Leave or Remain: How markets will react to Brexit vote

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Global financial markets have become captivated by the whims of British public opinion.

A rebound of support for remaining in the European Union in some polls sparked a revival of investor sentiment around the world on Monday.

In recent trading, the growing odds of Brexit depleted their appetite for risk, contributing to a sell-off of stocks and other higher-risk assets.

Another swing in the polls in the lead-up to Thursday's referendum would undoubtedly restore that fear, raising the spectre of a global shock emanating from Britain's withdrawal.

European officials have been unrestrained in warning of vast economic, financial and political fallout should the world's largest trading bloc lose its second-largest member economy. European Council President Donald Tusk went so far as to say Brexit could bring about the end of "Western political civilization."

The long-term implications would take years to unfold, but investors would likely waste no time in reacting forcefully to a Brexit vote on June 23. Few quarters of the market will be unaffected by Britain's decision this week. Here's how various asset classes might react to the vote.

Stocks

Leave: The past couple of weeks have provided some evidence as to how global stock markets might deal with Britain leaving the EU. After the Leave campaign surged to a lead earlier in June, the FTSE 100 index declined by as much as 6.7 per cent up to late last week. But as is the case when a potential destabilizing shock stokes investor fears, sentiment tends to align globally and correlations between markets rise. Over the course of the recent slide in British stocks, the S&P 500 index and the S&P/TSX composite index declined by 3.3 per cent and 4.4 per cent, respectively. When dealing with a momentous political event such as Brexit, in which the lasting costs are highly unclear, the force of the flight to safety is difficult to forecast. Beyond the blow to short-term investor confidence, the British economy is likely to suffer, on the order of up to a 5.5-per-cent reduction in GDP by 2019, according to the International Monetary Fund. With sustainable growth already so hard to come by, additional strains on the global economy would also ripple through stock markets.

Remain: Depending on how the rest of this week plays out up to the vote, equity markets could snap back meaningfully if the EU stays intact. As the tide has shifted back in favour of remaining over the past two trading days, resurgent risk appetite has driven stock prices up almost everywhere. Prior to this most recent shift toward safe havens, U.S. stocks were just a single good trading day away from setting a new all-time high in the S&P 500 index. The S&P/TSX composite index, meanwhile, recently emerged from a bear market, having advanced by 21.3 per cent from mid-January up to early June. With Brexit removed from atop the list of potential calamities, investors will be watching for those indexes to build on their recent highs, subject to the risks that previously dominated investor anxieties – the Chinese economy, the commodity downturn and the removal of stimulus by the U.S. Federal Reserve.

Government Bonds

Leave: The flight to safety that would follow Brexit also has a handy precedent from the past two weeks of risk aversion. On Thursday, 10-year government benchmark bond yields fell to their lowest level since February in the United States, to their lowest on record in Britain and into negative territory for the first time in Germany's history. Declining sentiment is likely to put more downward pressure on sovereign bond yields, further squeezing financial sector profits, which does not bode well for bank stocks.

Europe's riskier debtors, however, could buck the trend. Some peripheral euro zone countries saw yields on their sovereign debt soar in 2012. Brexit risks "raising the threat of a reignition of the [euro zone] debt crisis," said Jonathan Loynes, chief European economist at Capital Economics, in a note last week.

Remain: A relief rally in riskier assets would also likely see yields on sovereign debt collectively rise from historically low levels. "Equities may continue to rally if the vote is an official Remain on Thursday, but sovereign bonds may be where the real action could be considering how stretched that rubber band is," said Peter Boockvar, chief market analyst at the Lindsey Group, on CNBC. A Remain vote may also obviate the need for further monetary stimulus. Averting a Brexit and the potential financial and economic contagion emanating from it might at least save central bankers from venturing further into the uncharted territory of ultralow and negative interest rates. Last week, U.S. Federal Reserve Chair Janet Yellen cited risks posed by the referendum as one justification for refraining from raising U.S. policy rates.

Commodities and currencies

Leave: The British pound is a likely casualty of a vote to leave, but the greater concern is that "Brexit could lead to renewed worries about the durability of the euro, to the extent that it may encourage moves by euro zone countries to exit the EU and eurozone," said Shane Oliver, head of investment strategy and chief economist at AMP Capital, in a recent note. Investors looking for safety would likely pile into the U.S. dollar, driving up the value of the greenback and putting downward pressure on emerging-market currencies and commodity prices.

Remain: A renewed appetite for risk that might follow a victory by the Remain campaign would at least remove one potential threat to the recent commodity rally. After nearly doubling in price between February and early June, crude oil has been trading more or less in sync with broader market sentiment as the Brexit debate has unfolded. On the other hand, gold has made gains as a safe haven asset amid the lead-up to the referendum and is now trading near a year-and-a-half high. Should the status quo prevail in Britain, gold could lose some of that momentum.