British Pound at Threat of Brexit Warn BofA Merrill Lynch

Bank of America Merrill Lynch Global Research have warned on the near-term negative impacts posed to the economy and pound sterling should the United Kingdom vote to exit the European Union.

There is little economic case for the UK to leave Europe warn Bank of America and risks to the pound sterling and economy are skewed to the downside.

The negative analysis on Brexit echoes similar investment bank warnings on the issue with Morgan Stanley suggesting growth would be stunted by such a move.

"In our view there would be serious economic fall-out for the UK in the short- and long-term if voters choose to leave the EU," says a note from BofA Merrill Lynch.

The warning comes as polls suggest that the result of the UK's referendum on its EU membership, due by end-2017, is too close to call.

For now, issues such as unchecked immigration into the EU appear to be holding greater sway than arguments warning over potential economic slowdown.

This is acknowledged by the author of BofA's research, Robert Wood:

"Many contingent factors are likely to play a role: any exacerbation of refugee issues could help 'pro-outs', while any strengthening in the European economic recovery may support 'pro-ins'."

What is guaranteed is economic uncertainty, as the poll draws closer markets will get jittery and inward investment will wane.

The uncertainty could require the Bank of England to introduce fresh stimulatory measures - an interest rate cut or further quantitative easing.

If currency markets get a sniff of this we would certainly expect the British pound to fall a few big figures.

The Best Outcome

Wood concedes that in the long term, the UK could cope outside the EU: other countries do.

"But coping does not mean the UK would be better off: exiting would be a costly backward step in our view. How costly would depend on post-exit policies. The fallout could be acute if Britain chose to withdraw from the process of globalisation," says Wood.

The best outcome, in BofA's view, would be to achieve further liberalisation, especially services, while remaining in the EU.

This is a stance mirrored by Prime Minister Cameron and his Government who are seeking concessions to be made by Europe.

What Would the Impact of Brexit be on the Pound?

The value of the GBP relies heavily on the flow of money into the UK made by inward investment.

Investors crave a stable political environment and uncertainty over the UK's future membership of the European Union will have a predictable negative impact.

"Our valuation suggests that GBP is overvalued and, in an extreme scenario where capital inflows temporarily slow in the run-up to the referendum, it could face large declines," says Kamal Sharma, FX Strategist at BofA Merrill Lynch.

However, Bank of America believe the FX market should be better prepared for this referendum than it was for the Scottish equivalent.

"Thus we expect the first investor reaction in GBP FX options space as a premium for the referendum event is potentially built in," says Sharma.

The strategist believes GBP could be faced with a binary response following the EU Referendum
result; a vote to remain in the EU would be GBP positive whilst a vote to leave the EU would be GBP negative.

Do not expect the markets to wait until the Referendum result to give their verdict on GBP.

Both the Scottish Referendum and the General Election offer insights on what might happen to GBP in the run-up the Referendum.

BofA analysis confirms that in the two weeks before the Scottish Referendum as polls suggested a much tighter race, that GBP/USD fell nearly 4% in the space of 10 days.

Similarly in the days running up the General Election, GBP came under pressure again (falling approximately 2.5%).

The extent of the fall in the GBP is difficult to quantify but our valuation metrics suggest that GBP is currently 3% overvalued.

In real effective terms, GBP TWI is more than 8% overvalued relative to its 10-year rolling average.
"In our view, a catalyst for such a correction would come as a result of a marked slowdown in capital inflows needed to finance the deficit," warns Sharma.