As you probably already know, last Thursday the UK voted to leave the European Union (EU). The Brexit vote caught the market by surprise, as most believed that the UK would vote to remain in the EU. Since then, risk assets have sold off and there has been a flight to quality, with most fixed income instruments rising in value. British Prime Minister David Cameron will resign (most likely within 3 months) and new leadership will be elected to help navigate the UK’s exit from the EU. Ironically, it was David Cameron who suggested during his election campaign that if he were elected he would hold a vote on whether the UK should remain, or exit the EU. Ultimately, it cost him his job.
This event is unprecedented, as no country has ever left the EU, which represents a political and economic union among 28 member states primarily in Europe. Of these 28 countries, 19 have adopted the Euro as their common currency. The other 9 members of the EU (including the UK) continue to use their own national currencies.
There is always a catalyst for market declines. The key is determining if the catalyst has the ability to drive the economy into recession, or whether it simply causes the market to correct.
The consequences of this decision are difficult to assess at this point in the process. Trade agreements between the UK and other countries in the EU will have to be renegotiated, and it could take years to ultimately determine whether the UK’s economy is more open and prosperous or poorer and more isolated after Brexit. Additionally, the outcome of this referendum could trigger other countries in the EU to decide to hold their own referendums on membership. In light of this uncertainty, equity markets have sold off around the globe, and we expect to continue to see elevated volatility going forward. It’s worth noting political instability has been a staple characteristic of emerging markets for decades, but with the UK’s vote to exit and increasingly populist regimes around the globe, we are beginning to see more developed markets rocked by political uncertainty as well.
We feel in the coming weeks markets will stabilize after digesting the initial shock of UK’s vote to leave the EU. Given that the UK is going to continue to function as a member of the EU until they are no longer a member (which will take years), we expect the U.S. economy to continue to grow slowly and avoid a recession. There is no doubt that risks are now elevated for a recession, but Central Banks around the world have already made it clear that they will stand by to provide any needed liquidity to markets in the coming days and weeks. When Fed Chairman Janet Yellen spoke two weeks ago after the Fed’s decision to not increase interest rates, she cited the Brexit as a potential risk. It appears the Fed will remain on hold with any near-term interest rate hikes (which is accommodative for equities), and could entertain a neutral policy through early 2017. Although banks have traded down significantly after the Brexit with no interest rate hikes in sight, there is no doubt that the financial system is in much better shape today than preceding the crisis of 2008. In addition, Congress could begin talks of a fiscal stimulus package if the economy were to slow significantly, which would likely offer further support to the market. Corporate tax reform could also act as a positive catalyst for U.S. markets, but we are not likely to see any proposed legislation until 2017 at the earliest.
In closing, we are experiencing plenty of uncertainty in the markets but remain steadfast in our investment process. We will continue to monitor this daily and will act if we feel changes are warranted.
Investment advice offered through Stratos Wealth Partners, Ltd., a registered investment advisor.