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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.

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