UK referendum on EU membership – Darkness before dawn

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Negotiations over – One-and-done referendum set for 23rd June 2016

For the second time in just over a year the British electorate will take part in a key national vote, with Prime Minister David Cameron having confirmed a public referendum on 23rd June 2016 on whether the United Kingdom (UK) should remain a member of the European Union (EU). David Cameron announced last week that he had negotiated and agreed with the EU executive to improved terms and conditions for the UK’s EU membership in the key areas of migrant welfare payments, safeguards for Britain’s financial services and the UK’s independence from further EU integration and regulations.

Olivier desbarres UK referendum chart

Sterling’s nominal effective exchange rate (NEER) weakened sharply on Monday to a two-year low after London Mayor Boris Johnson formally announced on Sunday afternoon that he was joining the “leave” camp, also referred to as Brexit (see Figure 1). Sterling has weakened sharply versus both the euro and other major trading partner currencies since mid-November 2015 (see Figure 2). The FTSE 100 is up 2.3% so far this week, but it has been volatile in the past 6-7 sessions and is down 12.4% in the past year.

At the risk of stating the obvious, this latest price action highlights markets’ concerns about the impact of Brexit on the UK economy and currency and more generally the unwelcome uncertainty associated with this referendum, which has at least seven distinct layers (discussed in more detail below):

  1. How the electorate will vote;
  2. The (un)reliability of opinion polls;
  3. The lack of political unity;
  4. The lack of precedent;
  5. The lack of explicit contingency plans;
  6. Prime Minister Cameron’s future; and
  7. The possibility of another Scottish referendum

Olivier desbarres UK referendum chart

Uncertainty likely to keep sterling under pressure near-term

This uncertainty, coupled with the slowdown in UK GDP growth in 2015 and opaque outlook for the Bank of England’s interest rate policy, is likely to keep sterling under pressure near-term.

For starters, the lack of a clear macroeconomic and political outlook could dent investment flows into the UK required to finance a current account deficit which widened to about 4.7% of GDP in the four quarters to Q3 2015 (see Figure 3). Furthermore, it could cause households to delay or reduce their expenditure – a concern as household consumption, which rose 0.7% quarter-on-quarter in Q4 2015, is still the main driver of UK GDP growth which was yesterday confirmed at 0.5% qoq in Q4 (see Figure 4).

The difficult-to-quantify impact of Brexit on the UK economic landscape could also see domestic companies postponing planned investments until after the referendum, in turn putting pressure on economic growth. UK business confidence is already very fragile according to a number of recent indices and business investment contracted 2.1% qoq in Q4 2015 – the second largest quarterly contraction in seven years – which wiped out the growth in the previous two quarters (see Figure 5).

Olivier desbarres UK referendum chart

Scope for sterling appreciation under core scenario of UK remaining in EU

Any forecast of the referendum outcome remains at best tentative but I maintain my core scenario that Cameron will secure an “in” vote, premised on:

  • The greater domestic support for “in” camp from the political and business sphere, which will count when campaigning really intensifies in the weeks running up to the referendum. Also, while the Bank of England is theoretically meant to remain neutral, I see a greater chance of the BoE tacitly supporting the UK’s membership of the EU than its exit.
  • The UK’s electorate’s conservative nature. The “yes” vote in Scotland’s 2014 referendum on UK membership suggests the collective desire to be part of a union should not be under-estimated, while the incumbent Conservative Party’s convincing win in the May 2015 elections underlines the electorate’s affinity for continuity, rather than the unknown.
  • A rise in international support for the UK’s EU membership in the run-up to the referendum. The EU, which has been divided by the Greece and immigration crisis, could ill-afford to lose the EU’s second largest economy (after Germany) and a member since 1973. The fact EU leaders agreed to a new deal for the UK, however modest it may be, and were willing to set a precedent for other countries to also re-negotiate the terms and conditions of their membership, points to their desire to at least try to keep the UK in the EU, despite some of their public rhetoric.

Olivier desbarres UK referendum chart

In this scenario there would be scope for sterling to rally in the run-up and aftermath of the referendum. While there is no precedent for a country leaving the EU, the UK electorate has twice in the past 18 months voted in elections which could have significantly changed the UK political landscape and direction of economic policy: the Scottish referendum on 18th September 2014 and the general elections on 7th May 2015.

In the six months prior to both these votes, the sterling NEER followed a broadly similar path (see Figure 6). The currency was quite volatile in the fortnight up to the votes but in the seven trading sessions after the Scottish referendum and 2015 general elections the sterling NEER appreciated about 1% and 3%, respectively. The currency weakened nearly 2% after the 6th May 2010 elections which I would attribute to the election outcome – only the second hung parliament since World War Two – and associated uncertainty as to the composition of the likely coalition government.

