerabilities of the UK economy, in particular its twin deficits, with the country heavily reliant on trade and foreign capital flows.

If the UK decides to leave the EU, uncertainty is likely to persist, although the Bank of England and currency depreciation could cushion the initial blow to the domestic economy. However, there is scope for Gilt yields to rise as non-resident investors switch to other more stable alternatives.

DIERK BRANDENBURG is a Senior Sovereign Analyst at Fidelity. Dierk joined Fidelity in 2003 as a senior credit analyst and currently leads the financial team in the fixed income division.

Prior to joining Fidelity, he held the role of Deputy Head of Credit at the Bank of International Settlements.

 

ANDREA IANNELLI is an Investment Director at Fidelity. Andrea joined Fidelity in 2015, and represents the Fidelity fixed income investment team to institutional and wholesale clients in Southern Europe and Latin America.

 

The odds: Brexit unlikely, but possible

In less than two weeks, British citizens will go to the polls to decide whether the UK should remain a member of the European Union, or leave instead. After a heated public debate, polls remain tight (Chart 1), with a significant part of the electorate still undecided. The outcome could swing in either direction on polling day with the turnout of younger voters potentially proving decisive.

Despite the tight opinion polls, financial markets have remained surprisingly sanguine on Brexit risks, mainly because polls have proven to be unreliable in the recent past, and are likely to be even more so in this occasion, given the unique nature of the EU referendum.

Historical experience suggests a bias towards the status quo in the final vote. Other barometers, such as spread-betting odds and currency exchange rates indicate that a Remain vote is still the most likely outcome, although the latest public debates have prompted a sudden increase in the support for a Brexit vote. (Chart 2).

Chart 1: Polls indicate that it will be a very close call …

*All expressing an opinion. Source: Fidelity International, Wikipedia, 13 June 2016.

Chart 2: …while the odds suggest Brexit is unlikely, but possible

Source: Fidelity International, Bloomberg, 13 June 2016.

Political risk will stay elevated post polling day

Political uncertainty is likely to stay elevated over the summer, unless an overwhelming majority votes against leaving the EU. The referendum debate has amplified large divisions within the two main political parties that are unlikely to go away and which threaten the survival of the current government. Moreover, in case of a low-margin victory by the Leave camp, there is a risk of a constitutional crisis, as it is not clear how Parliament would vote given that crucial details are missing on the future trade regime with the EU. This issue of EU trade has been inextricably linked to the issue of free movement of people by the Leave campaign.

Migration requires better management of welfare benefits

Though not formally part of the referendum, migration has emerged as the most divisive issue. From an investment perspective, immigration has allowed the UK economy to grow above its trend growth rate since the financial crisis, despite stagnating productivity. It allowed the labour force to grow (Chart 3) without inflationary pressures despite low unemployment and a high participation rate (Chart 4). Any radical shift in UK immigration policy would have the effect of reducing potential growth of the economy.

On balance, immigrants tend to contribute more to the economy than they take out. The latest statistics show that immigration has been a net positive for the government’s budget and for the UK corporate sector. The average age of migrants coming to the UK is low and immigrants tend to have few old-age dependants. While there is an upfront cost, migrants will not add to the public pension burden for a long time, if at all. Moreover, European migrants tend to be well educated and healthy, providing an additional source of skilled labour to UK employers without weighing on the National Health Service.

Migration is a secular trend driven by demographics and wealth gaps that will persist for many years to come. We expect that many richer EU countries will be restricting cash benefits for new arrivals over the coming years, exactly as agreed with the UK in its membership renegotiation earlier this year with regards to the UK’s four-year ban on in-work benefits for new arrivals.

Chart 3: Contribution to labour force growth evenly split between UK and non-UK born workers

Source: Fidelity International, Haver, 9 June 2016.

Chart 4: UK unemployment back to pre-recession levels

Source: Fidelity International, Haver, 9 June 2016.

