Late last week, Britain voted to leave the European Union.
It surprised me. It surprised markets.
During the month-long circus leading up to the vote, I felt pretty confident the British people would run from the uncertainty of actually leaving the EU.
This week, I figured we’d be talking about how voters had succumbed to the fear-mongerers who were bent on keeping Britain in. And yet, here we are.
Good for voters.
Bad for markets … so far.
I was Skype chatting with my father as the Brexit outcome was being called. Together, we watched as currencies and futures digested the news.
He used the word “stunning” and said he’d never seen moves of the magnitude we saw Thursday night/Friday morning.
Before the U.S. markets opened on Friday, the pound was down as much as 10%. Crude oil was down 5% and U.S. long bonds were up about 7 points.
As the U.S. trading session ended Friday, the S&P 500 was down almost 3.5% for the day.
Friday’s trading action in the S&P 500 and in ETFs representing the British pound, the euro currency and European stocks.
Let’s get focus for a moment on the British pound …
Was Great Britain’s participation in the EU really inflating the value of the pound by 10% … or however much Friday’s selling decided upon?
No and yes.
No because, if anything, EU constraints impacting the UK trade balance maybe should have actually required the pound to be undervalued in order to compete.
After all, Germany is the big beneficiary in the Eurozone economy because it has been granted a captive market. In it, Germany runs large trade surpluses with its EZ counterparts. The relationship between the UK and Germany is similar, thanks surely to the EU artifice.
And yes because the UK should need to fortify its trade competitiveness. After all, it now controls its own destiny, so to speak. And a cheaper currency can help British companies’ competitiveness by making their exports relative cheaper.
Listen … I’m obviously not sitting in London or Brussels. And I have no idea how trade negotiations and transition will unfold, practically and logistically.
But again — will the trade relationships between the UK and its EU counterparts look materially different when all is said and done? I doubt it.
I guess that’s what markets are for — an adjustment mechanism in the pursuit of fair value.
That’s certainly what currencies are for.
And restoring a semblance of British sovereignty should ultimately be a positive for the British pound and British companies. They’re kicking to the curb an unfathomably long list of EU regulations that keep UK businesses bound to what … silliness?
Why shouldn’t the British pound rejoice at the thought of fresh air?
So how do we react?
I don’t think the Brexit is something that should generate investor panic outside specifically-exposed UK and European companies.
But while economic uncertainty in Britain and the EU does not pose a systemic risk, I know a thing or two about how things really work. And in this era of financial market madness, I would be remiss to dismiss the threat of contagion.
The danger is that selling begets selling begets selling. We saw that on Friday as the U.S. markets greeted the day with losses, then curbed those losses a bit, and spent the rest of the day falling even more.
Ever since the 2008 financial crisis subsided, a new crisis in confidence has always been the biggest threat to markets that are constantly propped up by the perceptions-management & risk-taking teams at central banks.
Gold rallied about 7% or so in reaction to the news.
The Japanese yen as much as 5%.
Global stock markets are in the tank.
It is plainly and simply a risk-averse reaction: Historically safe-haven assets catch a bid while risk assets undergo selling that begets more selling.
My kneejerk feeling is that the sell-off will fizzle.
The lingering danger, in my mind, is that contagion selling creates problems at banks, sparks liquidity issues and credit freezes up.
I can’t say I have a good reading on the likelihood of a credit crisis, but consider …
Bank of England Governor Mark Carney said the BOE is ready to pump billions of pounds into the financial system, an extra 250 billion pounds ($345 billion) through its existing facilities if needed.
"We are going to continue prudent monetary policy, use multiple monetary-policy tools and keep reasonably ample liquidity and maintain financial stability," the [People’s Bank of China] PBOC said in the statement.
Bank of Japan Governor Haruhiko Kuroda promised that central banks will do the best they can to provide liquidity.
“The [European Central Bank] ECB stands ready to provide additional liquidity, if needed, in euro and foreign currencies. The ECB … considers that the euro area banking system is resilient in terms of capital and liquidity.”
That’s just the top line. These central banks have all kinds of facilities and mechanisms in place to absorb the potential blow markets could deal to the financial system.
That’s certainly meant as a confidence-booster. And it’s an indication that they’ve learned a lot about how to manage markets in the last seven or eight years.
But even with all those mechanisms and credit facilities and swaps and sheer readiness, there is one proverbial thorn in the side:
The U.S. Dollar
By virtue of overseeing the world reserve currency, the Federal Reserve is tasked with ensuring that dollar-based liquidity can flow freely throughout the globe.
The problem is when those flows flow freely back into the U.S.
When risk appetite increases, dollar-based capital flows outward into risk assets. When risk aversion sets in, capital flees back inward.
Since the Federal Reserve has been flirting with normalizing its monetary policy (by trying to raise interest rates) … and since all these other central banks are playing prevent defense by ensuring more and more monetary accommodation … U.S. dollar-based assets attract capital and exacerbate the risk-averse capital flight into U.S. dollars.
The globe — developed and emerging markets alike — is not in a position to handle the repercussions of capital outflows and rising costs to finance cross-border (typically dollar-based) debt.
This fact alone is enough to shock financial markets.
Add it to the Brexit fallout, and there is a real risk that contagion selling has legs.
Only the lender of last resort — the great and powerful Federal Reserve — has even a chance at altering the fate of markets if a vicious feedback loop of selling ensues.
Fortunately — or, “fortunately” — the Fed has somehow created room whereby it can actually ease financial conditions in the U.S. from super-easy to super-super-easy.
So I suspect one of two things will happen:
Either the Brexit sell-off will fizzle once investors realize there isn’t much to be scared of …
Or, if the selling does not fizzle soon, I suspect market focus will quickly shift away from Brexit to reflect the market’s obvious dependence on the Federal Reserve and global dollar-based liquidity.
It’s like déjà vu all over again … all over again.
Speaking of which, but of the forward-looking variety …
The Plain-Sight Unintended Consequences
Before I end this post-game wrap, I want to leave you with one thing to consider that could drag out the weight Brexit is putting on markets:
Follow the leader to freedom!
There is a chance that Brexit sets a precedent and other nations seek the return to sovereignty — to freedom.
Denmark and Sweden have said they may want out of the EU if Britain goes.
Now Scotland may want to split from the UK.
Parts of Spain could feel compelled to split apart.
Marine Le Pen, a rising star in French politics, called it a “victory for freedom” and suggested France and every EU country should hold a referendum vote.
Clearly no one can know what such a chain reaction would bring, especially since it could shake the Eurozone and threaten the existence of the euro currency.
So there’s that.