BREXIT FEARS and REALITY

At any point in time there are various items that cause investors angst.  There is a name for this condition, the “Wall of Worry”.  When the market goes up we say it is climbing the Wall of Worry, meaning that despite all the negative possibilities, the market is strong enough to overcome them.  Some of the worries never go away – inflation, deflation, earnings weakness, slowing global growth, etc.  Some of the worries are called external events.  These events, if they occur, could have a negative effect on the economy or the stock market.  Probably the most famous external event was Y2K.  We were rationally fearful that planes would drop from the sky, bank account balances would disappear, and computers would stop working. 

Most external events quietly go away – Greece demolishing civilization, China devaluing their currency, Bernie winning the nomination.  But now we have BREXIT - Britain voting to leave the European Union.  An event that all the experts and polling told us would not happen.  We were told that British citizens would vote to remain in the EU, the market would breathe a sigh of relief, and the world could start worrying about the really big external event - Trump.  Except, the British people refused to follow the script and voted to leave the EU and all hell broke loose.  The stock market immediately nose-dived, currencies went crazy, the price of oil declined because economic activity would now stop, bond yields dropped because no one would ever need to borrow money again, the British Prime Minister resigned, and world order seemed to be hanging in the balance. 

We finally got that negative external event that everyone was worried about.  So far the reaction has been as bad as the worst fears.  Much of the reaction is due to the unexpected nature of the event.  BREXIT was not supposed to happen.  Just Thursday, the markets rallied on the inside knowledge that a “remain” vote was in the bag.  All weekend, pundits and experts lectured us about the devastating effects of the vote for Britain, the EU, and the US.  Other EU members are now clamoring for their own referendums on leaving the EU, Putin is celebrating as are the terrorists, and George Soros is making money betting against continued world order.                              

There is one big problem with all the analysis and the knee-jerk reaction – no one knows what will actually happen in the future because of this vote.  The EU is a group of 28 nations with agreements on trade, immigration, and finance.  It began with six nations and was named the “European Coal and Steel Community” in 1951.  Over the years new countries joined and the original purpose was greatly expanded.  No nation has ever left the EU.  It is possible that Britain’s exit will doom the entire EU.  It is also possible that the EU will change some of its positions and become stronger.  Maybe Britain’s financial industry leadership will be challenged by Germany or the remaining EU nations will not trade with Britain. On the other hand, maybe Britain will expand its trade with India and Australia with whom the EU does not have trade agreements.  The fact is that uncertainty is at a premium now.  Since financial markets hate uncertainty, volatility in stocks, commodities, and currencies will likely continue for weeks or months. 

I do not believe BREXIT is a prelude to a 2008 type market downturn.  The actual effect on our country and markets should not be major.  Our banks are stronger than they were in 2007 and the economy, while not robust, is expanding.  Below is a chart of the Weekly Leading Index, a measure of trends in the economy.  The shaded areas are recessions.  Notice how the index (and the economy) weakened before the start of the last two recessions in 2001 and 2007/2008.  Currently, the index is rising and at its highest level since 2008.

Look for a rebound attempt for the stock market in the next few days followed by some possible base building.  I think this is a time when patience will be rewarded.