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Friday, June 24, 2016

A Post-Brexit World

Financial Review

A Post-Brexit World

DOW – 610 = 17,400
SPX – 75 = 2037
NAS – 202 = 4707
10 Y – .17 = 1.57%
OIL – 2.49 = 47.62
GOLD + 59.30 = 1316.60

Britain has voted to leave the European Union, forcing the resignation of Prime Minister David Cameron. Global financial markets plunged. The pound fell more than 10 percent against the dollar at one point to touch levels last seen in 1985, on fears the decision could hit investment in the world’s fifth-largest economy, threaten London’s role as a global financial capital and usher in months of political uncertainty. The pound finished down almost 8%. The euro slid 3 percent. Those are huge moves for currencies.

World stocks saw more than $2 trillion wiped off their value, with indices across Europe heading for their sharpest one-day drops ever; the Nikkei 225 fell nearly 8 percent and the German DAX traded 6.8 percent lower; the CAC 40 in France down 8 percent; Italy down 11.5 percent. By contrast the FTSE 100 in Britain was down 3.1 percent.

Britain’s big banks took a $100 billion battering, with Lloyds, Barclays and RBS plunging as much as 30 percent at one point. Goldman Sachs, JPMorgan, and BofA closed down around 7%, while Citigroup lost almost 10%. Ten-year U.S. Treasury note yields hit a low of 1.406 percent, its lowest since July 26, 2012, before bonds started paring gains. The 2-year yield hit a low of 0.499 percent, its lowest level since April 17, 2015. The German 10-year bund yield fell back into negative territory. Gold hit its highest in more than 2 years around $1331 an ounce.

Last night, as the results were first coming out, waves of selling in stock futures sent S&P 500 indexes on the Chicago Mercantile Exchange into a limit-down trading curb. The rules were triggered when S&P 500 contracts declined 5 percent from the previous day’s close. E-mini futures plunged 5.07 percent to 1,999. After the first strong reactions, prices have started to shake out and settle.

The U.S. Federal Reserve, already undecided on when next to raise interest rates, now has one more reason to wait. Not that the Fed needed another reason. Weaker-than-expected growth in U.S. jobs in recent months had already forced U.S. central bankers to put off a rate hike at their meeting last week. But while data due early next month on June U.S. payrolls growth could help clear up doubts about the strength of the labor market, the political and economic consequences of Britain’s exit from the EU will take months or years to unfold. Interest rate futures markets rallied so hard that they have erased any probability of an increase in the Fed’s benchmark overnight lending rate for both this year and next. In fact, they are pricing a possibility that the federal funds target rate may be lower in September or December.

The Bank of England said it would take all necessary steps to shield Britain’s economy from financial shock. The economy was already slowing as the referendum approached and BoE Governor Mark Carney said in May that it could suffer a technical recession — a contraction in two consecutive quarters. Carney said earlier this year that a Brexit vote would also test the “kindness of strangers” who fund the country’s big current account deficit. The BoE held two extra liquidity auctions ahead of the referendum and is due to hold another one on Tuesday in order to help banks.

As time passes, and the financial markets calm down after the voting, Britain will still be dealing with the economic fallout of this decision. It hardly seems a good time for capital investment in the UK. Things like business confidence, market swings and central bank responses shape the economy in the short and medium run, but over time it is bigger forces that prevail. And this is where there is the most uncertainty of all. The UK could break up over this decision. Nicola Sturgeon, Scotland’s first minister, said that a new referendum on independence in Scotland was “highly likely” now that Britain has voted to leave the EU. Sinn Fein has asked for a vote in Northern Ireland to join Ireland.

There are now many questioning whether the EU will fall apart. And the Eurozone has already been experiencing stagnation, with extreme weakness – actually a depression in Greece, and something very near depression in Spain and Portugal and Italy. What holds these countries to the Euro union? Promises of more austerity and privatization? Even the Dutch are talking about leaving. It seems clear that the European project – the whole effort to promote peace and growing political union through economic integration – is in deep, deep trouble. Brexit is probably just the beginning.

