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Brexit: Looking at the Fact

We like facts. Facts are our friends. No matter how much you try to spin them, they remain facts, their truthfulness unsullied. What we don’t like is when opinions, biased perspectives and speculation masquerade as facts. When contentious issues arise, folks frequently claim “the facts” support their arguments, overlooking the fact their evidence isn’t really factual. This is commonly the case for the  “Brexit” referendum, in which Brits will decide whether or not to remain in the EU. Since Prime Minister David Cameron announced the vote in February, both the Leave and Remain camps have played fast and loose with the truth. Here are several Brexit “facts” offered by both sides that we would like to add colour to or outright dispel for investors. Like all political matters, we’re neutral on the actual debate, but some myth-busting should help investors assess the vote’s potential economic impact (or lack thereof).

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On Trade

One of the biggest misperceptions voiced by the Remain camp is that a Brexit will torpedo UK trade. Everyone from Cameron to the IMF warns forfeiting EU membership would cost Britain free trade with other member-states as well as nations that signed free-trade agreements with the EU. Indeed, it wouldn’t be great if the UK were suddenly cut off, because even though the majority of British exports go outside the EU, the Continent still receives a significant chunk of those goods and services. UK consumers also benefit from a wealth of EU imports. However, a decision to Brexit doesn’t immediately nullify all agreements. Per Article 50 of the Lisbon Treaty, the UK will have two years to negotiate a new relationship with the EU, during which all treaties will remain in effect. During those two years, the UK can negotiate new trade agreements with the EU and its extant free-trade partners. Some in the Leave camp argue trade will be even freer outside the EU, as the UK will finally be able to negotiate its own bilateral deals. Whilst it is true the UK would be able to negotiate bilateral deals for the first time in decades, it’s speculative to claim that spells better, or even equivalent, deals. New trade deals aren’t exactly easy to nail down. Most take far more than two years. So any potential improvements would come in the very long term.

Regardless, UK trade won’t suddenly plunge if voters pick Brexit—it has time. It’s a wild card, but another mitigating factor is the UK’s “most favoured nation” status at the WTO. Thanks to that, Britain already faces ultra-low tariffs and easier administrative barriers in trade with fellow WTO members. So even in the absence of new free trade agreements, a protectionist backlash shouldn’t loom.

On the Current Account Deficit

With the current account deficit at record-high levels, some fret Brexit will test “the kindness of strangers” funding British investments, perhaps harming the economy. As a quick explainer, the current account deficit is the difference between the value of exports and income on Brits’ foreign investments against the value of imports and income on foreigners’ investments in the UK. Britain typically runs a trade deficit because it imports more than it exports—a hallmark of a services- and consumption-oriented economy (which isn’t a negative). The UK’s outbound foreign direct investment has been knocked by the commodities downturn, as many of the world’s largest Energy and Materials firms are based in the UK. And on the flip-side, UK assets have done well for foreign investors. None of these metrics suggest anything wrong or surprising about the UK economy. Nor do they make the UK unattractive for foreign investors. Heck, those high returns on inbound foreign investment, which detract from the current account, are quite enticing to those abroad.

On Sterling

Besides knocking growth, some pundits argue a Brexit would sink the pound. However, this misunderstands how currencies work. For one, currency “strength” or “weakness” is always relative, as currencies trade in pairs—Sterling is “weak” compared to the US dollar, yet “strong” compared to the Japanese yen. So whilst folks could argue a Brexit will weaken the pound, a counterargument could say a completely separate, unrelated factor is “strengthening” the other currency. Plus, as with any liquid capital market, presuming Event A automatically brings Outcome B is an error. Markets often do what few expect. Supply and demand impact a currency’s strength over time, and EU membership isn’t the primary determinant of Sterling’s relative standing. And besides, in the developed world, currency fluctuations aren’t huge determinants of economic health.

