In cheery news, all 33 of the large US banks passed the Fed's annual stress tests. With lots of capital on hand and strengthening balance sheets, it's another vote of confidence for the recovering US financial system. Financial shares (NYSEARCA:XLF) traded strongly Thursday, as investors look forward to the increased dividend or share buyback possibilities coming from leading US banks.
With that bit of positive news out of the way, we can now get to today's rather dire Briefing while having accentuated yesterday's silver lining. The story of Brexit's unexpected passage has been widely reported, let me get straight to the immediate investing implications.
The Currency Moves Are Most Important
The foreign exchange market has, for lack of a better phrase, come unhinged following the Brexit vote. The British pound (NYSEARCA:FXB) plunged as much as 11% overnight, reportedly its biggest one-day drop in decades. It now sits at levels not seen since the early 1990s.
The pound's downfall is being focused on and with good reason. However, there's much more to it than just that. Look at the table of the major currencies:
They're all up or down 2%, this is far from just a European event. The yen (NYSEARCA:FXY) is leading the way higher, as it remains, above all, the ultimate safe haven risk off currency of the moment - the franc being dinged by its presence in Europe and SNB intervention.
Despite Japan's efforts to weaken the yen, it continues inexorably higher, retesting the 100 mark to the dollar last night. Any economic green shoots in Japan have been extirpated over the last quarter; the yen has completely collapsed those plans as it has soared more than 10% in recent weeks. Against other currencies, the yen's strengthening has been even more dramatic. Against the British currency, the yen has made a breathtaking run from 180 to the pound at the beginning of the year up to 140 now.
For the US dollar, the 2.6% move higher goes against expectations of many market participants. Some of the recent hopefulness in the market came from the prospect of a weakening dollar as the euro toyed with topping 1.15 again. Well forget about that, the euro dove as much as 5 cents overnight and remains sharply lower now. This will put a huge cloud on earnings for US-dollar based multinational firms in the back half of 2016.
On the losing side, it's not just the euro and pound that are falling. The whole arc of commodity currencies is also getting hit.
Led by oil (NYSEARCA:USO) down 5% and copper down big as well, the rush is on to sell the periphery currencies such as the Australian and Canadian dollars. To the extent that these currencies and nations' equities markets rallied on the prospect of sustained $50 oil, those gains will be reversed.
Emerging Markets: Bloodbath
Another big thing to watch are the emerging markets. Early quotations show all sorts of trouble. My favorite short, Brazil (NYSEARCA:EWZ), is quoted at 7% lower this morning.
The rally in many of these markets was driven by firming oil prices. The agricultural commodities that countries such as Brazil rely on are all well in the red today as well. A stronger dollar simply suffocates global liquidity and the most dodgy of investment destinations take a big hit.
An instructive example would be the plunge in the Mexican peso. It fell from 18.2 before the vote to as low as 19.6 to the dollar overnight, an 8% move on the session. Mexico has very little exposure to Europe. As the de facto manufacturing arm of the US, it's relatively insulated from overseas issues.
Regardless, the peso plunged to new all-time lows before putting in a reversal to pare its losses somewhat. However, it shows that nerves are edgy and even reasonably good assets will get thrown out as hedge funds - facing margin calls - throw out liquid assets haphazardly.
Other emerging currencies such as the South African Rand show massive losses this morning. It will be a dark day for the smaller markets. The effects of the Brexit decision span far beyond Europe. A stronger dollar is a huge negative for the global outlook generally.
If you're not familiar with the 1997-98 financial crisis, this is a good weekend to get yourself up to speed. Parallels are developing between then and now.
China: Another Devaluation Looms
On that note, one must mention the elephant in the room. China's economy continues to struggle - things have taken a turn for the worse lately - and the last thing they wanted was a huge rip higher in the currency (the dollar) that they're pegged to.
The yuan has been slipping in recent weeks as investors grew to expect another devaluation. If you were wondering why Bitcoin spiked recently, supposedly it's due to fearful Chinese money moving out ahead of the country ahead of the expected devaluation. Even prior to Brexit, the Chinese economy didn't appear durable enough to endure its overvalued exchange rate. With this sudden plunge in the exchange rates of Europe, Chinese goods face an even more disadvantageous position on global markets.
I was (and remain) very concerned about the market impact should the yuan devaluation become disorderly. By good fortune I happen to have a large holding in way out-of-the-money volatility (NYSEARCA:SVXY) options that will post huge gains today. I actually bought them because I was concerned about China and poor US earnings prospects; I didn't expect Brexit to pass. Better to be lucky than smart sometimes.
And make no mistake, China is the big potential trigger that can start a bear market overnight if things really start to unwind there. Most of the robust recovery in commodities since this past winter has been premised on China muddling through and turning the corner, boosting demand for oil, copper, iron ore and other such inputs. I don't buy it; and if Brexit forces China to take drastic economic actions, the emperor's lack of clothes could become a pressing issue.
Rate Hikes Off The Table
The old joke appears to have had merit after all. When trying to figure out why the Fed was raising rates at the end of 2015 as the economy already showed serious signs of slowdown, we joked that they needed to raise rates so that they could cut them again when the next crisis hit.
And here we go, US futures are now starting to price in a rate cut. US treasuries (NYSEARCA:TLT) are making one of the largest one-day up moves I recall seeing, as yields simply collapse in creditworthy nations. Germany's 10-year yield plunged to well below 0% today, as money moved out of the weak European PIIGS back into the core. Japanese yields are also farther into the negative.
It appears Yellen's stubborn campaign for more 2016 rate hikes has met its match. We're back to a panicky risk-off environment, one in which the market will aggressively re-price rates and not wait for guidance from the Fed.
As far as the possibility of a rate cut goes, the Fed has a history of making dramatic moves after international shocks. Its unprecedented two rate cuts within three weeks following the Russian default and collapse of Long-Term Capital in 1998 being one memorable example.
Watch The Banks
Heading back to Europe, where all this did get started, the key indicator to watch today will be the banks. As of this writing, Deutsche Bank (NYSE:DB) is off 18% pre-market and appears to be getting little traction even as other hard-hit stocks show signs of stabilization.
Santander (NYSE:SAN), Spain's perpetually struggling bank, is off (I double-checked this) 24% this morning! Credit Suisse (NYSE:CS) is down a solid 16%. I could go on, but the point is clear. There are real concerns that the global margin calls caused by Brexit (particularly the plunges in FX and oil) will cause a capital shortage and run on the European banks.
I expect the ECB to take strong measures to try to avoid this sort of outcome, but obviously the market is still pricing in the real possibility that things come apart.
After years of steady bull market, the natural conclusion is to expect a "V" bounce today or early next week at the latest. There's still a good chance markets will rip higher, it is what traders have trained for in recent years. And ultimately, the economic effect of Brexit in Britain should be fairly mild.
However, there's a chance this turns into a serious multi-week roller coaster ride. Notably, watch the dollar, the European banks and oil.
If the move higher in the dollar keeps going, it will put a cap on any potential US stock upside as earnings estimates dive. The European banks are the most visible risk indicator of the state of things in Europe. And oil, given the massive amount of speculative long money there, serves as a sort of global margin call indicator, along with being a barometer of how much fire the emerging markets are taking from the global imbalances.
Safe trading out there today. Don't panic and mindlessly sell stocks in a manner you'll later regret.
Disclosure: I am/we are short SVXY, EWZ.
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.