photo is from: www.cityindex.co.uk
By Brian Dolan, Head Market Strategist, DriveWealth
Markets Stunned by Brexit Vote
Global markets are being shaken by the surprise UK vote to ‘Brexit’ the European Union. I and most other market analysts got our predictions completely wrong, as did financial markets, which saw risk assets (stocks/commodities/risky-FX) all rally sharply in the 48 hours before the vote. We all relied on polls and bookmakers’ odds and clearly underestimated the role of emotions in the referendum. That will be the major takeaway to remember going forward.
Today’s sell-off is largely in line with forecasts of what would happen if Britain did indeed Brexit: risk assets would be sold, sending global share prices lower, while safe haven assets (government bonds, US dollar, Japanese yen and gold) would be bought—a classic ‘risk-off’ reaction. The reaction so far has only been to reverse the risk-on rally that immediately preceded the vote, as seen in the EURO Stoxx 50 chart shown below. The decline in the British pound (GBP) has obviously exceeded the previous rally (not shown). This suggests to me that markets have yet to fully react to the larger new reality of a UK without Europe.
Source: Bloomberg; DriveWealth
The days ahead will be absolutely critical to understanding the near-term direction of stocks and other risk markets over the next few months. We have a weekend in front of us, giving market participants a chance to digest what has happened and formulate new strategies. It would be an understatement to say that many in the markets have no idea what will happen next. We’ve never been here before.
How Might this All Play Out?
To give investors some strategies to consider, I’ll suggest a few scenarios and price levels to better interpret market moves yet to come. In no particular order:
- 1. Much ado about nothing: Markets return on Monday and shrug off Brexit, deciding that the two year timeframe to negotiate terms of Brexit with the EU means that the current moves are premature and represent deep discounts to otherwise attractive assets. Risk markets rebound sharply and are quickly back testing the gaps created by the Brexit result. The key price point will be this week’s highs, and whether a break above them can be sustained. A failure, or near-failure, to close the gap suggests the tide would turn negative quickly.
- 2. We’re All Gonna Die: The shock of Brexit and uncertainty surrounding the EU’s future compounds fears of global slowing, intensifying risk aversion and sending global stocks and risk assets directly lower/ JPY, USD, XAU, and US Treasuries higher. Spain is holding a general election on Sunday and the results will be interpreted for what they mean about EU solidarity post-Brexit. A loss by the pro-EU incumbent government would likely spark intense negativity on Europe and the euro, while a win would suggest that Britain is the anomalyàrisk-positive. (The UK has had a fraught relationship with the Continent since the earliest days of the European project.) Declines below the Feb. lows in the Euro Stoxx 50 Index would suggest further downside. For the S&P 500, weakness below the 2040-50 level (23.6% retracement of the rally since Feb. lows and bottom of the daily Ichimoku cloud (blue zone in the chart below)) would suggest further weakness ahead. A drop below the 2025 neckline would suggest a double/triple top has formed and target declines to the 1930 area, which coincides with the 61.8% retracement of the rally since Feb. The 2000 level offers as psychological round-number support as well as the 38.2% retracement (2001) of the move from the Feb. lows. Strength above 2060-80 area (top of cloud (orange)/Kijun (yellow)/Tenkan (purple) might suggest the sky is clearing.
Source: Bloomberg; DriveWealth
- 3. Investors Begin to Differentiate between Markets: At some point in the weeks ahead, markets are likely to begin treating markets differently, focusing on Europe and the UK as separate concerns from the rest of the world. Brexit harms the UK economic outlook most directly and primarily represents political risk for the EU. The economic impact on the rest of the world should be minimal in the long run, and short-term fallout should dissipate relatively quickly. The risk here is that investors panic and market fallout turns into economic fallout. I would focus on key safe haven currencies, such as the USD, JPY and CHF, and if they begin to decline against other currencies (except EUR and GBP), it would suggest risk aversion is abating and the crisis is ebbing.
I would not be surprised to see a combination of all three scenarios play out in the weeks ahead as we move from a short-term reaction to a longer-term adjustment. I would utilize abrupt declines in US and Japanese/Asian stock markets, in particular, to enter into opportunistic long positions. I would also suggest patience and avoid chasing any short-term rebounds. Given the global outlook, now burdened by Brexit, it seems highly unlikely that risk assets are about to explode to the upside. At some point ahead, I would also be inclined to re-engage with continental European stocks.
Lastly, it is also possible that Britons will wake up over the weekend, or in the weeks ahead, and ask “What have we done?” While mostly unlikely given the intensity of the Leave campaigners, the dawning of the real-world impact of Brexit on average Britons’ lives may lead to a massive re-think.
The referendum is non-binding on the UK government, and a reversal in public sentiment could lead the British government to postpone exit negotiations. Investors will need to stay on top of such British developments over the summer and beyond. A popular theory in the Remain camp is that if Brexit won, Britons would spend the next five years trying to exit the EU and the next five years trying to get back in. Perhaps it transpires in a shorter timeframe.