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'If you leave me now' - Rathbone Investment Management look into the implications of Brexit for the UK economy and markets

Posted Monday, 11 April 2016, 10.06am

"We believe that even if the UK votes to leave, the economic and financial implications are likely to be more finely balanced than newspaper headlines imply.

"We explore five of the main issues surrounding the debate by challenging some of the hyperbole, in order to help assess the implications more accurately. The first of these is that immigration has held down wages and pushed up unemployment for UK nationals. On balance, the evidence suggests this has not happened. Therefore, we do not expect wage growth to increase or unemployment to fall substantially if the UK votes in favour of Brexit.

The second myth is that UK trade would collapse after leaving the EU, which we believe is an exaggeration. In the first instance, the government may be able to withdraw but negotiate special terms of access to the common market — a kind of ‘soft Brexit’. Even under a ‘hard Brexit’, the UK would remain protected from any unfavourable treatment by global trade rules. However, EU trade tariffs are not uniform and some sectors would suffer more than others, particularly autos, food and clothing.

The third myth is that the Swiss financial services industry has thrived outside the EU, and that this is a model for the UK. Yet Switzerland’s relationship with the EU is complex and could not be replicated. Evolving legislation could push financial services activity towards the Continent if the UK votes for Brexit, which would cause a gradual loss of business and investment.

This is not a short-term risk, however, and one should not underestimate London’s history of financial innovation, predisposing government policy and the network effects of three centuries of global financial activity. Further, we would not necessarily expect regulation to become less onerous if the UK were to leave. Recently, some of the most controversial directives have been proposed by the UK and it is far from clear that London has less regulatory zeal than Brussels.

The fourth myth is that the UK’s public finances would improve substantially if it leaves the EU. A simple calculation suggests the country would be £9 billion better off in the current tax year if it did not have to make contributions to the EU. Yet at least two-thirds of this saving would probably be eroded by state support for industry; continuing contributions to the EEA under a ‘soft Brexit’ scenario; and losses from the positive contribution of new immigrant workers. Perhaps the greatest risk to UK finances is that Brexit would create uncertainty, which could reduce growth and, in turn, government tax receipts.

The fifth myth is that foreign investors will withdraw from the UK if it leaves the EU. To date, at least, it is difficult to conclude that the prospect of Brexit is derailing investment flows. 2014 was a record year for inward investment on many measures, despite the impending inevitability of the referendum. Surveys indicate that R&D will be the focus of investment projects over the coming years, and here the UK has a near unparalleled attractiveness.

However, an Ernst & Young survey highlights that 72% of investors polled state that UK membership of the single market is at least ‘fairly’ important to the UK’s attractiveness as an investment destination. Although it is difficult to forecast the long-term implications of Brexit, we do not expect a divestment of foreign investment in the short to medium term, but suggest that investor uncertainty could adjourn future inflows, particularly in the financial sector.

Looking ahead

The referendum result could push the UK in a number of different directions, which makes it difficult to forecast the long-term effects on economic growth, interest rates and the current account balance. If the country votes to leave the EU, it could make a clean break or retain many rights of access to the single market. If the UK remains within the EU, the benefits will rely on the European project progressing successfully — and solving any problems decisively along the way.

Meanwhile, in an increasingly globalised world, the UK economy should do well if the country can successfully negotiate new treaties of economic integration with higher growth nations. We assign some probabilities to a simple schema to show that the likelihood of a sustained negative deviation from the current trend of UK economic growth is perhaps at worst 1 in 6, and more likely 1 in 10 (EU completion pursuant to ‘hard Brexit’). These numbers do not suggest a trivial risk, but it is important to think, like markets, in probabilistic terms.

In the short term, the referendum is unlikely to have a substantial directional impact on financial markets in the run-up to voting day or in the immediate aftermath if the UK votes to leave the EU. Yet we expect markets to react to any lack of clarity and associated uncertainty. Mid and small cap UK equity indices seem particularly sensitive to measures of economic uncertainty, although relative performance does not appear to have suffered yet. Meanwhile, we expect sterling to suffer the most volatility, and there are already indications that currency traders are positioning for some extreme moves."

Rathbone Investment Management

Rathbone Investment Management have some useful information/infographics on Brexit on their website here. If you would like to read their in-depth Brexit whitepaper, you can find it here.

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