As we approach Britain’s Vote on whether it will remain in or leave the European Union (EU), polls are suggesting a tighter race, and market volatility has increased.

On May 11 we addressed the risk of Brexit as a real possibility, even though markets at the time did not adequately price in the uncertainty of this referendum. However, in the past 10 days, several new polls suggested that the gap between the two camps is quite narrow. Some polls have even suggested that the “Leave Camp” is ahead, which in turn led to increased volatility and a sell-off of risk assets.

Why We Believe a Brexit is Still Less Likely Than a Bremain

Despite the recent reversal in some poll results, which is not uncommon in election and referenda polling, we maintain our base case that Britain will vote to remain part of the EU on the basis of long-term historical observations. For example, consider the Scotland Independence Referendum of 2014, in which the lead for those who favored remaining part of the UK narrowed significantly in polling results toward the referendum date. Within weeks prior to referendum day, some surveys even showed a lead for those who favored independence. In the end, Scotland remained thanks to 55.3% who voted “no” to independence (compared with 44.7% who voted “yes”) and won by a wider margin than what most recent polls had suggested at the time.

Quebec’s 1995 referendum on independence is a more striking example. Earlier polls indicated a forthcoming vote in favor of remaining part of Canada, yet the results reversed completely in the final two weeks of the campaign, with a majority of them suggesting that the independence camp was in the lead. In the end, Quebec remained with Canada, albeit through victory by a tiny margin of the popular vote.

There are several other examples of referendums in Europe in which the status quo prevailed. Since the 1970s, there have been only two UK-wide referendums—one in 1975, on whether to remain in the European Economic Community; and the other in 2011, on the alternative vote system. In both instances the status quo prevailed, as we believe will be the case in the forthcoming referendum on Brexit.

Potential Outcomes for the Markets

Our base case for “no Brexit” is admittedly a very close call. The capital markets now place the odds of a Brexit at 39%1 and, in our view, may yet reach 50% over the next few days—and we are managing risk accordingly. What might happen after referendum day?

In the case of “no Brexit” we think risk assets will stage a relief rally across the board, whereas a vote to leave the EU will result in a risk-off environment in the near term, the magnitude of which is difficult to predict. Yet we believe such an environment will create opportunities to invest in select assets at attractive valuations. Exhibit 1 outlines potential market scenarios that we expect right after the referendum, as well as over the following two quarters, under each of the referendum outcomes.

Exhibit 1: The Market Scenarios We Expect Following Each of the Referendum Outcomes
Vote 1-3 weeks after vote 3-6 months after vote
A vote against Brexit Credit markets: Risk assets stage a relief rally, especially credit securities of European banks.

Mergers and acquisitions: Pent-up demand for M&A activity that has been delayed because of uncertainty finally materializes.

Rates: Yields of core government bonds move slightly higher.

Foreign exchange: The pound sterling rallies modestly, implied volatility declines, many emerging market currencies rally, and Central European currencies (such as the Polish zloty and Hungarian forint) appreciate against the euro, the U.S. dollar, the Japanese yen and the Swiss franc.

There is only limited impact on the economies and monetary policies of the UK, Europe and the rest of the world.
A vote for Brexit Credit markets: Credit spreads widen, particularly for domestic UK banks.

Rates: European and UK interest rates initially fall, with long-maturity rates outperforming short-maturity (curve flattening), but UK rates could sell off on the back of an extremely weak pound sterling.

Foreign exchange: The pound sterling weakens, while the Japanese yen and Swiss franc outperform most European currencies.

Policy response: The Bank of England, the European Central Bank and others coordinate a monetary policy response to lower prices of risk assets. Governments would enact a fiscal response as well if market volatility continued, and Eurozone policymakers would take concrete steps toward a stronger union.
The UK: It would take time for the economic effect to show, but markets would continue to be volatile as a result of the political fallout, and they might stabilize if reasonable plans to manage the Brexit are proposed.

Europe: The risk of more volatility increases throughout European markets. There is the perception of a higher probability of an EU disintegration. At the same time, we expect a strong policy response by the European Central Bank to offset concerns about European disintegration.

Source: OppenheimerFunds, as of 6/15/16

Investment Strategies for the Brexit Referendum

Our cautious approach has allowed us to set aside some “dry powder” (i.e., cash and cash-equivalent securities) for tactical deployment as we approach the referendum. Over the past week, valuations of many financial assets have moved closer to the view expressed in our May 11 blog. We are now starting to see select opportunities for structuring trades in various asset classes.

Within our International Bond strategy, we have approached the Brexit vote in three ways:

  • Changing the type of risk exposure: Our strategy remains committed to buying corporate credit in Europe. As the European Central Bank continues its quantitative easing (QE) program, financial conditions ease and credit markets normalize, we believe corporate credit should exhibit an attractive risk/reward profile. However, to account for the risk of a Brexit, we have restructured some of our positions in order to change the type of risk we are taking. In credit, for example, we have selectively rotated out of bonds of domestically focused UK banks (which could be most affected in the medium term)—and into bonds of global banks we deem attractive.
  • Adding risk: We have selectively added risk in some areas characterized by attractive risk/reward profiles, including options strategies in currencies that stand to be affected by the referendum.

    Specifically, we have altered the mix of foreign exchange in our portfolio and restructured some existing positions by taking advantage of higher volatility in options markets. In addition, we are mindful of the impact this may have on cross-currency pairs such as the Polish zloty versus the Japanese yen (PLNJPY).

    As we write this blog, we see pressure building on rates of some emerging markets such as Poland and Hungary. In our view, a general risk-off period would most likely create significant opportunities in countries that are perceived as riskier, whose markets typically decline more than usual during flights to quality.
  • Exploiting tactical opportunities: We have identified a game plan for how to take advantage of post-referendum opportunities, whether short or medium term, as described in Exhibit 1.

    In our view, the challenging lever is interest rates. As in our foreign-exchange strategy, we will continue to alter our risk profile by converting directional rate positions opportunistically into option positions with a defined downside. However, we remain uncertain about how “core rates” (i.e., the interest rates of G7 nations) will behave in the medium term, given their low absolute levels.

    Finally, we are considering implementing select tail hedges—not as overlays for our entire portfolio, but rather specific hedges that would allow us to take advantage of additional opportunities that may arise if our base case for a “no Brexit” vote turns out to be wrong.

Follow @OppFunds for more news and commentary.

1 Source: Bloomberg, “Number Cruncher Politics UK Bremain Probability Index,” as of 6/14/16.