Arguably the forthcoming referendum could more dramatically impact the UK landscape than either the Scottish referendum or the 2010 and 2015 elections and therefore I would expect even greater volatility in the run-up to 23rd June. At the same time, if the UK votes to stay in the EU there is greater scope for a sterling bounce in my view.

Moreover, the 9% collapse in the sterling NEER in the past three months and thus greater currency competitiveness should start feeding through positively to trade and current account data in coming months, although weak global demand is likely to dull any narrowing of the UK trade deficit. Finally, the depreciation in sterling should, all other things being equal, have an inflationary impact (as the sterling-cost of imports rises). With headline CPI-inflation still running near zero, inflation is very unlikely to become an issue any time soon. But even a modest inflationary impact from a weaker currency may be sufficient for the Bank of England to communicate a less dovish, if not more hawkish, policy stance.

1. Uncertainty – A Nation divided

The British electorate is divided as to it how will vote on the 23rd June. An average of six opinion polls since September shows that, amongst decided voters, support to remain within the EU has trended around 52.5%, versus 47.5% for Brexit. But with an estimated 20% of voters still undecided, the gap between the “in” and “out” camps in the polls is too narrow to predict with any great certainty the actual outcome of the vote. If the referendum outcome is simply too close to call (even after a recount) it would not be inconceivable that the referendum be re-run at a future date, despite the prime minister and chancellor’s claims of a once-in-a-lifetime vote[1].

In an opinion poll which I conducted on 8-11 July – well before Cameron officially started negotiations with EU leaders and announced a referendum date – the over-riding consensus amongst portfolio managers, analysts and finance specialists surveyed was that the UK would remain within the EU in years to come. Specifically, 87% of respondents with a view forecast the UK to still be an EU member in three years (see Survey: UK to stay in EU, Greece to stay in eurozone near-term, 14 July 2015).

The divided opinion on whether this new deal for the UK is good or bad is likely contributing to this split in the electorate, although recent opinion polls suggest the electorate is perhaps slowly warming to this new deal. According to the latest YouGov poll conducted on 22nd February, 26% thought it was a good deal and 35% thought it was a bad deal, versus respectively 22% and 46% in a poll conducted on 2nd February.

Importantly nearly four out of ten voters were still undecided, suggesting that how convincingly both camps make their case for and against this new deal in the next few months will be key (the government has to present its cost-benefit analysis of Brexit to the Treasury Select Committee by 25th May – see Figure 7). Furthermore, the legality of this new UK deal within the European Court may not be settled conclusively until the treaties are amended accordingly.

Olivier desbarres UK referendum chart2. Uncertainty – (un)reliability of opinion polls

The comprehensive victory of the Conservative Party in the UK general elections on 7th May 2015, despite opinion polls showing the Conservatives and Labour Party broadly neck-and-neck right up voting day, seriously undermined the reliability of opinion polls in helping to predict political outcomes in the UK (see Conservatives win landslide victory in UK elections, 8 May 2015). The post-mortem of why opinion polls failed to capture the strength of support for the ruling Conservative Party has revealed a number of flaws in polling methodology which over-estimated the support for the Labour Party.

These flaws, even if unrectified, may not be as damaging to the reliability of referendum opinion polls which in essence are far more straightforward than general election opinion polls. After all, those surveyed are being asked to provide a yes/in or no/out answer, rather than choosing among a myriad of political parties which in turn generates an almost infinite number of parliamentary outcomes.

Nevertheless, market participants are likely to take with a pinch of salt the results of opinion polls in the next four months, unless these polls point to a clear-cut outcome for the referendum – which is certainly not the case at present.

Betting firms arguably did a better job of predicting the results of the May elections than opinion polls so there is some value in tracking current pricing for the EU referendum. Paddy Powers currently offers odds of 1/3 for the UK to remain within the EU and 9/4 for the UK to exit the EU – pricing that clearly favours the odds of the UK staying rather than leaving the EU.

3. Uncertainty – Lack of political (and business) unity

It is unsettling for markets to face a divided political leadership on the issue of whether the UK should stay or leave the EU, particularly as the domestic outlook remains unclear and the global macroeconomic picture is far from bright.

Prime Minister Cameron has made clear his preference for the UK to remain within the EU and he enjoys the support of a majority of his cabinet members and leaders of the main opposition parties, including Labour, the Liberal Democrats, the Scottish National Party and Plaid Cymru (see Figure 8).