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On Interest Rates

Many argue Brexit will impact UK interest rates, to the Treasury and economy’s detriment. They claim long-term debt costs will soar, presuming EU membership drives creditworthiness. Some warn the Bank of England will have to raise interest rates earlier than anticipated in order to prevent capital outflows, choking the expansion. Now, put aside any attempts to forecast the BoE—central banks are unpredictable. Rather, consider what determines long-term interest rates: supply and demand for sovereign debt. Demand for UK gilts stems from their liquidity, stability, high quality, relatively higher yield and the solid backing of Her Majesty’s Treasury. These traits don’t disappear if Britain leaves the EU, so we question why demand would plummet—especially when there are so many willing buyers, like banks, pension funds, central governments and individual investors. Besides, markets move ahead of widely anticipated or feared events, so if these fears were founded in facts, markets would likely already reflect this via higher interest rates on government debt. Yet that hasn’t happened. (Exhibit 1)

 

Exhibit 1: UK 10-Year Gilt Yields in 2016

Source: FactSet, as of 2/6/2016. 10-year Gilt yields from 31/12/2015 – 31/5/2016.

On EU Administrative Costs

Many Leave proponents argue the £18 billion it costs annually to be in the EU could be better spent at home, perhaps abating the alleged need for “austerity.” This £18 billion is based on the UK’s 2014 gross [i] payment to the EU budget. Whilst it sounds like a big number (and it is, in isolation), it’s also just 3.9% of the total amount of taxes Her Majesty’s Revenue & Customs collected in fiscal year 2014-15. Yet using the gross figure is a bit misleading, since it doesn’t account for the UK’s rebate and public sector receipts. These deductions mean that the UK’s net contributions to the EU budget were £9.7 billion—a bit more than half the number trumpeted in headlines (and 2.1% of tax revenues). Now, we won’t debate whether the UK’s bureaucrats could better spend this money better than EU bureaucrats—that’s an opinion. But there is just no evidence an extra £9.7 billion in the coffers would have prevented certain benefits cuts.

On EU Regulations

Whilst regulations will always have opponents, some of the criticisms of EU rules are just outright wrong. Some have highlighted absurd-sounding EU rules as evidence of Brussels’ inefficiency, which drags the UK’s government down along with it. These include: campaigning against shrimp chips, banning the recycling of tea bags, preventing kids under the age of eight from blowing up balloons and requiring olive oil to be sold in five-litre cans. Yet these rules either don’t exist (as is the case with tea bags and balloons) or have specific applications (the olive oil requirement is for domestic, not commercial use, the argument being larger cans for home use risk the oil going rancid). Critiquing a rule is fair game, but that rule also needs to be represented fairly, too. Plus, whilst many pin such odd regulations on the EU, the UK voluntarily adopted many of them, and there is no guarantee Parliament would suddenly agree to repeal them.

On the Finality of a Brexit

Contrary to what some on the “Leave” side argue, a vote to Brexit isn’t an opportunity to renegotiate for better EU membership terms. Politically speaking, this would be untenable. For one, some EU members are staunchly opposed to reopening membership negotiations, fearing it could set a bad precedent—other members could try similar tactics if the British were successful. But more broadly, if the Leave camp wins, renegotiating new terms would directly oppose the will of the majority of voters—the backlash would be significant. If voters decide to Brexit, Cameron will invoke Article 50 and have two years to come to a departure agreement.[ii] Could Britain and the EU arrive at an improved agreement during those two years? It’s possible! But politically speaking, a vote to leave is a vote to leave—not a vote to try negotiating again.[iii]   

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[i]The “non-deduction” definition of the word, not the icky version. Though giving up money to a government body is arguably icky too.
[ii] This timeline could be extended if all EU members unanimously agree.
[iii] Unless you’re Greece, and the UK is not Greece.

This article reflects the opinions, viewpoints and commentary of Fisher Investments MarketMinder editorial staff, which is subject to change at any time without notice. Market Information is provided for illustrative and informational purposes only. Nothing in this article constitutes investment advice or any recommendation to buy or sell any particular security or that a particular transaction or investment strategy is suitable for any specific person.