The decision was not expected, and a period of adjustment is needed. The U.S. dollar should continue rising, while U.S. stocks could decline sharply over the medium term.
Goodbye to the U.K.
Following months of a harsh campaign, the sovereign citizens of the United Kingdom voted for a new future away from the European Union. It was an unexpected decision that could take some time to digest. In fact, a few years of intense negotiations with the EU are now necessary, considering the strong trade ties between the two entities. Incertitude would undermine economic growth in the U.K., resulting in less job creation and more unemployment. Scotland might take the opportunity to hold another referendum and vote to leave the U.K. The Bank of England should cut interest rates to zero and increase extraordinary measures to support the economy. As a result, the pound sterling should lose more ground against other currencies.
The easiest way, nonetheless, would be for the U.K. to stay in the European Economic Area (NYSE:EEA), which means following European laws concerning the single market, paying some duties to the EU budget, and allowing EU citizens to live and work on the island (U.K. citizens could do the same on the European continent). Things will be more complicated if the U.K. does not join the EEA. All treaties should be renegotiated on a bilateral level. On the positive side, a weaker currency will boost competitiveness. The U.K. could directly decide on regulations and laws that can best help the country. Europe, on the other hand, is expected to change gears and build a leaner, more efficient community. Otherwise, the price would be more countries asking to go it alone, especially during hard economic times.
Will the U.S. be affected?
Trade relations are too limited for the U.S. to suffer from an economic slowdown on the island. However, lesser growth in Europe would be felt on the other side of the Atlantic as well. The U.S. dollar could play the safe haven role again, and the U.S. Dollar Index could increase to 102. Stocks are targeting 2100/2160 again on the belief that the Federal Reserve will not touch interest rates until the end of this year. In May, the job report was a big surprise. Non-farm payrolls rose by a tiny 38,000, the smallest increase in six years. In addition, the jobless rate declined to 4.70%. However, this might signal that more people are leaving the workforce, as the labor participation rate declined to 62.60% from 63% in March. In effect, the number of part-timers rose in May after falling for all of 2015. As a result, wages fell 2.4%.
It is true that one month of data does not make a trend. The next five months will be watched carefully by the Fed. In reality, the U.S. economy is still benefiting from the positive momentum. U.S. personal spending rose 0.4% in May on top of April's 1.1% increase. Durable and non-durable goods improved. More Americans are going to restaurants and spending on cars. Will it last? Only time will tell. The effects of the British referendum on a globalized economy are yet to be seen. A fast separation is crucial. Nonetheless, stocks are reaching a critical point and could decline 30% to 50% over the medium term. Why? Since the bottom of 2010, the Dow Jones Industrial Index has risen more than 60% (high-low) without any important corrections. In 100 years, the market has behaved in a similar way twice. From 1932 to 1936, the DJI increased about 79% (high-low) and then corrected 50% of the move. In 1982-1987, it jumped 72% (high-low) and declined about 50%.
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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. I have no business relationship with any company whose stock is mentioned in this article.