Scottish Independence Referendum: U.K. Survives Intact but the Story Continues
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Scottish Independence Referendum:
U.K. Survives Intact but the Story Continues
October 2014
The world watched as Scottish voters went to the polls last month to vote
on one fundamental question: Should Scotland be an independent country?
Few issues have galvanized the populace of an established Western democracy
as this one, as evidenced by the astonishing 84.5% turnout of eligible voters on
September 18. The “no” vote prevailed by a margin of 55% to 45%, enabling the
Martin C. Schulz, J.D.
Managing Director 307-year-old union between Scotland and the rest of the United Kingdom (U.K.)
International Equity to remain intact.
While all pro-union supporters breathed a deep sigh of relief at the outcome, no one was more
relieved than U.K. Prime Minster David Cameron. A vote for independence surely would have
been the end of his leadership, and the fragile Conservative-Liberal Democrat governing
coalition would have been flung into turmoil. A diminished U.K. would have cut a weaker
figure on the world stage, and the breakup would have created uncertainty for many U.K.
and Scottish businesses.
Scott Camp
The impact of an independent Scotland would not have stopped at Britain’s shores. The
Analyst/Trader
continent is not immune from the pressures. The European Union (EU) would have been
International Equity
in uncharted territory as it too deals with its own resurgence of populist and nationalist
sentiment. An independent Scotland would have emboldened other peoples in the EU –
most notably a potential Belgian partition and the Catalonians in Spain – to press their
claims for separation, independence, and autonomy. It is indeed ironic that the Scots are so
pro-European in outlook and yet felt compelled to entertain the thought of leaving the U.K.
PROTEST – THROUGH THE BALLOT BOX
The developments leading up to the vote are representative of the pressure that all nation
states are experiencing globally in the aftermath of the global financial crisis. Since the fall
of the Berlin Wall almost 25 years ago, the world has experienced relative stability, rising
incomes, and unprecedented economic expansion. The global financial crisis changed all
that. Technology, social media, and globalization, coupled with perceptions of income and
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political inequalities, highlight the convergence of factors leading to greater anxiety and a mismatch of
expectations. The result is that political factors are influencing economies and markets as never before.
The demonstrations in Hong Kong are but a current example.
The Scottish votes have been counted, and the issue of independence is resolved for now. However, as Yogi
Berra famously said, “It ain’t over till it’s over” – the U.K. and Europe will be dealing with the aftermath of
the referendum for some time to come. Cameron and his allies will be hard pressed to deliver on promises
to give not only Scotland but England, Wales, and Northern Ireland greater independence within the U.K.
He has a real balancing act to perform as he struggles to keep the most right-wing members of his party
in line, especially important with an election looming in 2015. To top it off, the U.K. may be going to the
polls in 2017 to vote on whether it stays in the EU.
European parliamentary elections in May, Swedish election results, and recent regional elections in
Germany highlight the continued tightrope that politicians need to walk to manage anti-establishment or
eurosceptic voters. Populist sentiment will demand that the steps taken to fight debt and deflation and
engage meaningfully in structural reform must be undertaken via socially acceptable means. And that will
be no easy task.
The clearest message coming from all of this is to stay tuned – there’s going to be a lot to watch in Great
Britain and the EU over the next few years. From a market and investment perspective, our stance on the
U.K. and Europe remains essentially the same as when we last wrote about it (The U.K. and Scotland: The
Implications of Independence for England’s Northern Neighbor, June 2014). We continue to underweight the
U.K. given ongoing uncertainties, Britain’s large current account deficit, and the adverse consequences of
a stronger U.K. pound sterling against an ever weakening euro. As it relates to our U.K holdings, we also
seek to minimize our exposure to the EU where possible, which includes hedging with offsetting exposure
to other areas that have better growth prospects and/or currency tailwinds.
Change Relative to British Pound
THE ECONOMIC OUTLOOK AND
8.00%
THE SCOTTISH REFERENDUM
6.00% The U.K. economy has been on a path of
steady recovery and is now 2.7% higher in
4.00%
terms of output than its 2007 pre-recession
2.00% peak. In the second quarter of 2014, gross
0.00% domestic product (GDP) expanded at a rate
of 3.2% from a year earlier, the strongest
-2.00%
performance since the final quarter of 2007.
-4.00% Much of the improvement was driven by
-6.00% double-digit growth in business investment.
The adverse impact arising from uncertainty
Oct-13
Nov-13
Dec-13
Jan-14
Feb-14
Mar-14
Apr-14
May-14
Jun-14
Jul-14
Aug-14
Sep-14
over the referendum is widely expected to be
Source: FactSet — USD/GBP — EUR/GBP modest, and the market and business focus
will now return to fundamentals.
