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Putting the ‘Brexit’ question in context

by Alastair Irvine
23 Feb 2016

The referendum on the UK’s membership of the European Union (EU) will be held on 23 June. The Prime Minister has made it clear that he will campaign for remaining in a “reformed Europe” (a British exit from the EU has been given the label ‘Brexit’).

The starting gun has already been fired for the referendum campaigns and both sides will bombard us with statistics, facts, propaganda and rhetoric, all of it impassioned, little of it balanced, and much of it openly partisan. There are many factors which will determine the outcome, not least people’s views on the emotive subjects of sovereignty, border control and migration.

In terms of the UK’s economic relationship with the EU, some context is useful:1

  • Balance of trade: In 2014, EU countries were the destination for 45% of UK exports and were the source of 53% of our imports;
  • Investment: In 2014, EU countries accounted for £496 billion of Foreign Direct Investment (FDI) into the UK, 48% of our total. The UK is the largest beneficiary of FDI in the EU.
  • EU funding: The UK is the second largest net contributor to the EU budget (only Germany is larger): in 2015 our contribution was £8.5 billion and is forecast to fluctuate between £7.9 billion and £11.1 billion a year between 2016 and 2020.

The EU is therefore important to the UK from an economic perspective. We’re not trading with an institutional bloc, however; these flows represent trade between individual countries and companies that are within the EU. Plus, remember that the rest of our overseas trade (roughly half of the total) is with non-EU countries. Although David Cameron is on record as saying there is no Plan B, if we leave it would nevertheless be incumbent on the government to negotiate the best possible terms to minimise the risk to that flow of trade and investment.

Answering the big question

And so to the referendum question itself: “Should the UK remain a member of the European Union or leave the European Union?” The available answers will be “Remain” or “Leave”. It’s a seemingly straightforward question with a clear, binary answer. Or is it? In fact there are many unknowns, particularly when considering the decision to leave.

If your decision is to remain, you have a reasonable idea of what you’re voting in favour of: continuing EU membership as now, modified by the reform packages agreed between the UK and the other 27 EU member states.

If you vote to leave the EU, though, what exactly does “Leave” mean in this context? The Prime Minister is not going to provide a helpful menu of the alternatives, as it will be actively campaigning to remain. So to ensure an even-handed and robust debate in which all issues are fully aired, the “Leave” campaign will need strong and articulate leadership.

If the result of the referendum is that the UK should leave, then under Article 50 of the EU Treaty, there will be a two year negotiating period. It’s at this point that we will definitely need a Plan B (plus, like in any divorce, a very good lawyer!).

What therefore might the possibilities be for the UK outside the EU? Let us consider what I see to be three of the most obvious:

  1. Join the European Economic Area (EEA): the EEA comprises the 28 EU member nations plus Norway, Iceland and Liechtenstein. The EEA agreement with the EU says that those three countries, in return for benefiting from full access to the Single Market, should adopt all EU legislation governing its operation. These include the four freedoms covering the free movement of goods, services, capital and people; adopting competition law and state aid rules; enforcing equal rights and obligations within the Single Market for citizens and economic operators; and cooperating in such areas as research & development, education, the environment etc. Areas specifically excluded from the agreement are agriculture & fisheries, foreign & security policy, justice & home affairs and, of course, monetary union.

    Under this structure the EEA countries have many of the same obligations and responsibilities as if they were EU states, but they have absolutely no political representation at the EU, nor do they have any voting rights. The three EEA countries also still contribute to the EU budget: Norway contributes €600 million a year for example. Using the size of Norway’s economy as a basis, the UK contribution would be an estimated €4 billion a year if we signed up to the same deal.
  2. Join the European Free Trade Association (EFTA): EFTA includes all the EEA nations plus Switzerland. Switzerland also has access to the Single Market, but does so via an array of individually negotiated bi-lateral agreements with the EU covering all aspects of the governance of that market. Switzerland also makes a contribution to the EU budget. The UK was a founder member of EFTA until 1973 when we left to join the Common Market, the fore-runner of today’s EU. It is no secret that the EU finds many aspects of the Swiss arrangement cumbersome, nevertheless it is one of the potential alternatives for the UK.
  3. Leave entirely: If neither of the above is possible or palatable, the UK could sever all current formal ties with the EU and the Single Market. That would then require us to negotiate new bi-lateral agreements with all our trading partners (including the 27 remaining EU nations) in order to protect our ability to trade openly, fairly and competitively without fear of barriers and tariffs. Such a process would be time-consuming and not without risk. An obvious area of competitive challenge would be to the City of London. Our continental neighbours, particularly in Frankfurt, harbour long held jealousies of London’s pre-eminent position as a world financial centre. They would dearly love to benefit from an increased share of the substantial capital flows in the foreign exchange, bond and equity markets which currently channel through London.

