The UK Prime Minister announced that the EU referendum will be held on 23 June, 2016. David Cameron’s bruising negotiations last week set the tone for the run-up to the EU referendum. We now face an extended period of political, economic and financial uncertainty until June.
After a trying start to 2016, investors could be forgiven for wondering what else this year might throw at them and they are starting to examine all outcomes, including a full-scale retreat from the EU.
Ahead of the EU referendum, what action can an investor take, and what are the implications if the UK votes for a “Brexit”?
Mr Cameron convened the first Saturday cabinet meeting since the Falklands War to win the backing of his senior ministerial team and to endorse an official recommendation that the UK should stay in a “reformed EU”.
Of course, Brexit is not a foregone conclusion. The Scottish referendum and last year’s general election showed a bias to preserving the status quo. Most analysts put the probability at no more than 30% or so. It’s no one’s base case but is also not a trivial risk and, with the market impact of an “out” vote being so much greater than an “in”, it is unsurprising that most of the attention is on the less likely outcome.
Given the uncertainty of the vote, it would be nice to think there might be agreement on the implications of any decision to leave the EU. There isn’t. Citi describes the effects of Brexit as “large and painful in economic and political terms”. Credit Suisse predicts “an immediate and simultaneous economic and financial shock” if the UK casts itself adrift. Capital Economics, in a note commissioned by Neil Woodford, is more relaxed: “We doubt that Britain’s long-term economic outlook hinges on [Brexit].”
Positive or negative, the net effect of an “out” vote would certainly not be insignificant. A fall in the pound to $1.20 or so, as some predict, would have implications both good and bad. Inflation would probably rise; the Bank of England could be torn between rising prices and slowing growth.
On investment, the issues are even more nuanced, largely because of the composition of the UK stock market. With only around 20% of the earnings of UK-listed companies derived from their home market, and energy and basic materials companies dominating the benchmark index, the economic impact of Brexit on Britain is arguably less relevant than the outlook for emerging markets and commodities.
A fall in sterling may be bad news for holidaymakers, but for many companies it would be unequivocally good news. For UK-based investors dependent on dividends from blue-chips, the dollar denomination of those payouts means they are more likely to be maintained or increased.
One area where we can be more conclusive, and where investors might take useful action ahead of the vote, is in the sector allocation of their portfolios. Here there does seem to be some unanimity. Five trades look to be worth considering if the polls start to point decisively towards Brexit.
First, favour the FTSE 100 over mid- and small-caps. The latter are more domestically focused than blue-chips – in the case of small-caps, the exposure to the UK is around three times as great as for the FTSE 100. As such, they will most likely underperform if sterling weakens, the UK economy slows or potential growth declines on the back of a change in immigration policy. This trade will make even more sense if oil bounces back later in the year on the back of lower supply, or commodity prices rise on firmer demand.
Second, be cautious about cyclical sectors such as housebuilders and retailers. Both would obviously suffer from a slowing economy. Retailers in particular would also be hit by a fall in sterling on two fronts: it would squeeze the margins of those that source predominantly overseas, and it would increase interest rate risk by putting upward pressure on inflation.
Third, reduce exposure to financials. UK banks would suffer from a slowing UK economy and less predictable political and economic backdrop, not to mention any reduction in their ability to “passport” services to the EU.
Fourth, prefer companies with a high proportion of sales in overseas markets or in particularly defensive sectors. Tobacco, mobile telecoms, pharmaceuticals and household goods tick these boxes. Luxury goods sellers might benefit from overseas revenues and an uptick in inbound tourism on the back of a weak pound.
Finally, Brexit would increase the risks attached to all Scotland-exposed stocks as it would encourage the SNP to have another go at independence.