The “no” vote also means that the Bank of England (BOE) will likely proceed with its plan to raise interest
rates if the labor market continues to improve. It will be the U.S. Federal Reserve and the BOE that will
likely begin the process of monetary tightening first as Japan and Europe head in the opposite direction.
BOE Governor Mark Carney has said that if interest rates begin to increase in spring 2015, the country
would be on target to reach the BOE’s 2% target in three years. Carney’s concern is that keeping interest
rates low for too long could encourage other risks to build up in the financial system, including in the
housing market. He’s also worried about the possibility that low interest rates could cause financial
2 Scottish Independence Referendum: UK Survives Intact but the Story Continuesmarkets to be mispricing risk. Higher rates, however, would support and strengthen the sterling against
the euro, and that has implications for the current account deficit.
After an initial positive reaction to the Scottish referendum “no” vote, the U.K. pound to U.S. dollar and
the euro dropped back below pre-referendum levels. While a weaker pound to the dollar will help British
exporters that rely heavily or solely on revenues from the U.S., the currency remained strong against the
euro. This may create headwinds for the U.K.: The EU is Britain’s single largest export market – just over
50% of all U.K. exports go to Europe – and exports to Europe account for 15% of GDP in the U.K. (sources:
FactSet and the U.K. Office of National Statistics). A stronger pound makes U.K. goods and services
sent to the Eurozone less competitive due to higher prices. The impact is already evident in industrial
manufacturing, and consumer discretionary (retail, luxury, travel and leisure), information technology
(software and hardware), and healthcare (pharmaceuticals, medical devices) may be impacted similarly.
The U.K.’s balance of payments has worsened significantly over the last few years. Equal to 1.5% of GDP
in 2011, the current account deficit soared to around 4.5% of GDP in 2013 and has grown even higher in
2014. A stronger pound would ensure a persistently high trade deficit and potentially slower growth in
the years ahead.
PROMISES MADE, PROMISES KEPT?
A 10 percentage point margin in most votes is usually considered a comfortable victory, but not so in this
referendum. Initially viewed as a long shot, the independence movement gained strength during
the summer until the outcome became too close to call by September 18.
To combat the independence side, each of the U.K.’s major parties – Conservative, Labor, and Liberal
Democrats – vowed to give Scotland greater control over its affairs if it remained in the union. The U.K.
has a highly centralized government with important decisions made in London, a situation that has rankled
many Scots. Shortly after the votes were counted, Cameron made a bombshell of an announcement,
stating that it was time for a new constitutional arrangement for the entire country. Called “Devo Max”
by the media, his plan calls for transferring more powers to England, Wales, and Northern Ireland, along
with Scotland. Devo Max creates uncertainty from an investment perspective, which will be especially
nettlesome for Scotland. England and Wales have a conservative bias as opposed to Scotland, which will
continue to be less business friendly in its policies.
Cameron’s proposal would produce a more federal structure for the U.K., one that would be more similar
to the U.S. than it is today. The scheme would give the four members of the U.K. greater independence over
taxation, healthcare, welfare, and public spending – a sweeping change in the way the nation is governed.
Cameron wants to have the new laws drafted as early as January 2015, only a few months before the
general election in May. Parliament would then vote on a finished bill after the elections.
Devo Max is already the subject of heated debate. While all three political parties agree on the need for
devolution, each has its own opinion about the best approach. As the main opposition party, Labor will
likely present Cameron with the starkest differences and challenges.
ELECTION PRESSURES
If Cameron felt relief with the outcome of the Scottish referendum, it was short-lived. The next general
election is already scheduled for May 2015. After Cameron’s Conservatives failed to win a majority in 2010,
it was forced into a coalition government with the Liberal Democrats. He has serious difficulty keeping his
own party together, as right-wing Conservatives have been especially assertive about maintaining U.K.
independence from the EU. Cameron also faces pressure from the anti-establishment euroskeptic U.K.
3 Scottish Independence Referendum: UK Survives Intact but the Story ContinuesIndependence Party (UKIP). Recently, two of his colleagues defected to the UKIP, highlighting the split on
the right and also the public discontent over the economic recovery.
Labor has consistently been ahead of the Conservatives by a few percentage points in the polls. The
Liberal Democrats are well under 10%, while the UKIP is garnering around 15% of the popular vote. The
latter will continue to exert pressure on Cameron to prevent him from moving too close to the center and
to a warmer embrace of the EU.
