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Brexit – What is it? – A question that is long overdue an answer.

Ravi Lockyer has been getting an increasing amount of questions around this new found term of ‘Brexit’.

Particularly, what is it? how can it affect the UK? These questions have become more and more frequent with the referendum fast approaching in June.

To try and help answer some of the questions, Ravi has taken to the blog to explain what he knows about the Brexit, including what the impact may be on the UK markets in the run-up to the referendum and post-referendum.

If you have had any questions about the Brexit before, this is the post you want to read to gain some clarity!

“Brexit” (Britain Exit from EU membership); What is it?

Question Time last week…. For me, the best moment was a member of the public, who quite candidly said she hoped the issues would be clarified, confessing she only had a partial understanding of the referendum. All the arguments and “what ifs” crystallised, do people understand the implications of “Brexit”? It made a mockery of the whole Question Time.

The politicos/ media heavyweights queued up to intellectualise and fine tune their arguments. Far from participation, the public response was, “I don’t understand what you are talking about”.

We expect the referendum question will be simple. But what is not simple is an understanding of the merits or otherwise, the risk factors of leaving, how we have come to the point when this issue, decided in 1973, is coming around again?

“Brexit” the historical context

The UK first tried to enter the EEC in 1963 under Harold Macmillan and in 1967 under Harold Wilson. Both times, French Premier Charles de Gaulle vetoed the UK application on the grounds that he doubted the UK’s sincerity. The British have never considered themselves Europeans, said de Gaulle. De Gaulle thought the UK’s ideology was too US focused/ “Atlanticist” – the UK did not respect the EEC’s objectives.

The UK had to wait until de Gaulle passed away in 1970 for a third approach. PM Edward Heath convinced de Gaulle’s successor, Georges Pompidou that the UK would be a constructive EEC member. But since the 1973 entry, de Gaulle’s wisdom has been apparent. There have been few issues where the UK and EU have agreed. “Agreements” have been cobbled together with plenty of opt-out clauses.

Europe has provoked heated debate for years. “No, No, No” said Mrs Thatcher about monetary union. But it was Maggie that took us further into Europe via the Single European Act 1986 and ERM entry in 1990. The UK signed up to the EU’s infrastructure and bureaucracy because it requires access to the EU trading bloc. It also wants the EU blocs’ protections.

Under the EU’s trade umbrella, if a non-EU country imposed tariffs on the UK, then the EU, not the UK would respond with tariffs. This factor helps the UK access overseas markets. The EU is the destination for half of UK trade.

It is true the UK has negotiated more opt-outs from EU legislation than any other EU state. The UK opted out of the single currency, the Schengen agreement, the Lisbon Treaty’s Justice and Home Affairs legislation, the Fundamental Charter of Human Rights, to name some.

Even the election of the community President Jean-Claude Juncker, the UK government bitterly opposed his “federalist” credentials and candidacy, only to be outvoted 26-2. On many occasions, for successive governments, the UK’s EU misgivings are apparent.

When EU problems have arisen, such as the Greek bailout, the current migrant crisis, the UK has not wanted to help very much, if at all. The UK behaves very differently to other large EU members, it rarely leads, it tends to oppose. The UK has repeatedly blocked moves to create EU military forces despite the Russian issue.

This is another major bone of contention and hard to justify – why should Britain insist the EU rely on NATO exclusively?

The EU is a club, as with any club, it has rules. The UK has cherry picked its way through the rules for years, but now the club’s articles of association are changing. The Europeans want closer political union not just an economic union.

The Germans say the UK and Denmark can have a “two speed” Europe and move at a slower pace than others. The German approach to managing the UK’s differences have so far bought time.

But the UK wants a total halt to further EU integration. On this point, it seems isolated, the UK does not want EU federalism but the EU does.

Far from an EU super-state imposing its will on EU citizens, The Lisbon Treaty Article 5 enshrined the principle of “subsidiarity”, ensuring the governmental actions are taken by individual countries except where action cannot be resolved at member state level or where action at EU level has clear advantages. The EU does not want to reduce member state sovereign authority. It wants national governments to act as often as possible.

Why does the EU agree on UK opt-outs?

One reason is defence. The UK has the EU’s second largest nuclear deterrent behind France. If the UK left, the EU would be entirely reliant on NATO and the French nuclear deterrent to defend a vast EU border- would this be sufficient in itself? The Russian issue has made the UK army/ defence more important to the EU. Hence the need for EU armed forces.

The EU wants to avoid the loss of credibility of a member state leaving. It agreed to forgive a vast portion of Greek debt to keep the least compliant member state in the union. To keep the UK in it is, therefore, bending the rules again for the UK, essentially creating two rulebooks. This leads to other countries demanding the same special treatment, weakening the system overall.

The Eurozone system is being carefully managed. As the EU moves closer to the unchartered waters of deflation, the avoidance of a new problem is desirable. Whilst the UK is not in the Eurozone, a “Brexit” could weaken the perception of the EU and the Euro by giving the impression the Eurozone could split.

