Brexit: Caveat Emptor!

Market Latin: ‘caveat emptor’ says the Governor; ‘Et tu Brute’ rejoin shocked British Brexiteers; ‘Quo Vadis?’ shout investors. Will a Brexit vote be bad for the equity market, and if so, what sectors is a Brexit vote likely to hurt?    

The Governor of the Bank of England’s foray into Brexit prophecy has provoked outrage and anger in the Brexit camp. The belligerence of some of those who criticised him – for publically presenting the analysis and conclusions of bean counting forecasters about the economic impact of the UK’s leaving the EU – carried more than a hint of fanaticism. The call for the Governor’s head seemed an extraordinary ‘over the top’ reaction. It characterises the style and nature of the national debate on the subject of whether the UK should give up its semi detached membership of the European Union. Much of it has not, so far, resembled a rigorous process for distilling the pure spirit of probability through objective analysis, but rather exaggerated name calling between competing Premier League football club tribes. Fortunately, no ‘battle’ buses have been attacked yet.

As a member of the dogmatically uncommitted, I welcome the Governor’s presentation of worked-through forecasts of the economic soothsayers and rune readers. I do so for two reasons: first, because the Governor would have been negligent not to have ordered a survey of the possible economic and monetary impact of leaving (and even worse, having got it, keeping it quiet!); second, because we can all now feed the conclusions into the crude, subjective synthesiser of our own individual, imperfect, judgmental processing. It seems almost eccentric in a democracy to complain about information supplied by forecasters. Predictably, the response of the British Brexiteers was not to answer it point on point but a resort to Billingsgate or shooting messengers. That included questioning the integrity of the voguish Christine and calling the IMF forecasters rubbish. On the other side it’s more fire, plague and pestilence.

For my part, experience tells me that any major uncertainties which may arise from a vote to hand in the keys and head for the open sea will lead to probable weakening in economic activity, investment and markets. I rather believe that a Brexit vote will induce an immediate sense of uncertainty. There seems little probability of hats being thrown into the air and a surge of buying in the expectation that the exchange rate of sterling will rise and the UK economy surge.

Instead, it is most likely to signal a period of uncertainty as markets wonder how things will pan out. (The old lore about markets and uncertainty is too well understood to require further explanation.) In circumstances where a nation determines to radically alter the nature of its settled pattern of international trading operations in a day, with an indeterminate but no doubt long period of negotiations to follow, a period of market and industrial circumspection seems the most likely bet to me. Naturally, investing and other financial institutions will try to hedge such an outcome short term. They are buying in referendum voting intention surveys, but it must be difficult to call.

The economic and financial facts that are pertinent include the following: Firstly, the pound sterling is much more of a marginal currency compared with the US dollar and the Euro. Movements into and out of sterling from those currencies are, because of their sheer scale and volume, likely to move sterling up or down significantly. Second, a Brexit vote will almost certainly cause treasury departments around the world to ask whether the uncertainty of change in the UK’s circumstances as a trading nation and economy, would justify reducing exposure to sterling and sterling denominated assets. (Mind you, they might well ask the same question of the Euro as a sustainable and predictable store of exchange value.) Would there be a flight from both to the safer havens of the US dollar and/or gold? I suspect that they will ask the question and probably do a bit of diversification as a matter of conventional prudence. All one knows for certain is that it will be uncertain.

At that point, they will review sterling’s weaknesses, which include the fact that there is a large and growing trade deficit (because we do not earn enough from traded exports to pay for our traded imports); that the UK has a noted productivity problem due to a lack of investment; that as trade deficit nation, the UK is worryingly dependent of flows of hot money into London to balance the current account; and that the UK property market (the recipient of such hot lucre) looks overbought and vulnerable.

As a deficit nation, the UK arguably needs to convey a sense of continuity and reliability to retain the confidence of foreign investors. A Brexit vote will make that less easy. The Chancellor knows that better than anyone. His reasons for concern seem rooted in practical rationality. H.M. Treasury must be doing that thing that usually involves the unusually painful method of producing bricks – something else our remarkably unproductive economy seems to be short of adding to our balance of trade problems.

So, assuming that there is a Brexit vote, what are the likely investment implications for investors? A decline in the exchange value of the pound against the dollar as some investors hedge their bets by moving some liquidity out of sterling into a presumably less risky looking dollar? So will other currency groups no doubt! Gold is likely to benefit from that as well. In consequence, dollar earners should be attractive to UK equity investors.

However, counterbalancing that, overseas holders of UK sterling traded equities might well be tempted to lighten such UK equities, to avoid currency translation costs. Longer term, if sterling were to fall significantly, foreign investors may think about moving back.

A sterling devaluation would also look attractive for UK-quoted exporting manufacturers who have had a tough time due to the strength of sterling. UK international hoteliers should also benefit from weaker sterling. That particularly likely to feed into bearish inflationary calculations as the cost of imports rise for home consumers, making the current account balance of payments even more difficult to reconcile in the short term until – in theory at any rate – a lower sterling exchange rate brings a longer term, long awaited, increase in the volume of UK exports. A fall in the exchange rate of the pound would represent a cut in consumer spending at home prompting more exports by companies seeking profits. That is how things are meant to work in the economic model.

Banks, because of their gearing, will become more problematic investments in a Brexit situation. Longer term, they may have to think about moving resources to ambitious Euroland financial centres like Frankfurt or Paris, depending on whether British based bankers will get a ‘passport’ for their services into the UK. Another bit of uncertainty! UK retailers and other UK-reliant companies would, on the analysis of a weaker pound, find life tougher. That is also likely to underwrite current weakness in the London property markets.

But then, we may not have a vote in favour of Brexit! It is too close to call. People don’t know if they should vote for a European war or for a Neo-Nazi triumph.