While St. James’s Place is not taking a position on the EU referendum question, investors should consider some of the bigger issues at stake.
It was far easier for Harold Wilson.
The former Labour leader and UK prime minister called a referendum on the UK’s membership of the European Economic Community, forerunner of today’s EU, in 1975, in order to head off eurosceptics in his own party. After securing some cosmetic changes to Britain’s relationship with the EU, he won the support of the British press. Two thirds of voters elected to remain in the union.
Continued membership of the European Union looks to be a much harder sell for David Cameron. In 1975, Britain was one of just nine member states of the community, whereas today there are 28 members. Integration has reached much deeper levels, too; today, 19 of those members share a currency and central bank. Moreover, whereas the vote under Harold Wilson was known as the ‘Common Market Referendum’, today’s EU remains an incomplete common market but has extended its remit into a number of other areas.
The prime minister’s job of persuading voters is therefore not easy. The eurozone crisis and European migrant crisis have provided focuses for discontent and UKIP gained almost four million votes at the 2015 general election.1 After falling significantly behind, the Leave camp has enjoyed a strong fortnight, leading in a handful of polls. One of the latest ‘poll of polls’ readings puts Remain at 46%, against 43% for the Leave camp, while Ladbrokes puts the likelihood of a vote to leave at 27%.2 But the last general election showed that the pollsters and bookies can get it wrong.
Markets dislike political uncertainty, of course, and volatility has increased ahead of the referendum, exacerbated by thin trading volumes as investors sit on their hands. Further volatility should be expected in the immediate aftermath of an exit vote. Yet for long-term investors, a few weeks of heightened volatility is ultimately less important than the long-term economic and financial ramifications of a British exit.
Britain spurned the European Economic Community in 1955, and received a veto from France when it sought to join in 1961. By the time the UK joined in 1973, it was the ‘sick man of Europe’ – its economy had been overtaken by Germany, France and Italy. It is now the second-largest economy, and 44% of British exports go to the EU – more, if you include the EU’s external trade deals.3 On the other hand, membership has locked the UK into EU-wide trade regulations and increased the transfer of sovereignty to Brussels, where the power of the unelected European Commission adds to the sense of democratic deficit.
A vote to leave the EU would have a few immediate consequences. Since a rerun of negotiations has been ruled out, the first move would be for Britain to trigger the exit clause introduced in the 2007 Treaty of Lisbon, initiating a two-year ‘departure lounge’ negotiation over its post-exit deal before ‘take-off’ (or, for Europhiles, ‘descent’). The EU would lose a significant member, especially in terms of economic, military and diplomatic clout. It would also lose its leading financial hub. As for the UK, there is a risk that a second Scottish independence referendum would see Scotland choose Brussels over London.4
The economic impact is more difficult to predict. In a report commissioned by Neil Woodford, Capital Economics argued that the economic difference between the two outcomes would in fact be relatively marginal, but that an exit was slightly more likely to be economically positive than negative. A Barclays report argued that a British exit would be far more negative for the EU than for the UK, and could even precipitate capital flight to the UK, which would be perceived as a safe haven amid the increased uncertainty in the EU.
On 16 May, a pro-leave letter was published in The Daily Telegraph, signed by 306 business figures. Among them were heads or founders of Cheapflights.com, FTI Consulting, Lombard Street Research, Reebok, Robert McAlpine and Wetherspoons. Paul Geoghegan, former chief executive of HSBC, wrote in favour of an exit in the Financial Times while Jim O’Neill, former chair of the Goldman Sachs UK Asset Management business (and inventor of the acronym ‘BRICs’) said in 2013 that an exit should not be feared and offered “huge” opportunities.
But the three largest ratings agencies have warned that they might cut the UK’s credit rating in the event of an exit. Pro-Remain letters to The Times and FT carried the signatures of 198 business leaders and 36 heads of FTSE 100 companies, respectively. Those represented included Asda, BT, HSBC, Jaguar Land Rover, Lloyd’s of London and Royal Dutch Shell. Mark Carney, governor of the Bank of England, has made several warnings about the implications of a British exit, citing risks to sterling, growth, trade and the City. The UK Treasury, IMF, WTO, OECD and Institute for Fiscal Studies have all published studies that warn of the negative effects on the UK should it leave the EU.
