July 1, 2016
If you weren’t familiar with the term “Brexit,” you are now.
That’s the name adopted by media and market analysts to describe the scenario of Britain leaving the European Union, a possibility considered highly unlikely right up until the moment it actually happened.
For two days in June, the Brexit changed everything. Fueled by media coverage seemingly intent on inspiring fear, stock markets tanked. Uncertainty soared. Bond yields fell to historic lows. Panic, fortunately, did not take hold. In the final few days of the month stock prices rebounded sharply, investors seemed to regain their composure, and the major equity benchmarks bounced quickly enough to ultimately finish higher than they began.
We saw an especially wide disparity in sector performance in June. Six of the 10 sectors in the S&P 500 were positive. Investors seeking safety and yield bid up prices on already expensive Telecoms (+9.34%) and Utilities (+7.81%), the two best-performing sectors year-to-date. Financials (-3.21%) and Technology (-2.76%) were among those categories most adversely affected by spiking volatility and a plunge in interest rates.
|Index||May 2016||YTD 2016|
June 23 proved to be the most significant date on last month’s calendar. That’s the day voters in the United Kingdom (comprised of England, Wales, Scotland, and Northern Ireland) took part in a referendum to determine whether to remain in, or leave, the European Union. The speculation, however, began weeks in advance.
The S&P 500 fell five consecutive days in mid June based on fear of a potential Brexit and the consequences it could have on the global economy. After June 15, global equities rallied significantly leading up to the referendum. Both markets and British oddsmakers priced in a near certainty that a Brexit would not happen, which was especially interesting since polls suggested the “Remain” vs “Leave” support among UK voters was nearly even.
When Americans awoke on Friday June 24, everything changed.
British Prime Minister David Cameron, who lobbied against a Brexit, immediately announced his intention to resign. The UK’s currency, the pound sterling, fell precipitously to its lowest point in 30 years vs the US dollar. Many 10-year government bond yields in Europe fell to record lows, including the German bund, already trading with a negative yield. By month’s end, the yield on the 10-year US Treasury was threatening its all-time low of 1.38% set in July 2012.
S&P downgraded the UK’s sovereign debt from AAA to AA, explaining that the country’s departure from the EU “will lead to a less predictable, (less) stable, and (less) effective policy framework.”
That’s a lot of information to digest in a short period of time and global equity markets responded by shedding nearly $2 trillion of value in the first trading day following the Brexit vote. The Dow Jones Industrial Average fell 610 points (3.4%) on June 24, then another 260 points the next trading day to its lowest level since March.
At this point, we should explain that the Brexit vote does not result in an immediate departure from the European Union. The UK could take as long as two years to negotiate the terms of its exit, but since no country has ever willingly left the EU, we simply don’t know the long-term consequences. The void in political leadership created by Cameron’s pending resignation adds another layer of uncertainty.
The EU was created in 1957 (known then as the European Economic Community) to improve free trade and peaceful travel among its 28 members, but is not equivalent to what’s known as the “Eurozone,” which consists of 19 countries sharing a common currency (the euro). The United Kingdom joined the EU in 1973, but always maintained its own currency and has never been a member of the Eurozone.
Together, the countries of the European Union represent the only economy in the world larger than the United States. EU countries enjoy a place of prominence in the global economy and a stronger political voice than most would have individually. Why then leave? Concerns over immigration, especially in the wake of the Syrian refugee crisis, led Brexit supporters to conclude that the power to legislate policies independent of Europe was more important than the economic benefits provided by the EU.
It will likely take years before we understand the full impact of Brexit. We don’t know whether the US stock market, after the strong rally to end the month, indicates investors have moved beyond their concerns or if they are still trying to make up their minds. We don’t even know with 100% certainty that Britain will actually leave the EU because the referendum results are “advisory” but still require formal approval by Parliament to become effective.
Most of the other economic news in June was buried by the avalanche of Brexit attention. Unemployment continued its downward trend, a definite positive for the US economy. Initial jobless claims have now been below 300,000 for 69 consecutive weeks, the longest such streak since 1973.
On June 29, the Federal Reserve announced the results of its annual stress tests imposed on the largest American banks designed to assess whether each could continue to lend money in the event of a deep recession. 31 of the 33 banks passed “inspection,” which means they are free to boost dividends, stock buybacks, and pursue other capital spending strategies. The only two banks that did not pass the stress tests were the US affiliates of European companies Deutsche Bank (Germany) and Banco Santander (Spain).
The Fed’s June meeting came and went without any interest rate hikes, as expected. Strong manufacturing data released on June 30 also contributed to the late-month rally in equities.