If Britain votes to leave the European Union there exists no road map for investors. Not only would a split from the EU be unprecedented, the divorce could last for years.
This raises a dilemma: how can markets price in the risk of Brexit when the consequences are still unknown?
“If they were rational, investors would wait until they knew exactly what deal will be struck between the UK and EU,” says Nikolaos Panigirtzoglou, strategist at JPMorgan. “Until then, they will not know how a split will affect the economy.”
Unravelling 43 years of EU membership will not be easy. Even if the UK votes to leave, it will remain part of the EU until invoking Article 50 of the Lisbon Treaty, which carries a deadline of two years to negotiate an exit. David Cameron, the UK prime minister, has warned that hammering out terms and establishing a new trading regime with Europe could take seven years.
Yet markets are already experiencing record levels of volatility as investors pre-empt the outcome of the June 23 referendum.
In mid-June, signs the Leave campaign was gathering momentum prompted a renewed weakening of the pound and spurred buying of haven assets that left Swiss, UK, Japanese and German government bond yields at record lows and sterling at a two-month low of $1.4013.
On Monday, a modest swing in the polls favour of Remain reversed the trend, pressuring the price of haven bonds, bolstering equities and pushing the pound towards $1.47.
To Mr Panigirtzoglou, the moves are proof of investors seeking first-mover advantage.
“I don’t think prices are moving because investors know what the immediate impact of Brexit will be in the UK and eurozone,” he says. “I think it’s because they expect other investors to sell if the UK leaves and to buy if the UK stays so they want to get in first. It’s a self-fulfilling prophesy.”
While the UK government expects the country to suffer an economic downturn in the event of Brexit, with estimates ranging between a contraction in GDP of between 3.8 and 7.5 per cent.
The Leave campaign has confirmed that quitting the EU means departing the single market, which allows for free movement of goods, services, people and capital. But there is no consensus about an alternative model it will seek.
Domestic uncertainty could be further compounded by a possible second Scottish independence referendum and questions over Mr Cameron’s future as prime minister. In the eurozone, Brexit negotiations will coincide with elections in France and Germany, continued arguments over Greek debt and the refugee crisis.
“Uncertainty means less investment and that is what is being priced in,” says Nick Gartside at JPMorgan Asset Management. “This is binary event so it’s being seen as risk-on or risk-off depending on the outcome.”
More than four-fifths of investors polled by CFA — the professional body for the world’s largest institutional investors — expect the FTSE to fall and yields on UK government bonds to rise in the event of a Brexit.
James Clunie, fund manager at Jupiter, has already lightened his exposure to sterling assets in the expectation that the UK’s currency could depreciate sharply in the event of Brexit.
Richard Turnill, BlackRock’s global chief investment strategist, expects financial stocks to be particularly exposed amid a broad fear of global instability. The rebound in share markets on Monday was led by banks, highlighting the sector’s sensitivity to swings in sentiment over the referendum result.
However, Mr Gartside adds that any reaction will be relatively muted if polls successfully predict the outcome and investors successfully price in that result.
Boris Johnson, voluble supporter of the Leave campaign, has also attempted to repel gloomy market projections, saying that even if the pound falls sharply in the aftermath of Brexit, the currency will recover as the UK economy improves.
David Owen, chief European financial economist of Jefferies, disagrees. The best chance that sterling, equities and other perceived risky assets have of avoiding a sharp fall in the wake of a Leave vote is if policymakers step in immediately, he argues.
The Bank of England has already opened lines for cheap lending to banks to prevent a liquidity squeeze ahead of the vote, and central banks could come under pressure to pledge further support in the event of Brexit, supporting both equities and bonds.
“The BoE and ECB could cut interest rates and the BoE could kick-start QE,” says Mr Owen.
“At the very least, the ECB will be doing more, for much longer, anchoring interest rates in the core at extremely low levels for a very long time . . . the magnitude of the hit to GDP will, in part, depend on how quickly the markets stabilise.”