There are risks on both sides, but the jittery narrative about a post-Brexit Britain contains hidden assumptions that don’t bear scrutiny, says John Stepek.
It’s the Scottish independence vote all over again. With just a week to go, the European Union referendum has taken an unexpected turn. A slew of polls have put Leave ahead of Remain;
The Sun – with a solid track record of backing political winners – has come out for Brexit; and the odds on Leave at the bookies are shortening drastically.
Put simply, markets have suddenly realised there is a good chance that Britain might wake up on Friday 24 June with a mandate to leave the EU – a realisation that has been blamed for this week’s sliding global stockmarkets, soaring global bond prices, and all manner of wobbles in the pound.
Amid the panic, the Remain rhetoric has grown ever more strident. EU Council president Donald Tusk warned recently that “Brexit could be the beginning of the end, not only of the EU, but of the entire Western political civilisation”. In The Guardian, Polly Toynbee alluded darkly to the rise of Nazism.
But perhaps the biggest panic came from a rattled George Osborne, who teamed up with Labour’s Lord Darling to threaten to hit voters where it really hurts – their wallets. The chancellor warned that a Brexit vote would force him to call an emergency Budget to tackle the financial shortfall arising from the predicted economic hit Britain would take from leaving the EU.
We’d see higher income taxes, higher inheritance tax, and higher tax on alcohol and petrol. The schools, NHS, and defence budgets would be cut, and pensions spending would fall too. It’s come to something when a governing politician feels the need to threaten voters with a rise in all of the most unpopular taxes and cuts to all the most popular services.
Osborne, of course, has a get-out clause – this is a “credible illustration” rather than a promise. But amid all the accusations and counter-accusations, what are the real risks here? And what does it all mean for your money?
What would happen after a Leave vote
It’s morning on Friday 24 June. Depending on how close the vote is, we could know the result by as early as 4am, and certainly by the time the market opens. Say it’s Leave. What happens next? The Treasury and other commentators, such as the Economist Intelligence Unit (EIU), argue that a string of unfortunate events would befall the UK. Uncertainty would hit household spending and corporate investment, harming growth. The pound would slide. Inflation would rise as the weak pound drives up import costs. That would squeeze consumers and firms further.
Yet even as the pound weakened, “financial conditions more generally would tighten”, suggests the EIU, “with bond yields and lending rates increasing to reflect the additional risk premium associated with UK borrowers”. In short, growth would slow, borrowing costs would go up, profit margins would be squeezed, and investment and hiring decisions would be put off, resulting in rising unemployment and a recession.
It’s not an unreasonable-sounding narrative. But there are an awful lot of assumptions embedded in it. The most obvious is the idea that both the government and the Bank of England would simply stand by, shaking their heads and saying: “We told you so”. It’s easy to see why this case is being made. The point of maximum exaggeration was always going to come directly before the vote.
Remain wants to paint as bleak a picture as possible of life outside the EU; Leave wants to promise everything to everyone. But as soon as the vote is over, the political calculus will change – from one of damage/benefit maximisation to one of damage limitation and pragmatism. That means the reality of a Leave vote is likely to be rather less dramatic.
It beggars belief that, faced with a recession (by no means certain, in any case), Osborne would cut spending and raise taxes. Turning Britain into a high-tax economy is hardly the way to keep skittish employers and foreign investors onside. Moreover, if the chancellor tries to punish the electorate for voting “the wrong way”, he won’t be chancellor for long – 57 Conservative MPs have already said they would block such a move.
Instead, if Britain faces economic turmoil, it’ll be down to the Bank of England to sort it out, as has been the case since the 2008 crisis. Given that interest rates can’t fall much further, that would mean more money printing and gilt purchasing (quantitative easing – QE). That’s bad news for savers (just for a change), but it does make forecasts of rising mortgage costs and falling house prices look wide of the mark.
But wouldn’t a fall in sterling tie the Bank of England’s hands? Probably not. The Bank didn’t worry much when sterling rapidly shed 25% of its value during the 2008/2009 financial crisis, so there’s no reason for it to start now. Sure, there will probably be a rapid short-term reaction – there’s been so much talk of sterling falling that an initial panic seems inevitable, particularly as banks around the world are shipping in jittery, coffee-fuelled traders to man their foreign-exchange desks overnight.
Put it this way – we’d certainly avoid having any open sterling-related spread bets on Friday morning, and the fact that most big providers are widening margin requirements for the day shows that huge volatility is expected. But depending on what is already priced in to the market, we could equally see a rapid rebound.
Even if not, in the long run a drop in sterling would attract investment and drive up demand for UK exports, which would prop up the pound. In 2008 and 2009 foreign investors, given the chance to buy London property and other UK assets at a 20% sterling discount, rapidly took advantage, even in the face of global disaster.
As Charles Gave of Gavekal notes on CapX, the pound is also a lot less pricey today than it was then – most analysts argue it’s either fairly valued or undervalued compared with other currencies. As a result, says Gave, “any decline in the pound from this level would make UK manufacturers and service providers highly competitive. Car factories in the Midlands would quickly start humming to the swift detriment of Wolfsburg and Munich.”
Not-so-spiteful exes
What about the negotiation process? The fear is that other EU leaders will punish Britain by making life as hard as possible following a Leave vote, to ensure no one else gets any ideas. German finance minister and de-facto eurozone “bad cop” Wolfgang Schäuble told German newspaper Der Spiegel that no trade deals would be cut for a recalcitrant UK. “If the majority in Britain opts for Brexit, that would be a decision against the single market.”
