No man is an island, wrote John Donne, yet his fellow Britons have voted to make emphatic their island status, separate and apart from continental Europe, politically as well as geographically. The reverberations from the United Kingdom’s referendum to leave the European Union, however, were felt far beyond the British Isles.
Markets and economies around the globe are likely to continue to be buffeted by the shock waves from Thursday’s Brexit vote, which slammed stocks and sent currencies gyrating and bond yields plunging. Even as markets shuddered, with some major ones down more than 3% and bank stocks tumbling by double digits in the wake of the referendum’s outcome, this wasn’t a financial event like the collapse of Lehman Brothers in 2008.
Rather, it was a political event, says Felix Zulauf, a longtime member of the Barron’s Roundtable. Brexit is not an isolated happening, the head of Zulauf Asset Management emailed from his offices in Zug, Switzerland. It is part of a swing against the political establishment. Indeed, “the disintegration process of the EU is beginning,” he contends.
This weekend will see elections in Spain—which Zulauf notes hasn’t had a government in two years—that could produce a coalition of socialist and antiestablishment parties. Brexit contagion could result in similar referendums on the Continent, with the Netherlands probably coming first, he adds.
In France, Marine Le Pen, head of the right-wing National Front party, called for the same vote there. Populist parties in Denmark, Sweden, and Italy also favor similar referendums. Indeed, the U.K.’s vote to leave the EU could lead to the breakup of the U.K. itself. A second referendum, on Scottish independence, could follow, while Sinn Fein is calling for a vote on the reunification of Ireland, leaving mainly “Little England” (along with “littler” Wales).
All of which suggests “political chaos and turmoil for several years,” Zulauf continues. The divorce of the U.K. from the EU will take at least two years. British Prime Minister David Cameron announced his intention to resign after the Brexit vote, leaving the task to his successor, who won’t be known until the Conservative Party picks a new leader at its convention next fall. And there’s the small matter of the U.S. elections in November.
But this is all much more negative for Europe than it is for Britain, writes Christopher Wood of CLSA in his Greed & Fear newsletter. The political tremors across the Continent will be much more destabilizing for countries in the euro zone. (The U.K., of course, retained the pound.)
“Greed & fear continues to believe the real risk to a euro-zone breakup remains Italy. Anyone who doubts this should understand that the Italian economy has growth less than the Japanese economy since the establishment of the euro. Thus, Italy’s real gross domestic product has risen only 5.4% since 1999, while Japan’s real GDP is up 14% over the same period,” Wood writes.
In the short term, Zulauf sees a summer of high volatility, which will put downward pressure on risk assets, such as equities, and on the yields of prime sovereign bonds.
Stocks should make an “important low this summer”—at least as low as the intraday troughs seen on Friday and most likely somewhat lower than that. At that point, Zulauf adds, he’d cover his short positions (as he previously described in January’s Roundtable).
From there, he’d look for a medium-term recovery in stocks into late 2016 or the spring of 2017. “For almost all national equity indices around the world, this recovery attempt is the transition from the first mini-bear to the next bear-market down leg to lower lows below this year’s lows, perhaps in 2018.”
For the Standard & Poor’s 500 index, the Feb. 11 low was 1810.10, some 11% below Friday’s close of 2037.41. That came after a oneday
fall of 3.6%—the biggest drop since last Aug. 24, during China’s stock market slide after its sudden currency decline. Friday’s losses also wiped out 2016’s gains, such as they were. Still, there would be a lot more downside in Zulauf’s scenario.
Yet the raw numbers on Friday’s S&P decline don’t fully describe the global equity carnage. Financials got clobbered, with banks suffering drops ranging from 4% for Wells Fargo (ticker: WFC) to more than 10% for Morgan Stanley (MS). Asset managers, such as BlackRock (BLK), also took it on the chin, sliding 7%. (For more on the banks, see Streetwise.) And not surprisingly, European stocks also took a shellacking, with the Stoxx Euro 600 off 7% on Friday. (See European Trader.)