A DELICATE DANCE: THE U.K. AND THE EUROPEAN UNION
And it’s the U.K. relationship to the rest of the continent that is also in flux. The U.K. has had a long history
of balancing its interests within and with Europe against those of its long-time ally, the U.S. The U.K. has
historically managed to play the European powers against each other. In 2013, Cameron promised that he
would renegotiate the terms of the U.K.’s membership in the EU to get it more influence if he wins in 2015,
and he announced plans to hold a national referendum on the new agreement in 2017. While Cameron
intends to keep the U.K. in the bloc, he is balancing the U.K.’s national interests and influence within
Europe against domestic political pressures. Much like what is happening across Europe, he clearly feels
the need to placate the euroskepics and stanch the flow of votes to the noisy UKIP.
And a British exit from the EU – referred to as the Brexit in the media – could seriously hamper the U.K.
economy. Trading and business ties could be unravel forcing new terms on trade and the regulatory
environment. Britain’s global standing would be damaged and the country’s position as a dominant player
in world financial markets would likely be at risk. If Labor wins in 2015, however, no one expects a move
ahead on the referendum.
THE EU IS FACING ITS OWN DEMONS
The EU has its own internal issue to content with. In Spain, Catalonian separatists have aggressively
promoted independence from the rest of the country and are pushing for a November referendum in spite
of its unconstitutionality. Tensions between Barcelona and Madrid are increasing. Similarly, Northern Italy
and Sardinia have groups clamoring for separation from Italy, as does Corsica from France. Belgium has
long had the potential to break up, with Flemish-speaking Flanders and Francophone Wallonia having
decidedly different cultures. However, the only one of these to show any muscle this far has been in
Catalonia. And even though the Catalan Parliament passed a law allowing regional head Artur Mas to
call such a vote, the Spanish government has said it would violate the Spanish constitution and has
pledged to block it.
Cameron has taken a strident line within the EU to show U.K. voters just how independent-minded
he can be. He fought an unsuccessful campaign this summer to block the nomination of Jean-Claude
Juncker – German Chancellor Merkel’s declared favorite candidate and an advocate of a stronger and
more centralized EU – for the presidency of the European Commission. Cameron also secured the
appointment of a fellow countryman to be the EU commissioner for financial services, a position that is
especially important to the city of London as the region’s financial center and U.K. banking, investment,
and insurance interests. Going forward, Cameron is expected to press for a looser, less centralized union,
especially if it limits Germany’s hegemony in the EU.
THE POST-REFERENDUM U.K. AND EUROPE
The “no” vote on the Scottish referendum has major implications for the U.K. and Europe. For the British,
the government has been saved and a constitutional crisis averted. As for Europe, it keeps the genie in the
bottle, as would-be countries cannot find encouragement in a successful Scottish breakaway.
4 Scottish Independence Referendum: UK Survives Intact but the Story ContinuesThe story is more complicated over the long term, however. The same pressures that have evolved the
past several years – ranging from globalization, competitiveness, and rising expectations to technology
and increasing inequality – remain in force. The UK will be undertaking major changes in how it governs
itself, and the path ahead isn’t as straight forward as most investors would like. Uncertainties will mount
as knotty issues of taxation, spending, and regulation get hammered out. How successfully the UKIP
exploits the situation will be key. In Europe, regions aspiring to be independent or more autonomous may
have been disappointed with the outcome in Scotland, but they also learned a lot. By most accounts, the
pro-independence campaign in Scotland appeared far more vigorous and lively than the “no” advocates.
Expect separatist movements to build on that.
And as we’ve written before (The “Recovery” in Europe: One Step Back and Two Steps Forward”, September 2014),
Europe is healing – albeit slowly – but still has its issues. The ECB has been active, but it seems as though
monetary policy has been the only game in town. European policymakers are under great pressure to
manage the aftereffects of the sovereign debt crisis and must solve its structural and competitive issues,
stave off deflation, recapitalize its financial system, and deleverage – all the while managing to balance
social harmony.
As we approach the fifth anniversary of the start of the Eurozone crisis, eurosceptic parties appear to be
in the ascendancy, further complicating Eurozone policymaking. The populist rebellion first witnessed in
the May European parliamentary elections seems to be accelerating. Sweden’s far right Democrats took
13% of the votes and will play a kingmaker role in holding the balance of power in parliament. Recent polls
suggest that Marie Le Pen from the Front National would beat President Hollande in a head to head match
up in France.
