This is for investment professionals only and should not be relied upon by private investors
MAY 2016
What would Brexit mean for markets?
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Fidelity’s equity, fixed income and real estate teams give their views
on the market effects of the UK’s referendum on EU membership. While
polls suggest a ‘remain’ vote is more likely, the market reaction has
been less sanguine, with sterling particularly affected. A decision to
stay in the EU could, therefore, lead to a relief rally in the currency, risk
assets, and domestic and cyclical stocks, while a ‘Brexit’ vote could
see an extension of weakness in assets that are already softening.
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
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FIXED INCOME VIEW
The Brexit debate has already had a substantial market impact – mostly via falls in
sterling, lower Gilt yields and relative weakness in sterling credit. Our base case
expectation is that the government wins the referendum and Gilts weaken in favour of
risk assets, especially banks, with a subsequent uplift in sterling. In the event of a
Brexit, we expect the Gilt market (Chart 1) to be well supported. The Bank of England
will likely stay on hold until after the vote on June 23 (Chart 2), but the trajectory for
monetary policy thereafter will depend on the outlook for UK growth and inflation. We
expect the follow-on uncertainty will be a downside risk to growth, which would keep
interest rates lower for longer. While there is a risk that further weakness in sterling
puts upward pressure on UK inflation, we see the downside growth risk as the overriding factor that should keep inflation in check.
Chart 1. Gilts have been resilient
2.5%
UK
US
50
1.5%
40
1.0%
30
0.5%
20
0.0%
10
Jun-14
Nov-14
Apr-15
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Sterling depreciation is likely in the
run-up to the referendum,
particularly if the chances of a
vote to leave increase
Cyclical assets and UK small caps
have suffered from the uncertainty
In cyclicals, the market is pricing in
worst-case scenarios, which is
creating opportunities given the rerating that is likely to follow a remain
vote (the more likely outcome)
Separating sterling exposure from
euro-denominated assets will also
be an important aspect of real
estate portfolio management
Chart 2. BoE rate rise expectations have been pushed out
Germany
2.0%
-0.5%
Jan-14

h
Sep-15
Feb-16
0
Oct-15
Months to 1st Bank of England rate hike
Dec-15
Feb-16
Apr-16
Source: Bloomberg, 22 April 2016
Source: Bloomberg, Morgan Stanley, based off market pricing as at 22 April 2016.
Chart 3. Cost of insurance on UK govt debt has risen recently
Chart 4. Sterling has borne the brunt of the uncertainty
1.5%
95
% of Par
Value
Annual cost of protecting UK
government bonds against default
1.0%
GBP Trade Weighted Index
90
85
0.5%
0.0%
10
11
12
13
14
15
16
Source: Bloomberg, based off 5 year USD credit default swaps, to 22 April 2016
80
75
Jan-14
Jun-14
Nov-14
Apr-15
Sep-15
Source: TWI BPSP Index, Bloomberg, 22 April 2016.
For the Gilt curve, we would expect an initial flight to safety that would drive a rally across
the curve, albeit with steepening. This would reflect expectations of a lower–for-longer
policy rate flattening the short end while greater risk premium is built into the long end (i.e.
premium for higher UK government credit risk, as shown in Chart 3, and inflation
uncertainty). Brexit would likely place further pressure on sterling (Chart 4), in view of the
fiscal and current account deficits and likely reduction in foreign confidence in the
economy. This could potentially put Gilts under pressure in the event of a complete loss
of confidence (e.g. collapse of the Cameron government with new elections called).
Feb-16
Regarding GDP, the outlook for consumption is unclear but a dent in consumer
confidence would likely lead to some softening. A Brexit would certainly act to weaken
business investment in view of the heightened political and economic uncertainty (Chart
5). A look at long-term GDP contributions suggests that this could take 1% out of growth
in a severe case. But weaker domestic demand combined with a lower exchange rate
would also mean that net exports improve, and partly offset a fall in investment.
Within credit, UK banks have already been under Brexit pressure, and sterling credit has
lagged US dollar and euro markets in recent months (Chart 6). We expect banks would
be first in the firing line following an ‘out’ vote, with slower economic growth resulting in
higher impairments and loss provisions as unemployment rises and house prices fall. But
UK banks are well positioned to withstand a 1-2 year recession from a fundamental credit
perspective. We see risks for commercial mortgage backed securities, as a vote to leave
may result in weakening of the London office market.
