Market preview; how to play the ‘Brexit’

With a potential Brexit hitting the headlines, we attempt to unravel some of the key aspects for both the economy and markets in the lead up to the referendum.

Source: Bloomberg

The idea of a Brexit is firmly front and centre for UK investors following the unexpected decision from London mayor Boris Johnson to throw his hat into the ‘out’ campaign.

This has introduced a political element to the topic, with many seeing this challenge to David Cameron as a means to stake his claim for Number 10. With exactly four months until the referendum, it is worth understanding the issues at stake here and what this could mean for financial markets.

In the May 2015 elections, David Cameron swept to a surprise majority victory, pledging to renegotiate the UK’s relationship with the EU before holding a referendum on continued membership. The conclusion of those negotiations last week saw a somewhat mixed response, with Mr Cameron failing to fully achieve many of his goals from negotiations. Certainly there was an aspect of having to aim high to allow for almost certain pushback within negotiations.

The main reforms approved within the deal are as follows:

  • Limits on in-work benefits to migrants upon the imposition of an ‘emergency brake’ – this could even be judged as illegal discrimination by the European Court of Justice
  • Child benefits to be determined according with costs of their residential country
  • UK exempt from ‘ever closer union’
  • Safeguards for non-eurozone countries

The question is whether this really allays the fears of those seeking to leave the EU. The reaction from those within the ‘out’ camp suggests not, with polls showing a clear shift towards exiting the EU. The IG digital 100s binary market currently indicates a 33% chance of a Brexit.

UK economic impact
The impact upon the UK is a highly disputed issue, yet it seems likely that the UK economy will initially suffer, with a number of firms speculating that they would either move their operations or personnel in the case of a Brexit. HSBC's recent declaration that 1000 investment bankers would have to move to Paris is one such example of this.

From an export sense, much would be dependent upon the ability to agree similar free trade deals with the UK’s trade partners. Considering that exports to the UK made up over 2.5% of GDP in 2014, it is clear that the eurozone derives significant economic benefits from trade with the UK. Whether that is enough to force through free trade agreements in the fact of a highly controversial Brexit is another matter.

With a number of the most dominant EU nations exhibiting a trade surplus with the UK, it is arguably just as beneficial for many EU nations to obtain a free-trade deal in the event of a Brexit. In fact, the eurozone as a whole exhibited a trade surplus close to 1% in 2014.

Market impact
Boris Johnson’s shift into the ‘out’ campaign provided us with a perfect proxy for what will happen within financial markets should a Brexit become more likely. The pound is specifically the primary casualty, as highlighted by the circa 2% fall in the early hours of trading this week.

The rally in the FTSE 100 also highlighted how detached the index can be from the UK economy, with many of the 100 firms on the index being either internationally based or focused. Interestingly, the more UK focused FTSE 250 also saw a higher gap in response to the heightened chance of a Brexit. As such, it makes sense to focus upon the pound as a Brexit play.

Looking at GBP/USD on the monthly chart, we have seen a major deterioration in the past four months, bringing the pair back into the first of two a major support zones (shaded). There is little doubt that any increased chance of a Brexit, as reflected by opinion polls and media coverage would lead to a continuation of this sell-off.

Given that price is currently at the bottom end of this support zone, a break through $1.4063 could lead to another sharp devaluation to the second zone at $1.3682-$1.3504. However, much will be dependent upon how the debate progresses. The past 29 years have seen just a few fleeting moments of price action below these levels, with GBP/USD always ending back up above current price by month-end.

Considering that by current estimates, the UK is over 60% likely to remain in the EU, there is a good chance that we could be getting a little carried away with any further devaluation. As such, any flush below current levels, outside of the lower Bollinger band and into the $1.3682-$1.3504 zone could be a great area for a rebound in this pair. Especially if this is driven by hype and hysteria rather than any actual shift in the likeliness of a Brexit.

EUR/GBP has also reflected this recent deterioration in the value of sterling, with a circa 11% rally since early December. Interestingly, we have seen a bullish break through the £0.7764 resistance level which underpinned price throughout the 2000-2015 period. With price now back above this key level and above the middle Bollinger band, there seems to be further room for gains.

However, bear in mind that we have not seen price move through the upper Bollinger band for almost seven years. As such, any hysteria fueled rally into the upper band could also mark a sensible area for this pair to look unreasonably overbought. The key is whether any such move was accompanied by an actual heightened chance of a Brexit, or merely a continuation of this theme where people are simply selling sterling due to heightened media coverage.

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