The new lone star state

One of biggest risks for 2016, particularly for UK assets but also for Europe, is the impending referendum on Britain's European Union (EU) membership. As we progress through the year, the media's attention to this topic is likely to increase, starting in February when we will know more about whether David Cameron has managed to renegotiate any of Britain's EU membership terms.

In the market, the general thought is that the referendum will occur at some point in 2016. We agree with this expectation, although during the UK general election, the timeline provided suggested that it would not occur until 2017; markets dislike uncertainty and the sooner the outcome is known the better.

The referendum has only two outcomes to consider; an 'in' vote and it is business as usual. An 'out' vote and the status quo will begin to change. A potential exit is covered by article 50 of the Lisbon Treaty, but the exit negotiations could last two years or more. During this time, uncertainty surrounding the UK's economic outlook would increase and will likely lead to questions over what Scotland will do in terms of its own independence (potentially, it could look to leave the UK and stay in the EU).

In addition, there would be an escalation in risk for Europe as an exit vote would encourage eurosceptic parties in other countries to take similar action. As such, the political fallout could reverberate for some time.

Economic fallout

On the economic front, the potential impact on the UK would be significant, particularly for the services sector which accounts for around 36 per cent of the UK's exports to the EU. Unlike goods and trade agreements, services are not regulated by the World Trade Organisation (WTO).

Financial services are a key area in the services sector and a vote to leave could increase the risk of the City of London diminishing as a financial centre. It could also cause financial institutions to favour other cities in Europe, such as Frankfurt, or move further afield to areas in Asia.

Beyond the effect on the service sector, the potential implications of leaving the EU could dent consumer confidence and increase uncertainty over job security and income, thereby putting the UK's economic recovery under pressure. In turn, this could affect the path of UK interest rates - the EU referendum is likely to reinforce the general view that UK interest rates will stay 'lower for longer'.

For UK assets, a vote to leave should be expected to increase risk premia. This would occur at a time when the UK current account deficit means the UK is very much dependent on foreign capital to finance its deficit. Foreign investors own around £400bn of UK gilts, while they own over 50 per cent of the UK stock market (although a significant amount of this consists of large-cap international companies listed in the FTSE 100 Index, which are less dependent on the UK economy).

The FTSE 250, which is arguably a better barometer of the UK domestic economy, is likely to be more vulnerable. Key drivers of the pound sterling are the current account, interest rates, inflation expectations, and capital inflows / outflows. As such, it is likely that the pound will suffer (particularly against the US dollar), at least in the short term, in the case of a vote to exit.

In 2016, polls will be analysed as investors try to determine the probable outcome of the vote. However, most investors will also remember how unreliable the polls for the UK's general election were, so a fair amount of scepticism will likely surround vote predictions.

That said, if polls clearly show that a staying 'in' vote is likely, then the increased risk that will likely be priced into UK assets ahead of the event could diminish. Currently, polls remain unclear on the outcome, therefore we must consider the event's effect on the risk premia of UK assets as likely to increase during the year.

Given these issues, the management of investments will be challenging, although there are options for consideration. Diversification will be a key tool in the avoidance of risk. Investors will be able to reduce risk by diversifying across different regions, such as the US or Japan, while the use of different asset classes, such as alternatives and structured products, will also help. Likewise, taking a more market neutral stance within UK equities is also likely to be beneficial (as opposed to a long only position).

Claire Bennison is regional director at Brooks Macdonald in Manchester

She writes a regular in-practice article on asset management for Private Client Adviser

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