Chart 5. Business investment is at risk in the event of Brexit
20
% yearon-year
10
130
240
120
220
110
0
UK Business Investment
Economic Sentiment (RHS)
-20
90
140
60
08
10
Source: Bloomberg, 22 April 2016
12
14
16
USD
GBP
EUR
180
160
70
Basis
Points
200
100
80
-10
Chart 6. GBP credit has weakened relative to EUR and USD
120
100
80
60
Jan-14
Jun-14
Nov-14
Source: Bloomberg, 21 April 2016
Elsewhere, the credit impact will be name-specific. Generally, multi-nationals are better
placed given their diversified revenues. In the short-term, export-oriented, UK-based
issuers could benefit from weaker sterling, although that may be eroded over time if
inflation picks up. Overall, much uncertainty remains. Bond markets have already
discounted much of this and we believe a sharp reversal of recent moves is likely if the
UK votes to stay. A vote for Brexit, on the other hand, would likely see an acceleration of
existing trends. It is a binary event that is not conducive to directional investment
strategies. Staying well diversified is the only line of defence.
EQUITY VIEW
Uncertainty is the biggest consequence of the Brexit referendum, and this can have a
material impact on the real economy. Though polls are not always good predictors (last
year’s UK General Election being a case in point), bookmakers continue to see a ‘remain’
vote as the most likely outcome. Nevertheless, it is the lower probability, worst-case
scenarios that have had the upper hand in driving market action, depressing valuations
on more cyclical, economically-sensitive sectors (like banks, construction and consumer
discretionary, see Chart 7 next page). This is creating some good opportunities in cyclical
stocks, which would likely see a substantial re-rating in the event of a ‘remain’ vote.
The short-to-medium term impact of a ‘Brexit’ would be negative. Investment and trade
would likely slow in response to political negotiations between the UK and the EU. This
process could take years and create an unwelcome distraction from the day-to-day
running of businesses and public institutions. It is also likely that we would have another
Scottish referendum to contend with – given that the Scottish National Party (the
governing party in Scotland’s parliament) could argue that a Brexit did not reflect the
wishes of a more pro-EU Scottish electorate. The ‘Out’ campaign will have to counter
people’s innate bias against uncertain outcomes, and in this case, the powerful fear of
reduced employment prospects.
The status quo, particularly during times of economic improvement (such as now), will
have a lower hurdle to clear as far as the electorate is concerned.
Apr-15
Sep-15
Feb-16
Most of the volatility would be felt in foreign exchange markets. Sterling has fallen to its
lowest level against the US dollar since the financial crisis, and if a Brexit happens we
would expect GBP/USD to fall decisively through the $1.40 level which has held for over
30 years. This would increase the attractiveness of firms with revenues in non-sterling
currencies. As the purchasing power of sterling falls in overseas markets, it might be that
the current consensus view that UK inflation and interest rates will remain at current low
levels for the foreseeable future needs to be revisited. In this scenario, ratings agencies
would put the UK on credit watch for downgrades.
In the event of a Brexit, there would be opposing forces determining the short to mediumterm outlook for the market. Investors should bear in mind that 67% of the revenues of
unlisted firms (FTSE All Share) are generated in non-sterling currencies. These revenues
would benefit from any material depreciation in Sterling when translated back to the UK
and would, in turn, potentially drive earnings upgrades for the firms that generate them.
On the other hand, small cap indices, which contain a higher proportion of firms with high
earnings exposure to UK sterling, would likely underperform, in contrast with the last six
years (Chart 8).
Chart 7. MSCI UK defensive equities vs MSCI UK cyclicals
1.6
1.55
1.5
1.45
1.4
1.35
1.3
1.25
Jul-15
Oct-15
Source: Datastream, April 2016
Jan-16
Apr-16
Chart 8. UK Small cap/large cap performance
0.8
0.75
0.7
0.65
0.6
0.55
0.5
0.45
0.4
0.35
0.3
1996
1999
2002
Source: Datastream, April 2016
Many UK-listings will be relatively lightly affected by the Brexit issue, while some will be
heavily affected. As ever, only by thoroughly understanding company and industry
fundamentals can an investor form a grounded view as to what extent a stock’s valuation
should reflect a discount for this sort of risk.
