The UK has voted to quit the European Union after more than four decades in a stunning rejection of the continent’s postwar political and economic order, sending shock waves around global markets.
Sterling has plunged to the lowest since 1985, Asian stocks tumbled and US Treasuries surged in one of the most dramatic 24 hours in modern British history. Just after 0600, London time, as most votes were counted, the BBC said there was no way back for the pro-EU side, with voters having backed “Leave” by 52% to 48%.
Whilst the UK leaving the EU will have a strong negative on European equity markets, the impact will be nowhere near as bad as the fallout following the collapse of Lehman Brothers in 2008, according to Goldman Sachs.
In a recent note sent to clients by Goldman analysts led by Sharon Bell, the bank argues that European stocks could tumble as much as 15% in the event of a Brexit.
That’s a pretty massive fall, but less than a third of the 46% fall seen in the Stoxx 600 broad index of European companies after Lehman went under.
The fall in stocks will be driven, Goldman argues, by a substantial increase in the equity risk premium — basically the excess return investing in the stock market provides over a risk-free rate. Here is the key line from the bank:
“The largest impact of Brexit on European equities will likely be via a higher equity risk premium (ERP) in our view. Historically, we find all indices in Europe are negatively correlated to UK policy uncertainty and risk. From current levels we will expect a further 15% or so downside [to the Stoxx].”
Rather than being similar to Lehman, Brexit will be more comparable to an event like the European sovereign debt crisis in 2011, Goldman notes (emphasis Goldman’s):
“Exhibit 1 puts in perspective moves in the pan-European ERP1 following major shocks since the 1990s. During the European sovereign crises, the ERP rose by more than 200bp before receding following ECB president Mario Draghi’s ‘Whatever it takes’ speech in July 2012. During the Lehman Brothers crisis, the ERP rose almost 300bp on our estimates. Exhibit 2 summarizes these previous risk events, the rise in the ERP, and the impact on stock markets. The Lehman Brothers collapse provides an upper limit in our view and not one we think is an appropriate benchmark of comparison for Brexit.
The sovereign crises in 2010 and 2012 are probably a better guide to the degree of potential impact, or the Russia/LTCM crisis (which had direct implications for Europe). Interestingly, the UK leaving the European exchange rate mechanism (ERM) did not coincide with a significant rise in the ERP; markets shrugged it off quite quickly.”
Stocks that will be most affected, Goldman argues, are those that make up the bank’s UK Domestic Exposure Basket — basically companies with the highest exposures to the UK market. The companies in the basket include the likes of Lloyds Bank, ITV, supermarket chain Sainsbury’s, and high street stalwart Next.