How to trade the Brexit referendum

In Free by Cam Hui

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I have tried to refrain from comment on the Brexit referendum vote until the situation had settled down a bit. Now that the campaign is in full swing, it`s time to consider how the markets might react as we approach the June 23 vote.

CNBC recently summarized the debate this way:

  • First, the economy, and whether positives like free trade would exist outside of EU membership, and whether negatives like excess regulation would make a meaningful difference if removed.
  • Second, migration of workers, and whether this helps offset Britain’s poor demographics, or acts as an excess strain on the welfare system.
  • And third, sovereignty; is Britain ruled by the members of Parliament in Westminster elected last May by British voters, or by unelected bureaucrats in Brussels?

A probable roadmap

While I believe that the UK will ultimately vote to stay in the EU, there will many ups and downs to the debate. The addition of popular London mayor Boris Johnson to the Leave camp is undoubtedly providing a boost to the Leave vote.

The map below (via Ian Bremmer) shows the locations of battles in the last 4000 years and serves to underline the history of conflict and horrific carnage that the European Union was designed to avoid (see Lest we forget, or why you don`t understand Europe). The British are not as emotionally wedded to the idea of a united Europe as their Continental cousins by virtual of geography.

Here is the likely roadmap of how opinions and the markets are likely to behave. Watch for the Leave side to gain the lead initially as Briton are guided by their hearts and emotions. As time progresses, “Project Panic” will kick in, just as it did during the Scottish Referendum (via Business Insider):

While few may be swayed by the lightly amended membership terms, a plunging currency, tumbling share prices and fears for property values could drive enough Britons to opt at the last minute for the status quo rather than a leap into the unknown.

That was how the British political establishment managed by the skin of its teeth to hold the United Kingdom together in 2014, when Scottish voters tempted by the centuries-old dream of regaining independence from England ultimately chose safety.

It is also a plausible scenario for the EU vote, especially since a decision to leave would reopen the Scottish question.

Ordinary Brits tempted to give the unloved “Europe” a kicking may plump for stability to avoid economic uncertainty rather than risk financial and political turmoil.

I also agree with Antole Kaletsky that UK citizens will ultimately vote to stay because of the enormous economic costs to the UK economy because of the loss of jobs in the services sector:

The economic challenges of Brexit would be overwhelming. The Out campaign’s main economic argument – that Britain’s huge trade deficit is a secret weapon, because the EU would have more to lose than Britain from a breakdown in trade relations – is flatly wrong. Britain would need to negotiate access to the European single market for its service industries, whereas EU manufacturers would automatically enjoy virtually unlimited rights to sell whatever they wanted in Britain under global World Trade Organization rules.

Margaret Thatcher was the first to realize that Britain’s specialization in services – not only finance, but also law, accountancy, media, architecture, pharmaceutical research and so on – makes membership in the EU single market critical. It makes little economic difference to Germany, France, or Italy whether Britain is an EU member or simply in the WTO.

Britain would therefore need an EU association agreement, similar to those negotiated with Switzerland or Norway, the only two significant European economies outside the EU. From the EU’s perspective, the terms of any British deal would have to be at least as stringent as those in the existing association agreements. To grant easier terms would immediately force matching concessions to Switzerland and Norway. Worse still, any special favors for Britain would set a precedent and tempt other lukewarm EU members to make exit threats and demand renegotiation.

How to trade the vote

In effect, we will see a high level of market and public opinion volatility between now and June. The three likely phases are:

  • Leave camp ascendant
  • Market panic
  • Last minute recovery for the Stay camp
A useful vehicle to trade this kind of volatility is the EWU (UK stock ETF) vs. Euro STOXX 50 (FEZ) pair. This long-short ETF pair is useful because it trades in USD and therefore incorporates currency effects. As the chart shows, the pair is at the top of a trading range, with EWU outperforming FEZ, which is reflective of the optimism that the UK will stay in the EU. This might be a useful place for traders to short EWU against a long position in FEZ.
As the Leave side gains in the opinion polls, watch for eurozone stocks (FEZ) to start outperforming UK stocks (EWU). If and when it gets to the bottom of the range, traders would be well advised to consider reversing their positions and buy EWU against a short position in FEZ.
For readers who want to follow along at home, use this link for real-time updates.
Disclosure: No positions

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