The decision to call a referendum
Back in January 2013, David Cameron promised that, should the Conservatives win a majority in the 2015 general election, the Government would renegotiate more favourable arrangements for EU membership, before holding a referendum on whether the UK should remain in or leave the union. The reforms have been announced and the poll will be held on 23th
June 2016. The leave scenario has been widely labelled Brexit (short for British Exit).
Membership of the European Union (EU) has been a controversial issue ever since we joined the then European Economic Community (EEC) in 1973. This will be the second referendum to be held on the issue, the previous one being in 1975 when membership was approved by 67% of voters.
MPs have the right to choose which option they support and most, both Labour and Conservative are backing EU membership. The Prime Minister and a majority of his 29 strong Cabinet have declared a pro-EU stance and George Osborne is using the Treasury to make the economic case for Britain's EU membership. However, around 6 cabinet ministers will campaign for a Brexit, along with the London mayor Boris Johnson.
In this blog we outline the key issues that divide those in favour of Britain remaining in the European Union and the ‘Eurosceptics’ who oppose it. We then look at how the outcome might impact the economy and the stock market.
What new terms have been agreed?
After protracted talks with the European Council concluding with an EU summit, David Cameron announced on 19th
February that his 4 key demands had been accepted by the other 27 EU members. These relate to:
- Migration - for the next 7 years EU migrants will face a 4 year transition period before they can claim maximum in-work benefits and social housing. Child benefit sent overseas will be paid at the rate of an EU migrant’s home country.
- Sovereignty - the UK will be disengaged from the mantra of ‘ever closer union’. National parliaments will be able to ‘force ministers to amend or drop laws’ if 55% of them object.
- Competitiveness - steps will be taken to reduce the regulatory burdens on business including a single market in banking and digital products.
- Economic governance - to ensure Britain is not disadvantaged by being outside the Euro plus a guarantee that we will not have to bail out failed Eurozone members.
However, the legal implementation will only be voted on by MEPs after the referendum result so theoretically it could still be amended or thrown out altogether.
The role of the Electoral Commission
The Electoral Commission is the independent elections watchdog and regulator of party and election finance. It is an independent body set up by Parliament to set standards for elections. Its mandate is ‘to support a healthy democracy, where elections and referendums are based on our principles of trust, participation, and no undue influence’. Within approximately 6 weeks it will announce the name of the designated campaign for each side. Each incumbent is entitled to spend up to £7m plus a grant of £600k, receive free broadcasting and a mailshot to every home in the UK.
The ‘in’ campaign
The main campaign to keep the UK in the EU is ‘Britain Stronger in Europe’ which has the backing of many leading business figures, including Richard Branson and Karren Brady. Its’ Chairman is Stuart Rose, a former Marks and Spencer chief executive. The headline message is that a stronger economy, stronger security and stronger leadership on the world stage clearly outweigh the costs. There is also a separate Labour Party campaign, led by ex-Home Secretary Alan Johnson, who promises to "put the country's future above party machinations".
The pro-Europe groups point out that there are important trade and investment benefits from EU membership resultant from the freedom of movement of people, goods, services and capital. They argue that as nearly half of UK exports go to Europe, and it accounts for 53% of imports, a Brexit would have a disruptive effect on economic growth. A disproportionate amount of EU trade derives from less prosperous regions of the UK, such as the automotive sector, so Brexit could lead to further inequality within the UK economy. Furthermore, leaving the EU could diminish our influence over world affairs, and result in trade barriers between the UK and the EU.
‘In’ campaigners counter criticism of immigration with the argument that a flexible labour market makes it easier for companies to recruit skilled employees thus increasing industrial output. They also reference studies which conclude that migrants pay more overall in taxes than they claim in benefits and point out that non-EU net migration is greater than that from the rest of the EU. They back this up with statistics from the OBR (Office for Budget Responsibility) which show that higher immigration raises GDP and reduces public borrowing.