In summary, the ‘remain’ vote is still the mostly likely outcome according to polls and
bookmakers, yet the lower probability Brexit scenario has been at least partly discounted in
the market. Anecdotal evidence suggests that investors are sitting on cash until the
outcome is known, at which point a ‘remain’ vote could see significant cash-flows back into
sterling risk assets. In this scenario, we would also expect to see domestic cyclical stocks
outperforming defensive, quality stocks in a reversal of the recent trend.
REAL ESTATE VIEW
There are several macroeconomic issues that investors should consider in the lead up to
the vote. However, we expect the major pinch point to be in the currency markets. This
will inevitably feed through into the real estate market.
In the run up to the vote, we are expecting the currency to depreciate versus other major
currencies (especially the US dollar) with investors reducing their sterling exposure. At a
practical level, this would reduce the relative value of existing real estate assets but could
actually deliver a short-term opportunity for overseas investors looking to enter the
market.
The weak pound and weaker euro have been major pull factors for USD investors looking
to acquire European real estate in recent years. There is no evidence of global investors
staging a material withdrawal from the UK real estate market. In fact, the reverse has been
true. Chart 9 on the next page shows the growing importance of cross-regional (global)
investors to the UK real estate investment market. The latest INREV Investor Intention
Survey (January 2016) also indicates that global investors will continue to target the UK
market despite the risk of a Brexit (Chart 10, next page).
2006
2009
2012
2016
Chart 10. Most new capital is targeting Europe
2.25
2.15
2.05
1.95
1.85
1.75
1.65
1.55
1.45
1.35
1.25
90,000
80,000
70,000
60,000
50,000
40,000
30,000
20,000
10,000
0
Domestic
European
Global
£/$ Exchange Rate
Source: Fidelity International, Real Capital Analytics, Macrobond, February 2016
Average Exchange Rate - £ vs. $
Investment Purchases - £m
Chart 9. The profile of UK real estate investment
Expected destination for
investment in 2016
Europe
Asia Pacific
United States
Americas ex US
Other
Source: INREV, February 2016
In the event of a Brexit, the effect on trade is unclear but the process of the UK agreeing
its own bilateral agreements would be a time-consuming and lengthy one and markets
rarely react well to economic uncertainty. We could see a short-lived slowdown in
investment activity in the UK market as some investors choose to postpone decisionmaking until after the referendum. On the upside, a short-term fall in sterling may draw in
more global capital – especially USD-denominated investors.
UK financial services sector could be hurt if the EU decides to adopt its own financial
centre – currently it mainly uses London. However, it is unclear if Paris or Frankfurt can
offer the skills, deep labour markets, supporting business services (legal, etc) to seriously
compete with the City of London, under the Brexit scenario. Post-Brexit, it is a possibility
the UK could lose its reserve currency status, which would cause Gilt yields to rise. Rising
Gilt yields have traditionally prompted a rise in commercial property yields, but we are not
convinced this will happen as (i) spreads are already at historically high levels and (ii) the
market for prime assets is increasingly dominated by foreign investors, who are not
pricing real estate assets relative to 10-year Gilt yields.
In practical terms, investors who are exposed to an illiquid asset class like real estate can
do little to reduce the impact of a Brexit on their existing real estate exposure. The
decision to leave is a political one and the economic impacts are more likely to be macro,
rather than asset-specific. The main impact is likely to be a depreciation in relative value
as sterling weakens against the dollar and the euro. Having said that, the level of
depreciation is dependent on the timing of an investor’s entry into the market.
In the current cycle, a significant increase in fund launches and investing did not fully take
off until around 2011-2012, leading us to believe that the level of depreciation may not be
that significant for many existing investors, considering that they entered the market when
sterling was relatively weak. In addition, many investors have policies in place, designed
to offset currency exposures, such as balanced currency allocations or hedging. At
Fidelity, we separated our sterling and euro exposure into different funds, so any possible
negative impact is likely to be contained in our UK Fund. This decision was taken more
than five years ago as part of the overarching strategy to make all of our funds ‘currency
neutral’. This to a large extent protects investors from big movements in currency values
– the primary source of volatility in recent years across most asset classes.
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