Brexit: How Vulnerable are Markets if a Leave Vote Prevails?

Britain goes to the polls on Thursday to decide whether or not to stay in the European Union. Opinion polls have fluctuated regarding which camp is likely to prevail. Market based indicators had until recently exhibited little concern, but that began to change in the last two weeks as the 'leave' camp has gathered momentum. The FTSE 100 index of UK stocks slid 6 percent between June 8 and 14, after having rallied 14 percent from its February low. Over that time span the FTSE 100 volatility index spiked from 19 to 31. The pound fell from 1.45 to 1.41 to the dollar. The EuroStoxx 50 index fell by a similar amount, while gold rose and bond yields continued to fall.

Following the assassination last week of Jo Cox, a pro-remain member of Parliament, some of the 'leave' momentum was lost as campaigning was suspended for several days, and markets stabilized. The most recent telephone polls released over the past weekend showed the 'stay' camp once again in the lead, but on Monday, the Financial Times reported that its poll of polls shows a dead heat at 44 apiece, although it points out that most of these polls were taken before the murder.

Bookmakers have consistently indicated that a vote to stay would prevail, but those odds have fluctuated sharply as well in the past two weeks, from a low of 29 percent on June 8, to 43 percent on June 14, and back down to 31 percent on Sunday, June 19. Clearly, the ultimate outcome remains too close to call.

How Might Markets React to a Leave Vote?

The question for investors is, of course, how vulnerable are markets in the event that the leave vote prevails? This is a difficult question to answer since there is little historical precedence that might provide some guidance. But the relatively muted market reaction thus far does suggest that the risk of a leave vote is disproportionately to the downside. In a June 17 report, research firm BCA anticipates a potential downside to the FTSE 100 of 10.3 percent, versus a potential upside of 6.5 percent. For the EuroStoxx 50, the downside risk is 12.8 percent versus upside of 8.6 percent and for the S&P 500, there is a downside of 6.3 percent versus upside of 4.4 percent.

As for currencies, the downside risk for the pound is 7.6 percent versus upside of 3.9 percent. For the euro versus the dollar, the spread is down 2.3 percent versus zero upside. The impact on bond yields is also anticipated to be significant. For ten-year Treasuries, BCA estimates the downside to be 42 basis points, with an upside of 22. For ten-year gilts, the downside is 49 basis points versus upside of 34. And for gold, the upside potential following a leave vote is estimated to be 4.6 percent versus -0.1 in the event of a stay vote.

Whatever the outcome, this analysis indicates pronounced volatility following the vote. That volatility is no doubt likely to persist for longer if the leave vote prevails, since the economic and political impact, not only in the UK, but in the broader EU, will remain uncertain.

The Outcome from Last Week's Fed Meeting

Almost overlooked in the lead up to the Brexit vote was last week's Fed meeting. Following the weak May jobs report, the meeting lost much of its significance as expectations of a possible rate increase fell to zero. But the meeting was nevertheless informative regarding the Fed's future intentions. The statement that accompanied the meeting reversed the language from the previous meeting in April. Whereas the former statement referred to a stronger labor market and a weaker economy, the June statement spoke to a weaker labor market, but a stronger economy, especially noting improved household spending. What stayed the same was reference to a good housing market, but weak business spending.

Most notable was the lowered expectation of future interest rate hikes compared to the last round of forecasts from the March meeting. Back then one member of the committee indicated only one rate hike this year, whereas this time there were six. As was the case in March, nine members still anticipate two rate hikes. For each of the next two years, the number of expected hikes was reduced to three from four previously. In addition, this time there was no dissenting opinion. The upshot of the meeting was clearly a more dovish outcome, but one that remains subject to change depending upon the strength of the economic data. Prior to the Fed's announcement on Wednesday the odds of a September rate hike were 31 percent and December 49 percent. By week's end those odds had fallen to 19 and 38 percent.

Following the UK vote, investors will pivot to a focus on the political conventions in the U.S. The Republican convention begins on July 18, followed by the Democratic convention on July 25. While there is a long way to go before the election, the average poll taken over the past two weeks, as tracked by Real Clear Politics, shows Clinton opening a lead over Trump in a presumed head-to-head contest. What had been a virtual dead heat as recently as May 25, and in fact a fractional lead for Trump, now shows Clinton with a lead of almost six percentage points. Undoubtedly, these results will continue to fluctuate, and the choice of running mates may be particularly influential in this cycle. For investors, the political uncertainty that is keeping markets on edge will not go away with the Brexit vote. It may be just getting started.

Important Disclosures:
The S&P 500 is an index containing the stocks of 500 large-cap corporations, most of which are American. The index is the most notable of the many indices owned and maintained by Standard & Poor's, a division of McGraw-Hill.
The FTSE 100 is a market-weighted index of the 100 leading companies traded in Great Britain on the London Stock Exchange.
The FTSE Implied Volatility Index Series (IVI) is a series of end-of-day indices that measure the implied volatility of the FTSE 100 and FTSE MIB indices.
The EURO STOXX 50 is a market capitalization-weighted stock index of 50 large, blue-chip European companies operating within eurozone nations. The universe for selection is found within the 18 Dow Jones EURO STOXX Supersector indexes, from which members are ranked by size and placed on a selection list.
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