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BREXIT – 6 key impacts on the financial markets

Last updated: May 3rd, 2017 at 09:58 pm

Having weighed up the arguments for and against a Brexit, I am now going to look at the impact on financial markets. There are several ways that markets could be impacted. Here are 6 factors to consider in the event of a Brexit.



The impact on the Bank of England’s Monetary Policy

In the minutes from the Bank of England’s May MPC meeting, the committee warned that a vote to leave could harm economic growth and have a serious negative impact on the pound. Already it would appear that investment decisions and arguably retail sales have been negatively impacted by the uncertainty.

From an economic standpoint, a vote to leave would create huge uncertainty on the economic outlook. Slower growth could result, but according to the minutes, the MPC says that it needs to set the interest rate to meet the inflation target. This could mean that the Bank of England’s job to set monetary policy would become incredibly difficult.

Carney BoE

The problem is that whilst economic growth is likely to be impacted to the downside, and this would conventionally require looser monetary policy as a response. However, inflation could go higher too. A sharp depreciation in sterling would be inflationary because a collapse in the pound would make foreign goods more expensive. Would the Bank of England possibly be driven to hike interest rates to protect sterling and prevent inflation? Former Citibank chief economist Michael Saunders joins the Monetary Policy Committee in August and believes that inflation could soar to 4% in the wake of a Brexit meaning that the Bank of England could need to hike rates to 3.5% by the end of 2017.

However, with economic growth negatively impacted by the Brexit, the economy would be under significant pressure if the Bank increased rates, especially on debt-laden mortgage borrowers. Any sudden shock to economic conditions, whether it was an inflation spike or sharp moves in interest rates, would be detrimental to the economy. It would be bad for the confidence of both the consumer and also investors. It is unlikely that the economy would be able to handle a rate hike of the pace that Saunders is talking about. Subsequently the Bank of England would be in an incredibly difficult position. Most economists seem to believe the chances are that the Bank would resort to a rate cut to help against recession – but it is clearly not a simple decision.

The section below from the May Bank of England meeting minutes shows what a difficult position the Bank of England will be in if a Brexit becomes reality.  There will be significant uncertainty on the path of monetary policy. This will create significant volatility in UK assets such as sterling, Gilts and equity markets.

BoE minutes assets


The Impact of a Brexit on Sterling

The Bank of England believes that in the six months between November 2015 and May 2016, sterling has already been negatively impacted by the uncertainty of a Brexit. According to the minutes of the May MPC meeting, around half of the 9% decline in Sterling could be attributed to the risks of a Brexit. See below:

BoE minutes sterling

sterling decline

That would suggest that this value would quickly unwind if there was a vote to remain in the EU. This would theoretically drive sterling back towards $1.5100/$1.5200 against the dollar. However, the Bank of England believes that on a vote to leave the EU, the value of sterling could drop “significantly”. Investment banks agree. Lower demand for UK investments from abroad, in addition to the uncertainty, a negative impact on the UK economic outlook and raised concerns of foreign investors could mean a significant drop in demand for sterling. This would send the value of the pound sliding lower. Analysts at banks such as HSBC suggest that sterling could decline in value by as much as 20%. Whatever the result of the referendum, there will be significant volatility on sterling on the result, and even more so if the polls are too close to call.

Already we have seen options for 1 month Sterling/Dollar options trading at elevated levels not seen since the height of the financial crisis in 2008/2009, which suggests that the market is preparing for a volatile outcome.

 sterling volatility


Impact of a Brexit on other major currencies

The forex markets could be significantly impacted in the days following a UK vote to leave the EU. The likely sterling weakness would also have an overflow impact across other markets. On a broad level there could be a flight into safety and this would mean that currencies such as the Japanese yen and Swiss franc could be beneficiaries of any safe haven flows, however there could also be a strengthening of the dollar too.

dollar strength

How could a potential 20% weakness in sterling impact on the UK’s key trading partners?

  • Would a Brexit cause renewed economic growth decline/recession in the Eurozone? What sort of impact would this have on European Central Bank monetary policy? In the ECB press conference in June, Mario Draghi said that the ECB was ready for every eventuality. Would this result in further ECB monetary easing? There could therefore be downward pressure on the euro.
  • Would the Swiss Franc strengthen? With imports to Switzerland from the UK accounting for 12% of total Swiss imports, the relative underperformance of Sterling would be a sizeable problem for the Swiss National Bank that constantly has to battle against the strength of the Swissy. The flight to safety would also only exacerbate this. Would the Swiss National Bank also be pushed into cutting interest rates further?
  • Would a relatively stronger US dollar result in the Federal Reserve delaying any further rate hikes? A stronger dollar is deflationary, and the issue of a Brexit was mentioned as a risk in the April FOMC minutes and also by Janet Yellen in a speech on 6th It is clearly an issue for the FOMC to ponder at the meeting on 15th June.
  • Would a flood into the safe haven of the Japanese yen result in renewed jawboning / currency intervention / monetary easing from the Bank of Japan?

