British Shock! (Brexit)
Britain shocked the financial community by voting to leave the European Union (EU). Global equity markets plunged but then recovered to pre Brexit levels. The conventional wisdom is that, due to the uncertainty around the eventual exit, what it looks like, and how orderly it is, the risk of a global recession has risen. Domestic sentiment indicates the U.S. economy is fairly healthy and should manage to stay out of recession territory, even though risks have risen. The Federal Reserve seems highly unlikely to raise rates in the foreseeable future and further economic stimulus cannot be ruled out. International developed and emerging market (EM) stocks were up over the 90 days leading up to the British referendum, suggesting that investors were not pricing in a Brexit outcome, and we believe it may take some time for the shock to fully work through the economic, financial, and political systems in the United Kingdom and Europe.
Since the end of the financial-crisis induced global recession in 2009, a series of shocks have helped to keep growth, inflation, and stock market performance subdued. The shocks that have taken place in Japan, the United States, and Europe may offer some insight as to the potential duration of the market impact of Brexit. After the shock of the devastating earthquake and related nuclear accident in Japan on March 11, 2011, the Nikkei fell 16% during the next two trading days, but fully recovered those losses by July 8—a period of four months. It is worth noting that the lingering recession caused this initial rebound to fade into two back-to-back, double-digit declines and rebounds until stocks finally recovered their losses by the end of 2012. After the congressional standoff over the U.S. debt ceiling saw the S&P 500 slide 3% in one day, on August 1, 2011, members of the House cut a deal to end it the following day, prompting U.S. stocks to have a one day rebound on August 3; however, they fell another 12% over the next two months on fears of economic fallout, finally bottoming on October 3, 2011. The S&P 500 recouped these losses by the end of October, a period of three months. The European debt crisis forced Spain to unveil an austere budget and prompted labor strikes in “too big to bail” Spain from March 27 to March 29, 2012 and effected a shock that drove the Stoxx 600 down 3%. It fell another 10% from March 29 to June 4 as the Eurozone slid into a recession. By the end of July, stocks had recovered their losses, a period of three months.
Although the Brexit is not a perfect parallel with any of the above shocks, the delayed recognition of widening impacts from shock events could prompt a further slide in the stock markets after the initial reaction, as we have seen in the past. While past performance is no guarantee of future results, it is important for long-term investors to note that in each of these instances stocks rebounded to their pre-shock level in three-to-four months, even when a recession took place. The widening impacts of Brexit may include other countries calling for their own referendums on EU membership. This could put the European Central Bank (ECB) in a difficult position to continue its quantitative easing (QE) program of buying the bonds of countries that may chose to leave the Eurozone. It’s not hard to see France’s Marine Le Pen taking the same path as Britain’s, should she win the election in less than a year from now. A “Frexit” could be even bigger than Brexit in its impact on markets with an ECB that may be unable to effectively intervene. Pre Brexit polls placed about a 60% chance of staying with the EU. Current polls in France put the “stay” camp at just 35%.
With U.K. Prime Minister Cameron stepping down, a battle may begin among those who want to replace him, with each candidate arguing they will be most aggressive in negotiations with the EU. In response, EU leaders have made it clear they intend to be tough on the U.K., to make them an example. As the rhetoric heats up, the markets may become increasingly pessimistic regarding a trade deal that isn’t mutually damaging. Negotiations could drag out for years. As investors seek safe havens, the rise in the U.S. dollar (if sustained) will likely contribute to declines in commodity prices. This may renew cuts to earnings estimates and prompt an eventual devaluation of the Chinese yuan versus the U.S. dollar. These factors, combined with slower export growth to Europe (China’s biggest customer), may renew economic hard landing concerns for China. In addition, a rise in the dollar adds pressure on EM stocks due to concerns about dollar-denominated debts and tighter financial conditions.
Signs to watch for that may indicate the impact of the Brexit shock:
1) Economic: If the Bank of England (BoE) and ECB stabilize financial conditions, and the U.K. and Eurozone economies capitalize on the weakness in their currencies to ease the slowdown/recession, the economic data may be near an inflection point.
2) Political: When the surge in political upheaval in Europe catalyzed by Brexit settles down. Events to watch include referendum announcements in other countries and the results of the vote on a new government in Spain, along with an Italian constitutional reform referendum in October, and the polling on the upcoming 2017 French and German elections.
3) Currency: When we see an end to the flight-to-quality in the U.S. dollar and yen. The yen has been the best-performing currency recently during periods of heightened uncertainty. The lack of action from the Bank of Japan (BoJ) at the June policy meeting is allowing yen appreciation pressure to continue to build. While the yen’s move higher is negative for Japanese stocks—which have been in inverse lock step with the yen for five years now—an end to the rise in the yen may signal the worst is over.
Investors should be prepared for further stock market declines over the next three to-six months, similar to past shocks. We continue to believe volatility will remain a major characteristic of markets in 2016. However, longer-term investors should maintain their diversified asset allocations intended to weather volatility on the way to longer-term goals. Here, in the United States, we remain cautiously optimistic on U.S. equities and believe that the market will ultimately recover, but near-term uncertainty will likely contribute to more volatility and the possibility of additional sharp pullbacks. However, with recession odds still fairly low—although higher than they were a few weeks ago—we still don’t envision a prolonged bear market. The great unknown; Bumpy…but not bearish. The U.S. economy is hanging in there.
The apparent tightening of the labor market, with the standard measure of unemployment now at 4.7%, is helping to boost wages. This is bolstering the U.S. consumer as the strong April retail sales report was followed by another solid report for May. Wages appear to be strengthening and the continued extreme interest rate environment seems to be influencing corporate decision making—although likely not in the way policy makers were hoping. Stock buybacks and increased dividend payments seem to be the choice of many companies, while they remain reluctant to invest substantially in equipment and material that has longer-term potential benefits.
The next several weeks could be a tumultuous time in global markets and investors need to keep a longer-term view in mind. Global stock markets have tended to ultimately rebound from other sharp declines—often fairly quickly. It can be tough to get back on track once things reverse, so we recommend investors keep allocations in line with their long-term strategic targets and hold their nose.
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