Today marks the last day of campaigning in the EU referendum before the polls finally open tomorrow morning at 7am. Going into the vote, the opinion polls remained as close as ever. And while we continue to believe that the most likely outcome is a vote to Remain as voters, as they did in the Scottish referendum, cast their votes in line with economic self-interest rather than some woolly concept of sovereignty, there is clearly a meaningful chance that the result is for Leave. For markets, which have seemingly largely priced out that probability over recent days, the market impact would be immediate if a Leave vote starts to look likely through during the early hours of Friday morning, including:

• a precipitous drop in Sterling, with the euro also under pressure as the dollar, Yen and Swiss Franc benefit;
• a hit to global equity markets and futures;
• a flood of money into government bond markets, including Gilts and core euro area government bonds, but
• a significant underperformance of euro area peripheral bonds; and
• a hit to credit spreads, particularly of European financials and UK financials in particular.

Leave vote would cause serious economic/market damage…

Hardest hit, of course, would be UK financial assets. And while it may be expected that, after the initial knee-jerk response, some of the risk-off sentiment would quickly dissipate in most other markets, the likely economic and political fallout in the UK would affect asset prices there for a considerable period. From a growth perspective a vote to Leave could be expected to trigger recession, prompting the MPC to swiftly cut rates and ‎re-launch QE. Certainly, all respected institutions that have given an opinion on the likely path for the economy in the wake of a Brexit vote expect a sharp slowdown in its aftermath (see table) and, unlike the Leave campaign, we are not inclined to ignore the overwhelming opinion of the experts and the lessons of history.

Source: Daiwa Capital Markets Europe Ltd.

…and would usher in political uncertainty

The economic uncertainty generated by a Brexit vote would be compounded by what is sure to be enormous political uncertainty. While both sides have suggested that David Cameron should stay on as Prime Minister, it seems inconceivable that he would be able to. It could be expected that he would step down swiftly, triggering a Conservative party election contest that presumably would provide a relatively easy victory for Boris Johnson, giving him the position of Prime Minister that he has long coveted. But, like Gordon Brown before him, he would likely end up regretting taking the job. The Leave campaign, whose whole proposition centred on a set of, at best, dubious claims, have set out no plan whatsoever for how they would separate the UK from the EU. Some members of the campaign (and hence the Cabinet post-Brexit) have claimed that they would be in no hurry to enact the Article 50 process that would trigger formal negotiations with the other 27 countries to extricate the UK from the EU. Instead, they have threatened to unilaterally withdraw from parts of the EU Treaties, something that would be a flagrant breach of international law and would risk retaliatory action from the rest of the EU. At the same time, Johnson would face a House of Commons where there would still be an overwhelming majority of pro-EU MPs (and a pro-EU upper chamber), meaning that passing the enormous amount of legislation required to extricate the UK from the EU would likely prove impossible. This would be particularly true if a vote to Leave was only marginal. And, with the Tories having a working majority of just 17, there is no guarantee that Johnson would even be able to command a majority in the House of Commons on a non-EU matters (some Tory MPs may well refuse to vote with a Government led by him), with no-confidence vote and early election likely to be a constant threat hanging over any Johnson Premiership.

Leave vote may not end up with UK leaving

All of this would be occurring against a backdrop of recession, moves in Scotland to hold a second referendum on independence so that it can remain in the EU and a clear message from the UK’s EU partners that the UK will not be able to negotiate a special deal with the EU on trade. In particular, full membership of the Single Market would require the UK to continue to pay its dues to the EU (meaning the £350mn per week the Leave campaign have falsely claimed the UK gives to the EU would not be available for the myriad things the Leave campaign have said it would spend it on instead) and accept free movement of people (breaking the Leave campaign’s most effective campaigning tactic that leaving the EU would allow the UK to “control its borders”). Faced with reality, rather than rhetoric, and a realisation that the promises of the Leave campaign cannot be fulfilled without causing enormous economic damage, buyers’ remorse may well set in, and pressure would likely grow for a second referendum. If the vote does go to Leave tomorrow, there are plenty of reasons to believe that the UK wont eventually leave the EU. But the route to getting there would be a painful one.

Whatever the outcome, political uncertainty set to remain high

In short, a post-Leave vote would mean that political risk, traditionally one of the UK’s strengths, would become a significant weakness. The continued existence of the UK in its current form would be in serious doubt, while the threat of an early General Election could be ever present, all of which would merely add to the massive economic uncertainty that a Leave vote would trigger. And even though a vote to Remain would hopefully see the economy rebound quickly as uncertainty about the UK’s relationship with the EU dissipated, political risk may well remain heightened. David Cameron would presumably be safe as Prime Minister. But with a working majority of just 16 and enormous bitterness towards him among the Eurosceptic wing of the Conservative Party, he could well find that majority evaporating either as Tory MPs resign the whip or defect to UKIP. If that is the case, a no-confidence vote and an early election could well again be the outcome.