But a number of senior cabinet members, including Justice secretary Michael Gove and Secretary of State for Work and Pensions Iain Duncan Smith, and policy-makers including popular London Mayor Boris Johnson, UKIP leader Nigel Farage and DUP leader Arlene Foster, will be campaigning in favour of Brexit. While UKIP only has one seat in the 650-seat House of Commons, it came third in last May’s general elections with about 3.88 million votes or about 12.7% of those who voted. Furthermore, about 140-150 of the 330 Conservative members of parliament have explicitly or implicitly given their support to the “out” campaign.

Olivier desbarres UK referendum chart

About 200 UK business leaders employing 1.2 million people, including 36 chairmen or chief executives of the FTSE 100 companies, have signed a letter warning that Brexit would put the economy at risk and calling for the UK to remain within the EU. But that also implies that nearly two-thirds of FTSE 100 heads did not sign this letter, although some of these company heads may still tacitly be in favour of the UK remaining in the EU.

4. Uncertainty – No precedent

From a legal perspective, the Lisbon Treaty which entered into force on 1 December 2009 contains a clause providing for a member to leave the EU. But the debate about the short and long-term economic costs and benefits of the UK exiting the EU is complex and arguably inconclusive in part because there is no precedent of an EU member country exiting the politico-economic union of 28 member states (although Greenland, an autonomous province of Denmark, withdrew in 1985).

As a point of comparison, the Y2K (also known as the Millenium bug) may hold some valuable lessons. There was by definition no precedent for computers having to handle the digit change from 1999 to 2000 and it was the fear of the worst-case-scenario which rattled markets in 1999 but ultimately forced governments, corporates, markets and households to put in place robust contingency plans.

Proponents of Brexit have referenced Norway, which is not a member of the EU but is closely associated with the EU through its membership of the European Economic Area (EEA) in the context of being a European Free Trade Association (EFTA) member. But the comparison is far from perfect. For starters, Norway is a significant net exporter of oil (and aluminium) which has funded one of the world’s largest pension funds and affords it a degree of economic flexibility which the UK does not enjoy. Note that Norway held a referendum on EU membership on 24-25 September 1972 with the no-camp winning 53.5%. The referendum was repeated on 28 November 1994, with the no-camp winning a smaller 52.2%.

5.Uncertainty – No explicit government contingency plans

Chancellor Osborne has explicitly stated that the Treasury has been focussed on negotiation talks with EU leaders and has not made contingencies for a possible exit from the EU. Of course the prime minister and chancellor would be undermining their case for and confidence in the UK staying within the EU if they publicly admitted that they were working in parallel on a Plan B. Bank of England governor Carney has been more forthright in acknowledging that the BoE had made contingency plans.

Furthermore one would assume that, should the electorate vote in favour of Brexit, the government would allow a sufficient timeframe between the vote and actual cessation of EU membership in order to prepare the UK for the many legal, institutional, political and economic changes likely to ensue. However, this assumption would likely to be tested during this interim period.

6. Uncertainty – Prime Minister Cameron’s future

Prime Minister Cameron has hinted that he would not resign should the British electorate vote to leave the EU. While there is certainly no legal basis for him to do so, it may be politically untenable for David Cameron to remain as leader of the Conservative Party and prime minister given that he initiated the referendum and has invested much political capital in keeping the UK within the EU. A change of leadership would probably not have a material impact on the government’s overall policy direction (and the next elections are not due till 7th May 2020) but it would add an extra layer of uncertainty at a crucial time for the UK.

7. Uncertainty – Another Scottish referendum?

Nicola Sturgeon, Scotland’s first minister and leader of the Scottish National Party, argues that if the electorate voted in favour of Brexit, Scotland would conceivably want to hold another a referendum on its membership to the UK in order to determine whether it wants to be member of the EU.

Scotland held a referendum on UK membership o 18th September 2014, which returned a clear vote (55.3%) in favour of the “in” vote, and the government is under no legal obligation to hold another referendum on Scottish membership of the UK. However, in the event of the UK no longer being an EU member state, the Scottish electorate may well have a stronger case for leaving the UK if it does not want to be part of a union which imposes a degree of constraints but does not confer the full benefits of EU membership. The government may have little choice but to agree to a second Scottish if the tide of popular sentiment clearly favours Scotland leaving the UK (and potentially re-joining the EU as an independent state).

 

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] Cameron has dismissed claims that a vote to leave could trigger a fresh renegotiation and that a second referendum would ignore “profound points about democracy, diplomacy and legality”. Chancellor Osborne has also stated that this would likely be a “once-in-a-lifetime decision” and the one and only British referendum on EU membership for the foreseeable future.

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