And most significant, recent September regional elections in Germany highlight the challenges that even
Chancellor Merkel will increasingly face in Germany. The anti-euro Alternative für Deutschland (AfD)
party is now an electoral force to be reckoned with as it garnered between 10% and 12% of the vote in
regional elections. Its rise may engender potentially significant and lasting effects on German domestic
politics. This development will make it more difficult for the chancellor to compromise with her French
and Italian counterparts – and more important, for the ECB to continue on its path of providing greater
stimulus. And simultaneously, the Catalan push for independence forges on – regardless of the recent
outcome in Scotland.
While we are not underestimating the resiliency of Europe and see glimmers of hope as the continent
slowly heals itself, recent economic weakness, especially in Germany, the continued pressure from the
nationalist parties, and a reticent ECB that has disappointed markets, may force Europe into another step
backward. Selectivity and patience are the mantras to follow.
WHERE DO WE GO FROM HERE?
Everything is relative, and our view is that the foreign stocks will likely outperform their U.S. counterparts
in the foreseeable future. For the short term, the PNC Capital Advisors International Equity team will
maintain its underweight position in the U.K. For the foreseeable future, valuation, risk metrics, growth
prospects, and momentum are more compelling elsewhere. We will continue to search selectively for
U.K. domestic structural growth stories and retain a watchful eye on any companies exposed to a stronger
pound sterling. Over the longer term, uncertainties surrounding the U.K. political structure will be harder
to quantify. Even more important from an investment perspective are the risks associated with leaving the
EU, if that is the path the U.K. takes. A Brexit would adversely impact the lion’s share of the U.K. economy.
Importantly, it would threaten the stability of the huge financial services industry in London, which would
damage consumer spending and housing prices, especially in southern England.
5 Scottish Independence Referendum: UK Survives Intact but the Story ContinuesScottish Independence Referendum:
UK Survives Intact but the Story Continues
As for the EMU, it all comes down to a matter of valuation, whether the ECB will be successful, and timing.
European area shares are trading at a 35% discount compared the S&P 500 shares on a cyclically adjusted
price to earnings ratio (see graph below). We continue to see potential value on the European continent
tempered by the existing deflationary and political pressures. European fiscal balances are slowly healing,
banks are easing lending standards, credit to the private sector is contracting at a slower pace, and Mario
Draghi will likely end up purchasing riskier assets in a bid to increase the size of its balance sheet, boost
aggregate demand, and further weaken the currency. For now, we remain cautious.
From a global, relative perspective, we believe
US vs. Europe Cyclically-Adjusted Price Earnings
that the upside may be limited for U.S. equities
1.40
after a strong run. We sense value in Europe
1.35 and potential upside in Japan. In spite of the
1.30 challenges facing both the U.K. and Europe
after the Scottish vote and the inherent
1.25
uncertainty it has engendered, the seeds
1.20
of future upside market success are being
1.15 planted. As the cyclical rebound in U.S. stocks
1.10
wanes, foreign stocks may be taking the baton.
The UK will determine its place in the region
1.02
and the world, and Europe will be taking one
1.00 step back – but then two forward.
Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13
Source: Bloomberg — SP500 PE/MSCI Europe PE (CAPE)
This publication is for informational purposes only and reflects the current opinions of PNC Capital Advisors, LLC. Information contained herein is believed to be accurate, but has not
been verified and cannot be guaranteed. Opinions represented are not intended as an offer or solicitation with respect to the purchase or sale of any security and are subject to change
without notice. Statements in this material should not be considered investment advice, a forecast or guarantee of future results. To the extent specific securities are referenced
herein, they have been selected by the author on an objective basis to illustrate the views expressed in the commentary. Such references do not include all material information about
such securities, including risks, and are not intended to be recommendations to take any action with respect to such securities. The securities identified do not represent all of the
securities purchased, sold or recommended and it should not be assumed that any listed securities were or will prove to be profitable. Indices are unmanaged and not available for
direct investment. This publication has been prepared without taking into account your objectives, financial situation or needs. Before acting on this information, you should consider its
appropriateness having regard to your objectives, financial situation or needs. Past performance is no guarantee of future results.
This publication is the property of PNC Capital Advisors and is intended for the sole use of its clients, consultants, and other intended recipients. It should not be forwarded to any other
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PNC Capital Advisors, LLC is an SEC-registered investment adviser, offering an array of investment strategies. PNC Capital Advisors, LLC is an indirect subsidiary of The PNC Financial Services Group, Inc.
IN V E S T MEN T S: NOT F DIC IN S URED - NO B A NK OR F EDER A L G O V ERNMEN T GUA R A N T EE - M AY LO SE VA LUE
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