Our base case scenario is that the UK will remain in the EU, but recent trends in the opinion polls and bookmakers’ odds suggest it is a close call. We therefore attach a relatively high probability to a Brexit. Through much of April, the vote to Remain had the upper hand, but that has now changed with the Leave vote polling at 45% against 42% for Remain. However, generally, the differences between the two camps in the polls have been within the margin of statistical error. Meanwhile, the oddschecker indicator – which is based on bookmaker quotes – currently gives an implied probability of Brexit of around 38%, significantly higher than a few weeks ago.
The starting point for the rest of Europe also makes the continent vulnerable to political contagion.
Nick Kounis Head of Macro Research
The outcome of the UK’s referendum to leave the EU looks like an increasingly close call – the possibility of Brexit is very real
A vote to leave would likely trigger a UK economic downturn and a further sharp fall in sterling
Financial market stress and European political contagion could lead to global spillovers
Central banks could react to ease stress by providing liquidity, via a co-ordinated interventions in currency markets and by stepping up stimulus
The outcome could be swayed by events. The awful murder of MP Joe Cox has led to speculation that the Remain camp could get the upper hand. She was an ardent supporter of the Remain campaign and she was apparently murdered by a nationalist. In addition, there is often a swing towards the status quo in the run up to electoral polls and referendums. On the other hand, surveys show that older people are more Eurosceptic and are also more likely to turn up and vote.
The UK’s EU referendum timetable (UK time)
22:00– Polls close. There will be no TV exit polls
00:01 – Just after midnight the first results come through
00:45 – Result for City of London
01:30 – Result for area of Salford – one of the bellwethers for the national outcome
04:00 – Large majority of results should be in
07:00 – All results published
What would Brexit mean for the UK?
We think that a vote to leave the EU, would likely trigger a downturn in the UK. Although the UK’s relationship with the EU would not change for two years following the vote, the uncertainty could lead to corporate retrenchment, with companies pulling back investment and hiring. This would be particularly the case for companies – both UK-based and foreign – whose business could be hurt by a change in UK’s access to EU markets.
However, there could be wider financial stress in the UK and beyond. The UK has a large current account deficit, trending at around 5% GDP. That means it has to attract that flow of capital annually to finance the deficit. Yet Brexit is a headwind to portfolio inflows and FDI. This makes the sterling exchange rate particularly vulnerable to a vote to leave the EU. Sterling has already fallen significantly, but we would expect an even sharper fall in the event of a Brexit. There would also likely be weakness in growth-dependent UK assets such as equities and corporate bonds as they price in the downturn.
As the uncertainty eases and the economy adjusts to the new situation economic growth will recover, also helped by the fall in sterling and easier monetary policy. This could take a year or so though, and would depend on the extent of the political spillovers to the rest of Europe. Overall, UK economic growth would likely be lower over the long-term assuming that it will lose some access to the EU market.
Is Brexit a global risk?
Over the last few days, financial markets globally have been driven by perceived shifts in Brexit risk. For instance, the VIX has moved around in recent days in sync with the probability of Brexit as judged by bookmakers. This raises the question whether this is justified. The direct effects of Brexit would be severe but would mainly fall on the UK, which is not big enough to destabilise global growth and markets.
However, worries seem more justifiable from the perspective of the indirect effects on the rest of Europe and from the point of view of financial spill-overs. If Brexit fans anti-EU movements in other countries, raising the risk of EU/euro fragmentation, then Brexit does constitute a more global risk. The selloff in peripheral government bonds when Brexit risks were seen to intensify seems to fit this explanation, as does the general poor performance of the euro and eurozone equities in this environment. Large swings in currencies can destabilise markets, while uncertainty can lead to a more general tightening of financial conditions.
This is especially the case given the weak starting point for the global economy, financial vulnerabilities in emerging markets, and the lack of easy options for central banks to provide further support.
Is the rest of Europe vulnerable?
The starting point for the rest of Europe also makes the continent vulnerable to political contagion. Political risk has risen, not just in one or two country-specific cases, but in most countries. Euro-skepticism is on the rise and seems to be part of a wider anti-establishment trend. A cocktail of poor economic performance, high unemployment, austerity and concerns about immigration have led to political fragmentation in Europe. The popularity of radical parties on all sides of the political spectrum has risen. This is making it more difficult to form effective governments, while also increasing the chances that a radical party has a strong influence on government policy.
Recent polls suggest that a significant proportion of the public in a number of other countries would also be in favour of an EU referendum in their country. In a recent Ipsos-Mori poll, more than 50% of the French and Italian participants wanted one. It must be said that there is still a majority in every country in favour of both the EU and the euro in member states. However, markets may still react to the risk of EU/euro fragmentation if it looks as if sentiment is moving in that direction. This could lead investors to once again worry about countries in the periphery with high budget deficits and/or levels of government debt. In addition, there is not a unified EU stance on what to do following a Brexit. France has suggested that it would be a trigger for further integration for the rest of Europe, while Germany has doubts about this.
What will policymakers do?
A big question is how policymakers will handle the direct aftermath of a UK vote to leave the EU. In terms of easing concerns about the economic impact, an early and strong statement from both the UK and the EU that they would intend to pull out all the stops to keep the current trading relationships in place would make a major contribution to stemming the adverse economic and financial market effects described above. However, this does not seem likely.
Although it is in both the UK and EU’s economic interest to agree on free trade, the politics are pointing in the other direction. The EU may want to drive a tough bargain with the UK in order to dissuade other countries from following the UK’s path out of the EU. At the same time, the UK would likely not be willing to accept free movement of people and other regulations necessary in order for it to have full access to the EU market as this would be a key factor behind the vote to leave in the first place. It is more likely that the negotiations will be difficult, long-lasting and possibly heated and acrimonious.
So policymakers would more likely need to deal with the fall-out rather than the root cause. We see three sorts of policies. First of all, enhanced liquidity provision, including via swap lines between central banks. In addition, central banks would likely generally move to more accommodative monetary policy. The BoE could step up QE. The Fed could throw its rate hike plans out the window, or even consider more stimulus. The ECB would probably also enhance QE, whereas a further deposit rate cut to weaken the euro would also be an option. Finally, there could be globally coordinated intervention in FX markets to prop up sterling.