Brexit? Don’t leave us this way
On 23 June, the UK will hold its long-awaited referendum for voters to determine whether to remain in, or leave the European Union. Although the run-up to the event has been long and dragging, very crucial questions regarding possible outcomes, consequential scenarios and market reactions have only come to the fore in recent weeks. In this note, we summarise what we think are the most important facts and figures surrounding the event.
Unfortunately, we cannot forecast the vote outcome with any degree of certainty. Until recently, opinion polls and bookmaker odds saw the “Remain” camp in a more or less clear lead over the “Leave” one. However, in recent days, the odds have swung significantly in favour of „Leave“. In addition, both bookmaker odds and opinion polls have proven to be unreliable forecasters in UK elections and the Scottish referendum, so it would seem unwise to rely on them. Given the recent swings in public opinion and the narrow margin between the support of the two campaigns, we believe that the outcome of the referendum is too close to call.
To that extent, a Brexit is a very real threat, and thus, we look at some crucial what-if questions in a macroeconomic context. Since there is no precedent for an EU exit, forecasts are hard to make, but building scenarios based on plausible assumptions should help find some guidance for the time after the referendum.
1.How did we get here?
The British government’s decisions leading to the referendum this month have been received with much head-shaking on the continent and abroad. However, EU membership was always more controversial in the UK than in most other member countries. The delay with which the UK joined the EEC in 1973, 16 years after the Treaty of Rome was signed, is early evidence of this. In June 1975, the first EU referendum in the UK had 67% of people approving the decision to join. Since then, however, the domestic debate about the advantageousness of British EU membership has cost many political lives, and is dividing the UK electorate into two camps of almost equal size.
Persistent pressure on UK governments to justify EU membership to a sceptical public has contributed to the special treatment and the special role the country has in the EU today. It goes beyond the UK rebate negotiated by Margarete Thatcher in 1984 which reduces its contribution to the EU budget, beyond the EMU opt-out clause and the exceptions from and modifications of EU law David Cameron negotiated for the UK earlier this year in preparation of the referendum. Economic arguments are, however, not the focus of today’s referendum debate. If they were, we’d feel comfortable to forecast the “Leave” campaign to lose.
However, the perception in large parts of the UK electorate that too much control has been transferred to Brussels, that EU-controlled migration is a threat to the UK, and that excessive and centralised regulation of many commercial and private activities hurts British interests is harder to fend off. Whether it is strong enough to make economic risks associated with BREXIT appear acceptable will determine the outcome of the vote.
2. What are the odds of BREXIT?
Two ways of gauging a tendency for the likely outcome are popular today: Opinion polls of various pollsters conducted mostly by telephone or online, and analysing the odds for “Leave” and “Remain” at large bookmakers.
As to the former, there is a long history of forecast errors and skewed predictions, depending among others on the polling technique (telephone vs online, for example). But still, the tendencies they display should not be ignored entirely. Bloomberg are calculating composite indices of UK referendum voter intention surveys that comprise all major pollsters. The crude indices are quite volatile, but illustrate how the “Leave” has surpassed “Remain” in recent days.
UK opinion polls: Bloomberg Composites of Voter Intentions
Source: Bloomberg, Oddo Meriten AM GmbH
The chart not only shows the current lead of the “Leave” camp, but also highlights that the margin between the two camps is much smaller than the share of undecided voters. And this is indeed confirmed by the individual polls entering the composite index which differ substantially. Hence, in our view the opinion polls do not allow for firm conclusions, but rather suggest that the race is entirely open. Swings in the last days before the referendum may push the result in either direction.
There are also model-based forecasts of the result available, eg, one published by Number Cruncher Politics (http://www.ncpolitics.uk), a non-partisan blog analysing the opinion polls and applying statistical methods in order to account for skews and distortions. As we go to press, its model-based analysis has also shifted substantially in favour of leave, suggesing only a 67% probability of a “Remain” vote, down from 76% one week earlier.
And finally, there is the bookmakers whose odds many consider to be more reliable forecasts than opinion polls or models because they reflect risks evaluated by “real money agents“. Bloomberg is calculating the average implied probability of Brexit from bookmaker quotes. In the latter part of May, they had shifted towards “Remain”, suggesting only a 20% probability of Brexit. But more recently, the implied probability of a “Leave” victory more than doubled to over 40%. This evolution is consistent with model-based predictions of the referendum outcome.
