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Could Brexit vote cause a stock market crash?

MoneyWatch Headlines for June 24, 2016
MoneyWatch Headlines for June 24, 2016 01:11

In or out?

That's the key question for investors as British voters prepare to cast their ballots on Thursday in a national referendum on whether the U.K. should remain in the European Union or withdraw from the 28-country bloc.

The vote looks too close to call, with the nation seemingly divided. The stalemate caps a three-month sideways crawl for stocks, which in turn caps a three-year sideways crawl. The world, it seems, teeters on the edge of the unknown once again, echoing the worry over the fiscal cliff, the Federal Reserve's rate liftoff, the Greek bailout vote and a number of other events over the last few years.

Will Brexit impact your 401k? 05:11

Should American investors be worried? U.K. voters appear to have warmed in recent weeks to the idea of a "Brexit" from the EU, with many expressing anger over issues such as immigration, deflation, economic stagnation and the bureaucracy of Brussels.

Three of the four latest polls show those favoring a U.K. stay in the EU in the lead. NatCen shows 53 percent remain support versus 47 percent leave support. The ORB/Telegraph poll showed 53 percent for remain with 46 percent for leave. IG/Survation poll showed remain at 46 percent ahead of 44 percent for leave. The online YouGov poll for the times showed leave beating remain at 44 percent to 42 percent.

Bookies are more definitive, putting the odds of Brexit at around 20 percent.

Billionaire investor George Soros warned of the dangers of Brexit in an op-ed in The Guardian, saying a leave result would cause "bigger and more disruptive" pound sterling devaluation than the 15 percent drop that occurred on Black Wednesday in 1992. He also highlighted the lack of awareness among voters of the political consequences of leaving. Voters in the EU's weaker states, such as Greece, would suddenly feel empowered to ditch the project as well.

From a financial markets perspective, any fallout would be concentrated in European bond and equity markets, with high-debt sovereign bonds (think Spain and Italy) and Eurozone bank stocks taking the brunt of the damage. With major central banks already preparing for coordinated liquidity injections, any selloff would likely be short lived.

How bad could it get? Morgan Stanley warns British stocks could lose nearly 20 percent in a Brexit win scenario. Bank of America Merrill Lynch believes U.S. stocks could lose upwards of 7 percent. Citigroup sees European stocks down 20 percent. Deutsche Bank sees 10 percent downside risk.

A more persistent downturn would depend on U.K. politicians actually following the will of the electorate. Remember that leaders in Athens, under great pressure from Brussels, basically ignored an anti-bailout, anti-EU referendum last year.

Instead, it's more likely that U.S. stocks are just biding their time waiting for clarity on issues such as the ongoing corporate earnings recession, uneven economic data, ongoing pressure on Japanese and European banks from negative policy rates, and whether or not the Fed is serious about its two-quarter-point rate hike forecast for 2016.

It is worth noting, however, that options traders are preparing for a negative surprise by bidding up protection against a selloff. That's boosted the CBOE Volatility Index (VIX) -- known as Wall Street's "fear gauge" -- in recent days. The result has pushed up the value of near-term VIX versus "normal" medium-term VIX by the most since last August's market selloff driven by China's surprise currency devaluation.

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