On June 23 Britain will hold a referendum on whether to remain a member of the EU. So what happens if Britain votes to leave (the so-called Brexit) and just how likely is that outcome?
If the British vote to leave, on June 24 we will wake up and nothing will have changed except everything will have changed. Let me elaborate.
The referendum is not legally binding, and it is up to British parliament to then implement the Brexit. There is no real mechanism in the EU for leaving so there will be long drawn out negotiations on how to leave. In addition Britain will need to negotiate new trade agreements, likely along the lines of what Switzerland and Norway have with the EU. Most estimates I’ve read say this process will take at least two years. This is what I mean by nothing will change on June 24. It will be business as usual, kind of, until the process is actually completed years later.
On the other hand the entire process of leaving will cause a lot of uncertainty for large global businesses, particularly the financial sector, based in Britain. It’s probably a good bet that global firms will shift hiring and expansion plans from Britain too elsewhere in the EU. In a healthy economy running at full steam this probably wouldn’t be enough to drag the economy down into a recession or negative growth. Unfortunately for Britain, David Cameron and George Osborne have embarked on another ill-fated round of austerity and budget cuts. The first go around with austerity several years ago saw Britain almost fall into a recession. Indeed, initial GDP readings showed two quarters of negative growth; however one was revised up later. Given the weak state of the economy in Britain it’s possible a Brexit coupled with the renewed austerity push could force the economy into a recession . There is, however, a silver lining to all of this. It’s projected that the pound will fall 10% to 20% upon a Brexit. The weakening of the pound would reduce Britain’s trade deficit and just might be enough to make up for any other Brexit economic hits. Therefore, it may not be all doom and gloom should Britain leave the EU.
With that being said what are the chances Britain leaves?
Will there be a Brexit?
We believe there is a much higher chance of a Brexit than the market currently thinks. The elites, politicians and the media seem to underestimate just how much dislike or outright hatred there is for the political establishment, in this case the EU. The U.S. and the U.K. have had a very similar economic experience over the past decade. We’ve had a debt-fueled housing bubble that masked serious underlying economic problems. Once the bubble burst these problems were exposed. While the U.S. and U.K. had two of the strongest recoveries after the great recession, there are still severe issues affecting the social and economic fabric of both countries.
Like the U.S., the U.K. has one of the highest levels of income inequality in the developed world.
(Graphic via https://www.equalitytrust.org.uk/scale-economic-inequality-uk)
Just like the U.S. the U.K. still has historically high levels of household debt.
Perhaps even more alarmingly the level of household debt is set to rise as the recent ORB projection below shows.
And just like the U.S. the unemployment level is still above what would be considered full employment.
All this means that, just like the average American, the average Briton is not in great economic shape. This leads to the populace lashing out (rightfully so perhaps) against established political institutions. In the U.S. we can see this in the form of people supporting nonestablishment political candidates. Donald Trump won the Republican nomination and Bernie Sanders gave the establishment Democratic nominee a tough challenge. Both things the elites thought unthinkable. In Britain there is much of the same anti-establishment mood, and it would be unwise to discount a vote for Brexit simply because it seems politically unthinkable and not “the sensible thing to do.” So how do we assess the odds of a Brexit?
What are the odds of a Brexit?
The British polling industry as a whole is horribly inaccurate. British pollsters did not accurately predict the last two major events, David Cameron’s re-election and the Scottish independence vote. In fact, they were not even close. This means that polls are generally not the best way to assess the probability of a Brexit.
The quirks of the British polling industry are fairly well known. There is a pretty broad consensus that phone polls are more accurate then online polls. All polls often overstate the support for the option representing change. Also, generally speaking people supporting the “Remain” option are harder to reach and thus underrepresented. But the pollsters are attempting to make improvements and several sites attempt to correct for the problems of the polling industry to produce (hopefully) more accurate forecasts. For example, Matt Singh and Number Cruncher Politics, Britain’s version of Nate Silver and FiveThirtyEight.com, have the probability of Brexit around 33% as of this writing.
A good option for assessing the probability is the betting markets as well as polls asking people what they think will be the most likely outcome (the same concept as the betting markets but without money changing hands). People tend to be more honest when money is on the line and strangely more accurate at forecasting how they think the vote will turn out than how they will actually vote. The betting markets currently have the chance of a Brexit around 40%.
Rather than focusing on individual polls investors are better off focusing on the polling aggregates put together by sites like Number Crunchers and focusing on the betting markets. It’s also good to keep in mind the historic tendency of polls and odds makers overestimating the chances for the change option while at the same time remembering we are in an era that does favor change.
Our opinion
Right now we think that the betting markets and polling aggregate websites are correct in their assessment that "Remain" is the favorite, especially given the historical trend of voters swinging toward the status quo in the final days before the vote. However, as we discussed at the beginning of the article there is a lot more anger at the establishment than the elites realize, and we think the true odds are much closer to 50-50. We’ve made some moves in our portfolio to protect against the risk of a Brexit (and also reduce our exposure to the domestic UK market given the renewed austerity push by Cameron). In a follow up piece tomorrow we will detail some strategies investors who don’t have access to foreign currency trading can use to hedge their portfolio against a Brexit.
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