The Brexit Shock And Its Aftershocks

| About: Vanguard FTSE (VGK)

I just spent some time looking at stock market reactions around the world, over the past three trading days. I'm too lazy to compute all the exact numbers, but I'll give you a rough sense of what I found:

1. The FTSE 100 is down less than almost any other market, but I originally misinterpreted this fact. It's dominated by large multinationals that benefit from the lower pound. Vaidas Urba suggested looking at the FTSE 250, which focuses on domestic British companies. There we see a drop of around 10%. Think of that as one bomb going off - the "British economic chaos bomb".

2. The German and French markets are down by about 8%. Think of those as representing the heart of the eurozone. The PIGS seem to be down about 13%. So the Brexit explosion detonated another blast in southern Europe, which we might call the "potential eurocrisis bomb". The 8% declines in Germany and France represent fallout damage from these two bombs. The UK is not directly impacted by the euro bomb, and that explains why it suffered only slightly more than Germany and France.

3. Sweden and Denmark are outside the eurozone, and declined by 4% to 6%. This is collateral damage from generalized European risk.

4. At a global level, you tend to see declines of around 3%, say in the range of 2% to 4% in places like the US, Canada, Australia, Korea, Hong Kong, etc. So that's collateral damage to the global economy.

5. China actually went up, but it tends to follow its own drummer.

6. Japan is down about 6%, and fell especially sharply last Friday. I see this as a third bomb. As the first two bombs detonated, there was a flight to safe havens, and for some reason, I don't understand very well the yen is considered a safe haven. So the yen appreciated strongly and the "strong yen bomb" drove Japanese stocks down by more than other non-European markets.

7. The FTSE 250 did especially poorly on Monday (compared to other markets), which fits my political chaos theory, as the media portrayed the British government as being clueless about how to handle the situation. Things were a bit better on Tuesday.

A few points I'd like to emphasize. This general market pattern was somewhat predictable, conditional on the vote (which of course was not well predicted). In other words, prior to the Brexit vote, we'd seen markets rise on optimism that "Remain" would win, and so it was possible to clearly see how investors thought a Brexit vote would affect various markets. The size of the declines (after the results were announced) was not really a surprise, given that markets had rallied strongly on small increases in the probability that Brexit would fail. We knew this was a really big deal.

The second point is that I think it's useful to view market reactions in terms of one bomb triggering another, albeit often for very different reasons. The hit to Greek stocks occurred for very different reasons from the hit to Japanese stocks. Outside of the UK, this was an almost purely monetary story, and commenters tell me that even within the UK, markets rallied strongly on a statement of support by (BOE head) Mark Carney. So I still think at a non-British level, this is essentially a monetary story, and within the UK, it is mostly real, but partly monetary.

This article claims that almost all experts agree that this is basically a British problem:

Experts agree: When the dust settles, there will be a clear main victim of Brexit.

After the Brexit vote, economists agree that the UK economy is going down.

Just to be clear, I think that is certainly a possible outcome - recession in Britain and no recession elsewhere. But I also think we need to take these stock market reactions more seriously. Even with the recoveries today, eurozone markets are down sharply from Thursday's close; declines almost comparable to the UK (FTSE 250), or (in the case of the PIGS) even steeper. The markets are telling us that there are big risks for all of Europe, and non-trivial (but modest) risks for the global economy.

Because the shock to the UK is more of a real shock, perhaps the damage there is more unavoidable. In that sense, I agree with the article. But if the eurozone damage is more uncertain (a crisis may or may not occur), the size of the stock price decline suggests that if a crisis does occur, it could well be worse that the recession that might hit the UK. The 8% German/French stock price decline could represent a one in five chance of 30% or 35% declines if a eurozone domino effect develops. So we should not be complacent and assume that this is just a UK problem; the rest of Europe needs to take this very seriously. Right now, almost no plausible amount of monetary stimulus from the ECB would be excessive. It's pedal to the metal time.

Fed stimulus would also help. Perhaps a statement by Yellen that the Fed is ready to move very aggressively to address any global problems that could also impact aggregate demand in the US.

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