By now, you’ve probably become quite familiar with the term “Brexit”. This is the shorthand way of referring to the UK leaving the economic and political partnership known as the European Union. While the vote that took place on Thursday, June 23, 2016, will have many far reaching consequences, the effect on the financial markets is definitely worth strong consideration on the part of investors. Here, we explain what we know now, our observations and what this could potentially mean for you moving forward. What we know:The UK joined the EU on January 1, 1973. Now, 43 years later, the UK electorate has voted to leave the EU becoming the first member state to elect to leave since the European economic bloc was established. For now, nothing has technically changed, as the UK should remain a member of the EU for at least the next two years according to Article 50 of the Lisbon Treaty that allows two years for an exiting country to negotiate the terms of its departure. The departing country controls when it triggers Article 50, and the UK will not do so until resigning Prime Minister David Cameron’s replacement is named in October. Our thoughts are that it is too early to make a call on how this will play out. There are too many variables and too many parties involved to make an accurate prediction of how this will affect the UK, the EU, and the global markets.
Our main observation: the polling on Brexit was fairly close in the days leading up to the vote but that’s not what the traders were watching. They were watching the betting line on Brexit, which was heavily favoring a “remain in the EU outcome.” The Brits bet on everything, and their betting line for global events has been a remarkably accurate and widely followed indicator over the years. Global markets rallied last week through Thursday as the betting line approached 90% odds that the UK would stay. On Thursday night, when the polls closed and the voting results started trickling in, the betting line immediately reversed to 90% odds that the UK would exit the EU. The reversal in odds (and eventual outcome) caught many traders off-guard. As a result, the futures sold-off and the Asian markets opened with panicked selling that carried into the European markets. The U.S. markets opened in a more controlled manner and despite the pressure to sell, the major indexes held up relatively well compared to their global counterparts.
What’s worth noting is despite what sounded like mass hysteria on Thursday night and Friday, the result was actually a minor loss for the week in the U.S. markets. In spite of Friday’s pull-back, the S&P 500 and the Dow Jones Industrial Average were down just 1.64% and 1.55% respectively for the week. Our view is that for the past two years, the markets have been looking for a reason to sell-off and Brexit became the worry du jour. Between 2011 and 2015, we went over 1,400 days without a 10% correction in the S&P 500, which was the third-longest streak in history. In the past year, we have had two minor 10% plus corrections in the S&P 500. We recovered quickly from both and were approaching new all-time highs before Thursday night’s Brexit vote. It’s rare for the markets to go this long without a more meaningful correction.
We are not discounting the impact of Brexit, it will create a lot of uncertainty over the coming years, especially as related to the EU and the markets dislike uncertainty. But Friday’s global market reaction was less about Brexit and much more about slowing U.S. and global economies and a tired bull market. We need the markets to digest the Brexit related issues and we need global growth to accelerate before we can expect the markets to rally again in a sustainable manner. This will take time so we expect more volatility in the months to come.