Europe: The Final Countdown

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On Thursday 23rd June, the British electorate will hold arguably the most important vote in a generation, with the result of the UK referendum on EU membership due to be announced on Friday.

The latest opinion polls have the remain camp slightly ahead and bookmakers attribute a 75% probability of the UK voting to stay in the EU. But caution is warranted as opinion polls have swung back and forth in recent weeks. Turnout, and therefore the weather, may be a critical factor with a high turnout likely to favour the leave vote.

I am nevertheless sticking to my long-held view that the British electorate will vote for continuity and for the UK remain in the EU.

The popular assumption is that after the referendum UK markets and global risk appetite will move in clear directions. This belief is likely to be tested, particularly if the British electorate votes in favour of brexit as the government is not legally bound to the referendum result.

Specifically, the consensus expectation – which I share to a degree – is that if the UK votes to remain in the EU, sterling, UK equities and to an extent the euro and global equities will rally sharply. But this rally could start to fade after a few days, with “business-as-usual” resuming.

Conversely, the over-riding view is that sterling and global risk appetite will weaken, potentially very sharply, in the days following a vote for the UK to leave the EU.

Importantly I see six potential sources of uncertainty and a number of possible scenarios (see Figure 6), particularly if the leave camp wins by only a very narrow margin and/or turnout is low.  Market volatility could thus persist for weeks and potentially months, keeping sterling and UK equities on the back foot:

  1. Prime Minister Cameron’s future;
  2. The risk of the British government ignoring the referendum result;
  3. The risk of the British parliament ignoring the referendum vote, the government re-negotiating a deal on the UK’s membership to the EU and holding another referendum;
  4. The risk of a second Scottish independence referendum;
  5. The risk of a protracted UK exit from the EU leaving the door open to a decision reversal; and
  6. The re-negotiation of new trade treaties.

48 hours until the most important British vote in a generation…and still much uncertainty

In two days time, on Thursday 23rd June, the UK will hold its long-awaited referendum on European Union membership – arguably the British electorate’s most important vote in a generation. No member state has ever left the EU[1] and the UK has only ever held two UK-wide referendums and therefore there is limited precedent to rely on.

The House of Commons expects individual and regional counting areas to announce results early Friday morning and the official national referendum result to be announced later in the day (see Figure 1). If either the remain or the leave vote are significantly ahead when counting begins, it may become obvious as early as Friday morning who has won the referendum vote (even if the official count is only announced hours later). It is a simple majority vote and there is no minimum turnout required for the referendum to be valid.

Olivier Desbarres Referendum Scenarios image 1

The latest opinion polls have the remain camp slightly ahead, driving yesterday’s 2.5% bounce in sterling’s nominal effective exchange rate (NEER) and 3% rally in the FTSE-100 (see Figure 2). Bookmakers’ latest prices attribute a 75% probability of the UK voting to stay in the EU. But caution is warranted.

 

British weather could impact turnout and referendum outcome

Opinion polls have gyrated back and forth in recent weeks, contributing to both sterling and equity market volatility. Polls conducted by phone have the remain camp ahead but on-line polls have the remain and leave camps broadly neck and neck. Ultimately, a number of factors could swing the outcome either way.

Turnout, and therefore the weather, is likely to influence the referendum result, with most polling companies finding that a lower turnout on polling day would favour the leave campaign. One reason is that undecided voters, which account for 10-15% of all voters and are less likely to turn up on voting day, are more likely to vote in favour of remaining in the EU according to recent polls. Put differently, if the weather is nice, undecided voters would be more likely to show at voting stations, swinging the vote in favour of the remain camp. Conversely, if the weather is bad on Thursday undecided voters may stay at home, swinging the vote in favour of the leave camp.

Unfortunately, the weather forecast for Thursday is inconclusive. The Met Office is currently predicting “generally sunny spells and showers through the period. However, turning increasingly warm and humid in the southeast with heavy, perhaps thundery, downpours”.

I am nevertheless sticking to my long-held view that the British electorate will vote for continuity, as it did in the Scottish independence referendum in September 2014 and the UK general elections in May 2015 (What to expect in 2016 – same, same but worse, 19 January 2016).

The popular assumption is that once the referendum result is confirmed, most likely on Friday afternoon, this uncertainty will lift and UK markets and global risk appetite will move in clear directions. This belief is likely to be tested, particularly if the British electorate votes in favour of brexit.

 

If UK votes to stay in EU, sterling and equity rally…followed by “business-as-usual”

Specifically, the consensus expectation – which I share to a degree – is that if the UK votes to remain in the EU, sterling, UK equities and to an extent the euro and global equities will rally sharply – scenario 1 in Figure 6. Importantly, the British parliament will not have to vote on the referendum result in this scenario.

But this rally could start to fade after a few days, with “business-as-usual” resuming. If the remain camp win by only a  very narrow margin, the incumbent Conservative Party may pressure Prime Minister Cameron to resign and elect a new leader, at least temporarily denting UK currency and equity markets. In any case, markets will ultimately re-focus their attention on global data and events, including the forthcoming US Federal Reserve policy meeting on 27th July. Moreover, the UK will continue to face structural challenges, including a large current account deficit and low productivity growth, regardless of whether the UK remains an EU member.

 

If UK votes to leaves EU, cue acute uncertainty and market volatility

Conversely, the over-riding view – which even the leave camp accept – is that sterling and UK equities and to an extent the euro and global equities will weaken, potentially very sharply, in the days following a vote for the UK to leave the EU.

There is a faint silver lining, namely that the sterling NEER has already weakened 8.5% in the past seven months (see Figure 2) and this improved currency competitiveness has seemingly contributed to a recent rebound in UK exports (see Figure 3). But capital account outflows from the UK in the event of brexit would likely overwhelm in the near-term any narrowing of the still large UK current account deficit and see sterling weaken.

