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Scotland’s Referendum: The First Domino by Matthew Sankary


mattsankaryCommon Sense welcomes guest writer Matthew Sankary, who writes about the potential impact of the Scottish and Catalan referendums on markets.

Mr. Sankary is a native of Los Angeles and a graduate of the University of California Santa Barbara with a degree in History. He owned a successful real estate and property management business before moving to Spain in 2006. He now works as a proprietary fixed income trader in Madrid.

The opinions of the author are his own and do not necessarily represent those of Common Sense. This article is printed with the author’s permission.

Scottish Referendum – The First Domino

Make no mistake, barring an outright war with Russia, the collapse of Iraq, or a terrorist attack on the scale of 9/11, this is the major risk event of 2014. The market is not foreseeing the chain reaction that will occur if the Scottish exit the United Kingdom and, aside from a weaker pound, the market has not reacted. However the Spanish bono fell 17bp, on Tuesday September 8th.

Why NOT to worry

Even though the polling has been shifting over the past months from a “NO” vote to “YES”, polls might not be showing the whole story, especially when it comes to who might actually go out and pull the lever to leave. Most of the polling has been done online and the latest YouGov poll that scared the market over the weekend was an online poll. These polls obviously sample a younger voter population than overall. Online and cell phone polls usually under-represent pensioners who do not use these services but who vote in large numbers and over represent young voters who might vote in a poll but not in a ballot booth. In addition when the actual vote occurs, voters in general might be more conservative and vote for what they know in a booth than in an online poll.

Why to worry

The trend has not been favorable for the “NO” vote the past few months. The dynamics of Scottish politics are important to understand the situation. Going back to Margret Thatcher, the Scots have felt underrepresented in the UK as Scotland is majority Labor. Conservative governments have constantly ignored the Scots preferred policy wishes. And the current conservative government has only poured more gasoline on this fire. In addition, the actual “NO” campaign has been run poorly, losing all of the TV debates. The Scots no longer trust the Labor MPs and hate the conservatives who have all argued for a “NO” vote. This dynamic has set up this situation.

What a “NO” vote means (economically)

If a “NO” vote occurs, Scotland will stay in the UK. There will be large moves in Sterling FX and possibly in UK interest rates. The market will continue to look at the next event and there might be a limited relief rally in other markets. However, the relief rally in cross markets will be limited because there has been little movement in other markets.

What a “YES” vote means (economically)

If a “YES” vote occurs, it will set a precedent and will become a major theme we will look back on over the fourth quarter and into the first quarter 2015 and beyond. In my opinion, it is the beginning of the end of the EU as we know it.

The United Kingdom

Even though the vote is taking place on September 18th, the actual process of separating would take place over the course of the next year. What currency would Scotland use? How much debt would they take from the UK? Who or what would backstop their banks with assets at 12x GDP?  Will they join the EU? What trade deals will be made? All these questions and others need to be answered over the course of the year and into 2016.  This uncertainty will deeply affect the Scottish economy and the rest of the United Kingdom. Credit Suisse is predicting a 20% decline in foreign direct investment, as well as 5-10% depreciation in either wages or a new currency for Scotland to be competitive. The BOE will have to move to protect the banking sector, something they commented on at their press conference on sept 10. The pound will be hit with many banks calling it to target a 1.55-1.40 range. This will affect the inflation outlook but expect retail sales, consumer and business confidence, FDI, business construction, jobs, all to lag or even reverse last year´s up trends. In general, the growth of the UK and Scottish economies will come to screeching halt. Aside from its effects on FX, major UK and now new Scottish banks will be at risk of illiquidity as short-term funding dries up, which could impact the LIBOR curve.


Spill over to the European Union

The EU will deeply be affected by a “YES” vote. Will Scotland be able to join the EU? I think not; Spain will adamantly veto any request by Scotland. The first effect will be on the upcoming Catalonia referendum on November 9th, which the market has ignored completely: until today as the Spanish Bono jumped 17bp before pulling back on September 9th. How will it go? Will it be allowed to take place? What will it do to Spain? What will be the effect on the Spanish economy which is only just beginning to recover from its massive recession? If Cataluña leaves you can be assured that the Basques will follow. And afterwards, Belgium? At the same time as EU countries break up and the UK begins a possible exit, the dynamics in France could be in the final nail in the EU coffin.

I believe this will start another Eurozone crisis where the debt dynamics work against the EU. Spain, Italy as well as France will all be in recession with negative inflation. And to add insult to that, the new UK will be more conservative after losing the Labor Scottish party. Cameron might be forced to resign with a new Tory Prime minister fighting off a challenge from UKIP in the 2015 elections, where Labor can only hope to contend for a top 3 spot, putting a UK exit on the table for 2015 instead of 2017 as the Tories will turn rightward hoping to stave off a UKIP surge. It will also dramatically change the politics of the EU leaving an exposed Germany. Germany and the UK have been leading the charge for Market reforms. It will also hurt consumer and business confidence, FDI, inflation as well as possibly strengthen the Euro as currency flows will leave the UK and head back to the EU. All of these issues will take time but the market will be hard pressed to ignore the situation as these things begin to play out starting in Spain the day after a “YES” vote.

Secondary Spillover effects –INTO the US Markets

With the UK and EZ in turmoil, dealing with numerous issues of nationalism and hurting any recovery, the market will begin wondering about global growth. China has been moving along, but currently has growth of only 7.5% and an inflation rate of 2.3%. These are multiyear lows and at the lower band needed for China. Japan is experiencing -0.1% GDP and 3.4% inflation (1.3% after the recent tax hike is stripped out) and is still fighting to edge out deflation. That leaves the US and FED as the world´s economic engine. It will also leave the FOMC as the only major central bank looking to raise rates, even as all of the others are standing still(new BOE policy, China) or in the process of printing (ECB, BOJ) . It has not been the FOMC policy to fight headwinds, and a dovish Yellen will look for any reason to keep rates lower for longer. Will it be enough to keep the economy going?  As the European currencies weaken against the dollar will it push inflation down?

We can only hope that the Scots will vote with their check book and not with their hearts.



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