Is It Time To Brexit The Market? I Fear Not...

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Includes: DIA, GLD, IEV, IWM, QQQ, SPY
by: Daniel Carlson

Summary

Markets in turmoil in front of vote.

Immediate impact of Brexit is muted.

Meanwhile, the Fed has turned more dovish.

Fade the fear; sell gold and buy European stocks.

Brexit is all over the news these days. Will the people of Great Britain vote to leave the EU? Or, will they stay? There are, of course, many repercussions for the financial markets based on the results of next weeks' vote; more so if there is a vote to exit the EU than one to stay. I believe, however, that the potential impact of an exit vote has been overly feared by the markets and investors should be proactive in positioning for a post voting snap back.

It was not too long ago that the thought of a vote to exit the EU was almost disdainfully dismissed. As recently as early June, the betting odds were over 80% for remaining in the EU. As the below chart shows, however, the odds for Brexit have increased dramatically.

Click to enlargeThe result of this change in the tide has been a swift counter punch by those in the remain camp. Sadly, their whole thought process behind convincing people to stay in the EU has been one of instilling fear into the voting populace. For example, check out these headlines.

"Osborne Warns Brexit Means Tax Rises and Spending Cuts" - Financial Times

"'Brexit' Would Cause Big Problems for German Banks" - CNBC

"Brexit would pose huge problems for rural Ireland" - RTE News

I could list dozens of more headlines, each one with a varying take on the doomsday that is an exit vote. However, I think you get the gist; the powers that be want Great Britain to remain in the EU and they are willing to scare the bejesus out of the exit voters in an effort to keep the status quo.

And, that strategy might work. There remains a better than 50% chance, according to the bookies, that Brexit is shot down. But, meanwhile, the strategy is having the tremendous side effect of throwing global markets into semi-turmoil; not a complete meltdown, but a serious impact nonetheless. What we are seeing, as the rhetoric heats up, is a major flight to safety. Look at how gold has traded over the last 10 days.

Click to enlarge

And, a major sell-off of equities. Check out the last couple days in the DAX.

Click to enlarge

The immediate impact of Brexit is exactly…what???

Here's the deal, markets are in turmoil because they fear a vote in favor of Great Britain leaving the UK. It's understandable on one level; a vote for Brexit is truly a vote against globalization and all the benefits thereof. It makes no economic sense and is strictly driven by a "Trump-like" fear of immigration. Yet, it's possible and, were it to happen, there would be repercussions.

Exactly what the repercussions are, however, is up for debate. Britain wouldn't leave the EU immediately, instead they would have a 2 year window to negotiate a trade deal with the EU. And, there is the precedent of both Norway and Switzerland that have free trade agreements with the EU despite not being members. It would appear that the immediate impact of Brexit is actually quite negligible, with the longer term impact to be negotiated by politicians.

The Economist, a major supporter of a Remain Vote, sums up their concerns thusly, "The immediate effects of a Brexit vote are likely to be bad. Prolonged uncertainty over Britain's new relationship with the EU will discourage investment, especially foreign direct investment, of which Britain is the biggest net recipient in the EU."

I'm looking at gold rallying and equities selling off and keep coming back to that quote. If the issue is "prolonged uncertainty" and less foreign investment in Britain, do the world markets really need react violently? I don't think so.

The Fed is getting clued in

While Brexit is dominating headlines out of Europe, the Fed's meeting here yesterday was probably more meaningful for the longer term direction of markets. In their open market policy meeting, there was a noticeable turn towards a dovish policy for interest rates from the Governors.

As shown above, the Fed is indicating a less aggressive stance towards interest rate increases. This has broad implications for financial markets that are very counter to what has been taking place. When the Fed moves towards an easier monetary policy, one would expect a USD sell-off. A move we had started to see since the last employment report, but one that had been reversed of late due to Brexit concerns.

As you can see, the reversal of Fed hawkishness has been overwhelmed by the flight to safety induced by the increasing concern over Brexit.

Fade the move; sell gold, buy European stocks

Markets are inherently forward looking. They predict the future and react in anticipation thereof. In the case of Brexit, I feel they have dramatically overreacted in anticipation.

First off, the odds of an exit are still 50-50…at most. I'm a believer that people are rational and it's irrational to vote for an exit, so I expect a vote to come out in favor of remaining in the EU. This would result in a reversal of the fear trade.

Even if I'm wrong, however, I still believe that we have seen an overreaction in the markets to the fear of Brexit. A vote in favor of exit would have little to no immediate impact. And, the impact would be felt primarily in Great Britain. The rest of the world will chug along happily. Meanwhile, the bigger news, a less aggressive Fed, is being ignored.

Thus, regardless of the vote, I expect to see a reversal of recent market movement to come next week. I think the dollar will weaken and risky assets will do well. I am expecting to see gold reverse its recent strong moves and back off, meanwhile I think equities will rally. I would be a seller of gold into and on the news, and a buyer of European equities at the same time.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.