As shown with Sterling/Dollar 1 month options, with all these uncertainties over the impact on major currencies, the one big winner would be volatility. There are many questions posed by the prospect of a Brexit and major forex markets could take weeks to settle down. It could be a while before traders are confident with the re-pricing of not only sterling, but also currencies such as the euro, Swissy, the yen and the dollar.


Impact of a Brexit on Equities

UK equities would come under pressure in the event of a Brexit. The negative affect of the economic and political uncertainty in the UK, would impact across UK assets. If there is a flight to safety, a Brexit would therefore be negative for UK equities which are a relatively higher risk asset class.  According to UBS the FTSE 100 could fall as much as 10% in the next year if the UK votes to leave the EU on 23rd June.

FTSE 100

However, within this there are likely to be winners and losers, at least on a relative basis. Around three quarters of the revenues in FTSE 100 companies are generated abroad, with the significant weighting in the mining and oil & gas sectors being a key factor. Subsequently, this large proportion of international revenues would benefit from a sharp weakening of sterling which translates positively when exchanged back into sterling. Furthermore, some of the biggest dividend payers in the UK are dollar based and these would also benefit from the sterling weakness. According to MorningStar, two fifths of UK dividends (of FTSE 350 companies) are paid in dollars and would therefore benefit from sterling weakness (on relative dollar strength). These stocks are likely to outperform.

Despite this though, there are likely to be companies that significantly underperform too. Stocks with sizeable exposure to the UK economy will be targeted if the UK moves into recession. Also, any company with significant links to European trade can be expected to come under selling pressure as the negative impact on the EU is also factored in.

The FTSE 250 Index (mid-cap stocks) tends to be more linked to the performance of the UK economy than the FTSE 100, with over half the revenue generated by companies in the FTSE 250 being UK based. Therefore if a Brexit does drive and economic slowdown/recession in the UK, the FTSE 250 have greater exposure to UK earnings and would also be expected to underperform the larger cap FTSE 100.

UBS also believes that if the UK votes to remain in the EU, the FTSE 100 could subsequently rally by 5% in the next 12 months.


Impact of a Brexit on Gilts

UK Government bonds could come under pressure in the wake of a vote to leave the EU.  Credit rating agency Moodys has already stated that the economic costs of Britain exiting the EU would “outweigh the potential benefits”. If this is the case then a Brexit would put the UK’s Aa1 credit rating by Moodys at risk. The ratings agency has stopped short of putting the UK on “negative watch” so far, but there is clearly a very real risk of a ratings downgrade.

credit rating

Additionally, if Moodys’ downgrades the UK credit rating, then there is likely to also be a risk that other ratings agencies such as Standard & Poors (currently the UK has a AAA rating but is on negative watch) and Fitch (currently AA+ rating) could change their ratings too.

One or more ratings downgrades, would likely have a negative impact on UK Gilts. Any selling pressure would push Gilt yields higher and subsequently increase the UK Government’s cost of borrowing. This would mean more would be spent on debt servicing and could therefore mean either a reduction in government spending and/or higher taxation.


Impact on House Prices in the UK

The impact on house prices is very much open to debate as there are several conflicting factors here. Initially it is likely that there would be a drop in transactions as the uncertainty takes hold, which would drag prices lower. However, the question is, for how long?

House prices

Once the decision is taken to formally leave the EU, according to Article 50 of the EU Treaty, the UK will be completely free of the EU after two years. After this, a significant source of flexible labour for the housebuilding industry that comes with being part of the EU will no longer be available. Subsequently without the Freedom of Movement from the EU, could there be a shortage of labour which subsequently hits the number of houses being built (or should I say even fewer than are currently being built)? This could eventually end up being supportive for house prices.

Furthermore, once the dust settles, international investors would still see the UK market as a safe haven and possibly even use any weakness as an opportunity to buy. With the legal and political advantages still present in the UK, the attractiveness of the UK for overseas buyers who believe that parking their money in housing assets is a good strategy, would still be present. Not only that, once the depreciation in sterling has settled, their dollars, roubles, yuan or whatever currency they are exchanging would be able to buy much more. This could eventually help to drive a house price recovery. A Brexit could mean a wild ride in the coming years for house prices.

Additionally, it has been interesting to note the relative underperformance of the London listed housebuilding stocks on days that that the Leave camp have shown improved ratings in the opinion polls. It is reasonable to assume therefore that the share prices of housebuilders would come under significant pressure in the event of a Brexit.

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At Hantec Markets Ltd we provide an execution only service. Any opinions expressed by analyst Richard Perry should not be construed as investment advice or an investment recommendation. This report does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. Forex and CFDs are leveraged products which can result in losses greater than your initial deposit. Therefore you should only speculate with money that you can afford to lose. Please ensure you fully understand the risks involved, seeking independent advice if necessary prior to entering into such transactions.