One business poll asked more than 700 company executives in UK and Germany-based companies how they would respond to a British exit: 29% said they would reduce capacities in the UK or relocate, and 79% were opposed to a British exit.5 A poll of 600 economists conducted in late May found that 88% believed an exit would damage the UK’s growth prospects.6 Nevertheless, a British Chambers of Commerce survey conducted in mid-May showed a first-quarter increase in the number of UK businesses favouring an exit. Yet for both sides, it is widely agreed that trade deals and success in deregulation will determine the actual growth impact of an exit.7
The financial sector has also weighed in on the implications of an exit. Blackrock warned of the impact on UK stocks and property; JP Morgan’s outgoing CEO warned of “massive dislocation” in the City as companies lost their EU passport; HSBC said it would shift 1,000 jobs to continental Europe. Paul Richards, head of regulatory policy at the Capital Markets Association, warned that financial regulation would increase; uncertainty would rise; foreign investment would slip; some City jobs would be lost; and trade deals would take years to negotiate.
John Longworth quit in March as chief of the referendum-neutral British Chambers of Commerce in order to be able to air his views. An article in The Daily Telegraph followed, in which he argued that the single market worked well for French agriculture and German industry, but did not allow for a free market in services – the UK’s strong suit; Longworth favours a British exit. Roger Bootle, head of Capital Economics and author of The problem with Europe, argued in a recent speech that a British exit would aid trade deal flexibility; that the EU’s single market doesn’t do what it’s supposed to; and that London has too many advantages to suffer a mass exodus of City companies after an exit.
Taking the many strands together, the debate over UK’s membership of the EU has two themes right at its centre: sovereignty and the economy.
Membership of the EU requires some pooling of sovereignty (and more than is required for membership of NATO or the UN), in terms of accepting the EU’s power to override the UK parliament in certain areas; abiding by EU trade regulations; paying the membership fee; and agreeing to EU border controls.
The other main area of concern is the economy. Trade is a headline issue, as 44% of UK exports go to (or through) the EU. So too is foreign direct investment, since the EU accounts for almost half of the UK’s inward investment,8 and a dip would affect Britain’s balance of payments. A third concern is what an exit would mean for employment.
In reality, the issues of sovereignty and economics cannot be prised apart – the cost of deep access to the EU market is the pooling of at least some sovereignty, even for non-EU members.
The precise economic and financial outcomes of a British exit from the European Union are impossible to chart – the club has only ever grown. Much would depend on the success of the UK’s ensuing trade negotiations with the EU and other partners.
These imponderables mean that uncertainty is likely to dominate in the remaining weeks leading up to the referendum. Markets may not like bad news, but they dislike uncertainty at least as much. In February, sterling fell to a seven-year low.
Volatility is thus likely to remain high in UK-focused stocks ahead of the referendum; in the case of a vote to leave, it is likely to persist for some while, but the uncertainty this reflects does at least have an end date if there is a vote to remain. It is therefore important for investors not to allow this volatility to lead them to make hasty decisions, either before or after the referendum.
Equally, the temptation to delay investing, or to switch to the ‘safe haven’ of cash, before the vote, risks ‘missing the bounce’ if markets respond positively to the result. Market timing is impossible to get right consistently and risks preventing investors from making the decisions that will affect their long-term financial security. History shows both that short-term volatility is an inevitable feature of stock markets, and that markets do recover. Against the short-term uncertainty in markets over the referendum is the certainty of record low returns on cash.
Although predictions vary, a number of leading economists on both sides of the debate predict a further drop in sterling in the wake of an exit vote. Gilts, on the other hand, have remained popular with investors since the referendum was announced. Although there could be a risk of capital flight after an exit vote, it is also expected that interest rates would be held down for longer, which attracts inflows to government bonds. When it comes to the stock market, opinions vary widely on which sectors might be helped or harmed by a British exit. The FTSE 100 is a very international index, so any adverse effect would be less pronounced for those stocks than for some of the smaller domestic stocks listed on the FTSE 350. A weaker currency in the event of a vote to exit may support global players and hurt smaller domestic businesses.
As ever, a well-diversified portfolio, with significant exposure to different geographies and asset classes, is the best long-term strategy to help protect investors against uncertainty.
The exit door has now been unlocked. Rather than trying to identify an exit strategy, investors should remain focused on companies’ long-term growth outlook and on whether that outlook is reflected in their valuations. Successful companies, and successful investors, will factor political risks into their decisions without being governed by them. If they do, then the EU referendum should claim more victims in politics than among those investing prudently for their future.
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This material is not intended to be relied upon as a forecast, research, or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any strategy. Where the views of third parties are given, these are not necessarily shared St. James's Place Wealth Management.
2 www.ft.com/brexit-polling; http://sports.ladbrokes.com/sports-central/uk-eu-referendum/, accessed 2 June 2016
6 Ipsos Mori poll conducted for The Observer