Don't Overly Fret The Fed's Next Move...Or Brexit

| About: ProShares Inflation (RINF)
This article is now exclusive for PRO subscribers.

By Gary Alexander

The worry warts are all over the Web, TV, and newspaper accounts, concerned about whether the Federal Reserve will raise rates tomorrow (or in late July). Next week, we'll worry about the British vote to exit the EU ("Brexit") on June 23. These fixed-date fears have a long heritage in market history. The fear of a specific event on a known date helps to focus the media on creating scenarios of potential catastrophe.

First, let's take a brief look at the market's behavior during the Fed's most recent rate-rising cycles:

  • From February 4, 1994 to February 1, 1995, the Fed raised rates six times, from 3.25% to 6.0%. Fed Chairman Alan Greenspan was fighting phantom inflation. His first rate hike shocked the market, causing a 2.3% drop in the S&P 500 that day; but when the final rate increase came a year later, the S&P was a bit higher - and over the next five years, the S&P 500 tripled in value.
  • From June 30, 1999 to May 16, 2000, Greenspan's Fed raised rates five times, from 4.75% to 6.5%. During that span, the S&P 500 rose 7%. In the first half of that rate-raising cycle, the Fed also flooded the nation with liquidity in advance of Y2K, in anticipation of widespread cash hoarding due to the expected collapse of computerized systems on January 1, 2000. Then, when no crisis happened, the Fed sopped up that liquidity in early 2000, precipitating a popping bubble.
  • From June 30, 2004 to June 29, 2006, the Fed raised rates 17 times, by 0.25% each time, from 1.0% to 5.25%. In that time, the S&P 500 rose 11.3% from 1140.84 on June 30, 2004 to 1270.09 on June 30, 2006. Gold grew even faster in those two years, despite the widespread myth that gold falls when rates rise. Gold rose from under $400 in mid-2004 to over $600 in mid-2006. (Sources: Yahoo Finance for S&P 500; New York Fed for rate increases; Kitco for gold prices.)

There are no hard and fast conclusions to draw from these three previous rate-rising cycles, but one tentative conclusion is that external events will likely have more of an impact on the market than a few 0.25% rate increases. Even with two more 2016 rate increases, short-term rates will still be under 1%.

As for Brexit, Europe is undergoing what the Economist (May 21 edition) calls "Referendumania." Not counting referendum-crazy Switzerland and Liechtenstein, Europe has staged 210 referenda in the last 24 years, averaging 8+ referenda per year. There was a recent referendum in Holland on whether to accept the EU's trade deal with Ukraine. Most voters know nothing about trade mechanics, and most citizens are easy to manipulate through protectionist rhetoric, so 61% of Dutch voters rejected the Ukraine trade deal.

Referendum Vote Fatigue in Europe Bar Chart

Upcoming referenda include Italy voting on a new constitution, Hungary voting to relocate migrants, and another two votes on trade deals in Holland. Last year, Scotland voted on whether or not to leave the UK.

British Prime Minister David Cameron proposed a Brexit vote last year, but

In the campaign to date, the prime minister has informed the British public that the vote he has offered, should it go the 'wrong' way, will lead to global recession, a simultaneous rise in mortgage payments and a slump in housing prices, the invasion of Europe by Vladimir Putin, the end of peace on the Continent, and the arrival of at least three out of the four horsemen of the Apocalypse. (National Review, "The Case for Brexit," June 13, 2016).

Goldman Sachs believes that a vote to leave the EU would push the pound down 15% to 20%. The British Treasury sees an immediate 12% to 15% drop (source: Wall Street Journal, June 7, "Volatile Pound Underscores Market Jitters as Brexit Vote Looms"). The pound's recent decline reflects those fears.

There was a similar brouhaha over whether Britain should adopt the euro in the 1990s, with warnings about the dire events that would happen if Britain stuck with sterling. That argument went on for years, but Britain was able to maintain a certain level of independence by holding on to its venerable currency.

