Uncertainty over the U.K.’s European Union referendum has already affected its economy by way of a sharp decline in the exchange rate since the start of 2016 and — probably — some delay in planned investment in the U.K. by domestic and foreign businesses.
Even with a vote in favor of the “Remain” camp, the uncertainty over the long-term place of the U.K. in the EU is unlikely to be resolved if the Brexit campaign garners significantly more than 40 percent. In that case, there seems to us at J.P. Morgan Asset Management a strong chance of another referendum within ten to 15 years, one that the pro-EU side may find more difficult to win if closer integration in the euro zone has made the EU less hospitable to the U.K. and if popular concerns about immigration have not subsided.
Some have suggested that another referendum could occur after a popular mandate to leave the EU, with voters, in effect, casting ballots on whether to accept the terms of a U.K. exit. This outcome cannot be ruled out. It is the nature of this sort of campaign, however, that before the vote, the pro-EU side must insist a departure is impossible. The larger point is that it is impossible to know what will happen after a vote to leave — or what arrangements would be made for U.K. businesses.
Investors cannot hope to predict the exact shape of the post-Brexit landscape. They can, though, think about the macroeconomic and microeconomic considerations that would come into play in such a scenario.
In recent statements and interviews, Mark Carney, the governor of the Bank of England, has reiterated that a possible Brexit vote poses the biggest domestic risk to the country’s economic outlook in the short and medium term.
Though the currency has recovered recently, the exchange rate remains 5.6 percent lower on a trade-weighted basis than at the beginning of 2016. The pound sterling has declined further than can be explained simply by the fall in U.K. rate expectations relative to the U.S.’s since the end of the year. During the referendum campaign, the cost of insuring portfolios and business activities against further weakness in the pound has spiked to the highest level since 2010, and derivative markets are forecasting that sterling volatility will remain high well into the summer.
The other key consequence of the referendum for the economy is likely to be reduced investment, as businesses inside and outside the U.K. defer projects until the outcome has been decided. Recent figures show that U.K. investment declined by 2.1 percent in the final three months of 2015, after growing by an average of 1.4 percent in the preceding nine months. We cannot know how much of this slowdown was because of referendum fears, but it underscores that this is an unfortunate time to be giving businesses something else to worry about. A 25 percent reduction in the volume of investment because of the referendum could theoretically knock 0.25 percentage points off the annualized rate of growth in the economy in the second quarter.
If the U.K. votes to remain in the EU, we would expect most of the hit to investment to be reversed. The pound might also retrace some of the ground it has lost. It is not obvious to us that the pound would return to the levels seen in mid-2015, however, given the country’s still significant current-account deficit of just above 4 percent of gross domestic product. On the basis of that external deficit, the International Monetary Fund recently estimated that the U.K. currency was 5 to 15 percent overvalued at the end of 2015.
So it would not entirely be business as usual after a vote to stay. But the direct macroeconomic impact would be modest and probably far outweighed by developments in the broader global economy. Indeed, with the immediate uncertainty associated with the referendum removed, investors might see the relative weakness of the pound as a reason for renewed interest in U.K. assets, at a time when the commodity sector is expected to be less of a drag on FTSE earnings than it has been in the past few years and the consumer side of the economy is still performing well. Many of these positives would also be there after a decision to Brexit, but as we will discuss in a follow-up piece, it could be a bumpy road for U.K. assets in the immediate aftermath.
Stephanie Flanders is chief market strategist for the U.K. and Europe at J.P. Morgan Asset Management in London.
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This piece is the first of a two-part series by Flanders on the potential economic outcomes of a Brexit.