Brexit tumult recalls Black Wednesday

Second referendum would extinguish market uncertainty

The UK is in a fast-changing situation with much at stake. The degree of uncertainty over the future path of government policy calls to mind the days running up to Black Wednesday in September 1992, when the UK attempted to raise base rates twice to defend the pound before crashing out of the European exchange rate mechanism.

Prime Minister Theresa May has outlined three options for the UK as it looks to exit the European Union: her deal, no deal, or no Brexit at all. Each has different implications for the economy and financial markets.

The withdrawal deal looks unlikely to make it through parliament, which will vote on the matter on 11 December, in its current form. Conservative Brexiteers and Remainers are unhappy about Britain’s potentially permanent rule-taker status, Northern Ireland’s Democratic Unionist Party does not want special treatment for its country, and the opposition Labour party will not support May’s deal.

From an investment point of view, Brexit is about risk control rather than trying to predict the outcome. According to Treasury estimates, the scenario closest to the government’s agreed deal would leave the economy around 4% smaller 15 years from now when compared to staying in the EU, due to reduced migration and increased trade friction. That equates to around three years of lost growth.

May argues that these estimates are uncertain, that the costs may turn out to be small and that the economic hit is a price worth paying to stop free movement of workers and implement the result of the 2016 referendum. However, some in her Conservative party are making the case for a no deal exit under new leadership as the only way to achieve full independence. Treasury estimates show this as the most damaging outcome of all, knocking an expected 8% off the economy. Interestingly, the offsetting benefit of making free trade deals with faster growing parts of the world is estimated at less than 0.5%.

A no deal exit is not inevitable if the deal fails to clear parliament. Members of the House of Commons could mandate a referendum with remaining in the EU on current terms as an option. This possibility is more plausible in the light of the European Court of Justice’s preliminary ruling that the UK’s Article 50 notification to leave can be revoked unilaterally. There would be no need to join the euro or Schengen area, and former Prime Minister Margaret Thatcher’s 1985 rebate on contributions would be intact. Surveys suggest most people would opt to Remain if such a vote were held today.

These are the three possible outcomes and, though none seems probable, one of them must happen.

It is unsurprising that sterling volatility has risen to its highest level since the referendum. The pound would fall sharply in a no deal exit but would strengthen significantly if the UK does not leave the EU after all.

For UK-based investors with a low risk appetite, it makes sense to avoid or to hedge overseas currency exposure until things settle down. Those with a higher appetite for risk might choose to balance equity holdings with property. The UK equity market should rally if the pound weakens on a no deal outcome, as in 2016, given the high proportion of earnings sourced from overseas. Property prices would rise sharply if Brexit were cancelled, however.

The events leading to a reversal of Brexit would undoubtedly mean increased market volatility in the short term. But pressing on with Brexit, with or without a withdrawal deal, would mean years more uncertainty for investors as future trading arrangements are hammered out in fractious negotiations.

Black Wednesday was embarrassing for the government of the day but in hindsight most people, including then Chancellor Norman Lamont, see the 1992 devaluation and sudden change of economic policy as a good thing.

A democratically-backed decision to stay in the EU on current terms would extinguish the uncertainty dogging the UK and could boost the economy in a similar – and immediate – way.

Trevor Greetham is Head of Multi Asset, Royal London Asset Management. This article was first published by FT Adviser on 4 December 2018.

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