Others worry that a vote to exit the EU will lead to a wave of similar referenda in euro-zone nations (see Bloomberg, June 7, "Brexit Contagion is Spreading Across the EU). Anti-EU sentiment is 61% in France:

European Union Favorability in Europe Bar Chart

Worst case, if Britain votes to leave the EU, that is not necessarily the last word. There can be (and have been) appeals or re-votes of referenda that did not come out in alignment with the reigning government. In 2005, there were referenda on the EU constitution in France and the Netherlands. Some ads compared pre-EU conditions to Auschwitz. "The insinuation was that the sole alternative to ever-closer union was a return to Auschwitz." In 2005, the Dutch and French rejected the new EU constitution but EU authorities called for a re-vote until they came up with the 'correct' answer, and then stopped having referendums" (National Review, June 13). Given the closeness of the polls, June 23 may not represent the final verdict.

According to BBC News (June 9, "The UK's EU referendum: All you need to know"), the result of the June 23 vote is "not legally binding - Parliament still has to pass the laws that will get Britain out of the 28 nation bloc, starting with the repeal of the 1972 European Communities Act." Brexit would "have to be ratified by Parliament - the House of Lords and/or the Commons could vote against ratification."

Fixed-Date Phobias Usually Fizzle

Fixed dates make for wonderful focal points for major debates. We tend to imagine the worst, which seldom happens. Here are a few examples from my nearly-50 years' experience in market-watching.

May Day 1975: Wall Street's brokerage brotherhood was terrified of the advent of discount brokers on May 1, 1975 - May Day, or "Black Thursday," as the brokers called it. James Needham, NYSE chairman then, said cut-rate fees would be a "disaster." Critics predicted "the downfall of our free enterprise system." But "the exact opposite happened," according to Donald Weeden, former chairman of Weeden & Co., "Getting rid of those monopolistic restrictions led to the most explosive profitability ever." Discounter Charles Schwab said, "Deregulation provided the window for people to begin to innovate…It turned the whole industry upside down and led to this great mass flourishing of services and pricing and technology" (source: "Lessons of May Day 1975 Ring True Today" by Jason Zweig, April 30, 2015).

By the way, the S&P rose 4.4% in May, 1975 and +56.7% in the years 1975-76 (source: Yahoo Finance).

Hong Kong's Transfer to China on July 1, 1997. Hong Kong was a British colony from 1842 to 1997. Mao called it "a pimple on China's backside." In 1984, British and Chinese officials negotiated a transfer date for mid-1997, but the long negotiations were so terrifying to Hong Kong citizens and global investors that the Hang Seng Index collapsed and thousands of natives made plans to leave the Crown Colony. Real estate values plummeted and the construction industry collapsed. The cost of visas soared.

Hong Kong's Hang Seng stock market index fell below 750 in 1982, 1983, and 1984. With that index currently around 21,000, investing in Hong Kong stocks returned 28-fold gains in 32 years, but it was a rough ride. In this logarithmic chart, you can see 50% or greater declines in 1972-74, 1981-82, 1987, and 1996-97, before the handover, but China has treated Hong Kong respectfully - "one nation, two systems."

Hang Seng Index Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Y2K (January 1, 2000) is the classic case of the fear of the unknown tied to a specific date. Planes were supposed to drop out of the sky but didn't. Another case was the Mayan calendar calling for the end of the world on December 21, 2012. So was the date of budget sequestration (March 1, 2013). Lesser known doomsday dates were November 29, 2003 (by the Japanese cult Aum Shinrikyo), September 12, 2006 (by the House of Yahweh, Texas), or April 29, 2007 (by TV host Pat Robertson) (Source: Wikipedia, "List of dates predicted for apocalyptic events"). Ironically, September 11, 2011 was not a predicted catastrophe.

As Jason Bodner shows this week, Black Swan events are - by definition - unknown and unseen, but they cause the greatest damage. What we fear most impacts us the least, since we prepare for it (example: selling the pound in advance of Brexit). It's the surprise from out of nowhere (like 9-11 or last Sunday morning's tragedy in Orlando) that does the most damage, but there's no way to expect the unexpected.

Disclosure: *Navellier may hold securities in one or more investment strategies offered to its clients.

Disclaimer: Please click here for important disclosures located in the "About" section of the Navellier & Associates profile that accompany this article.