Originally posted at Briefing.com.
Should the United Kingdom (UK) remain a member of the European Union (EU) or leave the European Union? That is the very question that will be put to UK voters on June 23. It's a big question that will inevitably invite a big answer for the capital markets.
The decision by UK voters to stay or go might not strike US investors as being all that significant. On the economic surface, it isn't. In 2015 goods exported to the UK accounted for less than 3% of total US exports.
Now, there might be some real relationship friction between the EU and the UK if the majority of voters choose to leave the EU, yet it's safe to say that the trade relationship between the US and the UK won't be impacted to such a degree -- if at all—that it would have a meaningful impact on US GDP growth.
The latter point notwithstanding, a majority "Leave" vote could be quite significant in the short run for US investors.
Two Sides to Every Story
At the heart of the voting matter for UK citizens is a cost-benefit analysis. Is the benefit of being a part of the European Union worth the cost of its bureaucracy and political mandates?
There are reasoned arguments on both sides of the matter about trade dynamics, defense, sovereignty, cultural identification, and immigration control.
The two campaigns waging battle over the referendum are assertively named "Vote Leave" and "Stronger In." The impending referendum has been euphemistically labeled the "Brexit" vote, patterned after the "Grexit" moniker that was used when it was thought Greece would exit the EU (or be kicked out).
We aren't taking sides on the "Brexit" vote, yet there have been many influential parties that have stepped out with research and/or opinions suggesting a vote to leave the EU would be a mistake for the UK.
The OECD estimates the cost of leaving the EU would constitute a tax of £3200 per household per year by 2030 under its central scenario.
Christine Lagarde, the IMF's managing director, asserts the impact on the UK economy of leaving the EU is apt to range from "pretty bad to very, very bad."
Bank of England Governor Carney is concerned a decision to leave the EU will lead to a fall in sterling, boosting inflation and hurting growth. He added that a decision to leave the EU could create a scenario where the UK economy slips into recession.
Former London Mayor Boris Johnson has been the most vocal proponent for leaving the EU, and he has plenty of supporters on his side.
There's a lot of information out there on the pros and cons of EU membership, and it has understandably gripped the UK electorate.
The latest YouGov poll highlighting voter intention at this point shows Remain at 44%, Leave at 40%, Would Not Vote at 3%, and Don't Know at 12%. Incidentally, that is the highest level for "Remain" since August 2015.
The International Business Times, however, cited a separate poll conducted by the Evening Standard and Ipsos Mori as showing an 18-point lead for the "Remain" vote.
With such a divisive issue, it is perhaps only fitting that the polls themselves are mixed.
Status Quo is Easy
The easiest thing for the capital markets to digest would be a vote to remain in the EU. Such a vote would be tantamount to maintaining the status quo, and it would take away the uncertainty that would accompany a winning vote to leave the EU.
A winning "Leave" vote is what matters most for the capital markets. It would have far more impact in the short run than a winning vote to remain in the EU would.
The latter would presumably induce a relief rally of some kind, yet there is theoretically less upside potential in a winning "Remain" vote because it solidifies the status quo. A winning "Leave" vote, on the other hand, blows up the status quo and ushers in a heightened sense of uncertainty—and that's where US investors would get dragged more heavily into UK matters.
Must read Should Britain Leave the EU? Two Analysts Debate
One of the biggest concerns surrounding a winning "Leave" vote is that it would compel other EU countries to step to the fore with Remain/Leave referendums as well.
In a recent article, The Telegraph highlighted an Ipsos Mori survey that found at least 40% of respondents in seven other EU countries want to have a similar referendum, with Italian and French respondents showing the strongest interest at 58% and 55%, respectively. Strikingly, 48% of the respondents in Italy said they would vote to leave the EU if a referendum on membership was held now.
We suspect those numbers would go up if the UK voted to leave the EU, because what's deemed good for one can all of a sudden be deemed just as good for others in a union that has been anything but perfect in the midst of a debt crisis and secular stagnation.
To say the least, a breakup of the EU would be a total mess. That's not the base case scenario, yet the capital markets could be thrown into a tizzy if a groundswell of support builds for its dissolution.
There is potentially a lot at stake than with the UK vote, because the vote isn't just about the UK. It's about the standing of the EU.
If one member votes to walk away because it doesn't like the terms of its membership, it will create political, social, economic, and financial ramifications that will reverberate across the EU landscape, and, arguably, across the Atlantic.
Sidebar
To complicate summer matters, the Federal Reserve recently served notice to the market that it would likely be appropriate for the FOMC to raise the target range for the federal funds rate at its June 14-15 meeting if incoming data were consistent with economic growth picking up in the second quarter, labor market conditions continuing to strengthen, and inflation making progress toward the FOMC's 2 percent objective.
So far, the majority of the hard economic data in the second quarter (as opposed to the soft survey data) has been on the Fed's rate-hike side.
The Federal Reserve's stance, which was contained in the minutes of the April FOMC meeting, made it sound like a rate hike in June would happen simply if the economic data cooperated, never mind the uncertainty surrounding the "Brexit" vote.
Some Fed officials, though, are on record as saying the "Brexit" vote could affect the Fed's decision-making process in June. New York Fed President Dudley said as much the day after the minutes were released, although he was careful to offer the reminder that the June meeting is a live one when it comes to the possibility of raising the fed funds rate.
What we think is set to occur is that the Fed will raise the target range for the fed funds rate in June IF incoming data show growth picking up, and IF polls in a universal fashion show a high likelihood of UK voters intending to vote for remaining in the EU.
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The second condition is the key one. We don't think the Fed will risk raising the fed funds rate a week before the "Brexit" referendum if it doesn't have some solid assurances that the "Remain" vote is likely to prevail.
A rate hike by the Fed on June 15 followed by a winning vote to leave the EU on June 23 would be a double whammy for global markets that would likely create too much fallout for the Fed's comfort level.
If the Fed doesn't have the assurance of a "Remain" vote in the UK, it will want to minimize its risk of policy error. Accordingly, it would be more likely to wait at least until its July meeting to raise the fed funds rate.
What It All Means
The greatest ramification of a winning "Leave" vote is the heightened sense of uncertainty it would create. Presumably, the British pound and the euro would weaken, risk premiums would go up, and global economic prospects called into question.
That would all potentially benefit the dollar, but obviously not for the best of reasons. Dollar strength driven by risk aversion is not the same as dollar strength motivated by the prevalence of strong economic growth.
We have seen already this year how a weakening dollar benefited the stock market. That weakness fortified a belief in the idea that economic and earnings growth would show some notable improvement in the second half of the year. Renewed strength in the dollar driven by a safety trade, however, would challenge that belief and act as a headwind for the market.
Should the UK stay or go? That is up to UK voters to decide.
The question that will be asked of them on June 23 calls to mind the fascinating question posed by Hamlet: to be or not to be?
Readers of the great English playwright William Shakespeare know that Hamlet falls, so he was ultimately not meant to be for long.
Why bring Hamlet and Shakespeare into the mix here? Well, for no other reason than to end this week's column with an artful, English twist.
Our sense of things when it comes to the "Brexit" referendum is that UK voters will ultimately elect to be in the EU. In the event they don't, though, it could be poison for US investors in the short run.
