Inevitably, debate around Brexit focuses attention on the UK current account. While there is a surplus when it comes to services, and particularly financial services, trade in goods is negative. Britain imports more goods than it exports. 
The result is not a happy picture. Not since wartime has the UK current account balance been so negative, flirting with 5 per cent of GDP. The majority of the deficit is with the rest of the EU, thanks to imported cars, food and drink.
The imbalance between services (where there is a surplus) and goods (where there is a deficit) is problematic. In the event of Brexit, negotiating a new trade agreement may not be straightforward and may not even help if services aren’t included. Imported goods would continue to come into the UK, but without the ability to export services to Europe, the current account deficit is likely to widen further.
Financial services represent a matter of profound importance to the UK economy, and we think the consequences of exiting the EU would be serious. There is no precedent for accessing the EU market in services without paying a contribution to the Union and without complying with its regulations.
The UK’s current account deficit has, until now, in the words of Mark Carney, been financed by the “kindness of strangers” thanks to capital inflows from international investors into the UK. There is no guarantee that these flows will continue as we get closer to the referendum date, or indeed afterwards if the vote goes in favour of an exit.
A focus on sterling
Practically, the mechanism through which capital flows will need to be attracted into the UK has to be through a cheaper sterling.
Relative performance of sterling in 2016
Source: FE Analytics
There has not been an exact match for this event in the past, but previous times of stress have seen sterling depreciate by 15 per cent to 20 per cent on a trade-weighted basis. Research we have seen suggests that sterling could have to weaken by 25 per cent to 30 per cent in the event of Brexit, to continue to attract capital flows, slow imports and boost exports for the UK economy.
However, sterling would not be alone. We would also expect the euro to decline in the uncertain aftermath of a vote in favour of Brexit, although sterling would be likely to be the weaker of the two.
Of course, such profound currency depreciation would also have consequences for the UK economy. It would be highly inflationary.
In turn, this would present the Bank of England with a particular dilemma; whether to raise interest rates to control inflation and risk slowing the UK economy, or do nothing, look through and see inflation rise by as much as 4 per cent or 5 per cent.
Assessing the asset markets
If the current account deficit is to be managed, the UK will need to offer global investors an attractive set of risk premia.
Many short and intermediate-dated gilts are held by foreign investors, while UK institutions are generally the owners of longer-dated paper. This makes short and intermediate gilts most vulnerable to uncertainty. Observing periods of stress in the past, we would quantify the risk premium required as an additional 150 basis points. That’s a significant correction.
Ten-year UK gilt yields over 3yrs
Source: FE Analytics
Long-dated securities will not be immune, however, and could be particularly vulnerable to any uptick in inflation.
In terms of equities, the prospect of a depreciation in sterling would be likely to favour UK-listed multinational companies, such as those in the FTSE 100 Index, able to benefit from international revenues.
That would be a reversal of the way many investors have been positioned, when small and mid-caps have been able to benefit from low import costs and strong domestic demand. Smaller companies would, in the case of Brexit, be likely to suffer from a combination of cost increases and weak demand.
A difficult negotiation
There is still uncertainty whether the referendum will be considered “politically binding” by the government, and whether a second vote would be considered.
Under the Treaty of Lisbon, the UK would be given two years to structure an orderly exit, during which there would be an attempt to negotiate new terms for the trading relationship between UK and the EU.
There is no doubt that the challenges would be difficult, particularly in negotiating a new trade agreement with the EU. In my view, the EU will not want to set a precedent and would not want to signal to other member countries that there is an easy way to “leave and renegotiate”.
Post-Brexit concessions to the UK would send the wrong signal to other EU countries where nationalistic movements are growing. This could result in a political chain-reaction that could easily trigger a series of national referendums in numerous member countries.
In terms of financial commitments, if the UK leaves the EU, it would save around £10 billion in net contributions.
The government would, however, be likely to need to step in to help sectors and regions which would stop receiving European structural funds, and which could be disproportionately affected by tariffs on trade. It is also not yet known what level of payment would be required to permit the UK business sector to access the 500 million people living in the EU.
Marino Valensise is head of multi-asset & income at Baring Asset Management. All the views expressed above are his own and shouldn’t be taken as investment advice.