Global equity markets surrendered some $2 trillion in market value on Friday, measured in dollars, relates Howard Silverblatt, S&P’s master of all manner of market data. That put stocks worldwide down almost $1.5 trillion year to date.
The FTSE 100 Index seemed to have gotten off easily, falling only about 3% after the Brexit vote. But that was in British pounds, which collapsed utterly as the first ballot counts showed the vote tipping toward Leave. More relevant to dollar-based investors, the iShares MSCI United Kingdom exchangetraded fund (EWU) plunged 12% in the week’s final trading session.
After ticking to a high just over $1.50, sterling slid as low as $1.3238 in the wee hours of Friday morning—a stunning 11.9% collapse. The pound recovered somewhat, but still ended down 9%, more than twice its plunge on Black Wednesday in 1992, when it was forced out of the European Exchange Rate Mechanism, the precursor to the euro.
The pound could slide further. John Vail, chief global strategist at Nikko Asset Management, has a year-end target of $1.27 for the currency. Britain still has a substantial current-account deficit (some 7% of GDP), which means it must attract foreign capital to cover the gap. That hasn’t been a problem previously, in part because of the U.K.’s status as a commercial, financial, and cultural center, plus its membership in the EU. But the period of uncertainty ahead isn’t apt to be attractive to global capital.
Similarly, Zulauf also looks for the euro to fall, given his dire expectations for the dissolution of the EU, which similarly should deter capital inflows, while the dollar gains. That’s what happened on Friday, with the euro slipping 2.4%, to $1.1117. But while the flight to quality went to greenbacks, it went even more strongly to Japanese yen. The dollar fell 3.7%, to JPY102.20 (right around Vail’s year-end target), after briefly trading under 100.
Currencies were at the nexus of the post-Brexit whirlwind and are likely to continue to be. The plunge in the pound isn’t an unalloyed disaster for the U.K., as it will increase competitiveness, boost exports, and make a trip to London almost affordable for Yanks. In that sense, the currency acts as a shock absorber to allow the real economy to adjust—rather than the other way around, as in a fixed exchange-rate system such as the euro zone.
But whether weaker sterling can offset Brexit’s negatives for the U.K. is uncertain
House prices have an outsize impact on the British economy, owing to the wealth effect’s influence on homeowners’ spending, both positively and negatively. The FTSE 350 Real Estate index was down 15% on Friday in the post-Brexit selloff.
Exchange rates also have become the main transmission mechanism of monetary policy. Interest rates are near zero or below in many cases, and evidence of the effectiveness of negative rates is mixed, at best.
The European Central Bank and the Bank of Japan also are engaged in quantitative easing, the purchase of securities to pump up the money supply and credit, which could be expanded further if need be. The BOJ could ease further, but with Japanese interest rates already in negative territory all the way out to 10 years, the main aim would be to lower the yen, whose strength is squeezing exporters’ earnings. Think of Lexus autos having to compete with BMWs and Jaguars that are benefiting from a weak euro and pound.
For the Federal Reserve, the Brexit vote has all but eliminated any chance of an interest-rate boost this summer or fall, and probably for all of 2016. Indeed, federal-funds futures show a greater probability of a rate cut than an increase at the July, September, and November meetings of the Federal Open Market Committee, according to Bloomberg’s analysis. Only by December do the futures show a marginally higher probability of a hike (15%) than a reduction (11%). Which means the U.S. central bank is most likely on hold for the rest of the year.
To CLSA’s Wood, Brexit provides all Group of Seven central banks with the excuse to accelerate unconventional monetary policies, such as fiscal stimulus in the form of infrastructure spending paid for by central banks’ bond purchases. He suggests looking for stocks that should benefit from ramped-up infrastructure spending, some of which were listed in this space last week.
Whatever central banks do or don’t do, global markets face a prolonged stretch of political and economic uncertainty, which will tend to reinforce each other. U.S. stocks already were confronting a problematic mix of flat-to-lower profits and high valuations before Brexit. Vail thinks that there could be another 5% to 7% decline in the near term for American equities, while cash and bonds will likely fare better.
Equity investors therefore shouldn’t ask for whom the bell tolls. It tolls for them.
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