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Union Jack-Knifed

That thing that wasn’t supposed to happen has happened. A majority of voters in the UK voted in favor of leaving the European Union. It was an historic decision, the full implications of which are unknown and won’t be known for years.

 

The first implication, however, is that it has created a heightened sense of uncertainty that has reverberated in capital markets around the globe.

As you know, we have been decidedly underweight to the stock markets outside of the U.S. and have maintained a position in gold which have helped; however, no market or asset class outside of gold was spared in the aftermath of this historic vote. Although the U.S. market was down less than half of what the European markets lost, the U.S. stock market was still off sharply on Friday. Europe is a mess, but the U.S. should regain most of these losses for reasons I’ll discuss later in this note.

The Status Quo Goes Up in Smoke

The “Leave” vote will be particularly disruptive because it will blow up the status quo and usher in a heightened sense of uncertainty. The vote will also slow down the British economy and it is now forecasted to enter into a mild recession later this year as its international trade slows as it adjusts to its new reality.

The gist of the matter is that the vote wasn’t just about the UK.  It was about the standing of the European Union, which is now looking more wobbly than it was a short time ago when it was presumed by the financial markets that the “Remain” camp would prevail. Milton Friedman, the Nobel award winning economist for the University of Chicago, in one of his last published articles before his death argued against the long-term prospects of the EU and its currency-pegged Euro. Milton, right again.

The European Union was far from a perfect union in front of the vote, but now that one member has voted to walk away because it didn’t like the terms of its membership, there is added political, social, economic, and financial risk for a region that needs less of all of those risks.

It is hard to say what the Brexit vote means specifically for the United States.   One thing we can say with certainty is that the spillover effect won’t be zero.  The fallout in the stock market after the Brexit vote makes that abundantly clear. However, when you factor in that the U.S. remains a strong ally and trade partner with Britain coupled with the fact that the UK will now need to renegotiate all the interconnections and trade deals with its former EU counterparts, a case can be made that the US will see an uptick to its trade with the UK and the EU and the overall effect on the U.S. will be particularly muted.

There is a lot to think about now — a lot more anyway than there would have been had the “Remain” camp won.  Admittedly, I’m still thinking through it all, but today I wanted to offer some initial impressions pertaining to the decision by the majority of UK voters to leave the European Union.

Making a List; Checking it Twice

1. Democracy worked

2. The sharp losses following the vote will create further disillusionment for individual investors when it comes to investing in the stock market

3. There can be a very high price to pay for complacency — and the capital markets were far too complacent in the week leading up to the vote in the thought that the “Remain” camp would win

4. There are understandable concerns that the UK vote will encourage a push for similar referendums in other EU countries.  If the fallout in financial markets persists, EU members elsewhere may rethink that effort so as not to risk further financial pain.

5. Connections will likely be made that the decision by the UK to leave the European Union underscores a wave of discontent about the status quo that could also surface in the November election in the U.S.

6. A pickup in earnings growth in the second half of the year is going to be called into question with the spike in the dollar, the drop in oil prices, the volatility of the financial markets, and the increased uncertainty, which seem likely to impede business investment

7. The Federal Reserve won’t be raising the fed funds rate in July, because it will need more time to determine what economic ramifications there are now in the wake of the Brexit vote and financial market volatility.  Moreover, dollar strength acts as an effective tightening of policy since it will crimp export growth and help hold down inflation. We are sticking with our January 1, 2016 prediction that the Fed will not raise rates again this year, a position that looked outside the box in January has now become the common positioning of economists and traders.

8. The Brexit vote makes the Fed’s decision to hold off on raising rates at the June meeting look better than it did only a week ago… BUT… at the same time it exposes just how little room the Fed has to maneuver with interest rates in the event there is some significant financial market and/or economic dislocation

9. Portfolio diversification, with a mix that includes bonds and precious metals, has served its purpose as the exposure to precious metals has helped cushion some of the blow from the stock market selloff

10. There is more downside risk for global economic activity with the winning “Leave” vote than there would have been upside potential in a winning “Remain” vote

What It All Means

As noted above, it’s impossible to know what it all means at this juncture.  The UK’s divorce from the European Union will be a multi-year happening.

In due time capital markets will adjust to this new reality, yet the short term could feature a lot more volatility since this is something so new — and, frankly, surprising — that central bankers, government leaders, and professional money managers still need time to figure out.

The only clear deduction today is that it has unleashed a lot of new uncertainty for all parties.

The recognized fact today that the “Leave” camp won simply adds to those fundamental challenges, which drive our belief that stock market return expectations this year should be held in check.

As for the British voters who voted to “Leave”; be very careful what you ask for.