Morningstar's "Perspectives" series features investment insights from third-party contributors. Here, BlackRock shares an excerpt from their paper, ‘Brexit: Big Risk, Little Reward - The UK Referendum on Europe’.
UK voters will decide in June if the country will stay in the European Union or exit the bloc. The upcoming referendum represents a critical juncture for the UK and EU alike, and comes at a time when the global outlook is clouded by unusual uncertainty.
Volatility in UK and European assets will rise ahead of the referendum
While it is neither our practice nor our role to wade into political debates, we felt it was incumbent on us to help our clients think through the issues – and the choices on the table. Our bottom line is that a Brexit offers a lot of risk with little obvious reward. We see an EU exit leading to lower UK growth and investment, and potentially higher unemployment and inflation. Any offsetting benefits look more amorphous and less certain, in our view.
A newly independent UK would likely have reduced leverage to fashion trade deals for the crucial services sector and less clout to negotiate regulatory standards for EU market access. Both would be lengthy and painful processes, and we see the UK as economically worse off in the end.
The EU, for its part, would lose a major budget contributor, a leading voice for free markets and easy access to a world-class financial centre. A Brexit could spur separatist calls and embolden populist parties across the continent, but we do not see a EU breakup as a result.
We see volatility in UK and European assets rising ahead of the referendum. Global markets are already reeling from a deflationary scare driven by the oil price crash and a slowdown in China. An actual Brexit would hit global risk assets, we believe, whereas a vote to stay would reassure markets.
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. Conversely, we see depressed sterling bouncing back if the UK votes to stay.
What Will Happen to Bond Yields and Interest Rates?
A leave vote would likely increase gilt yields. Portfolio inflows could falter, pressuring domestic sources of funding for the budget deficit. We could see bank funding costs rise and credit spreads widen. The Bank of England would likely cut rates in such a scenario or revive quantitative easing, looking past any temporary rise in inflation caused by a weaker currency, we believe.
We could see a Brexit dealing a blow to domestically focused UK equities and would expect large cap overseas earners to outperform as sterling falls. A leave vote poses risks to the London property market as at least some corporate office demand is based on access to the EU’s single market.
A Brexit would cut into the financial industry’s outsized contributions to the UK economy, tax revenues and trade balance, we believe, and offset apparent fiscal gains from leaving the EU. We could see the EU pushing hard to harmonise standards for financial services and capital markets – to the detriment of a UK financial industry dependent on single market access.
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