Scottish independence: Why the referendum matters

 

Even a “No” vote will mean radical shifts in political power.

 

Warnings of market complacency have come thick and fast recently. Just yesterday, Bank for International Settlements chief Jaime Caruana said investors are ignoring the prospects of coming rate rises amid a giddy hunt for yield, while the geopolitical crises tearing through the Middle East have barely dented global risk appetite.

 

UBS economists last week added to this list, arguing that UK investors could be making a big mistake by not taking the upcoming Scottish independence vote seriously enough: “The referendum matters, because whatever the outcome, the status quo will not be maintained.” Disregarding the chance of a “Yes” vote for now (which still looks unlikely, despite a narrowing in the polls since the start of the year – see graph below), Scotland has been promised significantly greater powers after the referendum, which could shake-up the dynamics of UK debt. 

 

And in the event that the vote is close enough to keep the issue of independence alive in future years (UBS’s economists mention a 55 per cent victory for the “No” side as a potential level), the resulting “background hum of political uncertainty” could prove damaging. Sterling and gilt investors should take note. 

 

Regardless of the vote’s result, Scotland will have a far more powerful national government this time next year. Labour, the Conservatives and the Liberal Democrats have all promised significant further devolution to Holyrood, including the power to set taxation and spending levels within certain parameters. These changes could affect markets.

 

First, greater fiscal autonomy for Scotland will complicate some of the metrics used to assess UK debt. The UBS note points out that the amount Holyrood could borrow from financial markets for capital projects from next year will be small (around £2.2bn), meaning that its ability to deficit-finance is fairly limited. But the narrowing of Westminster’s ability to tax Scotland would “raise a question about the validity of debt-to-GDP metrics for the [UK] government,” adding to the uncertainty around gilts.

 

Second, a more powerful Scotland would likely have knock-on effects for Westminster politics. “If the Scottish Parliament gained further powers, it would make it harder to justify Scottish members of the Westminster Parliament voting on matters that do not affect Scotland,” argued Rob Wood of Berenberg in a recent report. When the Scottish Parliament was originally created, the number of Scottish seats in Westminster fell from 73 to 59, but there are still on average fewer people in each constituency north of the border. Devolution could lead to further change, and this would tip the Westminster balance slightly away from Labour, given the party’s dominance in Scotland relative to the Tories (see table). 

 

And given Ed Miliband’s policies on the energy and banking sectors, as well as the Party’s historical stance on deficit spending, even a slight change in the Westminster power balance could trace through to international investors – particularly those exposed to stocks (like the Big Six energy firms) that have nosedived in reaction to Miliband policy announcements.

 

Finally, anything other than a decisive defeat for the independence campaign could keep the issue alive politically. Wood points out that Quebec saw a comparable problem between its 1980 and 1995 referendums (despite a 60 per cent victory for the anti-independence campaign the first time around), and says that a similar situation “could harm Scottish economic prospects.” Moreover, argue UBS’s economists, investors would likely have to add a semi-permanent risk premium to bond and currency markets in the UK – mainly affecting sterling and government gilts – reflecting the added uncertainty. 

 

But what if nationalist leader Alex Salmond and his supporters defy current polling, and succeed in breaking up the Union? According to most forex analysts, currency markets have not priced in the risk of this event yet, meaning a sharp hit to sterling would immediately follow a “Yes” vote. And given that Salmond, in direct opposition to the Treasury, has pledged to do all he can to keep the pound as Scotland’s currency, few expect a swift resolution of this uncertainty – the issue would likely act as a headwind for sterling for as long as it lasts.

 

The same goes for gilts after a “Yes” vote according to Bank of America Merrill Lynch (BoAML). In a note last month, its analysts argued that the uncertainty could hurt demand for UK bonds until the issue of debt sharing between Scotland and the rest of the UK was resolved. 

 

And given that Scotland’s government finances are in a worse state than the rest of the UK (with both debt and borrowing projections significantly higher as a percentage of GDP according to the Institute for Fiscal Studies – see graph above) a sharp fiscal contraction would likely be necessary, argues Wood. This could hit domestic demand, in the short term at least. 

 

For equity investors, those stocks most exposed to regulatory and monetary uncertainty could be hit hard, say the BoAML analysts – with Scottish banks and insurance firms among the most vulnerable.