The worst has happened. The UK has voted to leave the European Union (EU). The markets had not expected a BREXIT. A day before the results were announced, all benchmark indexes in the U.S. rallied on hopes that the Britain will vote to remain in the EU. But the vote showed majority (52%) voting to exit the EU. While the verdict was unexpected, market's reaction was not. All global benchmark indexes tumbled. If anything, the losses in the U.S. have been contained. BREXIT calls for a review of ETF strategy.
Bullish On GLD
In my recently published note on gold and the Market Vectors Gold Miners ETF (NYSEARCA:GDX), I had noted that BREXIT would spark a rally in both. At last check, the SPDR Gold Trust ETF (NYSEARCA:GLD) was up more than 4%, while GDX was trading more than 6% higher. I believe that this is not just a short-term move.
While the short-term gains will be driven by fear, gold's long-term fundamentals have also got a boost with the BREXIT vote. You see in the wake of uncertainty created by BREXIT, the Federal Reserve will be forced to take a dovish stance. The Fed, in its latest monetary policy statement, said that it expects two rate hikes in 2016. That is highly unlikely as I have explained earlier. The Fed has ruled out a summer rate hike, which leaves the September meeting. The Fed has never raised rates ahead of a Presidential election. This means that only one rate hike is possible. This was of course in the case where U.S. economic recovery remained on track and more important there were no global economic uncertainties. Now there are.
BREXIT will have an impact on the British economy, but it also affects its largest trading partner the EU. Not surprisingly, the euro also fell today. The Fed's monetary policy is of course based on the state of the U.S. economy. But in the past, it has restrained from a rate hike when there was turmoil in global markets.
The Fed was expected to announce its first rate hike in a decade in June 2015. However, the central bank restrained after China's decision to devalue its currency led to a sell-off in global markets. The Fed eventually did hike rates in December 2015 but by then sentiment had improved. Whether sentiment will improve six months from now is difficult to predict given that there are so many uncertainties surrounding BREXIT. There is a high probability that we will not see a Fed raise interest rates this year. This, as I had noted in the recent note on GDX, is bullish for gold in the medium term as well.
While GLD and GDX are medium-term plays in the wake of BREXIT, the ProShares Trust Ultra VIX Short Term Futures ETF (NYSEARCA:UVXY) is an excellent short-term play. Volatility, not surprisingly, spiked up as the referendum results began to come in. The UVXY jumped as much as 40% in pre-market trading today. UVXY though still remains well below the levels reached in February this year. Volatility, at the start of this year, was sparked by concerns over China's slowdown and its implications. But actions from Chinese policymakers helped calm markets and in fact, the S&P has since rebounded sharply. While the Bank of England has said that it prepared to take action to calm markets, BREXIT uncertainties are here to stay. There is a serious risk of contagion in the EU. Earlier today, we saw the spreads between German bonds and bonds issued by peripheral euro zone economies widen. I believe that volatility is here to stay and UVXY could see a run at least in the near-term.
BREXIT Changes Sentiment
For now BREXIT has changed the market sentiment. After the sell-off earlier in the year, the S&P 500 had rebounded sharply. But the rally has been built on a weak foundation. We are likely to remain in risk off mode at least until there is more clarity on the terms of Britain's "divorce" with the EU. The split in all likelihood will be ugly. That is bad news for markets.
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