Market Insights: UK likely to dodge the Brexit bullet, for now at least

The impending United Kingdom referendum on European Union membership remains a major “event risk” for global markets over the coming month. That said, polling suggests the chances of the UK leaving the Union after this vote are diminishing, which means there might be scope for at least a short-term “relief rally” for the British Pound. More broadly, however, it’s worth noting that UK equities have underperformed their continental counterparts in recent years, and lingering concerns over the UK’s commitment to the European Union suggests investors might consider European investments that exclude the United Kingdom.

Odds Favour the “Stay” Vote

As seen in the chart below, the Financial Times Brexit Poll Tracker – which summarises the results from various national polls – suggests the “stay” vote still retains the edge. Indeed, in recent weeks there appears to have been a dip in those favouring a leave vote, with many of these voters moving into the undecided camp. This suggests growing voter apprehension about the potential economic and financial implication of the UK leaving the EU, particularly in light of many high profile organisations and individuals (including US President Barack Obama and Bank of England governor Mark Carney) that have issued warnings about the consequences.

Source: Financial Times Brexit Poll Tracker

Probably even more telling are the results from betting markets. Although traditional polling still suggests a relatively close result, especially with a critical group still undecided, betting markets have long suspected the “stay” vote was much more likely to win. Indeed, the probability of the “stay ” vote prevailing has generally increased since the referendum was officially announced on 20 February.

Source: Ladbrokes

The Pound Could Bounce

As we suggested in an earlier piece on the Brexit vote, the beaten down British Pound has staged a rebound in recent weeks as the odds of the “stay” vote getting up have shortened. Assuming the stay vote does win out, the Pound could potentially resume the trend rise against the Australian dollar that has been evident since early 2013. The case for further Pound gains against the Australian dollar is strengthened by the chances of further local interest rates cuts by the Reserve Bank of Australia (as we explained here), together with a resumption of commodity price weakness after a brief flurry higher in recent months.

Source: Stockcharts.com

UK Equities have underperformed

Longer-term, however, the UK’s wavering support for EU membership does pose some political risks. Some companies seeking a foothold in Europe, for example, may come to question basing the centre of their operations in the United Kingdom. London’s role as a European financial centre could also come under greater scrutiny.

Against this background, it’s also worth noting that the UK equity market has generally underperformed that of the Euro-zone in recent years. One factor is the UK’s generally higher exposure to mining and energy stocks, which have suffered due to the decline in global commodity prices. Another factor has been more aggressive monetary stimulus from the European Central Bank, which has also contributed to relative weakness in the Euro against the Pound and improved Euro-zone export competitiveness. Indeed, it remains the case that the ECB President Mario Draghi has promised to do “whatever it takes” to avoid deflation taking hold in the Euro zone, which could mean even more quantitative easing and Euro weakness going forward.

Investment Implications: Currency and Equity Investment Opportunities

For investors that want exposure to a possibly rising British Pound, the BetaShares British Pound ETF (ASX Code: POU), can be bought and sold on the Australian Securities Exchange (ASX) just as easily as a company share. By primarily investing in bank deposit accounts denominated in British Pounds, POU aims to track the change in price of the British Pound relative to the Australian dollar. If the British Pound goes up 10% against the A$ (i.e. the A$ falls in value), for example, POU is designed to go up 10% too, before fees and expenses. Obviously if the reverse occurs and the Pound was to fall in value relative to the Australian dollar, the value of POU would fall too.

For investors interested in investing in Europe but who may be concerned over the UK equity outlook, the BetaShares WisdomTree Europe ETF – Currency Hedged (ASX Code: HEUR) provides exposure to Eurozone equity markets (and hence excludes UK companies). This ETF also has the feature of being currency hedged, which guards against the risk of possibly significant future Euro exchange rate weakness should the ECB need to ramp up its quantitative easing program dramatically further.

Irrespective of currency direction, another advantage of currency hedging in the case of a region such as Europe with very low (in fact negative) overnight interest rates is that Australian investors are effectively paid to reduce their currency risk by hedging exposure to fluctuations in the Euro. That’s because the process of hedging currency risk is akin to borrowing Euros (at very low rates) – to offset the currency exposure from the investment in European equities – and then using these borrowings to buy Australian dollars which earn a higher interest rate return.

Like all BetaShares Funds, HEUR is also an Australian domiciled fund. Therefore, investors in HEUR do not need to fill out W-8 BEN forms, or risk any potential U.S. estate tax issues, unlike investors in “cross listed” alternative exposures.

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