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Three Brexit questions investors are asking, one week out

17 June 2016

By Bob Cunneen, Senior Economist and Portfolio Specialist, NAB Asset Management

Britain goes to the polls next Thursday. Will they vote to stay or leave the European Union (EU)? And what will be the implications for investors?
1. Will they vote to stay or leave? It's a close call

On Thursday 23 June, Britain will vote on whether to stay in the EU or leave. Polls prior to June favoured Britain remaining in. Yet these polls also featured a high component of "don't knows".

The probability of Britain remaining in the EU has fallen over recent weeks, as seen in Chart 1. The Financial Times 'poll of polls' now favours the exit vote at 48%, and "remain" at 43%. "Don't knows" currently account for about 9% (at 16 June 2016). So the polls are very confusing and the "don't knows" throw a lot into question.

What's more, the vote is voluntary. So the final outcome will depend a lot on how well each side can motivate the country to firstly turn up, and then secondly vote their way – especially for the large "don't know" population.

Given these mixed voting intention signals, the outcome essentially hangs in the balance.

Chart 1: Implied probability of winning the vote, from average UK bookmakers' odds (%)

Source: Steve Lawrence. Financial Times, 14 June 2016.

2. What's the potential impact on the British economy, if they decide to leave the EU?

There are a wide range of forecasts on the impact. The UK Treasury estimate is that Britain's economy would between -3.8% and -7.5% smaller by leaving, compared to remaining in the EU. By contrast, another forecast from the 'Economists for Brexit' estimate a net 2% rise in GDP by 2020.

However, the general consensus is there will be a negative impact on Britain, including:

  1. Lower investment from Europe: the EU accounts for 48% of Foreign Direct Investment.
  2. Lower trade: nearly 44% of UK exports are to Europe. British exports would find European markets more difficult to access, if they leave.
  3. Lower currency: the pound sterling is seen as vulnerable because the UK is running a very large current account deficit of more than 6% of GDP, shown in Chart 2. The UK relies on an increase in capital inflows to reduce this deficit.
  4. A higher risk premium for UK assets: Britain's share market would be sensitive to the potential higher cost for banks' wholesale funding and for corporate credit.

Chart 2: UK Current Account Deficit is very high

Source: UK Treasury, Bank of England. Lombard Street Research, as at 1 June 2016, 'Brexit Brawl'.

3. If they decide to leave, what's the likely impact on the global economy?

Britain's importance in the global economy should be placed in perspective. Britain accounts for about 2.3% of global GDP and is smaller than Germany (3%) and much smaller than the US (16.5%) and China (15.9%).

The impact of an 'exit' outcome will be more about confidence and politics.

Britain's exit would be a major concern for European politics. The concern is that the European project of monetary union will be set back. What's more, other countries may also decide to leave (contagion).

Looking at this in context, China's economic slowdown, weakness in emerging markets such as Brazil and Russia, plus the prospect of the US lowering interest rates present a more imminent risk to the global economy than Britain leaving the EU.

Should Britain decide to leave, the process will take up to two years, meaning its departure will probably have an extended but modest negative influence on the global economy.

However in the short-term, investors should prepare for volatility in both UK and European markets. But if the result is 'leave', this will probably last longer as the market will need time to process the full impact.

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