Nothing will happen fast. Prime Minister David Cameron said he would leave office by October. Cameron led the “Remain” campaign to defeat. Cameron has been premier for six years and called the referendum three years ago, in a bid to head off pressure from domestic eurosceptics.

The EU was poorly designed, having put the monetary cart ahead of the political horse. Lacking a well-articulated federal structure, power has devolved to bureaucrats and German bankers. Considering that Europe responded poorly to the financial crisis, in retrospect Cameron’s referendum suffered from spectacularly bad timing. He asked British voters to invest in a vehicle which is broken down beside the road.

The UK exit will take at least two years, maybe longer, under Article 50, which is the exit clause. Cameron will likely try to negotiate some sort of transition but another option is to just leave immediately. While holding-off on invoking the Article 50 clause to deprive the EU of leverage on timing. Any unilateral steps would seriously raise tensions with the EU. Brussels is looking at options to retaliate, including suspending the privileges enjoyed by British companies under the single market; making an example for other would-be insurgents. Meanwhile, Germany will likely have a harsh response.

If the Brits thought they could have a nice friendly divorce, and live like Switzerland or Norway; don’t count on it. Remember when Greece’s finance minister Varoufakis tried to negotiate terms with the EU? This is likely to be a brass knuckles brawl. Even before this, UK negotiators in Europe were almost universally despised by their European counterparts. I suspect lots of old scores will be settled.

Meanwhile, London is a financial hub for the Eurozone, thanks in part to passport agreements that allow financial services to be sold across Europe from the UK. Anyone actually buying and selling securities—the banks’ trading desks—are definitely affected and many may need to move to the Continent. For the time it takes to negotiate and exit, the UK and its financial sector remains subject to all European rules and agreements. That is one thing that can be said for sure. The other is that this sector faces great upheaval and high costs as it works out where and how it can continue to pursue its businesses.

The British government is likely to lose its AAA rating, which also means higher funding costs for its banks, since their borrowing rates are at a premium to the local currency risk-free rate. A recession is almost certain, since the UK exports services and imports goods and many of its imports don’t have ready substitutes, while the US and European banks will be doing everything they can to poach both British bankers and their clients, denting the UK balance of trade even more.

The sterling crisis and the less dramatic fall in the euro are likely to leave some UK and Eurozone financial institutions with large losses on net dollar and other foreign currency positions. While the British banks, given the magnitude of the sterling plunge, are the obvious focus of concern, many Eurobanks are undercapitalized. Worse, the Eurozone in theory will use a bank bail-in if any institution becomes impaired. This is a prescription for bank runs.

And with the US growth sputtering, our economy will feel the effects. Roughly 25% of S&P earnings come from Europe. The strong dollar will weigh on exporters. Europe is a major export market for China, and China may allow the renminbi to slide. Earlier this year, a devaluation of the renminbi was also seen as having the potential to trigger major upheaval. And throw in one more point, The Transatlantic Trade and Investment Partnership is probably dead.

This is the first day off the post-Brexit vote, but just the beginning of the Brexit problem. There will probably be a great deal of volatility in the coming weeks and months. I wish I could tell you one side or the other was right or wrong, but this has never happened before; this is new territory and we don’t know what happens next, good or bad. Keep calm and carry on.

We have a couple of economic reports here in the US. Consumer sentiment weakened in June; the University of Michigan index dropped in June to 93.5 from 94.7 in May. That was also well below its level a year ago, when it touched 96.1. Consumers were more bearish about expectations for the economy. That gauge fell to 82.4 from 84.9. Views of current conditions perked up, rising to 110.8 from 109.9.

U.S.-made durable goods orders fell a seasonally adjusted 2.2% last month after a revised 3.3% gain in April. Core capital orders sank 0.7% in May, a sign that companies are still not investing as much as they normally do when the economy is growing. This key reading has been down five of the last seven months.

Just a week before about $2 billion in bond payments come due, Puerto Rico’s governor has reiterated that the commonwealth will default on its general obligations even if he halted services on the island. Alejandro Garcia Padilla is currently in Washington lobbying for Congressional approval of a bill that would set up a framework for the commonwealth to restructure its $70 billion in debt.