The ‘out’ campaign
A plethora of groups (43 at last count) have been set up to lobby for Brexit with the common message that the UK would be able to better control immigration, conduct its own trade negotiations and be free from what they consider to be unnecessary regulation and bureaucracy.
One of the largest is Vote Leave which comprises MPs and peers from all political parties and has the backing of 3 Eurosceptic groups; Conservatives for Britain, Labour Leave campaign and Business for Britain. Rival Leave.EU was founded by UKIP donor Arron Banks with the backing of party leader Nigel Farage and some high profile hedge fund donors. However, Leave.EU has now joined forces with a newly launched umbrella group, Grassroots Out (GO), which is vying with Vote Leave for designated campaign status. Other cohorts such as ‘Better Off Out’ and ‘The Freedom Association’ are working with GO while remaining independent.
The Vote Leave campaign is focusing on economic issues and argues that excessive regulation is bad for business. GO/Leave.EU is concentrating its efforts on immigration issues, saying it pushes down wages in low skilled jobs, increases unemployment among UK workers and puts welfare budgets under pressure. The group objects to the inflow of migrants from countries in Eastern Europe which joined the EU recently.
All Euro sceptics consider that membership of the EU is too expensive and poor value for money. The net cost of membership (after subsidies and rebates) is linked to the size of our economy and has been increasing. In 2014 it was estimated by HSBC to be around £9bn or 0.5% of GDP, although many believe the true cost to be much higher.
What are the alternatives in the event of a Brexit vote?
If the electorate vote for Brexit the government has 2 years to negotiate a withdrawal agreement and there are several paths that the UK could take. For example, there are several models used by other non EU member countries.
Firstly, The European Economic Area (EEA) is a free trade area made up of the EU plus Norway, Lichtenstein and Iceland. With this affiliation direct EU contributions would decrease by around 17% but the UK would still be subject to EU regulations without having any negotiating power.
Secondly, The European Free Trade Association (EFTA) includes EEA members plus Switzerland. This body is not subject to EU regulations and our budget contribution would fall by c 60%. However, Britain would need to negotiate bilateral agreements (like the Swiss) to access the single market in specific sectors.
However, with both the above the UK would still be committed to freedom of labour mobility so it would not reduce immigration.
Thirdly, a Customs Union arrangement, which currently applies to Turkey, would preserve some membership benefits, mainly relating to trade in goods. It allows tariff free access to most goods markets but some regulation is required. Nevertheless, there would be no free movement of labour or capital and it would be negative for financial services which make up nearly 10% of our economy.
Finally, we could negotiate own free trade agreements with the EU and other countries and take advantage the World Trade Organisations’ most favoured nation status to set our own terms of trade. Leaving the Common Agricultural Policy would necessitate the introduction of barriers to agricultural trade (or subsidies) to prevent farmers being hurt by heavily subsidised growers from the US. Successive US administrations have indicated they would prefer to deal with the UK inside rather than outside the EU.
What would a Brexit mean for the economy?
The uncertainty surrounding the referendum and the possibility of companies putting investment plans on hold has already lead some economists to downgrade their forecasts for 2016 GDP growth. Estimates of the economic effect of a Brexit vary widely, from a small positive to significantly negative but overall the consensus is that it would be detrimental at least in the short term. Since forecasters use different assumptions and time periods the estimated impact on real GDP post a withdrawal from the EU ranges from +1.6% to nearly -10%.
Independent think tank Open Europe forecasts that GDP could fall 2.2% if suitable trade agreements are not put in place. This is mainly due to a decline in Foreign Direct Investment (FDI) from non-EU countries if Britain is not a route to access the Single Market. On the other hand, it thinks accommodative trade deals and an improved regulatory regime could actually boost GDP by around 1.6%.
However, most economists, including those at AXA IM, expect a worse scenario with the cost to GDP in the 2-7% range with financial services a key recipient of FDI particularly affected. Neil Woodford, on the other hand, has suggested that the country may well benefit from Brexit, despite short term negative impacts on the City. He has commissioned research which found Britain "would remain a haven for foreign direct investment" should it vote to leave and any economic disruption caused would be offset by the circa £10bn saved from no longer contributing to the EU budget.
