2016 June Financial Market Update

Brexit – A Political Earthquake Felt Around the World

On June 23, the U.K. voted by a narrow 52-48% to exit (coined ‘Brexit’ for Britain’s exit) the 28-nation economic and political bloc called the European Union (EU). It was a non-binding referendum, which means lawmakers in Britain could ignore the results, but that seems unlikely. In a nutshell, dislike of EU regulation and immigration requirements trumped the economic uncertainty of a Brexit.

Since most pollsters and analysts had forecast a win by the ‘Remain’ camp (and shares had rallied in anticipation of the vote), the following day’s market reaction was swift.

Senior analyst Howard Silverblatt at Standard and Poor’s tweeted June 24’s sell off shaved $2.1 trillion off global equity values. Meanwhile, relatively safer assets such as most European government bonds and U.S. Treasuries rallied (Bloomberg).

The reason for the selloff: markets hate heightened uncertainty. This is especially true of short-term traders versus those who have a long-term perspective and are more forgiving of disappointments. But as markets digested the news, cooler heads prevailed and stocks rallied. By month’s end, the S&P 500 had erased much of the early losses, surpassing its June 22 level (St. Louis Federal Reserve).

Two notable casualties: the referendum quickly claimed the career of UK British Prime Minister David Cameron, who favored staying in the EU, and the British pound fell to its lowest level in 30 years (St. Louis Federal Reserve) – see Figure 1.

U.S. impact

As the political fallout continues, many at home are asking, “How will this affect U.S. financial markets and the U.S. economy?” No one’s crystal is perfect, but let’s take a reasonable stab at it.

It’s hard to see how this alone becomes a Lehman moment that crashes into the credit markets and destroys liquidity. One week following the Brexit vote, credit markets are functioning well.

Banks in the U.S. are in much better shape today as the latest Fed stress test corroborates, the consumer is healthier than in 2008, and housing is on a firmer ground.

Yes, there are weak spots, such as business spending, but when Lehman Brothers imploded, the U.S. was already in a recession.

Risks of a U.S. recession have inched higher, but problems in Europe alone shouldn’t be enough to sink the U.S. economy. Let me explain.

Last year, U.S. exports totaled $501 billion to the EU (U.S. Census). But the U.S. economy towers over $18 trillion (U.S. BEA). It’s less than 3% of U.S. Gross Domestic Product (GDP) – see Figure 2. Compare that to consumer spending, which makes up 70% of GDP.

Note: GDP = Gross Domestic Product, the total value of goods and services for the economy

However, recession risks have spiked in the UK. According to the Wall Street Journal, some companies have already put British investment plans on hold and others are looking at pulling some operations out of the UK. While the drop in the pound will make UK exports cheaper, it will likely raise inflation as import prices rise.

Because Britain is the EU’s second largest economy (Wall Street Journal) a UK recession is bound to have an impact on Europe’s struggling expansion.

What markets want to see

Markets deeply dislike events that create unwanted uncertainty. Unwanted uncertainty creates added risk, which must be priced into stocks. Hence, we get volatility.

While there is an outside chance a UK exit may never happen, odds are very low at this juncture. So a quick resolution that brings certainty would be welcome.

Again, that’s probably not going to happen, as negotiators have two years to hammer out a very complex agreement. And the clock doesn’t start ticking until the UK officially states its intentions (Atlantic). That has yet to occur and probably won’t happen until after a new prime minister takes office in early fall.

In reality, the EU and the UK need each other. While German Chancellor Angela Merkel wants to take a cautious approach to a Brexit, she also said, “We will ensure the cherry-picking principle won’t apply in the negotiations. There must be—and there will be—a palpable difference between a country that wants to be part of the European Union and one that doesn’t (Wall Street Journal).”

In other words, Britain doesn’t get free access to markets of EU countries without accepting some of the ‘burdens’ that go with it. However, the UK posted its biggest trade deficit ever with EU countries in the first three months of 2016 (The Guardian). So the EU’s surplus with the UK gives Britain some degree of leverage.

Medium term risks

Will the referendum fuel separatist movements across Europe, creating additional uncertainty in the months and years to come. In turn, would that threaten the viability of the euro as a currency? These are difficult questions to answer.

Will global economic woes boost the dollar, which could be seen as a shelter from the storm?

While a stronger dollar lowers import prices, it also makes it more difficult for exporters to compete. In addition, large multinationals must translate overseas sales back into more expensive dollars, which modestly reduces revenues and profits.

A look ahead

Don’t discount the possibility of additional short-term volatility, but the quick bounce in stocks at month’s end was encouraging. Ultimately, the U.S. economy and corporate profits have the biggest influence over the long-term direction of U.S. stocks, not what happens around the globe.

We’ve witnessed international events that have temporarily created volatility before, including the Russian default and Asian currency crisis of the late 1990s, the tragic earthquake in Japan, the 2011/12 eurozone debt crisis, and chaos in the Middle East.

When the waves subside, the focus turned back to U.S. fundamentals. I suspect the market will eventually find its bearings in a post-Brexit world, and the Street’s focus will shift back to domestic events.

^{1 The Dow Jones Industrials Average is an unmanaged index of 30 major companies which cannot be invested into directly.  Past performance does not guarantee future results.}

^{2 The NASDAQ Composite is an unmanaged index of companies which cannot be invested into directly.  Past performance does not guarantee future results.}

^{3 The S&P 500 Index is an unmanaged index of 500 larger companies which cannot be invested into directly.  Past performance does not guarantee future results.}

^{4 The FTSE Developed ex North America Index is an unmanaged index of large and mid-cap stocks providing coverage of developed markets, excluding the US and Canada. It cannot be invested into directly. Past performance does not guarantee future results.}

^{5 New York Mercantile Exchange front-month contract; Prices can and do vary; past performance does not guarantee future results.}

^{6 London Bullion Market Association; gold fixing pricing; Prices can and do vary; past performance does not guarantee future results.}

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