Stocks Go So Low as U.K. Sets To Depart EU

Charles Schwab: On the Market
Posted: 6/24/2016 4:15 PM ET

Stocks Go So Low as U.K. Sets To Depart EU

U.S. stocks erased 2016's gains, joining a global rout for equities and the British pound traded to lows not seen in more than 30 years in the wake of the U.K. voting to leave the European Union. Financial and Technology stocks were the largest decliners, while the aftermath of the Brexit vote made it difficult to assess the possible market impact of lower-than-expected reads on domestic durable goods orders and consumer sentiment. Treasuries, gold and the U.S. dollar rallied and crude oil prices experienced a large, sharp drop.

The Dow Jones Industrial Average (DJIA) tumbled 611 points (3.4%) to 17,400, the S&P 500 Index fell 76 points (3.6%) to 2,037, and the Nasdaq Composite plummeted 202 points (4.1%) to 4,708. In heavy volume, 2.5 billion shares were traded on the NYSE and 3.8 billion shares changed hands on the Nasdaq. WTI crude oil dropped $2.47 to $47.64 per barrel and wholesale gasoline was $0.07 lower at $1.54 per gallon, while the Bloomberg gold spot price rallied $62.56 to $1,319.41 per ounce. Elsewhere, the Dollar Index—a comparison of the U.S. dollar to six major world currencies—jumped 2.1% to 95.50. Markets were lower for the week, as the DJIA and the S&P 500 Index decreased 1.6% and the Nasdaq Composite fell 1.9%.

Xerox Corp. (XRX $9) announced Jeff Jacobson will be the company's new Chief Executive Officer once the organization divides into two separate publicly-traded companies. The document solutions company said the split remains on track for the end of the year. Earlier in the month, XRX named Ashok Vemuri as the CEO of the smaller of the two companies, which will be named Conduent. XRX lost ground.

Sonic Corp. (SONC $28) posted fiscal 3Q EPS ex-items of $0.43, a penny above the FactSet estimate, as revenues rose 18.0% y/y to $165.2 million, compared to the projected $164.7 million. Same-store sales rose 2.0% year-over-year, below analysts' view of a 2.4% y/y increase. The drive-in burger chain said it now expects same-store sales for the year to increase 2%-4%, below previous projections of 6%, but it maintained its earnings growth forecast of 20%-25%. Shares closed sharply lower.

Durable goods orders lower than forecasts, consumer sentiment ticks lower

May preliminary durable goods orders (chart) fell 2.2% month-over-month (m/m), compared to Bloomberg's estimate of a 0.8% decline and April's upwardly revised 3.3% gain. Ex-transportation, orders declined 0.3% m/m, versus the 0.1% forecasted increase, and April's unrevised 0.5% gain. Orders for non-defense capital goods excluding aircraft, considered a proxy for business spending, declined 0.7%, compared to projections of a 0.4% increase, and following the upwardly revised 0.4% dip in the month prior.

The final June University of Michigan Consumer Sentiment Index (chart) was revised to 93.5 from the preliminary level of 94.3, and compared to expectations of a slight dip to 94.1, as the expectations and current conditions components of the report were both revised downward. The index was also lower compared to May's level of 94.7, where it sat at the highest level since June 2015. The 1-year inflation outlook rose to 2.6%, from May's 2.8% rate. The 5-10 year inflation forecast also moved higher to 2.6% from May's 2.3% level.

Treasuries were decidedly higher, with the yields on the 2-year note and the 30-year bond falling 13 basis points (bps) to 0.64% and 2.43%, respectively, while the yield on the 10-year note lost 17 bps to 1.57%. For our latest analysis on the bond markets see the article by Schwab's Chief Fixed Income Strategist, Kathy Jones, titled Global Bonds: A World Without Yield, at, while you can also follow Kathy on Twitter: @kathyjones.

U.K. vote shocks world, markets in Europe and Asia plunge

European equities finished deep in the red, after the U.K.'s stunning vote to leave the European Union (EU)—known as a Brexit—after four decades sent shockwaves through the global markets—a complete about-face from yesterday's optimism that the U.K. would vote to remain in the EU. The final vote tally was 52% for an exit, 48% against—a close election, as many had expected, however not the outcome that investors had banked on yesterday. In the wake of the results, Prime Minister David Cameron stepped down, saying, "The British people have made a very clear decision to take a different path, and as such I think the country requires fresh leadership." Cameron said he will remain at 10 Downing Street for the next three months, with a new Conservative leader to be appointed by October.