Twin deficits: Can the UK afford to leave?

A lot has been said about the likely negative long-term impact of a Brexit on the UK economy. While some may consider the analysis biased, it is difficult to explain an economic model that says leaving the world’s largest free trade area would promote long-term growth in the UK. So the long-term economic risks of a Brexit are likely to be negative, although it is difficult to estimate longer-term impacts under either scenario, especially where a lot would depend on policy decisions later on.

In the short term, a Brexit vote is likely to focus the market’s attention on the UK’s existing macroeconomic imbalances, notably the twin deficits in the government’s budget balance and the nation’s current account.

In the last fiscal year 2015/16, the UK cut its deficit by GBP 16bn to 4% of GDP, and the government plans a further improvement in the deficit to GBP 56bn, or less than 3% of GDP, for the current fiscal year. This would bring the country back in line with the EU’s Maastricht criteria.

Given that the economy is close to full employment, one has to assume that the deficit is by and large structural at this point making it already politically very difficult to reduce. Any Brexit-induced weakness to growth and employment would lead to fiscal deterioration and make it even harder to cut expenses or raise taxes.

A wider than planned budget deficit would, in turn, increase the Public Sector Net Borrowing Requirement (the amount of expenditures less the total receipts taken in by the government), and require higher Gilts issuance (Chart 5). Not surprisingly, with a debt/GDP ratio that is already above 80%, the rating agencies see the referendum as the key risk to their sovereign ratings. S&P, for example, has already said it would downgrade its AAA rating on the UK after a Brexit vote. It is likely that other agencies would follow a similar path, though Moody’s and Fitch already rate the country a notch lower at Aa1 and AA+, respectively.

Pressure on the credit standard of the sovereign is of particular relevance in the context of a potential Brexit vote, as foreign investors play a key role in the Gilt market (Chart 6), holding more than 30% of the free float (after adjusting for the Bank of England’s QE holdings). In the event of a loss of confidence, because of a Leave vote or due to domestic political uncertainty in case of a close Remain vote, investors would demand a higher risk premium on UK assets, including Gilts. This effect could lead to a deterioration in the UK’s financial conditions and reduce growth prospects further.

Chart 5: Public Sector Net Borrowing set to increase, requiring additional Gilts issuance

Source: Fidelity International, Haver, 9 June 2016.

Chart 6: Foreign investors play an important role in the Gilts market and in financing the government budget deficit

Source: Fidelity International, Haver, 9 June 2016.

Current account mirrors domestic imbalances

The public sector deficit finds its mirror image in the current account because the domestic savings rate is low and private consumption is growing strongly. As result, the UK reported a trade deficit of GBP 37bn in 2015 and a current account deficit of GBP 96bn, or 5% of GDP, which is the largest in the G7 (Chart 7).

While these deficits are backed by sizeable stocks of foreign assets, the outflows in the current account need to be financed through corresponding capital inflows, including foreign direct investment (FDI) or Gilt sales to foreign investors. This leaves the UK reliant on the “kindness of strangers”, as stated by BoE Governor Mark Carney earlier this year.

FDI in particular has played an important part in financing the current account deficit (Chart 8), and would be impacted by a Brexit vote for as long as there is uncertainty around the UK’s trade relationship with the EU. Moreover, given the UK’s traditional strength in services, any restrictions on EU ‘passporting’, especially in financial services, could make the trade deficit worse.

Chart 7: UK current account deficit is the largest in the G7

Source: Fidelity International, Haver, 9 June 2016.

Chart 8: FDI has played an important part in financing the current account deficit

Source: Fidelity International, Haver, 9 June 2016.

The currency would be in the crosshairs

In the event of a Brexit vote, the internal and external imbalances of the UK economy would put immediate downward pressure on the exchange rate as investors anticipate wider fiscal and trade deficits in the short-term. This already happened in March after the referendum was announced and the currency traded well below its interest parity (Chart 9). It could easily repeat in case of Brexit, possibly with a larger political risk premium.