Lastly, in the event of a decision to leave we must not exclude the possibility of a second referendum! Just ask the Danes, Dutch, Irish and French when they inconveniently delivered the ‘wrong’ verdict in their own EU referenda at various times in the past 25 years: they were told to go away, reconsider and vote again! Never underestimate the will of the European elite and pro-European governments to keep its project on course (not least while there are very real tensions between so many member states in trying to deal with the migrant crisis).

Unreliable polls

Pollsters have been having a hard time of it recently, with the results of the Scottish Referendum and the 2015 UK General Election confounding the predictions. For what they’re worth, the EU referendum polls currently vary widely depending on whether polled by phone (a consistently clear majority in favour of leaving) or online (equally consistent in favour of remaining). As a reference point, the February 14th poll of polls indicated 49% in favour of remaining, 41% in favour of leaving and 10% undecided (source: National Centre of Social Research).

Polls of business leaders, on the other hand, tend to be more consistently in favour of remaining. When asked to consider what their preference would be from a business perspective (rather than their own private views) 62% of the UK’s FTSE350 Index finance directors were in favour of staying, only 6% for leaving and the rest undecided.2

Potential outcomes – how might markets react?

Regardless of the rights and wrongs of staying or leaving, it’s just a fact that markets dislike uncertainty. If there is an increased perception of economic and investment risk to the UK there would be three likely near-term reactions in my view: 1) sterling would probably weaken; 2) regardless what happens to official interest rates, money markets would probably seek a higher rate of return to take account of the additional perceived risk so it is likely that the cost of borrowing for business could rise; 3) similarly, the yield of UK government bonds could rise and prices fall.

Longer term, markets will get a better feel for whether the risk (and the duration of that risk) to the UK economy is something really to worry about or not and will adjust accordingly. It’s worth pointing out that while the “we’re all doomed” fraternity tend to hog the headlines, it is perfectly possible to illustrate a set of scenarios in which the longer term economic outlook for the UK is better outside the constraints of the EU.

Remember too that Brexit is a political debate every bit as much as an economic one. David Cameron in particular is spending significant personal political capital in this process. If the vote is to leave, it could potentially render his position untenable and force a Conservative Party leadership election. The Scottish National Party have also made it clear that were the vote in Scotland to be overwhelmingly in favour of remaining in the European Union, even if the UK vote as a whole were to leave, they would seek a new Scottish independence referendum of their own.

On the other hand, if the UK remains a part of the EU, the most likely reaction in my view is that equity, bond and currency markets would breathe a sigh of relief and return to addressing other more pressing problems such as weak global commodity and oil prices, the slowing rate of global growth, concerns about China etc.

From an investment point of view, at this stage there are simply too many unknowns to arrive at a fixed view about Brexit. The polls are unreliable and unhelpful, the result is not a foregone conclusion either way and if we vote to leave, we’re being told little of what then happens. Against that background it is difficult to put forward an investment strategy purely centred on Brexit. What investors should do is follow the time-tested strategies of building diversified portfolios of high quality assets and focus on long-term returns. It goes without saying that investors need to be vigilant and mindful of potential short-term volatility which might arise in the lead up to the referendum and its aftermath, but they should not be paralysed by it.

Sources
1 UK-EU Economic Relations, House of Commons Library, January 2016
2 Deloitte, January 2016

Important information
This commentary is for informational purposes only and is not investment advice. The views expressed are those of the author at the time of writing and are not necessarily those of Jupiter as a whole and may change in the future. Every effort is made to ensure the accuracy of the information but no assurance or warranties are given. Market and exchange rate movements can cause the value of an investment to fall as well as rise, and you may get back less than originally invested.
Issued by Jupiter Asset Management Limited which is authorised and regulated by the Financial Conduct Authority. No part of this document may be reproduced in any manner without the prior permission of Jupiter Asset Management Limited.

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