Financials were in the eye of the storm, with the European bank index falling the most ever, while the British pound tumbled to touch a level not seen in over 30 years. Amidst the turmoil, and following Cameron's announcement, Bank of England (BoE) Governor Carney issued an early-morning statement, saying the BoE will pledge 250 billion pounds ($345 billion) to the financial system in what he called, "a period of uncertainty and adjustment." The BoE had previously supplemented funding auctions this month for lenders. Meanwhile, central banks across the globe have shifted to crisis-management mode, as the Swiss National Bank intervened in order to prevent a surge in the franc, the European Central Bank (ECB) said it stands ready to provide liquidity in euros or other currencies, and Bank of Japan Governor Kuroda said the central bank will do its best to provide cash.

Schwab's Chief Global Investment Strategist, Jeffrey Kleintop, CFA, offers in depth analysis of the vote in his timely article After the Brexit Vote: What Lies Ahead for Markets?, at, and be sure to follow Jeff on Twitter: @jeffreykleintop. Economic news in the region took a backseat to the developments surrounding the Brexit, with France's final GDP data unrevised from previous reports, Italy's retail sales rising less than expectations and Germany's Ifo Business Climate Index was slightly better than forecasts. The euro pared solid early losses, but did finish firmly lower versus the U.S. dollar, while bond yields in the region were negative.

Stocks in Asia finished sharply lower, being the first to react to the decision by the U.K. to quit the European Union, with Japanese equities posting their largest decline in more than 15 years, and triggering a circuit-breaker on Nikkei futures. Japan's Nikkei 225 Index tumbled 7.9%, with the yen surging against its foreign counterparts. Stocks in mainland China lost ground, but were somewhat insulated from the fray after policymakers in the nation championed their management of corporate debt, saying that defaults would not pose a systemic threat as long as the economy continues to be within an acceptable range. Meanwhile, securities trading in Hong Kong snapped a five-session winning streak, while equities in Australia, India and South Korea were sharply lower.

The U.K. has left the building

Stocks finished lower for the week as gains were wiped out early Friday morning on the heels of the U.K.'s highly anticipated vote, where it decided it will exit the European Union. As noted in the recent Schwab Market Perspective: British Shock—What's Next, Britain shocked the financial community and global equity markets plunged as traders searched for perceived safety in the midst of uncertainty. Since the end of the financial-crisis induced global recession in 2009, a series of shocks have helped to keep growth, inflation and stock market performance subdued. The shocks that have taken place in Japan, United States, and Europe may offer us some insight as to the potential duration of the market impact of Brexit. Read more at

The added uncertainty from the long awaited Brexit vote seemed to disproportionately increase the volatility in the financials sector. Schwab's Director of Market and Sector Analysis, Brad Sorensen, CFA, takes a deeper dive into some of the factors that most influence the performance of this sector in his recent Schwab Sector Views: Financials: Danger or Opportunity?. Brad notes that the financials sector has been under attack by politicians and unloved by investors since the financial crisis, resulting in some very volatile performance. He also hints at the heavy regulatory burden placed on the financials sector over the past several years. But there are some glimmers of hope here as well. Despite the heated political rhetoric being leveled against the financials sector, there does seem to be an increasing realization that the regulations may have gone too far and had unintended consequences. Read more at and follow Schwab on Twitter: @schwabresearch.

Heavy dose of manufacturing data ahead

Next week, the U.S. economic calendar will deliver a look at the health of the manufacturing sector of the economy with the release of the ISM Manufacturing Index, Markit's final Manufacturing PMI for June, the Richmond Fed Manufacturing Index and the Dallas Fed Manufacturing Index. Also, the third and final read for 1Q GDP will be released, with economic output expected to have ticked higher to a 1.0% quarter/quarter annualized rate of expansion, from the 0.8% pace announced in the second release.

