Insight on the Scottish Referendum

Scotland is having a moment. Andy Murray is about to take on the world's number one tennis player in the US Open quarterfinals. The titular main character of Doctor Who is Scottish for the first time in the show's 50-plus-year history. Oh, and on September 18 Scots will decide whether theirs should be an independent nation-and with polls showing a narrowing gap between the pro-union and pro-independence vote, the question of "what happens if voters channel their inner William Wallace?" isn't just academic. Scotland's secession from the UK would have far-reaching implications, and there would be winners and losers. However, for markets, the question isn't, "are there consequences?" What matters most is whether any of the potential consequences is a sudden surprise. In our view, based on what we've seen so far-and what we know of the likely negotiation process-markets should have plenty of time to slowly discover and get used to potential changes before they become the law of the land. A victory for the "Yes on independence" camp might bring some volatility, but the risk of a global bear market is slim.

The main issue here is time. The more time markets have to price in winners and losers, the smaller the chance of some massive surprise-and where Scotland is concerned, time is abundant. Two years have passed since the referendum was scheduled, which means two years of speculation and warnings of the risk associated with independence. Two years of questions about currencies, UK debt management, taxation, North Sea oil revenues, RBS's address, the future of Team GB at the Olympics, Scotland's potential EU and eurozone membership and all the rest-and two years of speculation over the answers. Thanks to the widespread discussion, markets are already well aware of most (if not all) possible winners and losers and the wide array of possible outcomes. Every open letter from Scottish business leaders warning of the dire consequences of independence-and every letter from another group of Scottish execs who claim independence will be a boon-is a little gift to the efficient market elves.

As are the polls, which help markets get used to the likelihood of a change. The "No" vote has led since the referendum was announced, but the gap has closed lately. In January, polls ranged from 29% to 37% for "Yes" and 44% to 52% for "No," but in the first half of August, "Yes" was up to 35% and 42%, and "No" had 46% to 55%. (Track them all here.) The latest poll, released on September 2 after Scotland's First Minister Alex Salmond's apparent triumph over Union spokesman (and former UK Chancellor) Alistair Darling in their second televised debate, showed 42% "Yes" and just 48% "No." Which way the large undecided contingent swings is anyone's guess, especially with both campaigns turning up the heat.

So what happens if they vote "yes?"

On the one hand, that introduces uncertainty, which markets generally dislike. One could argue this overhang is why UK stocks have lagged the world this year, losing relative ground as polls narrow. It also seems fair to say there would be plusses and minuses, winners and losers-and while it is premature to speculate over specifics, markets have plenty of time to discover and discount them. A "Yes" vote doesn't mean Scotland turns independent overnight. It simply gives Scotland's government a mandate to negotiate an independence agreement with the UK, which should be a long, laborious process. This isn't Sarbanes-Oxley changing the rules for US businesses overnight. We're talking a years-long process-the surprise potential is exceedingly small.

Among the issues investors would be mulling over? The currency. England's Treasury and the BoE have ruled out a formal currency union (like the eurozone), where they share a currency and central bank. If they stick to this position, Scotland could issue its own currency or use the pound, similar to how Ecuador and El Salvador use the US dollar. However, going Ecuadorean means Scotland would be subjugated to the BoE's monetary policy choices, and it would lack a lender of last resort in the event of a bank run-one reason several banks domiciled in Scotland suggested they'd up and move if the referendum passes. Also, politically, voting for independence in all matters but the monetary arena may not win as many hearts and minds as independence across the board.

Another point of contention is the North Sea oil industry. For one, the map of maritime sovereign rights would have to be redrawn to identify who owns the mineral rights. Assuming most production would be Scottish (likely), this would be their economic centerpiece. Which the "Better Together" camp knows, so they trumpet analyses arguing the North Sea's best days are behind it, with production having peaked in 1999. Tax and royalty revenue tied to the oil industry have fallen in recent years as well, to the extent that England's leadership claims the UK government's receipts tied to Scottish oil are outweighed by transfer payments to Scotland-hence, the nation itself may not be on sure fiscal footing if independence eliminates transfer payments. The Scottish government, however, released its own analysis in early 2014 showing more than half the North Sea's oil remains untapped. They claim high prices will incent firms to extract this oil, leading to a renewed oil boom-an argument Salmond has employed to whip up support.

The issue of oil revenue is key to this debate, because it's also tied with Scotland's ability to service a share of UK government debt. The UK says it will guarantee all debt issued up to the moment Scotland becomes independent, but the government still expects Scotland to shoulder "its fair share" of national debt thereafter. We aren't in the business of quantifying "fair," but analyses from the two sides suggest a figure in the area of £126 - £143 billion. Salmond, however, sees this claim mostly as a bargaining chip to revisit the currency issue, claiming Scotland will only take on UK debt if the UK formally allows Scotland to use the pound. Yet the UK counters with the claim Scotland's refusal to take on a share of debt would start out the new nation on poor footing akin to default, even going so far as to suggest borrowing costs would be payday lender-like.

Now, whatever you think of the rhetoric employed here, it's key to realize that's what it is: rhetoric. This is basically a game of point-counterpoint-largely political theater-seeking to win that big pot of undecided voters. If a "yes" vote comes, it will likely take significant time to iron out all these matters, and it's likely to play out quite publicly. Despite the fact this is an independence vote, it's not a very contentious situation where negotiation is impossible. When elections are over, rhetoric has a tendency to evaporate. We suspect that would prove the case in Scotland too.