Brexit: a serious issue, but not our main scenario

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ABN AMRO Private Banking, Expertise, Investments, Treasury and special products, Forex

Britain leaving the European Union (EU) is attracting headlines and is a serious concern. The reality, however, is that the risk and uncertainty of a “Brexit” have so far only had an effect on the currency market. Brexit polls in the UK point in the direction of the UK remaining in the EU. The margin of the vote, however, is not convincing enough for it to be seen as a foregone conclusion. Our main scenario, shared by Group Economics and the Global Investment Committee, is that the UK will remain in the EU. The probability of the UK leaving the EU is estimated to be only about 35%.

The Brexit debate has become more visible and exposed since 20 February, when UK Prime Minister David Cameron announced the result of negotiations and a referendum on 23 June. It is now a global issue. If the UK would leave the EU, it would have broad economic, political and institutional impacts on both the UK and EU nations and institutions. The stakes are high and will likely rise as the referendum date approaches.

Risks so far have materialised only in the currency market

The democratic choice that the UK is exercising has engendered a new form of market uncertainty. A decision to leave the EU would affect trade and the balance of power with the EU. It also raises the risk of a precedent being set, with repercussions for the EU and globally.

For the moment, Brexit risks and uncertainties have materialised only in the currency market. The equity and bond markets remain unaffected. The FTSE, for example, has only slightly underperformed European indices since the referendum was announced. The Gilt market is approaching yield levels close to their historical lows.

Despite the significance of the Brexit decision, it is important to recognise that in the months to come, the UK and European markets will likely be under the influence of other, more significant issues. In terms of timing, political tensions will increase as the referendum approaches. But other factors, such as the state of the world economy, overall market sentiment in financial markets, the evolution of commodity prices and risks in the banking sector will also have enormous (and likely more) resonance regarding the fate of UK and European assets.

Our view: Brexit is not the likeliest scenario

Our main scenario is that the UK will remain in the EU. We ascribe a low (35%) probability to the UK leaving the EU. Our asset allocation reflects this belief. The context for the asset allocation is a conviction that a modest global recovery will continue and the likelihood of recession is low. Moreover, we believe that central bankers and policymakers remain key players to support the slower than expected recovery that has been underway since the financial crisis.

Considerations for investors

We believe that for now, Brexit risks are confined to UK small and mid-cap companies, which would be hurt more from semi-isolation from Europe than larger, internationally diversified companies with more resilient corporate structures. We therefore recommend avoiding UK small and mid-cap investments.

Another recommendation from the GIC is for euro-based investors to not hedge the British pound. This is because a large part of the expected currency weakness has already occurred; and other factors, such as further policy easing by the European Central Bank, could mitigate the volatility of the euro versus the British pound. We do advise US-dollar-based clients, however, to hedge their British pound investments, as an agenda of rising rates in the US and a continuing accommodative Bank of England could weaken the pound versus the US dollar.

The risk of a Brexit will remain in the political and investment landscape in the months to come. The Investment Committee will actively monitor the situation and can act based on the perceived risks and opportunities associated with the possibility of the UK leaving the EU.

More information regarding four possible scenarios should UK voters choose to leave the EU can be found in today’s Macro Focus: Brexit Scenarios, published by Group Economics.

Didier Duret

CIO, Private Banking