Sterling is the most vulnerable to a Brexit vote. The impact on gilts depends on how the Bank of England reacts

OUR third look at the impact of the Brexit referendum* concerns the effect on the financial markets. Market movements can affect the economy (higher gilt yields, for example, would make it harder for the government to finance its deficit; lower equity prices could dent confidence) but they also act as a signal. Other things being equal, a decline in the pound, a rise in gilt yields or a fall in equities indicate that investors are finding British assets less attractive, and points to their assessment of the economic impact of the vote. As in the other blogs, I will be drawing on the views of investors, economists and thinktanks for evidence. On sterling, the view is pretty universal; a Brexit vote would cause the pound to fall. A Bloomberg poll of economists found that 29 of 34 saw a decline below $1.35 and only one saw the pound above $1.40 (at the time of writing, the pound is around $1.42). Among investors, Blackrock, the biggest fund manager in the world, says that

Sterling is most vulnerable to Brexit fears as it is the most liquid UK financial asset. A Brexit could pressure the UK's budget and current account deficits, hurting the currency and potentially triggering credit downgrades

While at Investec, John Wyn-Evans, the head of investment strategy says that

A Brexit would be distinctly negative for sterling because of its potential to impact the economy and international trade

The pound has already weakened ahead of the vote and Mark Carney, governor of the Bank of England has commented that

It's safe to say there's an element of referendum premium (in the pound)

in other words, investors are selling sterling to reflect the increased risk.

Of course, some of this weakness may reflect a market view that UK interest rates are unlikely to rise. But the pound has also been weak against the euro, which is likely to see further monetary easing shortly. Stephanie Flanders, the chief market strategist at J P Morgan Asset Management, says that

sterling has declined further than can be explained simply by the fall in UK rate expectations relative to the US since the end of the year. The cost of insuring portfolios and business activities against further sterling weakness has spiked to the highest level since 2010 and derivative markets are forecasting that sterling volatility will remain high well into the summer.

UBS thinks that the pound will fall to parity against the euro in the event of a vote for Brexit (it is currently trading at around €1.30). That is because the bank thinks Britain will struggle to finance its current account deficit (4.7% of GDP) in a Brexit scenario; a 30% fall would be needed to bring the deficit down to a more manageable 2% or so.



Another problem would be the impact on investment. As a previous blog pointed out, it would probably take two years to organise a Norway-type deal, in which Britain had access to the single market, at the cost (in sovereignty terms) of allowing free moment of labour and (in economic terms) of making payments into the EU budget. A looser free trade deal without submitting to EU rules would take longer. Goldman Sachs comments that

During this period, UK-based businesses would face considerable uncertainty: exporting companies would not know the terms on which they would be able to supply export markets abroad once Brexit is complete; importing companies would not know the terms on which they would be able to import; and all companies would be confronted with increased regulatory/legal uncertainty. Faced with such uncertainty, the option value for businesses of delaying investment would be high, at least until some clarity is reached. Business investment accounts for around 10% of UK GDP. A collective decision to pause a significant share of this spending would be materially negative for UK output.

All this could have an impact on the country's credit rating. Here is Moody's view

the economic costs of a decision to leave the EU would outweigh the economic benefits. Unless the UK managed to negotiate a new trade arrangement with the EU that preserves at least some of the trade benefits of EU membership, the UK's exports would suffer. It would likely lead to a prolonged period of uncertainty, which would negatively affect investment, in Moody's view. It would also place a significant burden on policy-makers who would have to renegotiate the UK's trade relations with the EU and other countries and regions, as well as reconsider other areas such as regulatory and immigration policies.



Moody's would consider reflecting those threats to the UK's credit standing by assigning a negative outlook to the sovereign's Aa1 rating following a vote to exit, pending greater clarity on the longer-term impact on the UK's economic and financial strength.

Is all this bad for gilts? Not necessarily, It depends on how the Bank of England reacts. A big fall in sterling would push up inflation (UBS thinks by as much as five percentage points). But because of the factors referred to above (the shock for confidence and investment), growth would slow. Stephanie Flanders reckons economic growth will be around 1 percentage point lower in the 12 months after a Brexit vote. The Bank may prefer to focus more on the weak growth than the higher inflation (as it did after the 2008 crisis). Ms Flanders reckons that

Monetary policy would likely be even looser in this scenario, with the first interest rate rise from the BoE deferred even further into the future

On the other hand, a Brexit vote would make it harder for David Cameron, the prime minister, to survive; the political turmoil might put off some gilts investors, especially as a divided Conservative party would create a greater chance for Jeremy Corbyn's Labour to take power in 2020. Longer term, if the UK went for the extreme out position, without free movement, Fitch another rating agency reckons that

Lower net immigration following Brexit could result in a worse trade-off between output and inflation. A slowdown in labour force expansion would reduce UK productive potential growth, implying more inflationary pressure for any given growth in aggregate demand.

That would definitely be bad for gilts.

So far, however, it cannot be said that there is a huge impact on the market; 10- and 30-year yields are lower than they were a month ago. The only sign of stress is that the cost of insuring against a UK default has risen, relative to Germany.

Finally, what of equities? The FTSE 100 index has rebounded from its weakness earlier in the year. Many of the companies in the FTSE 100 are multinational and the lower pound is good for their export prospects and boosts the sterling value of their overseas profits. One shouldn't overdo this factor, however; if devaluation/depreciation were the key to success, Britons would be driving around in Rolls Royces after 1931, 1949, 1967, 1976, 1992 and 2008.

Individual sectors could also face an adverse impact. HSBC points out that banks could suffer, if they have restricted access to the single market; sectors like retailing and construction could face higher labour costs oif EU workers leave; and airlines could suffer from the weak pound, and lower traffic.

How much has been priced in already? At the moment, Predictit is only pointing to a 28% probability of Brexit (from nearly 40% last week; unsurprisingly, the pound has perked up over the same period). The markets seem to think that, as with the Scottish independence referendum, voters will opt for the status quo in the end. But expect a lot more volatility if the polls (and the betting) start to point the other way.

* See also the pieces on regulation and trade.