How Vulnerable Is The Shaky U.S. Economy To Brexit Fallout And European Bank Meltdown?

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Business optimism "lowest since the height of the Financial Crisis."

You know things are getting bad when our leaders call for calm. US Secretary of State John Kerry just did that.

"It is absolutely essential that we stay focused on how in this transitional period, nobody loses their head, nobody goes off half-cocked, people don't start moving on scatter-brained or revengeful premises," he told reporters in Brussels on Monday after Brexit had thrown the EU into political turmoil while European bank stocks had their worst two-day meltdown ever on the toxic mix of Brexit and a full-blown banking crisis.

And all kinds of things are suddenly happening.

Fed Chair Janet Yellen was supposed to speak at the annual central-bank shindig in Sintra, Portugal, organized by the ECB. It started on Monday. But Bank of England Governor Mark Carney had bailed out after the Brexit vote. Then, an updated version of the event program showed on Monday that a panel with Yellen, Draghi, and Carney had been taken out. The Fed confirmed that Yellen, after the weekend meeting of the Bank for International Settlements, was returning to the US.

There are more important things to see to - even in the US, where the mood on Wall Street is suddenly souring.

"We have never seen a set of analysts' notes as negative and scary as these," Business Insider explained." Before the Brexit vote, "economists at the major banks expected the UK to continue growing, albeit at a slower pace, into the foreseeable future." But… "'Recession,' 'contagion,' and 'stagflation' are the words they're using now."

Here are some tidbits from BI's report:

Barclays' Fabrice Montagne figured that the UK "is likely to enter a period of stagflation," and that Brexit would "exacerbate current elevated levels of uncertainty and thus amplify already slowing economic momentum."

Barclays' Philippe Gudin fretted that a "clear and coordinated strategy to safeguard the rest of the EU and the euro area does not look to be present." So they expected "uncertainty to spread and euro area confidence and domestic demand to fall."

Deutsche Bank's George Saravelos wrote that the "extreme market reaction in GBP" - the crash of the pound - "is right" and that "a period of exceptional uncertainty now starts for the UK."

Bank of America Merrill Lynch's Robert Wood called it, "Hello recession." Uncertainty would be enormous: "We do not even know what the geographical boundaries of the UK will look like in a few years. This uncertainty is likely to be prolonged and will lead investors - including residential investors - to postpone decisions. The economy will turn down quickly in our view."

HSBC's Karen Ward et al figured that "Some market contagion is likely."

Bank of America Merrill Lynch's Ethan Harris wrote: "The decision for the UK to exit the European Union is another in a long string of confidence shocks, hitting an already vulnerable US and global economy."

Note how often the words "confidence" and "uncertainty" show up. They're key in any economy.

So how vulnerable is the US economy? The manufacturing sector has been in trouble, with industrial production in decline since November 2014 (read…OK, I Get it, the US is a Service Economy, but this Looks Terrible).

Manufacturing is only a small-ish part of the economy. The service sector dominates, but now it has to pull the US economy forward on its own, against the drag of manufacturing and the fallout from Brexit. Here's what Markit just reported about the sector on which all hopes are riding:

Reports from survey respondents suggested that relatively subdued demand continued to weigh on activity growth in June, reflecting heightened economic uncertainty and risk aversion among clients.

Service sector business activity at 51.3 was flat with May and "only marginally above the neutral 50.0 threshold," Markit said. Here are some gems from the report:

The degree of positive sentiment … was the lowest since the survey began over six-and-a-half years ago.

The survey data indicate that any rebound in the economy from the weak first quarter was largely confined to April, and that growth has since faded again. The June PMIs, which provide the first insight into national business activity in the second quarter, suggest the underlying rate of growth in the economy is only a meagre 1%.

However, even the service sector has seen growth weaken in recent months, with firms citing increased uncertainty over the economic and political outlook both at home and abroad.

Business optimism was the lowest seen since the height of the financial crisis, with firms seeing greater hesitation in spending on services by business and households.

Uncertainty looks set to intensify in coming months…

This survey of purchasing managers was taken before the Brexit vote! It sums up how vulnerable the US economy really is when it gets hit over time with Brexit fallout.

Uncertainty is anathema to this Fed-designed economy with its inflated asset prices, which have become a confidence game - confidence in the Fed's ability to keep them inflated and to somehow conjure up demand.

During the Financial Crisis, as the Fed was bailing out banks, Corporate America, and everyone holding assets, there was the notion that these asset bubbles would create demand. The "wealth effect," it was called. This has never happened, and as a consequence, the Fed and other central banks that played the same game have lost their credibility: It's now clear to everyone that central banks cannot create demand. All they can create are asset bubbles.

And even in that department, they've lost credibility, given the crash in European and Japanese stocks over the past year. Thus even more uncertainty.

With the Brexit vote, the veneer of confidence - what little remained - has come off the economy, globally. The uncertainties that have been beneath it all along have suddenly appeared on the surface. And given how lethargic the US economy has been for years, any loss of confidence and any increase in uncertainty are going to weigh on it, and on the markets.

The European banking crisis jumps to the next level. Read… European Banks Get Crushed, Worst 2-Day Plunge Ever, Italian Banks to Get Taxpayer Bailout, Contagion Hits US Banks