A key area of concern is the effect on the pound. Sterling has already weakened (it is the worse performer of all major currencies so far this year) and net outflows of foreign capital could put it under further pressure and exacerbate Britain’s already large current account deficit. This would probably have a knock on effect on the economy with GDP growth likely to decline due to falling business confidence and potentially higher inflation and interest rates.
How it would affect businesses?
Half of FTSE 100 chief executives have signed a letter backing the Prime Minister’s claim that Britain will be ‘stronger, safer and better off’ in a reformed EU. Furthermore, the Confederation of British Industry (CBI), after canvassing the views of its members (mainly larger companies), has declared that the UK should remain in the EU - warning that all the other options will bring ‘serious disadvantages and huge uncertainty’.
For companies within the EU umbrella the lack of capital restrictions and a single legal framework does makes the process of raising capital and investing across the union much easier. The Financial Services sector has a large trade surplus with the EU and would probably be most affected by Brexit. Global firms would lose their ‘single passport’ into Europe from their London base and may even decide to relocate their UK operations if Brexit goes ahead.
However, Brexit has more appeal among small and medium sized enterprises (SMEs) many of whom cite red tape and bureaucracy, immigration and foreign competition as the reasons for favouring this option. A weaker pound could prove beneficial to companies which derive a significant element of turnover from exports - this would favour FTSE 100 constituents. On the other hand companies with a greater domestic bias would be exposed to any setback in the UK economy.
How it would be received by the stock markets
Stock markets dislike uncertainty so with the outcome finely balanced they may struggle to make much progress until the outcome is clearer. Volatility is likely to remain high as polls fluctuate, reflecting the campaigning success or failure of either side, as was the case with the Scottish referendum.
The impact on stock markets longer term is hard to predict as there are so many unknown factors to account for. Share prices ultimately reflect the prospects for corporate earnings so if they were to come under pressure from a weaker economy following Brexit then stock markets may adjust downwards. On the other hand if we remain in the EU then stock markets could stage a ‘relief’ rally and companies should continue to trade much the same as they do today.
What outcome are the latest polls forecasting?
Current predictions are that it is going to be a close run contest with an average of the six latest polls showing small margin in favour in remaining inside the EU although support for a Brexit has been edging up. However, this masks considerable divergence of opinion from poll to poll.
Telephone polls which have historically been a better predictor show a higher percentage in favour of remaining. Of course polls are not always accurate, a recent example being their failure to predict the outcome of the last election, and there are still a considerable number of undecided voters. Brexit approval is notably more popular among the over 55s with the reverse true for the 18-24 age group.
It is worth remembering that campaigns that offer something different are often greeted with great enthusiasm, for example Scottish Independence and the UK Independence Party. Yet when it comes to an actual vote voters take a more conservative view.
The consensus seems to be that in the short term at least Brexit would be detrimental for the economy and the stock market. It is possible that the disruption around the poll is causing businesses to defer their investment plans which may result in subdued GDP growth this year. Furthermore, Ernst and Young has estimated that 31% of investors would reduce or freeze planned investment in the event of a Brexit.
In the longer term it will depend what deals we can agree with trading partners but putting these in place could be a lengthy process. David Cameron may decide to resign in the event of a vote to leave and George Osborne, as a close ally, could also quit. This would lead to further disruption to the negotiation of alternative arrangements.
If the Brexit popularity grows as the referendum date approaches we may see more volatility in both the equity and bond markets with the currency coming under pressure. However, history suggests that when it comes to the crunch people tend to settle for a status quo.
Whatever the result there will be winners and losers and well informed, active fund managers will no doubt be quick to rebalance their portfolios towards the best placed sectors. The referendum is primarily a UK issue, with some implications for investments in Europe, so a globally diversified portfolio could help to reduce volatility over coming months.
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