Investment Insight - Scottish Independence

Not long now

It has been years, decades, even centuries in the making, but the United Kingdom is now at a crunch point as the Scottish people vote on whether now is the time to go it alone or whether they are better off together with England, Wales and Northern Ireland. At Tilney Bestinvest we do not look to take sides and we recognise emotions are high on both sides. Instead, in what we hope is an unbiased view, we will look at some of the possible effects a ‘yes’ or ‘no’ vote will have on clients and investors. In any case, the short term effects are likely to create a lot of newsflow, but the actual magnitude of any measureable effect is likely to be fairly limited.

Too close to call

It was always likely to be a close race, and although polls have generally shown the ‘no’ (to independence) camp in front, we have already seen the first survey, from YouGov, putting the ‘yes’ campaign slightly ahead. The reality is that the polls are just too close to call, given the vagaries inherent to most polling techniques and the relatively large number of undecided voters.

TWO SELECTED POLL RESULTS ON THE QUESTION “SHOULD SCOTLAND BE AN INDEPENDENT NATION”

What if Scotland stays in the Union?

This remains the base case for many analysts, and this is the ‘business as usual’ outcome. There may be a minor relief rally in the currency market which has become increasingly nervous as the vote approaches, but that’s likely to be about it. For that reason, the rest of this note discusses what would happen if Scotland were to leave the rest of the UK, and the implications both for Scotland and the rest of the UK.

What if Scotland becomes independent?

A ‘yes’ vote on September 18 will have a number of ramifications and politicians have already put a date of May 2016 for elections to an independent Scottish Parliament. Clearly this will be a major event for Scotland which will take control of its own legislative future and will have to create the various institutions to support the new nation’s economy. Certain corporations that are heavily integrated into the English market system may look to shift their headquarters, but this is likely to be little more than changes on paper, with costs relatively minimal in the grand scheme of things.

There are also serious questions over the currency (discussed below), the split of UK debt repayment and whether an independent Scotland would want to, or be able to, join the European Union. Whilst EU membership might seem straightforward, a number of EU countries are facing their own separatist concerns, such as in Catalonia and Flanders. An easy ride into the EU for Scotland would risk encouraging these movements. Furthermore, one potential precondition for EU membership could be a pledge to adopt the euro as the national currency, which may not be popular with the Scottish electorate.

The impact on the rest of the UK

A ‘yes’ vote would also have a significant impact on the rest of the UK. The next general election is scheduled for May 2015, but once Scotland formally leaves the Union, the sitting parliament containing Scottish MPs would be unconstitutional and would need to be dissolved then re-elected. This could be a serious blow to Labour, who would lose 41 MPs (compared to just a single MP for the Conservatives) making it much harder to win a majority.

A further effect of the shock of losing Scotland from the Union could also be a wave of nationalism across England, stoking anti-EU sentiment. Given the Conservative pledge on an in/out referendum over Europe, this ultimately means a ‘yes’ vote in Scotland significantly increases the likelihood that the rest of the UK subsequently exits Europe.

The currency question

It remains very unclear what currency an independent Scotland would use and this has been a hot area for debate during campaigning. Politicians of all stripes in Westminster have flat-out refused to share the pound, whilst SNP leaders have threatened to refuse to share the UK’s current debt burden without it. There are a number of possible options here, for example Scotland could adopt the euro (not a particularly popular option), create its own currency or use the pound without the agreement of London (so-called sterlingisation).

Whilst it might sound pretty minor, the question is less about what the currency looks like and more about the central bank. Central banks, such as the Bank of England, control monetary policy, but they also provide vital support to the banking system by acting as a ‘lender of last resort’. This means that a new currency would require the establishment of a new central bank with sufficient reserves and credibility to support the banking system, which takes time to establish.

Equally, if Scotland adopted the pound without the backing of London, the Bank of England would be less likely to support the Scottish banking system and wouldn’t take account of the Scottish economy when setting monetary policy.

What is clear is that Scotland would require a functional currency, and this would be a priority in the immediate aftermath of a ‘yes’ vote.

What it means for investors in Scotland

Investors in Scotland would face the most uncertainty in the medium term. Aside from the question of currency, they will see a new establishment take control over taxation and investment regulation. Who benefits and who loses out as a result of these changes is unclear and both sides have been quick to throw out calculations on tax and spending that support their own campaign. The reality is most likely somewhere between the two and a newly elected government is unlikely to make unpopular changes in the short term. However, with its high exposure to cyclical sectors such as banking and petrochemicals, an independent Scotland could see its economic pathway diverge from the rest of the UK, making the outlook even more uncertain.

What it means for other investors

Markets strongly dislike uncertainty and the most significant effect of a ‘yes’ vote would be to raise questions such as the future of the currency and the burden of debt (HM Treasury has already guaranteed the debt, but the split of payments is still up for debate). The direct effect on equities is likely to be fairly muted, but both the pound and the UK government bond market could come under pressure as overseas investors look to more certain assets, though such events are likely to be limited. A ‘yes’ vote is therefore marginally negative for UK government bonds, but marginally positive for overseas investments and UK exporters.

More serious would be the medium-term impact discussed above, whereby a ‘yes’ vote in Scotland increases the likelihood of the remainder of the UK voting to leave Europe. It is difficult to make a strong positive economic case for leaving the world’s largest economic bloc, and such an eventuality would likely be strongly negative both for the pound and for UK equities, albeit at a juncture some way down the road.

Conclusion

Although there will no doubt be a lot of news around the referendum, the short-term investment impact is likely to be less significant than other events around the world, such as central bank policy moves and fall-out from the conflict in Eastern Ukraine. In the event of a ‘no’ vote, we are likely to see a ‘business as usual’ response, perhaps after a short relief rally. A ‘yes’ vote – now a real possibility – would create a significant level of uncertainty, which would in turn probably put downward pressure on the pound and UK gilts. A ‘yes’ vote also has longer-term political implications and increases the chances of the rest of the UK ultimately voting to leave the European Union, which would be strongly negative both for the pound and UK equities, though this would be some way out from here.