I was off to my tennis match with a clear head on Thursday night as the S&P futures were comfortably higher given the clear indication that the Brexit vote was solidly moving in favor of the ‘remain’ camp. The polls had been closed and initial results were rolling in. Betting odds (typically the most reliable indicator in these scenarios) continued to show a 85% chance that the UK would remain in the European Union at this point. Even beyond those odds, every prognosticator was still predicting that the UK would remain. That included me. This was the logical thing for UK citizens to do.
When I got home later that evening the complexion of the futures began to change. Volatility became the norm as they switched from positive, to slightly negative, then to significantly negative. By 11 pm central time it was becoming clear that the ‘leave’ contingency would win the referendum. The futures showed a triple digit loss in the S&Ps. This continued as I checked Bloomberg throughout a sleepless night.
Equity markets opened this morning at 55 points down. This was half of the loss the futures were predicting in the wee hours of the morning. By mid-morning the market recovered to down 38 points, or less than 2%. But we then experienced a slow melt down throughout the rest of the day to end down 76 points, or 3.6%. Emerging markets ended the day down 6%+ while the European bourses were off 11%+.
This was an ugly day for sure. But we didn’t see panic in the market as compared to what the futures were indicating the night before and by what most seasoned investors had anticipated.
What happens next? The Brexit vote is clearly a negative for the UK, no matter what some of the disillusioned politicians and voters say. Not even an island is an island as uncertainty will slow investment spending. Even the most conservative of assessments will lop off at least a point of growth. As GDP forecasts are for 1.5% growth in the UK, this could very easily push the UK into recession.
But the question remains, how will Brexit impact global financial markets? Many smart analysts state that this is a political crisis while our last debacle in ’08 was a credit crisis. A credit crisis revolves around payments and settlements. If a bank isn’t going to be paid by its debtor or other creditors, well then, the whole system gets gummed up. So, the thinking goes, so long as the payment systems are in tact and well funded then the risks are significantly muted.
Furthermore, the size of the UK limits it potential damage to the global economy as it contributes less than 4% to world GDP. So some perspective is necessary due to the small size of the UK.
At the same time, the UK is not Greece in that the UK was a member of the European Union but not a part of the common currency, the Euro. This makes a transition out of the European Union much easier given that UK already has its own currency (the pound). Thus, there could very easily be an orderly transition for the UK as well as the European Union.
And finally, those that tend to view the Brexit with an optimistic lens point to a Fed (as well as other central banks) that will remain accommodating in the face of improving domestic growth (2.5% forecasted real GDP growth) and even a whiff of some much needed inflation.
You can read more about this type of optimistic take on the situation from Cullen Roche here or from Paul Krugman here.
The counter to this optimistic take could be easily summed up from a quote I read from Peter Goodman earlier this morning, “No one really knows what happens now. The collective imagination leads to dark places.” I believe that the rationale by the ‘glass half full’ camp is sound, but markets can be driven by emotion and uncertainty. And emotion can be filled by a wave of nationalism that has the possibility of dismantling the Eurozone, taking away the currency which could be a catastrophe for the banking industry. I do not think this is the base case, but one would be foolish to dismiss the fact that this political crisis could morph into the next financial crisis.
One day of selling in the market is not enough for me to panic. The backdrop for stocks given a bumbling along economy and a Fed that wants to juice financial markets is not bad (even though valuations have become a bit rich). At the same time, I will be watching the price action of stocks to determine if more defensive positioning is necessary over the very short term.
As always, please call or e-mail with any questions or concerns. Have a nice weekend!
Chris
