The political fall-out of the EU referendum is likely to continue to influence investment markets for months or even years to come, believes David Zahn - and not just in the UK but across Europe too
Whatever the result of the 23 June ‘Brexit' referendum, the one thing we can say with some certainty is that the ramifications will likely be felt for some time to come - and not only in the UK. In particular, politics will likely become an elevated issue for UK financial markets over the next few years as the ruling Conservative Party, whose MPs have been deeply split on the Brexit issue, seeks to restore cohesion.
The current administration does not enjoy a large majority in Parliament. If a significant number of its MPs were to splinter off, the government could conceivably no longer have a majority and, in that event, a big question mark would hang over whether it would be able to govern effectively or even continue in power.
There is a widespread belief that, if the UK votes to leave the European Union (EU), prime minister David Cameron, who has been spearheading the ‘Remain' campaign, would stand down. The question would then be how his successor could bring the ruling party back together again. If the vote is to remain, it will be up to Cameron to reunite his erstwhile colleagues. In either case, it is unlikely to be an easy task, and the uncertainty is likely to unnerve markets.
In addition, there may be some concern that the question of Scottish independence could rear its head again - notably if Scotland votes to remain in the EU but the UK as a whole votes to leave. As such, the voting breakdown by region - England, Scotland, Wales and Northern Ireland - should be an important factor in the final reckoning.
The confusion could have considerable implications for the UK's inward investment, including foreign direct investment and equity investment as well as its currency. And we believe that, if there is enough political unrest, it could spill over into Europe.
Exit signs spreading to other EU states
With polls predicting a very close result, we are expecting the volatility the UK equity and bond markets, as well as sterling, have experienced in recent weeks will continue up until the day of the vote. But we also suspect there could be further volatility in mainland European markets as well, as more European political leaders make public their opinions in the run-up to the vote.
There are some indications that, if the UK were to vote to leave the EU, calls for referendums in other countries could intensify. Several political leaders, particularly those away from the mainstream but with growing popular support, are becoming more vocal in their criticism of the problems they perceive with the EU.
In general, we ae seeing evidence of growing dissatisfaction among voters, with incumbent governments across Europe. European economic growth in general has been rather anaemic and people are looking for someone to blame. Voters are starting to question whether the governments that are currently in charge should continue to be. That is why there have been a number of elections in Europe where the status quo has changed.
In addition to blaming their own governments, there are signs some people are also starting to lay the blame on a body that sits far away that they have never met and have no idea what it does - in other words, the EU. In quite a few countries, we suspect there is a fair proportion of people who would consider voting to leave the EU. The numbers may not be overwhelming, but it shows there is a level of dissatisfaction with the European government system in its current form - and specifically with the way it is managed.
In that respect, the referendum in the UK is actually acting like a lightning rod for politicians and others across Europe to air their views and that could create further market volatility. Additionally, we believe the ramifications of Brexit for the rest of Europe are far reaching - more so than many people think.
International financial bodies including the International Monetary Fund and World Bank as well as US Federal Reserve chair Janet Yellen have predicted that Brexit could be very unsettling, not only for the core European financial markets, but also for the global financial markets at large.
With that in mind, it is striking to us that European bonds generally, and peripheral government bonds in particular, do not appear to be adequately reflecting the risk of Brexit in their pricing. While there seems to be some reflection of the risk in prices for UK corporate and government bonds, we do not see that more widely in European markets.
Many observers seem to think the European Central Bank (ECB) could step in to offset a disruption. Yet while it is true the ECB's asset-buying programme is generally considered to be going well - it has spent a lot of money and this month started buying corporate bonds - it remains a concern for us that the full implications of Brexit do not appear to be priced in for non-UK European bonds.
If there is a UK vote to leave, or if the vote is close, it will likely create a lot of unknowns, and bond price spreads could widen in the short term. Let's not forget that, on 26 June, the re-run of the inconclusive Spanish general election is scheduled to take place. So, there are two relatively large political events happening in the course of three days, suggesting that, across Europe, investor interest in political machinations is likely to remain high.
David Zahn is head of European fixed income, Franklin Templeton Fixed Income Group
