For the past several years, the market has seemingly pushed through every obstacle to make new highs and continue the business cycle expansion. Sure there were some bumps around the debt ceiling debate, the U.S. sovereign debt downgrade and sequestration. Rolling European debt crises and multiple rounds of Greek-induced volatility prompted new extraordinary measures by the ECB to keep the long-run rally intact. More recently, we have seen macro volatility emanate from the Chinese economic transition.
Brexit, like Grexit before it, was supposed to be just another one of those speed bumps that the market found a way to get over. Even before the first vote in the referendum was cast, the pound had strengthened to year-to-date highs and global risk assets had staged rallies. The market turned out to be wrong, and the British are now set to exit the European Union.
With markets wrong-footed, the results of the referendum caused a swift reversal in risky assets and rallies in haven assets like U.S. Treasury securities. Markets will continue to weigh the impact of this change in the global paradigm over the coming months, which naturally prompts an investigation of the potential impacts. Since the referendum vote was announced, the top questions in the UK on Google Trends have included:
· What does it mean to leave the EU?
· What is the EU?
· Which countries are in the EU?
· What will happen now we've left the EU?
After a potentially transformative vote on the future of the country, and despite exhaustive campaigning in the lead-up to the polls, many Brits were unsure of what they had just voted on and what the implications of that vote would be. In the sections below, I am here to give my take on this historic decision, and my views on the potential market implications.
No Lehman Moment
The failure of Lehman Brothers in September 2008 accelerated the financial fallout from the Global Financial Crisis, seizing financing markets. Inter-relationships between financial counterparties were questioned. Retrenched lending and rising risk premiums contributed to a tremendous reduction in economic activity.
During the European Sovereign Debt Crises in 2011-2012, concerns about the impact on bank balance sheets from soured investments in heavily indebted peripheral European economies ultimately spurred extraordinary accommodation from the European Central Bank. Brexit, at this point, is not a financial crisis, and that is an important distinction between the Lehman era and even the euro crisis. The financial system still faces challenges from lowered yields and a potential reduction in lending in a market pocked by uncertainty, but a wave of credit losses that imperil the capital ratios of financial institutions does not seem imminent at this time.
The market mispriced the potential for a Brexit with risky assets rising into the referendum vote and swiftly reversing as the vote went with the Leave camp. For those looking for beaten down investments in the wake of Friday's correction, one should recognize that you are essentially buying assets at last week's prices. With volatility expected to remain elevated, you will get a better entry point than Friday to institute new longs.
Longer-term, investors will need to assess how much incremental equity risk premium should be applied to a given investment to account for the uncertainty in Europe. For domestic-focused U.S. companies, that premium is likely to be relatively small. For exporters and commodity firms, currency volatility and the potential for further strengthening in the dollar increases the risk premia to be applied to a stock's valuation.
Rising Event Risk
Does Brexit lead to a further fracturing of the European experiment? With elections throughout the continent over the next year, can Euroskeptic parties win power and halt further European integration? The rolling European sovereign debt crises of the past decade signaled the need for a banking union, closer fiscal integration, and most importantly, democratic accountability of the member states. As the union's second largest economy exits, European leaders will need to band together to strengthen the union and remind its citizens of its merits. The EU has its roots in the wake of two crippling wars that emanated on the continent and drew global combatants; the EU has contributed to peace and prosperity in the postwar era. The future of the EU is at stake, and this tail risk is going to be re-priced with various national polls, leading to a clustering of volatility.
The First 100 Days
After such a transformative decision, one would hope that leaders would be fully engaged in working towards an orderly transition from Britain's current role in the EU to a role as an important European partner outside of the union. With the resignation of David Cameron, there is a hole at the top of the UK government in a critical period for the country. For an orderly exit of the UK from the EU, new bilateral agreements need to be put in place with the Eurozone members. If the period of uncertainty is elongated, consumer and business confidence in Britain will be damaged, weighing further on the economy. Britain needs strong leadership at a time when there appears to be a leadership vacuum.
Democracies from Europe to the United States have done a poor job at selling the benefits of free trade and globalization. Voters supporting Brexit were disproportionately from the blue-collar areas of Britain - the populace most affected by the migration of lower skill jobs to lower wage countries. The relatively lower prices of goods and services produced in countries with a relative competitive advantage in producing those products is harder to see than the very visible example of a relocating factory. Global poverty has fallen over the last few decades at an unprecedented rate, and this improvement in global welfare has been driven by global trade. The drawbridge between England and Europe has been pulled up, and a major party U.S. presidential candidate has a wall predominantly on his agenda. The growth in freer trade appears jeopardized; rising protectionism could be a headwind for global economic growth and welfare.
In an article on market themes one year ago, I suggested the rising inequality will become a thematic constant that will inform global politics and policy. I wasn't quite sure how this inequality theme would manifest, but Brexit appears to be driven in part by the relative underperformance of lower income workers. There is no clear or ready solution to address income gaps, and this dynamic could lead to more surprising political ramifications that will impact financial markets.
Extension of Easy Monetary Policy
Monetary authorities will respond to this period of uncertainty with accommodation as needed. Federal funds futures are no longer pricing in a probability of near-term rate rises, but are now pricing in small chances of a reversal in the one rate bump we have seen. Developed economies have limited bandwidth to further increase monetary support, but they could signal that current support levels will stay in place. Rates look likely to stay very low in the developed world. As we have seen through rounds of quantitative easing, this monetary influence ultimately has a positive impact on asset prices, and should provide a ballast for risky assets domestically as the market works through this period of uncertainty.
The Swiss Example
Want an example of a European country operating outside of the European Union with its own currency? Look no farther than Switzerland. Switzerland, while not a part of the EU, participates in the European market through bilateral trade agreements. The Swiss model could be an example of Britain's future relationship with the Eurozone. This would be a bullish case for risky assets.
Safe haven flows into the U.S. Dollar could have a negative impact on commodity prices, spurring a return of stress that inflicted Energy and Metals markets over the last eighteen months. While S&P 500 (NYSEARCA:SPY) generates limited earnings from the UK (<3%), multi-nationals experienced some pain from the stronger dollar in 2015 and we could revisit that relationship, which would have a much larger impact on the US than its direct exposure to the UK economy.
We are likely to see continued volatility over the coming months as markets seek to handicap the downstream implications of a Brexit vote. The likelihood of a tail risk scenario involving the disintegration of the Eurozone as membership is revisited by countries in the union will be a driver of risk premia and remain very fluid. EU leadership and global central banks will mount efforts at mitigating some of the fallout, which could at least provide a modicum of support for risky assets. Absent a broader fracturing of Europe and exit of members from the currency union, there appears to be more limited financial linkages; a stress-tested global financial system should be prepared to weather volatility more aptly, reducing the risk of credit contagion and a sharper economic contraction. As markets price in greater risk premia for uncertainty, investors should measure this compensation in light of the expected linkage to events unfolding in Europe. Volatility can provide investment opportunity.
My articles may contain statements and projections that are forward-looking in nature, and therefore inherently subject to numerous risks, uncertainties and assumptions. While my articles focus on generating long-term, risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and educational information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance and investment horizon.
Disclosure: I am/we are long SPY.
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.