Tough talk. But if Schäuble always got his own way, Greece would have been kicked out of the eurozone long ago. The eurozone crisis has proved time and again there are no “red lines” in Europe when it comes to doing deals.
More importantly, governments are not the only stakeholders here. The BBC’s Kamal Ahmed reports that pro-Brexit British business leaders he has spoken to are already in talks with their German counterparts, who are “petrified” of the UK leaving the single market. These Mittelstand bosses “would demand that political leaders do a deal to allow goods unfettered access to the UK. And vice versa.”
Germany is not the only one. The Bureau for Economic Analysis in the Netherlands has warned that Brexit could cost the country up to 1.2% of its GDP by 2030. But if free-trade links are maintained, those costs would be sharply reduced. In short, “the economic needs of business in the rest of the EU may force the hand of political leaders”, says Ahmed.
The first domino to fall?
A bigger concern for many analysts is the impact of Brexit on the rest of Europe. Credit spreads in the eurozone have widened – borrowing costs for a fragile country like Portugal are higher compared with those for a solid economy like Germany, than they have been in recent months. This reflects fears that if Britain leaves, it will just be the first. Says Barclays: “A UK exit would set an unwelcome precedent” and potentially “revive the ‘redenomination risk’ in the euro area”.
In other words, Brexit means revisiting Grexit and all the other eurozone break-ups we’ve been through in recent years. This is a fair point. But we’d counter that Greece – under far more economic pressure, and having ceded its sovereignty to Germany and the European Central Bank (ECB) – still voted to stay in the eurozone when it had a chance to vote to leave last year.
Meanwhile, the ECB has won its battle to take a more activist role in propping up struggling nations, meaning it could step in faster in future. The eurozone has proved surprisingly durable despite its own internal contradictions, and if Brexit inspires others to leave, it’ll just be a case of having hastened the inevitable.
Remain: the risks
There are risks to Remain too, of course. If a comfortable majority votes “in”, then the government (or a future government) and the EU itself might take this as a green light for further integration. Time and again the British electorate has been signed up to new phases of European integration that we never had the chance to approve. The idea, put forward by many Remain voters, that if we don’t like it in another ten years, we can always leave, is disingenuous.
It took long enough to get this referendum – which mainstream political party will ever offer another like it? Remain isn’t a vote for the status quo, or a “let’s see how we go” option – it’s an active vote of approval for the EU. You may still prefer that, but it’s worth being aware of.
We’re not neutral observers – MoneyWeek argued for Leave long before The Sun – but we have no desire to downplay the risks. There are several, not least concern over how post-Brexit powerplay in our own government would play out (see below). We also need to have a serious discussion about the type of economy we want to see after a Leave vote. Brexit should promote a more open economy, not an enclosed one, as Merryn discussed.
But ultimately, if pragmatism wins over blind spite, then leaving the EU could be good for both us and the rest of Europe, demonstrating that we can enjoy a good economic relationship without having to hand over significant areas of political governance to an opaque, distant bureaucracy.
Brexit risks: the impact on investors
How would Brexit affect your portfolio? Firstly, don’t get caught up in the hype. Headlines screaming “Brexit fears wipe £20bn off FTSE 100” might make a splash, but Britain’s relationship with the EU is not the only thing concerning markets. The US economy saw very weak jobs growth last month, while long shadows still hang over China. Are global mining stocks really down because of Brexit, or because of the threat of weak demand from the biggest commodities consumer in the world?
Similarly, plunging government bond yields might demonstrate a dash to safety – but is this about Brexit, or a general fear that central banks still can’t trigger decent growth, and may be doing more harm than good? We suspect the latter. It’s hard to argue that Britain lies at the root of this when the yield on our own government debt (in other words, our cost of borrowing) is collapsing alongside everyone else’s.
As for your portfolio, sterling is probably the most obvious short-term issue. We’ve always advocated having exposure to overseas assets – or dollar earners, such as mining stocks, which you could play via the BlackRock World Mining Trust (LSE: BRWM), and big pharma – as well as sterling-denominated ones. We also suggest hanging on to gold in case of emergencies. So if you’ve been following our broad view, your portfolio should be well positioned to weather any uncertainty. As for post-Brexit opportunities, Charles Gave suggests that medium-sized UK companies “will see an immediate benefit from a cheaper pound”. A FTSE 250 exchange-traded fund such as the iShares FTSE 250 (LSE: MIDD) could be the best way to play this.
Article 50: Leave may not mean leave
Even a decisive Leave vote may not mean Brexit, writes David Allen Green in the Financial Times. “From a legal perspective, the immediate consequence is simple: nothing will happen… the UK will still be a member state… All the legislation which gives effect to EU law will still be in place.” The key issue “is when and whether the government invokes Article 50 of the Lisbon Treaty”. Once this happens, “Brexit does become a matter of law, and quite an urgent one” – the UK would have to leave in two years (unless extended “by unanimous agreement”).
Yet the EU referendum legislation did not provide for “any formal trigger”. So while it may be politically impossible for ministers to ignore the result, they “could try to renegotiate another deal and put that to another referendum” – particularly, perhaps, if the result is near-run, or turnout is low. “There is, after all, a tradition of EU member states repeating referendums on EU-related matters until voters eventually vote the ‘right’ way,” notes Green.
To invoke Article 50, British constitutional traditions suggest “that some form of parliamentary approval would be required – perhaps a motion or resolution rather than a statute”. In other words, politicians would have the final say. Given that “the policy of the government… is to remain”, it may “seek to put off the Article 50 notification, regardless of political pressure”.