Markets Awake to Brexit Risk as EU Reform Talks Advance

Uncertainties surrounding referendum aren't priced in.

Photographer: Krisztian Bocsi/Bloomberg

Progress in U.K. Prime Minister David Cameron’s talks with EU leaders suggests a deal on the U.K. government’s reform demands is possible at this month’s summit in Brussels on Feb. 18 and 19, increasing the chance of a referendum on Britain’s membership in the union before the end of June.

While the pound is weaker, trading at a six-year low last month, and the cost of protection via sovereign credit default swaps is at the highest level since October 2013, uncertainties surrounding an in-out referendum and the risk of the U.K. leaving the EU aren’t fully priced in, analysts say.

POUND MAY HAVE FURTHER TO FALL

The pound has dropped nine percent from its November peak on a trade-weighted basis.

Moves in sterling and gilts over the past few months suggest investors have begun to take Brexit risks more seriously, analysts David Tinsley and John Wraith at UBS group AG said.

There’s a high chance of ongoing pound weakness in the runup to the vote, the UBS analysts said. Analysts at Citigroup Inc. including incl Hans Lorenzen wrote Brexit risk is nowhere near being fully priced yet.

The pound could drop around 15 percent to 20 percent if the U.K. were to leave, Goldman Sachs analysts including George Cole said while Nomura analysts including Jordan Rochester wrote that a 10 percent to 15 percent drop on a TWI basis is possible, given the country’s current-account deficit and if foreign direct investment and portfolio inflows were deferred alongside falling investment.

CREDIT PROTECTION SOUGHT

U.K. sovereign CDS has jumped 18 basis points since October lows, while U.S. CDS has risen five basis points and German CDS has risen eight basis points over the same period.

In cash credit, pound-denominated high-yield senior financial debt trades five basis points wider year-to-date while their euro-denominated peers are 0.5 basis points tighter, according to data compiled by Bloomberg.

Bank of America Merrill Lynch analysts including Maciej Pisarek and Richard Thomas recommended that investors increase exposure to globally exposed U.K. credits which offer relative safety and have changed their recommendation on RBS PLC and Barclays PLC senior CDS to buying protection from selling.

Morgan Stanley analysts Greg Case and Jackie Ineke recommended reducing U.K. overweight in credit and selling RBS additional Tier 1 securities.

AND STOCKS?

The FTSE 100 has fallen nine percent year-to-date, while the FTSE 250, which is more exposed to the domestic economy, has underperformed and is down 11 percent.

Citigroup’s equity strategists said Brexit risks can be hedged through, among other ways, an overweight stance on energy against an underweight on financial sector, or overweight FTSE 100 versus underweight FTSE 250.

Jefferies analysts warned of “dividend famine” as the equity market appears to be “sandwiched” between poor outlook for international growth and sliding commodity prices on the one hand, and worries over the in-out referendum on the other.

Cumberland Advisers’s Chief Global Economist Bill Witherell warned against using the period before the vote as a trading opportunity because of the potential cost of being wrong about the result and other headwinds. It wants to see an improvement in the outlook for the global economy and for the U.K. resources sector before adding to the current small U.K. positions in its portfolios.

GILTS ARE LESS AFFECTED FOR NOW

While short sterling shows the odds of a rate cut by the Bank of England have surged, reflecting a view that the BOE may need to cut rates were the U.K. to leave, longer-dated instruments have been more immune.

Investors polled by RBS are split 60-40 on whether exit from the EU would be negative or positive for gilts while Citigroup analysts said Brexit has the potential to generate different reactions, at different times, adding that gilt investors have historically priced these risks later than other assets.

Barclays’s analysts including Marvin Barth, Philippe Gudin and Moyeen Islam calculated there’s little risk premium priced in longer-dated debt and recommend U.K. 2/10 curve steepeners.

Citigroup analysts Jamie Searle and Peter Goves said as the risk surrounding the referendum rises, the 5/30 curve may steepen, 30-year gilt swap spreads may cheapen and inflation breakevens may widen.

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