U.K. voters to decide: Should we stay or should we go?

In a June 23 referendum, the U.K. will vote on whether to “leave” or “remain” in the European Union (EU). We at Invesco Fixed Income (IFI) believe the U.K. will vote to remain in the EU. However, staying in the EU would change little in the way of the existing challenges for the U.K., the EU or even the world economy as a whole.

Argument versus counterargument

U.K. press reports have been saturated with referendum-related stories over the past three months. Numerous international bodies, including the International Monetary Fund (IMF) and the Organization for Economic Cooperation and Development (OECD), have suggested that the U.K. economy would be worse off if it exited the EU – a scenario known as “Brexit.” U.S. President Barack Obama warned “exiters” that the U.K. would be at “the back of the queue” for American trade deals if it left the EU. Domestically, the Bank of England Governor, Mark Carney, and the Chief Executive of the National Health Service, Simon Stevens, have also warned that a Brexit could be detrimental to the economy over the short term.

These warnings have been dismissed by “leave” campaigners. Those who argue against EU membership focus on issues of immigration and its strain on the U.K.’s social infrastructure, the high financial cost of EU membership, and limits on the U.K.’s ability to forge trade agreements with non-EU nations independently of the EU. The current European immigration crisis reinforces the concerns of exiters, who would like to be able to dictate how many individuals come into the country each year and have greater say over where they come from.

Despite the arguments and counterarguments, no one appears to be disputing the fact that the U.K. economy would experience an initial shock in the aftermath of a Brexit. How great could the impact be? How long would it last? What would the ramifications be for the wider European project? These questions are uncertain.

On the other hand, the “remain” camp has not argued that the U.K. would be better off over a longer-term horizon from a growth perspective, if it stays in the EU. While the U.K. recorded its 13th consecutive quarter of growth in the first quarter of 2016, recent economic data point to a near-term slowdown. Some attribute this apparent slowdown to uncertainty surrounding the EU referendum, but there are tentative signs that the U.K. housing market may be cooling. A meaningful decline in home prices would be a significant concern, in our view. The housing market has been a key driver of U.K. consumer confidence, and historically, consumer confidence has been highly correlated with the popularity of the “remain” campaign.

Invesco Fixed Income’s view

We at IFI expect the U.K. to vote to remain in the EU, but also believe that there is considerable uncertainty about the polls themselves, the outcome and indeed its impact. A clear lead had started to emerge for the “remain” camp in opinion polls. The Financial Times poll of polls (which eliminates outlier polls) gave EU supporters a 7% lead as of May 19, compared with a 1% lead the previous month. Telephone polls have generally pointed to a lead of around 7%, although online polls suggest a closer race.¹ But recent polls² suggest a swing back toward “leave.” We concur with the consensus view that this switch is due to the success of the Brexit campaign in shifting the focus of the political debate away from the economic impact of the referendum choice and toward popular immigration concerns.

“Remain” vote would not resolve existing economic challenges

In terms of macro fundamentals and the markets, in the shorter term, we believe there is more potential downside in the event of a “leave” vote, but not much upside, if any, in a “remain” vote. This is because staying in the EU would change little in the way of the existing challenges for the U.K., the EU or the world economy as a whole, whereas leaving the EU would open a host of new issues.

Key challenges in the “remain” scenario could include integrating the eurozone more deeply while balancing the national interests of the creditor countries to the north with the debtor countries to the south. In addition, there is the issue of balancing the need for deeper eurozone integration with the protections that were negotiated with the U.K. in the run-up to the Brexit referendum – and the prospect that other member states may want something similar.

The challenges in the exit scenario might include negotiating the U.K.’s exit from the EU and new trade deals with the EU as well as with most other trading partners – a process that could take many years; potentially, there could also be changes in the structure of U.K. politics, including leadership of the governing Conservative Party and the possibility of a second Scottish independence referendum.

EU challenges may include fending off copycat exit referenda in other euro-skeptic countries, including both long-standing and new EU members.

Implications for global investors

The markets are effectively pricing in the risk of Brexit on the basis of shifts in the polls, primarily in sterling. Sterling weakened meaningfully from last summer to Feb. 29, 2016, when it hit a low of 1.38 pounds per U.S. dollar.³ It has since appreciated, as the likelihood of a “remain” outcome has increased. At IFI, we have been overweight sterling versus the U.S. dollar since near the lows and believes that a strengthening “remain” campaign would be supportive in the run-up to voting day. Nevertheless, given the difficulty in separating the impact of a potential Brexit from global central bank policy, we expect to see sterling volatility in the coming weeks, depending on polling results. In general, we are keeping our U.K. exposures close to neutral at this stage (aside from sterling), and mitigating our risky asset exposures across global asset classes.