Market Insight – Foreign Exchange – Impact of the EU Referendum

Brexit possibility rekindled

After the “Remain” camp took a seemingly unassailable lead in voting polls towards the end of May, a bout of Sterling strength reflected market relief as a degree of uncertainty was removed from the upcoming vote. However, this reprieve turned out to be short lived, as six out of eight of the latest polls have shown the “Leave” camp ahead with an average lead of three percentage points (Source: FT Brexit poll tracker), rekindling investor concerns and stressing the considerable stakes at risk on June 23rd. Interestingly, average gambling odds (sample of 24 bookmakers analysed) have put the likelihood of a “Brexit” at around 30%, but this is unlikely to provide much comfort to market participants with assets to protect (see Figure 1). With a US interest rate hike looking increasingly unlikely this month, the EU referendum is the biggest event in the calendar and preparing portfolios adequately will be top of the agenda for investors. Below, we look at the primary assets that are likely to be impacted by the either outcome of the vote.

Sterling – Direct exposure

In the event of a “Brexit” the most immediate impact is likely to play out on currency markets, with the Sterling likely to see significant moves in either direction. Recently, the Sterling has been the clearest barometer of the market’s concerns over a “Brexit” scenario, having already fallen 9.1% since mid-November (on a trade weighted basis). The largest consideration over the decision to leave is the uncertain impact that it will have on the UK’s trading relationship with the EU, the largest consumer of its exports (EU accounts for 47% of UK exports, Source: ONS). Various scenarios outlined in academic studies by PWC, Oxford Economics and the Centre for Economic Progress (CEP) all predict UK trade to be adversely impacted by a decision to leave the EU, explaining why the Sterling is likely to be the primary victim should a “Brexit” materialise. As a vote to leave would be the first decision of its kind, market forecasts over the extent of a Sterling fall are disparate, ranging from 12% by the Treasury to over 20% by some sell-side analysts, such as Credit Suisse.

A “Remain” outcome would see postponed investment projects recommence and consumer/business confidence surge, offering potential support for the Sterling from current depressed levels. The UK’s strong reliance on its financial sector and large current account deficit makes the Sterling vulnerable to market volatility, but also means that the currency rallies when uncertain events pass or bouts of market instability abate (see Figure 2, EU referendum unveils Sterling opportunity).

UK equities – Financials and Real Estate vulnerable

For UK equities the outcome of the vote is likely to affect performance along multiple avenues. For the large firms that comprise the FTSE 100 index, a much smaller portion of revenues are generated in the UK compared to the broader FTSE 250 index. A “Brexit” scenario could provide a competitive boost for larger, more internationally focused firms through a weaker Sterling, but may hurt smaller enterprises that generate revenues domestically. In addition, for equity sectors that are vulnerable to the vote’s impact on the regulation of foreign activities and consumer confidence, like those in Financials and Real Estate, the outcome could spur significant moves.

Gold – Traditional hedge

Gold has traditionally been viewed as a safe haven investment, offering protection during periods of elevated uncertainty and market turbulence (see Figure 3). A vote to “Leave” is the result associated with the most uncertainty, and therefore is likely to see the market’s appetite for safe haven assets increase, which could be a supportive factor for the yellow metal. However, the gold price is less likely to experience a sharp reaction should the status quo in the UK be maintained, with investors instead turning their attention back to the US for any indications from the US Federal Reserve of further monetary tightening.

*All figures quoted are sourced from Bloomberg unless stated otherwise.

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