Europe ETFs Fall As 'Brexit' Vote Looms

With only a week left until the vote, the biggest story in financial markets is the upcoming U.K. referendum on European Union membership. The vote, scheduled for Thursday, June 23, will decide whether the United Kingdom stays in the 28-member EU or leaves.

Up until recently, investors were confident that U.K. citizens would choose to remain in the EU, maintaining the status quo and avoiding an uncertain "Brexit." However, the latest polls released in the past few weeks show that the "leave" camp has overtaken the "remain" camp.

A YouGov/The Times poll shows voters favoring leaving by a seven-point margin. An ICM Unlimited poll before that showed a five-point edge for the leave camp. The aggregate of all polls from Pollster shows the leave camp having a modest 45.8% versus 43.5% advantage over the stay camp.

To be sure, the polls are close enough that anything can happen on the day of voting. But investors must suddenly acknowledge that there is a distinct possibility that the U.K. could leave the European Union―a situation popularly known as the "Brexit."

Status Quo Seen As Positive By Markets

It goes without saying that the largest impact from the U.K. referendum will be on the U.K. itself. A vote to stay in the EU and maintain the status quo will likely be seen as a bullish scenario for markets and the economy, boosting stocks in the U.K. and around the world.

Economic growth has been steady in the U.K., ranging from 2% to 3% during the past three years (growth in the first quarter of this year was at the lower end of that range, at 2.1%).

The International Monetary Fund (IMF) says that economic growth is already being weighed down by the uncertainty of a potential Brexit, and that full-year GDP growth for 2016 may fall below 2% due to reduced investment and hiring.

If the U.K. stays in the EU, growth is likely to pick up toward its potential of 2.5% in the medium term, according to the IMF.

Big Trade Hit From Brexit

On the other hand, the U.K. economy could take a big hit if the Brexit comes to fruition. The biggest impact will be on trade.

"Following a decision to exit, the U.K. would need to negotiate the terms of its withdrawal and a new relationship with the EU—unless it abandoned single-market access and relied on WTO rules, which would significantly raise trade barriers," said the IMF in a recent report.

According to the IMF, the situation could "remain unresolved for years, weighing heavily on investment and economic sentiment during the interim and depressing output. In addition, volatility in key financial markets would likely rise as markets adjust to new circumstances."

The long-term impact on the U.K. economy is highly uncertain, with the hit to GDP estimated to be anywhere from 1.5% to 9.5%.

Also uncertain is the reaction in markets. According to the IMF report, "markets may anticipate [the] adverse economic effects... this could entail sharp drops in equity and house prices, increased borrowing costs for households and businesses, and even a sudden stop of investment inflows into key sectors such as commercial real estate and finance."

Europe ETFs Plunged In Past Week

Anticipating that the "Leave" camp may prevail in the referendum, stock markets in the U.K., in the rest of Europe and even outside of Europe sold off sharply in the past week.

Just in the last seven days, the iShares MSCI United Kingdom ETF (EWU | B-90) and the Vanguard FTSE Europe ETF (VGK | A-97) lost nearly 7.5% each. At the same time, U.S. stocks, as measured by the SPDR S&P 500 ETF (SPY | A-97), shed 1.8% in the period.

On a year-to-date basis, European stocks are notably underperforming U.S. stocks; EWU is down 6.1%; VGX is down 5.6%; and SPY is up 2.8%.

Meanwhile, the British pound sterling has been another victim of Brexit fears. The currency is currently trading near the lowest levels since the 2008/09 financial crisis, and the CurrencyShares British Pound Sterling Trust (FXB | B-99) is down 4% on the year.

YTD Returns For EWU, VGX, SPY, FXB

Market Impact Highly Uncertain

Though most analysts expect limited economic impact from the potential Brexit outside of Europe, it's another story when it comes to the markets. Large sell-offs in one part of the world often spread to others.

It's safe to say that if the Brexit comes to pass, there will be more losses in the pound and more losses in stocks around the world―at least in the short term.

Perhaps the declines won't be as big as some fear, or perhaps markets will rebound quickly; no one knows for certain.

In any case, investors everywhere, including the U.S., will be keeping a close eye on the U.K. referendum next week.

Contact Sumit Roy at [email protected].