Implied BREXIT probability from bookmaker odds and effective GBP
Source: Bloomberg, Oddo Meriten AM GmbH
Bottom line is that virtually all statistical metrics suggest that the “Leave” campaign has caught up in recent days, but that the uncertainty associated with opinion polls and the volatility of model- or odds-based metrics is too large to assign any degree of certainty to their conclusions. In other words: The referendum is simply too close to call.
3. What would be the process if the British vote for exit?
This is a big known unknown, and up to potentially complicated political wrangling. International commentators often describe the process after a potential Brexit vote as one by which the UK would immediately dump EU membership. This is, however, not the case at all.
This first open question in a Brexit scenario is whether David Cameron who fought to stay in would remain Prime Minister. He has said he would. Whether he would be accepted by his own Tory party which is deeply split over the issue, is another matter though. And so is the question if he could confidently bank on a solid majority in the House of Commons, or if a successor would have to seek broader support. Finding a successor would almost certainly take several months during which no major steps would be taken in the process.
David Cameron has said he would invoke Article 50 of the Lisbon Treaty immediately after a potential Brexit vote. This would be the starting point for a two-year time window for negotiations with the EU regarding the exit arrangements. Several political experts question whether Mr Cameron would really take this route immediately. Specifically if the vote is tight and/or had a low turnout, he might first seek parliamentary consent as all legislation regarding the EU withdrawal must be passed by Westminster. To that end, the referendum is not binding as Parliament will have the final say. If the vote is narrow and broader consent cannot be achieved, it is conceivable that the UK will need to have new elections in due course, and possibly even another referendum to confirm the results.
Even in the event of a clear result in favour of UK withdrawal, and even if the government invokes Article 50 swiftly, we believe there would be an extended negotiation phase of certainly more than a year in which the EU Commission would not be easily persuaded to grant the UK full access to its domestic market, and certainly not unconditionally. At the end of such negotiations the UK government might well find arrangements that are economically very disadvantageous – and economic reality might already have deteriorated by then. If so, the government might see a need to return to its electorate and opt for another referendum to see if voters still prefer exit – on the unfavourable terms they are presented with.
In summary, not only the outcome of the referendum appears unpredictable, but also the process that would follow in the event of a Brexit vote. There is no doubt, however, that a prolonged transition period would be damaging for the UK economy, and possibly for its trading partners.
4. What would be economic consequences of BREXIT?
A mountain of analyses has been published by international organisations, HM Treasury and bank economists on the economic impact of the UK leaving the EU. Most are focusing on the consequences for the UK, and most distinguish variants of the possible scenarios laid out in the Treasury analysis, broadly along these lines:
You will note that we shy away from putting numbers next to our freely formulated scenarios, neither on their probabilities, nor on the size of the expected economic effect. HM Treasury has done this for representations of the three exit scenarios we described above:
Source: HM Treasury analysis: the long-term economic impact of EU membership and the alternatives, April 2016
Unsurprisingly, the study concludes that the loss of trade linkages, tax receipts and other adverse effects would lead to a persistent aggregate income loss for the UK. Although we would point out that HM Treasury is not a neutral participant in the debate, and that the models applied could be criticised, we have no better or more reliable data available. We would also suggest that the results of the study are plausible insofar as they show a negative effect for every exit scenario, and the most dramatic one for the one we labelled “Cut-off exit”. To this end, we believe they may well serve as orientation for the economic consequences of a potential Brexit vote for the UK itself.
There are fewer analyses and certainly less dramatic direct economic consequences for the EU were Britain to leave. Rather, we believe the political damage would be more important as disintegration might spread also to other regions and possibly countries of the union. These are, however, impossible to foresee in detail.
Sticking with the economic fall-out, EU repercussions should be felt primarily in trade with the UK. The chart below provides an overview of the sensitivity of EU trade with the UK:
Source: Macrobond (IMF DOTS), Oddo Meriten AM GmbH
Unsurprisingly, the geographically closest and most open EU economies would be hit hardest if trade with the UK deteriorated post Brexit. In terms of the share of exports to the UK in total exports, Ireland stands out. However, for the cyclical effect of potential Brexit, the sensitivity of overall GDP growth is important. In this metric, Belgium, Ireland and the Netherlands are most vulnerable, but even for them, a slight deterioration of UK exports should be manageable. For the average of EU countries shown in the chart above, the proportion of UK exports to GDP is less than 2.5%. To this end, the effect of Brexit on foreign trade alone will not derail the EU business cycle.
