`Brexit' Opens European Front for Investors Weary of Contagion

Spanish money manager Guillermo Hermida lives in a country that’s failed to form a government for almost three months, yet when it comes to investment risk his eyes are on politics more than 800 miles north in Britain.

The June 23 referendum on whether the U.K. should remain in the European Union will challenge the bloc’s integrity, according to Hermida, who oversees 41 billion euros ($45 billion) at CaixaBank Asset Management in Madrid. Cracks in the EU would undermine investor confidence in its weakest members, the so-called peripheral nations whose ratings are lowest, he said in an interview in the Spanish capital.

“If the British leave, we may see greater tension over how the union functions, even a possible rethinking of how it continues in the longer term,” Hermida said. His team reduced bonds of those nations including Spain beginning last year, though in 2016 they’re no longer selling because the European Central Bank’s quantitative-easing program is supporting them enough, he said.

When investors sense a period of financial turmoil, bonds and stocks in the most indebted parts of Europe have shown they are on the front line. When Chinese stocks plunged earlier this year, investors sold sovereign debt from Greece to Portugal and bought that of their AAA-rated northern neighbors such as Germany or the Netherlands.

In Spain, the extra yield on 10-year government bonds compared with German bunds was 1.19 percentage points on Tuesday. While that’s below its 200-day moving average of 1.28 percentage points, the spread jumped to as high as 1.70 percentage points on Feb. 11 as world Equities descended into a bear market.

Precedent?

The latest surveys suggest the “in” and “out” camps for the U.K. referendum are running neck and neck. There is growing anxiety among some investors that a country pulling out after 43 years of membership of the common market could splinter the trading bloc and provide a road map for others to leave.

“It sets a precedent doesn’t it?” said David Tan, the London-based head of rates at JPMorgan Asset Management, which oversees about $1.7 trillion globally. “If one country can leave, then who may be next? Let’s not forget the U.K. is a very important member of the European Union, so it will really strike at the core.”

He said there was “little doubt” that what’s become known as “Brexit ” will be bad not just for U.K. assets, but for those “across of the rest of the EU” as it shows a “high degree of uncertainty in a very key area in the global economy.” Tan added that it will be negative for the regions stocks and bonds “including European peripheral bonds.”

Make or Break

With Britain closely linked to the rest of the bloc’s financial entities, the EU itself is also vulnerable, analysts at Societe Generale SA said. The European Investment Bank, which helps provide financing for projects across the continent, is “particularly at risk” Cristina Costa, a Paris-based analyst at SocGen wrote in a note to clients.

Hermida at CaixaBank said he expects British voters to choose to remain in the EU. If he’s wrong, though, he says there are two likely scenarios.

“First, Germany and France would reinforce the euro’s ties, and demonstrate their commitment to work for the union’s success, in which case peripheral bonds would benefit,” he said. “In the other scenario, each country could push for special treatment, which feeds doubt over the survival of the euro.”

To contact the reporters on this story: Macarena Munoz in Madrid at mmunoz39@bloomberg.net, Anooja Debnath in London at adebnath@bloomberg.net. To contact the editors responsible for this story: David Goodman at dgoodman28@bloomberg.net, Todd White, Rodney Jefferson

By: Macarena Munoz and Anooja Debnath

©2016 Bloomberg News