Olivier Desbarres Referendum Scenarios image 2and3

But unlike the relatively straightforward scenario in which the UK votes to stay in the EU, acute uncertainty and market volatility would likely persist for weeks and potentially months should the leave camp win this week’s referendum, particularly if it wins by only a very narrow margin and/or turnout is low. I highlight six potential sources of uncertainty, which open up a number of possible scenarios (summarised in Figure 6) and could keep sterling and UK equities on the back foot.

 

1. Prime Minister Cameron’s future

Prime Minister Cameron is likely to come under pressure to resign. If he stepped down, the incumbent party would have to elect a new leader, who would be prime minister until the next general elections scheduled for 2020.

 

2. Government ignores referendum result

The government could in theory chose to ignore the referendum result which is only advisory, not legally binding (scenario 3 in Figure 6). The UK Parliament website states that: “The national result, once declared, will be final but it is not legally binding. The European Referendum Act 2015 does not include provisions to implement the result of the referendum; legally, the Government is not bound to follow the outcome. However, it would be very unlikely for the Government to ignore the outcome of the referendum”.

Alternatively, the government could chose to ignore the referendum result but then try to re-negotiate a better EU membership deal for the UK before holding a second referendum on EU membership (scenario 4 in Figure 6).

These are admittedly low-probability events. There is no precedent for a UK government ignoring the peoples’ will as expressed in a referendum (see Figure 4) – doing so would arguably raise serious question about the British democratic process and set a dangerous precedent.

Olivier Desbarres Referendum Scenarios image 4

But again, the government may feel it is a risk worth taking. Moreover, the risk of early general elections would be small as it would require a two-thirds majority vote in the lower house of parliament or about 433 votes – about 120 votes more than the opposition currently enjoys (Conservative MPs would be unlikely to potentially vote themselves out of a job) and three times the number of seats currently held by pro-exit MPs (see Figure 5).

 

3. Parliament ignores referendum vote, re-negotiates UK deal and holds second referendum

In the more likely event of the British parliament holding a vote, it would be expected to vote in line with the referendum result (scenario 7 in Figure 6). After all members of parliament were elected to represent the people. Moreover, Prime Minister Cameron has described this week’s referendum as a once in a lifetime event, a “one-way ticket”, an “irreversible decision” and said there would be “no turning back” in the event of a leave vote.

But there is a non-zero probability of parliament voting against the will of the people. An estimated 478 members in the 650-seat lower house of parliament are reportedly in favour of the UK remaining in the EU versus only 145 in favour of Brexit and the remainder undecided (see Figure 5). And remember, the referendum result is not binding on parliament.

This could in turn open up a number of possible sub-scenarios and a period of acute uncertainty and market volatility.

 

A. A second parliamentary vote could be held (scenario 6 in Figure 6) within 21 days[2], with a House of Commons Library report pointing out that an infinite number of parliamentary votes could be held (scenario 5 in Figure 6).

B. The British government could use the referendum result as leverage to re-negotiate better terms and conditions for EU membership, eventually leading to a possible second referendum on EU membership. As the Financial Times highlights “There is a tradition of EU member states repeating referendums on EU-related matters until voters eventually vote the “right” way”.

C. Alternatively, members of parliament could force an early general election with a two-thirds vote. The BBC argues that “if the victorious party campaigned on a promise to keep the UK in the EU got elected, it could then claim that the election mandate topped the referendum one”.

 

4. Second Scottish independence referendum

In a scenario where parliament votes for the UK to leave the EU, Nicola Sturgeon, First Minister of Scotland, has argued that Scotland would push for a referendum on Scottish independence despite having lost such a referendum two years ago. All 54 Scottish National Party (SNP) MPs are reportedly in favour of Scotland staying in the EU (Figure 5).

Olivier Desbarres Referendum Scenarios image 5

 

5. Protracted UK exit from EU leaves door open to decision reversal

If the British parliament votes in favour of leaving the EU and invokes Article 50 of the Lisbon Treaty on the European Union, the UK’s exit procedure from the EU is in theory irreversible. The Treaty does not allow for a member state to turn negotiations on the terms and conditions of its exit from the EU into negotiations on a new membership deal. In theory, if that member state changed its mind it would once again have to go through the complex process of re-admission to the EU.

But in practise the UK would remain an EU member for up to two years or more, until the European Council voted (by a qualified majority) to approve the terms and conditions of the UK’s exit from the EU, as per Clause 3 of Article 50. Note that the European Council is extremely unlikely to vote differently than the British parliament.

It is therefore conceivable, on paper at least, that a pro-remain government could try during that two-year period to renegotiate a new EU deal and win a second referendum, particularly if it had some support from the EU itself (scenario 8 in Figure 6). Put differently, the UK will remain an EU member, regardless of how the electorate votes on the 23rd June, for potentially more than two years. This is a long time for a government and the European Union to consider their options.

 

6. Re-negotiation of new trade treaties

Assuming the British parliament votes in favour of the UK exiting the EU, the government will have to start the process of renegotiating its trade deal with the EU – a topic well covered by both the leave and remain camps and the press.

Olivier Desbarres Referendum Scenarios image 6a

 

Olivier Desbarres

Olivier Desbarres currently works as an independent commentator on G10 and Emerging Markets. He has over 15 years’ experience with two of the world’s largest investment banks as an emerging markets economist, rates and currency strategist.

 


[1] Greenland, part of the Danish Realm, voted to leave the EU’s predecessor, the European Economic Community (EEC), in 1985

[2] The Ponsonby rule on Treaties

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