Aside from a currency impact, likely effects include market volatility, a hit on UK government bonds and wider corporate spreads. Benedicte Gravrand reports
Ahead of the June referendum, UK insurers have spoken out on Britain leaving the European Union – or Brexit – but in the name of good risk management they must prepare their investment portfolios for either outcome.
Predicting the effects of a leave vote on financial markets is difficult, but some eventualities, such as a drop in currency value, seem fairly certain. News on the issue has already revealed some patterns. For example, when London mayor and Conservative party MP Boris Johnson announced in February his decision to vote in favour of leaving, sterling dropped sharply against other currencies.
Aside from a currency impact, likely effects include market volatility, a hit on UK government bonds and wider corporate spreads. This suggests that UK insurers will take a "risk-off" stance at home, insure portfolios against sterling weakness and volatility, and look east and west for alternative sources of returns.
Brexit effect on the industry
UK insurer Direct Line said Brexit would hurt its £6.8bn ($9.7bn) investment portfolio and cause regulatory uncertainty, according to Reuters. Its CIO John Reizenstein said: "We'd see some instability in investments and we have a large investment portfolio - sterling might weaken, gilts might weaken".
Gerry Grimstone, Standard Life's chairman, said his company, which has £307.4bn in assets under administration, has been preparing for a Brexit scenario, and that involves deep technicalities "associated with the running of our funds, including looking at currencies, contracts, and other impacts," he said, adding; "That's our bread and butter."
Stephen Hester, the head of British insurer RSA, said a British exit from the EU could have a negative impact on its business and the returns on its £13bn investment portfolio. Hester was one of the 198 business leaders to have signed an open letter at the end of February, saying that leaving the EU would put the British economy at risk.
UK insurers whose customer base is located in many territories, such as Legal & General, which has around £728bn in assets under management, may suffer little direct impact if Brexit takes place. But "a vote to exit, with a potentially lengthy period of negotiation and an uncertain outcome, would create uncertainty for markets and the broader UK economy in which we operate," the insurer said.
Prudential Plc, which has around £509bn of assets under management, is in the same position as L&G, as almost 88% of its business comes from outside the UK - mainly from Asia and the US. "Although we export a lot to the EU, especially through M&G (the insurer's UK investment arm), so it is in our interest for the UK to remain within the EU," a spokesman told Insurance Asset Risk.
Brexit effect on assets
BlackRock, which manages assets worth around $4.6trn, said it expects volatility in UK and European assets to rise ahead of the referendum. An actual Brexit would hit global risk assets, lead to a sharp sterling depreciation, a rise in 10-year gilt yields, less portfolio inflows and a widening of corporate credit spreads.
"Sterling is most vulnerable to Brexit fears as it is the most liquid UK market," BlackRock said in its paper, Brexit: big risk, little return. "A Brexit could pressure the UK's budget and current account deficits, hurting the currency and potentially triggering credit downgrades."
J.P. Morgan Asset Management, which manages around $1.7trn, expects sterling to remain weak for the duration of the campaign. "The cost of insuring portfolios and business activities against further sterling weakness has spiked to the highest level since 2010 and derivative markets are forecasting that sterling volatility will remain high well into the summer," it said in a briefing.
The vote will probably affect gilt yields as, according to BlackRock, "Heightened uncertainty and concerns about increased fiscal risk in the event of Brexit would likely lead to a steepening of the yield curve, we believe, with underperformance of long-dated bonds versus short-term gilts."
J.P. Morgan expects gilts to be much less affected than sterling thanks to Britain's sound fiscal position, and short-term money market rates may be held down by the Bank of England's "no change" stance on rates. If the 2014 Scottish Referendum is any guide, the yield curve would steepen slightly relative to the US, the firm added.
The UK two-year, five-year, 10-year and 30-year bond yields have been declining significantly in the past 12 months. The 10-year yield stands at around 1.47% whereas the two-year bond yield stands at around 0.46% (as at 9 March).
"We also see swaps outperforming government bonds," said BlackRock. "Corporate credit spreads would likely widen, especially for UK businesses that derive a high proportion of revenues from domestic and EU markets."
Brexit may have a negative impact on UK equities, but as the country's stock market is well-diversified and global, the extent of that impact would not be significant, said BlackRock. J.P.Morgan expects equities and possibly prime London real estate prices to fall.
"Expect most of these effects to reverse themselves in the event of a Bremain vote," J.P.Morgan noted. "But do not be surprised if sterling ends the year materially weaker, on a trade-weighted basis, than at the end of 2015. And do not be surprised if there is talk of another referendum on EU membership if the June vote is reasonably close."
While the UK economic (and interest rate) growth would slow down in the event of a Brexit, the eurozone would also see a short-term hit, according to J.P.Morgan. The firm expects that in the long term, "investors should be especially alert to the outcome for UK financial services firms, many of which could be negatively affected."
