Tuesday 21 June 2016 5:05 am

What will happen to UK equities if we leave the European Union?

The pound and the FTSE soared yesterday, as the Remain camp wrestled back its lead in the polls. But the outcome of Thursday’s EU referendum is far from clear, with pundits saying that voter turnout will be pivotal in determining whether the UK stays or leaves.

If Article 50 is triggered and sterling dives, what should investors expect from UK equity markets?

Weaker sterling

Since its nadir in February, the value of sterling has fallen with every perceived increase in support for the Leave campaign. According to the Treasury’s worst case scenario, sterling could fall by as much as 15 per cent following a Brexit vote.

A cheaper pound could be good for the FTSE 100, because its constituent companies derive only 20 per cent of their value from the UK, according to Credit Suisse, compared with 50 per cent for the FTSE 250.

Nonetheless, there are few who believe the FTSE would see the same 20 per cent surge it witnessed in 1992, after Britain abandoned the Exchange Rate Mechanism. As Capital Economics’s John Higgins has pointed out, the ERM aimed to limit currency fluctuations between the European Currency Unit and member states’ currencies, so sterling had much further to fall back then. This time around, much of the potential pressure has already been priced in, and sterling has remained very strong relative to other currencies. Brexit would probably not trigger a depreciation long or deep enough to give the fundamentals of UK equities any lasting boost.

Baring Asset Management’s Marino Valensise reckons that sterling would have to weaken by as much as 25-30 per cent for that to happen.

Financials

Question marks loom over the level of access which financials would have to the EU post-Brexit, especially around passporting rights for banks, and the Solvency II regulatory regime for insurance companies.

It is not yet clear whether UK financial firms would need a locally capitalised subsidiary inside the EU to continue offering services to retail customers on the continent. Staffing could be an issue for banks, says Phillip Capital UK’s Ana Thaker. HSBC has threatened to move 1,000 jobs from London, and the one-off cost of relocating services would hit share prices hard in the short term.

The notion that banks would move their operations immediately is unlikely, and the UK may still have to comply with the European Commission’s MiFID II regulations when they are implemented in 2018.

Nevertheless, uncertainty is unwelcome when the stakes are so high. A European market of 500m people is vital to UK insurers, for example, which sell £21bn more in insurance and long-term savings products to the rest of the EU than to the UK itself, according to the Association of British Insurers.

“Brexit is likely to exacerbate problems which already exist in sectors of the market,” says CMC Markets’ Jasper Lawler. The likes of Barclays have suffered over recent years, as regulators have demanded larger capital buffers, and low interest rates have squeezed their profit margins. Despite the chancellor’s claim that the Bank of England may be forced to raise interest rates to curb inflation after a Leave vote, Axa Wealth’s Adrian Lowcock sees interest rates being held lower for longer as a more likely post-Brexit scenario, which would keep banks’ profits tethered.

Housebuilders

“The financial sector would be sensitive to falls in property prices,” says Lowcock. “Housebuilders may also fall as foreign investors reconsider the UK as a safe haven for property prices.” The domestic orientation of the housebuilding sector is reflected in the way that shares in Taylor Wimpey, Barratt Developments and others have jumped as polls have swung back in Remain’s favour.

Seventeen large housebuilders, including the FTSE 100’s Barratt, Crest Nicholson and Berkeley Group, signed a letter saying that investment in the sector will suffer as confidence in the economy wavers. This has been borne out by a recent KPMG poll, with two thirds of 25 global real estate investors with over $400bn in assets under management saying that Brexit would lead to a decrease in property investment.

Brexit is likely to affect confidence about the long-term prospects of the construction industry, regardless of whether changes to employment laws or a reduction in access to cheap skilled labour actually materialises.

“The last few months have seen slowing demand at the luxury end of the market,” says Lawler. This trend may continue, with international investors deterred, but analysts point out that there has been plenty of demand from the middle of the market. Appetite for new homes may hinge in the short term on whether mortgage costs are driven up, as governor Mark Carney has said could happen, even if the Bank was to cut rates.

Staples

If uncertainty around Brexit is the biggest threat to UK equities’ success, pharmaceuticals companies, and providers of chemicals, energy and consumer goods like food, cleaning products and tobacco look like a port in a storm.

Indeed, a Leave vote is unlikely to dampen global demand for such necessities, provided that energy and commodities are not affected in the long term, because their revenues are not reliant on UK consumption.

In April, Unilever, which owns Dove, reported 8 per cent quarterly growth from emerging markets, fuelled by sales of soap and laundry detergent.

Such firms may be on high valuations, says Brewin Dolphin’s Guy Foster, but their non-cyclical nature makes them a proxy for bonds, and reliable in times of volatility. “If the actions of traders push them down, we will buy them.”

Is bigger better?

If international exposure offers equity investors some refuge from the domestic fallout of Brexit, is this reason to sell small and mid-cap stocks and buy the FTSE 100?

Not necessarily. Mark Martin, manager of the Neptune UK Mid Cap Fund, believes an end to Brexit speculation will see a raft of mergers and acquisitions within the All-share index and the FTSE 250 specifically. He has picked out FTSE Small Cap company Premier Farnell, which has been approached by Daetwyler Holdings, and Poundland, which the South African Steinhoff has its eye on.

Ultimately, Brexit jitters will die down, and investors should look under the hood to determine a stock’s long-term potential. According to Liberum, ITV, Wolseley and Balfour Beatty would outperform their sector in any scenario.