A second economic theme to be potentially considered is the labour market, assuming that the freedom of movement between the EU and the UK is not, at least not fully, maintained in a bilateral agreement after a potential Brexit vote. Given that EEA rules and even the EU’s agreement with Switzerland incorporate free movement, this would probably only be the case in the absence of any formal bilateral trade agreement post Brexit, ie, in the cut-off scenario described above.
There is hardly any dispute among economists that migration, which is promoted by the EU freedom of movement rules, is a gain for any participating economy as it helps to balance demand and supply in an integrated labour market. The UK is traditionally an immigration country and has experienced a substantial immigration boost from CEE countries as a consequence of the EU enlargement in 2004. This is the background to concern about an over-burdening of infrastructure and social systems which is a dominant theme in the “Leave” campaign. Economically speaking, however, the net immigration into the UK almost certainly has net positive effects, and to this end, restrictions to immigration would almost certainly have negative ones.
A third bigger issue that has been discussed in the context of the UK referendum is financial market regulation which is important due to the weight of financial services in overall value-added and employment. One general argument of the Leave campaign is that over-regulation from Brussels is holding back progress in the UK. As to the banking sector, there are specific fears that banking union and bank supervision, orchestrated by the ECB, might disadvantage the UK as a euro-out.
The counter-argument of the Remainers is that outside the EU, the UK would still have to accept many of the EU regulations (which are mostly part of global arrangements anyway) if it wanted to do business on the continent, but would lose its influence on the legislative process. To follow this line of argument, financial institutions operating in and out of the UK might well feel some long-term disadvantages from Brexit, and possibly reconsider their business model location, but the macroeconomic impact of Brexit through this channel is very hard to gauge
There are many more issues to be considered, and the ones touched upon in this note can be discussed in much greater depth. Indeed, the complexity of the process that would follow a Leave vote in the UK referendum on 23 June cannot be over-estimated. However, we feel comfortable to draw a crude bottom line here for a broad and general assessment of the likely macro impact of a potential UK withdrawal from the EU, and possible political knock-on effects.
5. Conclusions
For a long time, most commentators and analysts were convinced that the UK electorate will make a last moment shift to preserve the status quo and keep the UK in the European Union. Latest opinion polls do, however, suggest a tight race and the possibility of a Brexit has become very real. Effectively, it is impossible to predict the outcome of the EU referendum in the UK on 23 June, and hence we feel a need to carefully consider the consequences of a potential Brexit vote.
A Brexit result of the referendum would be followed by a lengthy period of negotiations about the terms of the withdrawal, and about the shape of the relationship between the EU and the UK in the future, in the fields of trade, regulation, freedom of movement and other things that so far have been regulated by harmonised EU rules. During these negotiations, companies would probably hold back investment in the UK, cross-border trade might slow and sterling would probably devalue, although we believe the ECB and the Bank of England would try to moderate any short-term disruptions and provide liquidity to financial markets. All in all, there is little doubt that the UK economy would already be adversely affected in the transition phase, and certainly after the effective withdrawal from the EU. The size of the damage is, however, hard to gauge and we would take the model results of HM Treasury’s research note only as a rough guide.
Economic effects on the remaining EU countries are less clear and should be more limited. Surely countries with strong UK trade relations would feel adverse effects, but others might benefit from Brexit if competitors in the UK are disadvantaged by less favourable trade arrangements and a possible introduction of tariffs. All in all, we believe that the business cycle in the remaining EU countries will barely be disrupted, but certain sectors of the economy and specific companies with UK trade relations may still be hit.
Finally, as we consider the referendum outcome to be unpredictable, our investment conclusions and advice would be to exert extreme caution ahead of the event. It would be very risky to place large bet on either the pro or the con side, and we look for heightened uncertainty and thus market volatility in the immediate run-up to the referendum, accompanied potentially by deteriorating liquidity.
This pattern would almost certainly improve and give way to relief in the event of a clear victory of the “Remain” camp. On the other hand, our sense is that the market is still not fully prepared for a potential Brexit and would thus be shocked by a decision of UK voters to withdraw. This risk is simply too large to justify strong positioning in the run-up to the Referendum.
Authors:
Laurent Denize – Global Co-CIO, Oddo Meriten AM
Holger Fahrinkrug – Chief Economist, Oddo Meriten Am GmbH