Other U.S. reports slated for next week include: Markit's preliminary Composite PMI for June, the Chicago PMI Index, the S&P/Case-Schiller Home Price Index, the Consumer Confidence Index, pending home sales, personal income and spending, construction spending and vehicle sales.

Next week's international reports: Japan—retail sales, industrial production, CPI, vehicle production, housing starts and 2Q Tankan Index. China—manufacturing and non-manufacturing PMIs, industrial profits and the Leading Index. Hong Kong—retail sales and trade data. U.K.—1Q GDP, consumer credit and 1Q business investment. Germany—GfK Consumer Confidence, national and regional CPIs and retail sales. France—1Q GDP, PPI, CPI and consumer spending. Eurozone—consumer confidence and CPI.

Brexit: What Does It Mean for the Bond Market?

Brexit: What Does It Mean for the Bond Market?

Key Points

  • Britain's vote to leave the European Union has pushed down U.S. Treasury yields, as risk-averse investors have flocked to the perceived safety of U.S. government bonds.
  • The Federal Reserve is now less likely to raise U.S. interest rates this year, and could even move for a rate cut.
  • Market turmoil underscores the importance of high-quality bonds as the core of a portfolio.
On Thursday, the British electorate voted to leave the European Union, ending 43 years of participation. It was a surprise. The market had been persuaded by early polls that voters would choose to stay in the EU for economic reasons. But anti-EU sentiment in northern England and elsewhere outside London proved too strong, as voters used the referendum to express their anxiety about the effects of globalization, immigration and regulation on industry. Prime Minister David Cameron has already announced he will step down. Once the prime minister has invoked Article 50 of the Lisbon Treaty, there will be a window of two years to negotiate the exit and Britain’s future relationship with the EU.

So far, here's what we're seeing as markets absorb the news:
  • U.S. Treasury yields are down as risk-averse investors have flocked to the perceived safety of U.S. government bonds. The 10-year yield is close to its 2012 low and the 30-year is back to the 1954 low of 2.37%. The market will probably scale back its expectations of a federal funds rate hike this year, and possibly build in expectations for a rate cut later in the year. I think a rate cut remains a very low probability, but the market will probably discount the possibility.
  • Risk aversion has also driven investors to German bunds and Japanese bonds, which have seen their prices rise. Yields—which move inversely to prices—are well into negative territory stretching out to 10-year maturities. However, peripheral European bond spreads are widening because of concerns that other countries, such as Spain and Portugal, could choose to leave the EU.
  • Credit spreads in the U.S. will probably widen. Based on credit default swap levels, it looks like energy and financials will be the hardest hit. The sharp rise in the U.S. dollar has sent commodity prices lower, while the financial sector has been hit because it is Britain’s largest industry. Some British-based banks may decide to leave the U.K. and set up headquarters inside an EU country. Some of the weakness in the financial sector will probably spread to U.S. financials. Preferred securities are vulnerable to a selloff due to the weakness in financials.
  • We don't believe this will lead to financial crisis similar to the one that followed the Lehman Brothers default in 2008. Banks are well capitalized and central banks are providing ample liquidity. However, it is negative for global growth, which is already very soft. Global trade is growing by less than 3% year over year—that is less than half the historical pace. The leave vote raises impediments to the free flow of goods, services and people, and that is bad for trade. Hence, it could slow the global economy further.

What investors should know

All in all, we're likely to see some volatility ahead. Here are a few things to keep in mind:
  • Situations like this are why it's important to hold high-quality bonds as the core of a portfolio. Unexpected events can happen, and high-quality bonds provide the ballast for a portfolio that allows you to ride out the ups and downs of the stock market.
  • Riskier parts of the bond market, such as high-yield and international bonds, are vulnerable because they are highly correlated with equities. That's why we suggest limiting your exposure to those asset classes.
  • We remain cautious about non-U.S.-dollar denominated bonds. Investors were facing a diminishing risk/reward outlook for their international bond investments even before the Brexit vote, due to factors including negative-interest-rate policies in various countries. This new shock will not improve the situation.

Next Steps

• Follow Kathy Jones on Twitter: @kathyjones