Markets awake to 'Brexit' risk amid EU reform talk

The pound could drop 15% to 20% if the UK were to leave EU, Goldman Sachs analysts say

Progress in UK Prime Minister David Cameron's talks with EU leaders suggests a deal on the UK government's reform demands is possible at this month's summit in Brussels on February 18 and 19, increasing the chance of a referendum on Britain's membership in the union before the end of June. While the pound is weaker, trading at a six-year low last month, and the cost of protection via sovereign credit default swaps is at the highest level since October 2013, uncertainties surrounding an in-out referendum and the risk of the UK leaving the EU aren't fully priced in, analysts say.

The pound has dropped nine per cent from its November peak on a trade-weighted basis. Moves in sterling and gilts over the past few months suggest investors have begun to take "Brexit" risks more seriously, analysts David Tinsley and John Wraith at UBS group AG said. There's a high chance of ongoing pound weakness in the runup to the vote, the UBS analysts said. Analysts at Citigroup, wrote "Brexit" risk is nowhere near being fully priced yet.

The pound could drop around 15 per cent to 20 per cent if the UK were to leave, Goldman Sachs analysts, including George Cole, said, while Nomura analysts, including Jordan Rochester, wrote that a 10 per cent to 15 per cent drop on a TWI basis is possible, given the country's current-account deficit and if foreign direct investment and portfolio inflows were deferred alongside falling investment.

UK sovereign CDS has jumped 18 basis points since October lows, while US CDS has risen five basis points and German CDS has risen eight basis points over the same period. In cash credit, pound-denominated high-yield senior financial debt trades five basis points wider year-to-date, while their euro-denominated peers are 0.5 basis points tighter, according to data compiled by Bloomberg. Bank of America Merrill Lynch analysts, including Maciej Pisarek and Richard Thomas, recommended that investors increase exposure to globally exposed UK credits which offer relative safety and have changed their recommendation on RBS Plc and Barclays PLC senior CDS to buying protection from selling. Morgan Stanley analysts Greg Case and Jackie Ineke recommended reducing UK overweight in credit and selling RBS additional Tier 1 securities.

The FTSE 100 has fallen nine per cent year-to-date, while the FTSE 250, which is more exposed to the domestic economy, has underperformed and is down 11 per cent. Citigroup's equity strategists said "Brexit" risks can be hedged through, among other ways, an overweight stance on energy against an underweight on financial sector, or overweight FTSE 100 versus underweight FTSE 250. Jefferies analysts warned of "dividend famine" as the equity market appears to be "sandwiched" between poor outlook for international growth and sliding commodity prices on the one hand, and worries over the in-out referendum on the other.

Cumberland Advisers' Chief Global Economist Bill Witherell warned against using the period before the vote as a trading opportunity because of the potential cost of being wrong about the result and other headwinds. It wants to see an improvement in the outlook for the global economy and for the UK resources sector before adding to the current small UK positions in its portfolios.