Global central banks are likely to intervene to ease financial conditions and curb FX volatility in the event of a Brexit vote, cushioning sterling somewhat. This would provide the Bank of England with much-needed room to cut rates, supporting domestic demand in response to the slowdown in economic activity that is likely to follow.

While an argument can be made that the BoE might be forced to raise rates to control the currency and inflation, we regard it as highly unlikely that the Bank would increase rates in a Brexit scenario.

The market is already pricing in the possibility of further easing by the Bank of England, with a 40% probability of a rate cut by the end of 2016. In the face of further softening of macro data, the front end of the Gilts curve would remain well supported.

Should the UK vote to remain in the EU, interest rate cut expectations would be quickly pared back, putting upward pressure on front-end yields. Monetary policy from then on would be dependent on both UK economic data and political uncertainty. While the former is likely to rebound as consumers and corporates re-engage in spending after a referendum-induced hiatus, political uncertainty is likely to persist in case of a tight referendum outcome.

Chart 9: GBP/USD vs. 3 month interest rate differentials

Source: Fidelity International, Bloomberg, 13 June 2016

Chart 10: GBPUSD volatility has increased in the run up to the referendum

Source: Fidelity International, Bloomberg, 13 June 2016

A steepening of the curve is likely in the event of Brexit

Gilts have rallied sharply since the beginning of the year, as both UK and global data releases point towards low growth and low inflation. With global central banks striving to keep monetary policy accommodative, pushing deposit rates further into negative territory and engaging in asset purchases, global government bond yields have been firmly on a downward trend (Chart 11). Moreover, yield curves have flattened considerably thanks to the strong demand for longer duration assets from investors in search for yield.

While the initial reaction to a Brexit vote could see Gilts rally as risk-aversion rises and the market seeks shelter in government bonds, the longer term implications for long-end Gilts are less obvious. The 10-year sector in particular would face the added headwind of a higher risk premium, with yields rising and the curve steepening as a result. Foreign investors would play a major role, given their significant share of the stock outstanding Gilts that they hold.

Foreign participation in the market has been subdued so far this year compared with 2015, with the domestic investor base driving the majority of the flow. It could rise, however, as investors reassess the fair level of risk premium on UK assets. Given that 10-year US Treasuries already offer a higher yield than 10-year Gilts and the currency across the pond looking more stable, this could be an easy choice for them to make.

The probability of an extreme outcome is limited, however, as the Bank of England would not stand idle, with the potential reopening of the QE programme should yields rise excessively, tightening financial conditions.

Domestic institutional investors would be happy to take advantage of any meaningful sell-off to add to their Gilts exposure in view of slower growth ahead, although they are more likely to focus on the very long end of the curve (30-year+), traditionally a liquid source of duration for liability-driven investment purposes.

Chart 11: Government bond yields on a downward trend

Source: Fidelity International, Bloomberg, 9 June 2016

Chart 12: UK gilts curve flattened considerably in light of weaker data

Source: Fidelity International, Bloomberg, 9 June 2016

Conclusion

With only a few days until the EU referendum and a still very uncertain outcome, investors should focus on the UK’s twin deficit as the reliance on foreign capital flows represents a key vulnerability.

While the Bank of England and the currency would provide support to the economy should the country decide to leave the EU, there is scope for Gilt yields to rise, and for the yield curve to steepen, as uncertainty is likely to persist and non-resident investors would switch to other more stable alternatives.

It is important to note that the outcome of the EU referendum, while important, will not be the only driver of UK government bonds. Politics will take centre stage outside the UK, with the US Presidential elections in November a key event on the horizon that could push volatility higher.

On the macro front, the still-challenging economic backdrop will continue to push central bankers to test the limits of monetary policy, keeping yields low and driving bond prices higher in spite of what standard economic theory might suggest.


You may also be interested in