The UK referendum on EU membership is contributing to a deteriorating risk/reward ratio for investors.
While there are still around two months until the British referendum on EU membership, the financial markets have long had their eyes fixed on the UK. The widespread hope is that the British will vote to remain in the EU on 23 June, while the fear is a so-called Brexit from Europe.
Conservative Prime Minister David Cameron is leading the remain campaign, while the leave camp includes leading members of his own party.
Predicting the outcome of the upcoming vote is near impossible, states chief analyst Bo Bejstrup Christensen in a new Investor Brief from Danske Invest, but we can try to assess the political, economic and investment impact of a vote to leave.
“If David Cameron loses the referendum, his position as leader will at the very least be severely weakened, while the power of the party’s eurosceptics will increase. However, a direct leadership challenge is also a possibility – hence, the British side in any subsequent negotiations with the EU on what should happen next might potentially be split and in conflict. The EU’s position is also difficult to gauge, though we do not expect the EU to offer the British a bill of fare for future collaboration from which they can pick and choose as they please. On top of this comes Scotland’s desire to remain in the EU. In short, we foresee an extended period of considerable political uncertainty, primarily in Europe,” says Bo Bejstrup Christensen.
The world will survive – but uncertainty may increase
The most pessimistic observers are predicting near catastrophic scenarios if the UK votes for a Brexit, but Bo Bejstrup Christensen stresses that a British no to Europe would not be the end of the world. It would not prompt a systemic crisis where the European bank system immediately collapses or trade between the UK and the rest of the world dries up.
“But the uncertainty would doubtless be negative for the UK economy, and the Bank of England would do all in its power to support growth and financial stability. That means low interest rates and ample liquidity for a long time and probably a further weakening of the pound sterling (GBP) and also the euro (EUR) relative to other global currencies,” he says.
The global impact on growth should be rather modest, according to the chief analyst. Nevertheless, Danske Invest has recently decided to reduce the equity weightings in its balanced portfolios.
“A potential Brexit is, however, just one of the reasons. Global equity prices are no longer quite as attractive as when we increased our equity holdings in January – but the main reason is that we now see Chinese growth as close to peaking and therefore likely to slow soon. Furthermore, we estimate the US economy will continue to demonstrate strength, so the US central bank will therefore continue to hike interest rates. Given that the markets are barely expecting one US rate hike this year compared to our two (and more in 2017), we see the combination of slowing Chinese growth and higher dollar yields as a major challenge to global equities,” says Bo Bejstrup Christensen.
Event risk could increase volatility going forward
When economic growth is accelerating and the world’s major economies are delivering strong economic data, there is a tendency for any negative events that occur to be drowned out, says the chief analyst. In other words, so-called event risk is relatively limited during these periods.
“However, in the context of a Chinese growth challenge and a reassessment of US monetary policy, event risks like a potential Brexit in June or the US presidential election later this year may cause greater volatility in the financial markets. Hence the risk/reward ratio has deteriorated, which is why we have decided to reduce our equity weightings, particularly in European stocks,” says Bo Bejstrup Christensen.
If the UK votes to leave the EU, the impact will be most keenly felt by European equities in the short term, he estimates. Overall, however, Danske Invest still retains a slight equity overweight in its balanced portfolios, reflecting an essentially positive view on the global economy.