For a Eurozone country, leaving the EU and Eurozone has far more serious implications than a “Brexit”, it would mean a national government would have to issue its own currency, reserve its central bank and run monetary policy themselves. Still “contagion” might create questions in Germany about the desirability of its role in the EU.

The UK PM, by pursuing a referendum on the EU membership has in effect brought this issue to a head. The UK government does not like EU federalism but realises it cannot stop it on its own. The UK approach at renegotiating its EU membership and then putting the advantages of another “deal” to a referendum vote tries to square the circle, by giving the UK government approach the backing of the people.

The EU is further bending for the UK, in order to secure the referendum vote – had it not been for this vote, it is unlikely to have agreed to amend migrant benefits and other contentious issues.

What impact will the vote have on already volatile markets?

The referendum is a risk factor for UK financial markets. The “magnitude” of the impact depends on the campaigns and the polling / betting. If the Scottish Referendum is instructive, the volatility of financial markets increased when the result was perceived as close (a high risk of Scottish independence).

With the Scottish referendum, volatility was elevated in the week before the vote. There was a relief rally post the result which lasted one day. All told therefore 6 days of volatile markets, the most volatile period was the week before the vote. In the end, 55.3% said “no” to independence. Had Scotland voted to leave the UK, obviously volatility would have remained higher for longer.

In the 2015 General Election, UKIP (which advocates leaving) won 1 seat. UKIP leader Nigel Farage did not even secure his own Westminster seat. How seriously can we take the case for leaving the EU? The polling suggests people are open to leaving, (45% of those decided (Daily Telegraph) but not via a UKIP government.

The USA has made clear its disdain for “Brexit”. President Obama said last July “The EU has made the world safer and more prosperous…having the UK in the EU gives us much greater confidence about the transatlantic union….we want to make sure the UK continues to have that influence [in the EU and rest of the world]”. Overseas investors will be nervous of “Brexit”.

The vote will impact UK markets significantly. If the Conservatives give only lukewarm support to the “in” campaign, it could fail. One suspects the party will be hamstrung by the “eurosceptics” who will oppose the government and the Tory “wets” who don’t want to get too involved. The Conservatives have pro-EU MPs but they have tended to get drowned out. It will be close.

What impact do we expect in the run-up pre-vote?

A) Sterling; remains weak in the run-up; possibly dropping to £/ €1.20/ $1.35. We attribute current sterling weakness as persisting for a number of reasons:-

i) The Bank of England has backpedalled on the issue of base rate hikes, rolling back a hike for 12 months. There is some risk, possibly a 25% chance of Base Rates even reducing to 0.25% due to deflationary factors. The BoE appears to be encouraging a weaker currency.

ii) Sterling status as a “petro-currency” and the linkage between the sinking crude oil prices. Whilst STG/ crude oil linkage is not as strong as for other currencies, (Rouble/ Krone/ C$) the weak oil price is a negative factor, at a time of high risk for STG.

iii) Asset weakness. Should “Brexit” risks increase there is the risk of an exit from UK equities – depressing sterling.

iv) Sovereign wealth fund repatriation, a factor in 2015 contributing to currency weakness.

B) UK property; unlike the Scottish referendum (which presented a currency risk if Scotland left) – the EU vote is unlikely to cause buyer fatigue in the short-term. We see limited impact on the broader UK market though it will deter overseas buyers in central London.

Overall UK property is more likely to be hit by changes to “buy to let” lending practices and tax treatment and other fiscal measures such as extending “Help to Buy”.

C) UK Gilts in the “run up”, the impact will depend on the yield curve position:-

 

Name                      Yield to Maturity                   Comment

UK Gilt 2Yr              0.33%                                    Limited impact, due to flat rate outlook

UK Gilt 5Yr              0.79%                                    Possible rate rise to 1.25%

UK Gilt 10Yr             1.48%                                     Possible rise to 2%

UK Gilt 30Yr            2.30%                                    Very sensitive, expect rise to 2.5%-2.75%

 

D) UK equities; “Brexit” will impact:-

i) The UK “Blue Chips”; positive impact from the higher value to overseas earnings / lower impact from portfolio repositioning/ lower weights to UK stocks. We expect a volatile market with a daily variance of possibly +/- 100 points – the UK 100 Index could lose 200-300 points in the run-up if the polls are close / or if the “in” campaign flounders.

ii) The UK “Mid Caps”; Midcaps have high UK/ EU exposure and stand the most to lose from friction with the UK’s largest trading partner. The UK 250 Index could move to a 200/-200 daily variance and a -1,000 point movement if polls show a close result in the run-up.

iii)UK Small Cap; limited impact – small stocks are very company specific hence, we see little sensitivity.

It will be volatile ahead of a June referendum. “You have to take the rough with the smooth”.

Download this blog post as a published report.


We hope that answered your questions you may have, there will be more research and writing produced in the run-up to the referendum, as it comes even closer to light.

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