The risks of Brexit
As the UK prepares to decide whether or not to continue its membership of the European Union, investors globally are considering the risks and opportunities should the UK decide to leave.
Brexit: executive summary
In this report, we discuss the risk of Brexit and the potential impact on the UK economy both in the near term and further out should the UK vote to leave. We also consider the likely reaction by markets for sterling, equities and bonds.
The analysis and evidence presented is intended to inform investors and not to persuade voters or influence the outcome of the upcoming referendum.
Key findings include:
- The EU is the UK’s biggest trading partner, while the UK is also a very important export destination for the EU. Both sides need to maintain a strong trade relationship, but this is at risk should other elements of the negotiations be prioritised ahead of trade. Brexit could offer the UK the freedom to negotiate trade agreements with third parties, but it may have to lose access to parts of the single market, and would almost certainly be outside the customs union.
- Foreign direct investment is an important source of financing for the UK. The UK has a large exposure to Europe and vice versa. Should Brexit cause the UK to lose access to the single market, it could cause capital inflows to slow or even reverse. The existing stock of assets and liabilities is very large, and is likely to have a huge impact on markets in a disorderly scenario.
- EU membership is often blamed for the UK’s perceived migration problem, yet most immigrants tend to come from non-EU countries. From an economic standpoint, EU migrants arrive ready to work, pay taxes, and ease the burden of an ageing population. Limiting migration in a Brexit scenario would almost certainly lower the UK’s trend growth, and increase the burden on the exchequer.
- The UK’s contribution to the EU’s budget does not represent a significant saving should the UK decide to leave the EU. At just 0.2% of gross national income, the saving would barely put a dent in the UK’s fiscal black hole. Moreover, if the UK chooses to follow the path of Norway or Switzerland, some subscription costs may also be required.
- Should the UK vote for Brexit, the near-term impact on the economy is most likely to be stagflationary1 compared to our baseline forecast. Uncertainty would hit both foreign sourced and domestic investment, while we forecast UK consumers to cut spending as confidence is dented. Sterling is likely to depreciate further which would help boost the contribution from net trade, but the overall impact would be lower growth and higher inflation. We forecast that a benign Brexit scenario would cause GDP to be 0.9% lower and CPI inflation to be 0.6% higher by the end of 2017 compared to our baseline forecast. The Bank of England is forecast to keep interest rates lower for longer in this environment.
- There is a one in four chance that the loss in confidence leads to much larger capital outflows, causing the pound to plummet, and for the Bank of England to raise interest rates to defend the currency. The UK’s huge twin deficits highlight the economy’s imbalances and leave it highly vulnerable to a balance of payments crisis. The impact on the economy would be more severe than our Brexit scenario – stagflationary initially, but then very deflationary in years to come.
- The long-term impact on the UK economy will be determined by how much access to the single market the UK manages to retain, how migration flows are impacted by government policy, and how much the UK government manages to save in subscription costs. Most studies offer a range of scenarios concluding that the most likely outcome would be lower long-term potential growth compared to remaining in the EU.
- Restrictions on EU migration could cause the UK labour market to become less flexible to demand, raising the likelihood of more pronounced wage, inflation and interest rate cycles. A more cyclical economy would not only make recessions more frequent, but international investors could demand a discount on UK assets given the higher volatility of expected returns.
- A Brexit scenario is likely to cause sterling to fall further. Having already seen its sharpest depreciation since the financial crisis in recent months, our analysis shows that a further fall is likely under Brexit. However our analysis also suggests that sterling could rebound should the UK vote to remain, as many investors have already started to hedge their sterling exposure.
- The outlook for UK equities is mixed under Brexit. The UK’s large-cap index has a large proportion of its revenues coming from outside both the UK and EU. Should sterling depreciate, these companies would see the sterling value of profits rise, and would therefore benefit. The mid and small-cap indices have more exposure to the UK and EU, and could underperform as a result.
- The outlook for bonds is also mixed under Brexit. Credit could see wider spreads as investors demand a higher premium against the risk of lower growth and higher default risk. Meanwhile gilts are likely to see higher domestic demand from safe haven flows.
A vote for Brexit will also have wider implications for the rest of the European Union with the loss of a large liberal member state.
Moreover, the UK government will struggle to recover from such a result, while Scottish nationals will probably push for another vote for separation.
It could take decades before we learn the true costs and benefits from Brexit, but in the meantime, investors seem ready to take precautionary action.
1. In other words, having lower growth and higher inflation compared to our baseline forecast. ↩