How would a Brexit impact the markets?

Britain’s decades-long debate about whether it’s better off leaving the European Union will be put to the test in a referendum sometime before the end of 2017.

For the majority of businesses in Britain, a “Brexit” scenario has very real implications on trade, jobs and regulations. For the financial markets, the direct impact could be even more significant – at least initially.

Brexit could trigger “economic and financial shock”

A UK vote to leave the European Union could trigger an immediate recession, according to analysts at Credit Suisse.

“If the UK votes to leave the EU, it is likely to entail an immediate and simultaneous economic and financial shock for the UK.

We can expect a drop in business investment, hiring and confidence. A sudden stop of capital flowing into the UK could make the large current account deficit difficult to sustain and lead to a sharp fall in sterling,” write bank research analysts Sonali Punhani and Neville Hill.

They added, “In its most extreme that could mean a level drop in GDP of 1% to 2% in the short term due to the toxic blend of depressed business confidence, tightening financial conditions, higher inflation and falling real incomes. In the medium term, we expect it to be negative for UK demand and supply, implying a weaker GDP growth path.”

Anybody monitoring the UK recovery knows this means trouble, as the country has fought hard to regain its footing in the aftermath of the financial crisis.

While the UK economy has returned to pre-crisis levels, growth hasn’t been strong enough to warrant an interest rate increase.

In fact, interest rates went unchanged for the entire duration of the Conservative government’s first term in parliament. That hasn’t happened since 1945-1950.

What’s more, Credit Suisse isn’t the only institution to believe that Brexit would harm the UK economy and financial system.

The vast majority of economists feel the same, according to an annual Financial Times poll of more than 100 top thinkers.

Fear of uncertainty

Perhaps the most immediate consequence of Brexit on the financial system is uncertainty. As we’ve seen repeatedly throughout history, uncertainty and investingdon’t go hand-in-hand.

Not only could this trigger a sharp decline in equity prices, but lead to a major slowdown in business investment and household spending. The long-term consequences on growth could be catastrophic.

Foreign companies looking to set up shop in Europe would also find it equally challenging to invest in Britain.

After all, the uncertainty wouldn’t end with the actual Brexit, but continue long after Britain’s newfound sovereignty.

For example, what model would the UK adopt in withdrawing from the EU? Would it follow the Norway model, where not much would change, or make a bigger break a la Switzerland?

How about a custom union, as adopted by Turkey? If you think investors are going to sit around waiting for this to play out, think again. This transition phase might have dire consequences on the UK economy.

According to London-based strategic advisory firm Global Counsel, the impact of Brexit on the financial markets might play out over a ten-year period as all the complexities are sorted out.

Impact on Sterling

Brexit could lead to a sharp fall in pound sterling as a result of drying capital flows into the UK, making the country’s large current account deficit difficult to manage.

A weaker pound would lead to higher inflation, placing more pressure on households and depressing consumer spending. This could reduce appetite not just for the pound, but pound-denominated assets.

How this will play out in the broader currency markets is less clear, although an event as big as Brexit could lead to an increase in pound speculation, resulting in a stronger US dollar.

The pound-dollar exchange rate is given an 11.9% weighted geometric mean in the US dollar index. In the event of a Brexit, the dollar index would most likely rise.

The political consequences of Brexit could also pressure the neighbouring euro, as the prospect of further EU disintegration may surely weigh on the common currency (for a reminder of what could happen, go back and study the impact of the Greek debt crisis on the euro).

Contagion? 

It’s unclear whether the European Union could survive Brexit. The latest round of Greek debt talks shook the foundation of the politico-economic union, not to mention the Eurozone.

Unlike Greece, which is considered a “peripheral” nation due to its smaller output, Britain is the region’s second biggest economy.

A fallout could not only impact the European Union economy, but potentially lead to contagion. If Britain left, other countries may want to follow suit, especially those wishing to curtail the influx of Syrian refugees (after all, one of the biggest motivations for Brexit is demand on immigration).

Assessing the benefits

If you think the Brexit argument is decidedly lopsided, you wouldn’t be alone. After all, only 8% of economists polled by the Financial Times believe

Brexit would strengthen the UK’s economic prospects. However, there are several strong arguments in favour of leaving. Most of these arguments capture Britain’s growing frustration with the EU project.

Back in November Prime Minister David Cameron set out four key objectives for renegotiating Britain’s membership of the EU.

The first objective is assurance that the UK is not compelled to offer bailouts to Eurozone countries and that it isn’t disadvantaged by being outside the single currency.

Cameron is also demanding increased sovereignty on important issues such as banking regulation and immigration. These issues are top of mind for British voters, who may not have a problem with economic integration per se, but are generally against labour mobility.

Brexit would ensure that EU migrants can’t access certain benefits unless they’ve been in the UK for at least four years.

Additionally, the direct and indirect costs of UK membership of the EU is estimated to be as high as 11% of GDP. That’s 11% of $2.8 trillion. Many argue that money could be better spent elsewhere.

The extent to which key UK industries would be affected by Brexit is subject to debate, but given Britain’s comparative advantage in finance, London is unlikely to see a mass exodus of banks and investment services.

As one top UK executive put it, “The Germans make cars and we do finance. Are asset managers going to up sticks and move to Frankfurt just because we are not part of the EU?”

Other analysts say that large multinationals, especially in the pharmaceutical industry, are unlikely to be affected.

One industry that could face challenges is manufacturing, but at just 11% of GDP, is unlikely to cause widespread economic casualties.

After all, the UK economy is still growing despite a deepening manufacturing recession.

Contentious debate to rage on

According to The Telegraph’s referendum poll tracker, 51% of Britons are in favour of remaining in the European Union.

The figure was as high as 55% at the end of last year. While no official date has been set for the Brexit vote, it’s becoming increasingly likely that the referendum will be held in the summer of 2016.

Letting it drag on longer than that could have adverse effects on the financial markets, which will no doubt be impacted by speculation about the outcome of the vote.

Whichever way the vote goes, Brexit matters a great deal, perhaps even more than a rise in oil prices or upward movement in US interest rates.

David Coombs, head of multi-asset investment at Rathbones Unit Trust Managers, summarizes this point very succinctly:

“The reason this is so important, is that while Brexit is unique to the UK, the contagion risk is high. Where the UK leads, the Poles or the Dutch may follow.”

With Euroscepticism rising throughout Europe, Brexit may cause much more than a disruption, but embolden nationalist movements throughout the continent.

These forces appear eager to get the ball rolling on an EU exit, or at least renegotiate important terms such as immigration.

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Nicolas Shamtanis is responsible for overseeing customer support and customer relationship departments at easyMarkets