Brexit: Breaking up is never easy, or cheap

•    The EU referendum is the key risk event facing the UK in 2016. Our base-case scenario is that the referendum will be held in June 2016 and the UK will vote to stay in the European Union.
•    The increased uncertainty around the referendum is likely to cause financial and economic volatility and negatively impact growth in the short term. Consequently, the timing and path of rate hikes may also get affected. However the impact is expected to be relatively muted if the UK votes to stay.
•    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. In its most extreme that could mean a level drop in GDP of 1%-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.
•    FX Strategy: Our FX forecasts should be seen as a probability-weighted expected move using roughly a 60:40 probability of staying in/leaving the EU. If the UK were to vote to leave, we would expect EURGBP to push on towards 0.83, its average level since 2009. This leaves room for GBPUSD to trade towards 1.20 if EURUSD pushes lower towards parity as we expect. Conversely, if Brexit is rejected, we would expect EURGBP to be around 0.70 in 12 months’ time, with GBPUSD well above 1.40.
•    Rates Strategy: We believe it makes sense to be long gilts on cross-market basis and we favour GBP 10s30s steepeners into the referendum. Should the UK vote to leave, we expect a bull steepening of GBP 2s10s.
•    ABS Strategy: We expect (i) structurally wider spreads, with the RMBS market underperforming both government and covered bonds, (ii) foreign-currency issuance to dry up. For investors concerned about the outcome, it makes sense to either reduce risk early, or to hedge via other, more liquid asset classes, that are likely to reprice sooner.
•    Equity Strategy: We continue to recommend buying UK-listed euro earners; remain cautious of UK domestic cyclicals (especially UK office REITs and London-focused housebuilders); be long the FTSE 100 versus FTSE 250, and we highlight a group of stocks we think could be negatively impacted. From a regional allocation perspective, we have not changed our benchmark recommendation on UK equities: with only 21% of earnings from the UK, weaker sterling would, we think, offset the higher discount rate placed on UK-related earning streams.

Credit Suisse
Global Markets Research