Why a decision to leave the EU will be costly for the UK economy and sterling assets

 

The outcome of the UK’s momentous referendum on whether or not to remain in the European Union (EU) is shrouded in uncertainty.

We do not pretend to have any more foresight into the result than the opinion pollsters and bookmakers who suggest the vote is hanging in the balance. However, we have more confidence in our view that there would be a negative impact on the UK economy and financial asset prices if the country opts to leave the EU.

In the following piece we bring together the views of our team of economists and investment professionals to help inform our clients’ thinking.

Firstly, we believe there would be a significant and negative knock-on effect on business sentiment, which would likely push the UK economy into recession towards the end of this year. And the consequences of a vote to leave wouldn’t just be felt temporarily. We would expect to see a permanent reduction in exports to the EU, while foreign-direct investment into the UK would also suffer, leading to higher unemployment and a decline in the country’s long-term growth potential.

Financial markets would undoubtedly react badly to a vote in favour of ‘Brexit’ too. We would expect an immediate and sharp fall in the pound. The UK runs comparatively large fiscal and current account deficits, and as such relies on foreign capital to finance the deficiency in domestic saving. If, as we anticipate, the uncertainty created by a vote to leave causes international investors to re-appraise their appetite for sterling assets, the decline in the pound could become more severe over time.

While the Bank of England would no doubt ease policy in response to any economic downturn, it seems unlikely this would prevent UK share prices from falling sharply. In particular, shares in smaller companies, which tend to rely more on the domestic economy, would probably underperform.

The impact on gilts is less clear. They may benefit from some domestic safe-haven flows, but at the same time, many international investors will be looking to sell.

Much can happen between now and June 23rd. And, as we have seen with any number of recent episodes, from the global financial crisis to the Greek debt tragedy, markets and businesses do not like periods of uncertainty. The UK referendum may finally bring some sense of closure to a debate that has dominated the political agenda since the General Election. However, a ‘Brexit’ vote could mean that the uncertainty for the UK’s economy and financial markets is only just beginning.