ANALYSIS
Recent market tumult over the growing risk that Britons will next week vote to leave the European Union may seem irrational, or at least overdone, to many.
After all, who cares if the peoples of a bunch of windswept islands off the west coast of continental Europe divorce themselves from what they essentially view as a convenient trade bloc of disparate nations?
According to the experts, however, global investors should be worried by the possibility of such a separation.
Why? Because risk markets – such as equities, and corporate and emerging market debt – don't like uncertainty, and a vote for "Brexit" would not only cast doubts on Britain's economic future, but also call into question the sustainability of the European Union itself.
Specifically, equity, currency, commodity and bond investors and traders are currently positioning to protect themselves from the following big risks.
1. The fallout for exports
British exporters like Burberry will be affected by Brexit's' impact on the pound. Photo: AP
The unwinding of the UK's favourable trade terms with the EU, its biggest export market, pushes up exporters' costs and so erodes their competitiveness. The flip side of this is pound sterling's depreciation, already well under way, which makes UK exports cheaper in the EU.
However, the euro is also likely to come under pressure if Britain leaves, so that currency advantage may be neutralised. A weaker pound can also make imported input costs more expensive, another consideration when weighing the benefits of a weakening currency.
2. Loss of investor money
How relevant will London remain as a global financial centre? Photo: Bloomberg
The UK, like Australia, runs a substantial current account deficit, meaning it relies heavily on foreign direct investment for long-term financing, and flows of money into shares and debt to help fund company expansion and government infrastructure. Britain's attraction as a financial centre stems largely from its position as an English-speaking member of the EU. If this ceases to be the case, funding inflows could thin out, again putting pressure on pound sterling.
A re-negotiated deal with the EU on trade and investment links would eventually offset this, but the UK's status as a global financial services centre would remain vulnerable in the meantime. The eurozone is already uneasy about London's dominance of financial assets trading; a win to the Brexiters could trigger retaliatory limits on access to continental investors' cash.
3. Pressure on rates
The pound has been bearing the brunt of concern about the British economy after Brexit. Photo: Bloomberg
The above, in extremis, could force the Bank of England to lift interest rates to attract capital. This could dampen economic activity, catch bond traders offguard and also hurt the equity market. Corporate borrowing spreads – the difference between government benchmark bond rates and what it costs a company to raise money – have already widened in the run-up to next Thursday's poll. This trend would continue under the uncertainty of a Brexit, and even more so under the BoE's higher rates scenario.
4. Triggering a chain reaction
Hundreds of migrants and refugees in Berlin, Germany, last year. Photo: AP
Of course, it take two to tango and the 27 members of the EU left hanging if Britain leaves will have their own consequences with which to grapple. What has most spooked markets of late is the risk of a "leave" camp success in Britain setting off a chain reaction among other eurosceptic nations, such as France. Rising concerns about the free movement of Middle Eastern refugees across EU states once inside the bloc has turned many erstwhile europhiles into eurosceptics. This is certainly the case in the UK. It's the possibility, rather than the reality, of an EU break-up that can affect asset prices in the short term.
Analysts say eurozone countries with troubled economies or problematic pasts, such as Ireland, Spain, Portugal, Greece and Italy, could see their sovereign and corporate borrowing costs rise, and their sharemarkets hit as investors deal with this doubt. Relatively healthy EU outliers such as Denmark – an EU member that hasn't adopted the common currency – might have the opposite problems.
As investors pile into the country's safe-haven government bonds, the currency appreciates and the country's export competitiveness suffers. Danish interest rates are already below zero, leaving the central bank with little ammunition to hold down the currency and fend off the disinflationary impact of a strong krone.
5. The final straw for markets?
Donald Trump's rise as the Republican presidential candidate is adding to the list of global uncertainties. Photo: 3AW
Market ructions of late reflect not only concerns about Brexit, but broader unease about slowing growth in China and across the world, the absence of "good" inflation, low commodity prices, weak demand, the potential of firebrand Donald Trump as US president and America's stuttering economic recovery. And this is despite years of low interest rates and other stimulatory measures by the world's central banks.
This is why Australian shares sold off on Tuesday and government bond yields, which fall as investors bid up prices, are close to historic lows.
As Amplifying Global FX Capital's Gregg Gibbs said on Tuesday: "In the event, if the UK votes to leave, it seems the market is ready to sell everything. This may be a vast over-reaction. But who is to say that it will not be the bale of straw that collapses the back of a fragile global economy threatened by weak growth, excessive debt, and gripped by political instability."
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