It’s useful to think of the medium term effects of the “leave” victory in the Brexit referendum as two connected sets of toppling dominoes.
First, there are the political dominoes inside the European Union (and the United Kingdom) itself.
In the immediate aftermath of the vote, right wing Euro-sceptic parties in the Netherlands, France, Sweden and Denmark have called for their own referendum on leaving the European Union. Special votes aside, beginning this Sunday with the Spanish elections, the calendar of the European Union is marked with a series of regular national votes over the next year that will see the voices of various “leave” parties raised in even higher volumes. It won’t help that the likely results of many of these elections will be a relatively weak status-quo government (in Spain and Italy, for example.) Or that the uncertainties that follow on the “leave” victory in the Brexit vote will slow already slow economic growth in the EuroZone. Or that the policies of economic austerity that dominate the debate in Germany, the de facto leader of the Euro Zone, are deeply unpopular in most countries in the European Union and have clearly demonstrated–to me at least–that they don’t work.
Back in the United Kingdom, we’re looking at political turmoil as Scotland, and Northern Ireland, both of which voted to stay in the European Union (by 62% and 58%, respectively), look to renegotiate their relationship with the government in London. (Assuming that London remains the capital. London too voted heavily in favor of staying in the European Union and there have been calls today for the start of a movement to have London leave the United Kingdom and join the European Union.) At the least I’d expect to see Scots nationalists push for a new vote on independence from London (and membership in the European Union.) Any likely Conservative government that will replace that of recently resigned Prime Minister David Cameron is likely to be headed by a politician that campaigned for “leave” (Can you say former London mayor Boris Johnson?) and be truculently opposed to any negotiating stance that smacks of compromise with the European Union or Scotland, Ireland, Northern Ireland, and Wales. (My nomination for the worst job over the next two years isn’t negotiating the terms of the country’s departure from the European Union, but hammering out some agreement on the treatment of the new border between non-EU Northern Ireland and EU-member Ireland.) The Labour party is likely to be in turmoil as members–thought to be about 60% to 70% pro-EU–blame current leader Jeremy Corbyn for the defeat of the “stay” position in the referendum. Add in the gonzo mess that is the UK Independence Party (UKIP) headed by Nigel Farange, with its ultranationalist rhetoric of keeping immigrants out and its belief that the United Kingdom will be able to negotiate tariff-free access to the European Union after the vote to leave (I’m not making this up. See here http://www.politico.eu/article/post-brexit-ukip-wants-tariff-free-access-to-eu-single-market/ )
Looking around the United Kingdom and the European Union as politicians begin the two-year process of negotiating the country’s departure from the European Union, the overall impression will be chaos, with out of control rhetoric, and nary an adult in sight. (How long can Angela Merkel find the energy to try to play this role? She does have her own domestic anti-immigrant party to worry about.)
Which would be bad enough if there wasn’t a good chance of seeing the United Kingdom and some parts of the European Union slide into recession in the next year. Think the uncertainty over the rules of the economic game won’t lead businesses to cut back on investment? Think tourists won’t decide not to take a trip because they don’t know what the border rules might be? Think English retirees won’t have second thoughts about buying property in the south of France or on the Spanish coast? Think Polish restaurant workers in London won’t decide this is a good time to explore returning to Warsaw?
Moody’s Investors Service lowered its outlook on the United Kingdom’s credit rating to negative from stable on June 24. It cited slower economic growth in the country as a result of the Brexit note and more pressure on the country’s finances as the United Kingdom continues to struggle with a current account deficit that requires large inflows of overseas capital. (Which is likely to require higher interest rates after the Brexit vote.) Fitch Ratings, the last of the big three credit rating companies to give the United Kingdom a AAA credit rating, called the high credit rating “untenable under the circumstances” after the vote.
Economic analysts seem to be divided between the optimists who simply see growth slowing in the United Kingdom after the vote and the pessimists who expect a recession. Deutsche Bank, for example, cut its forecast for 2017 to 0.9% from a prior 2.1% forecast. Pantheon Macroeconomics, in the pessimists camp, sees slowing corporate investment, lower employment, and depressed consumer spending leading to a recession. Hard to argue with that logic. The United Kingdom did $500 billion in trade with the European Union in 2015–the terms of that trade are now up in the air. (Ireland is the European Union member most exposed to any decline in trade with the United Kingdom since 18.6% of Ireland’s trade is with its neighbor.) On June 24 the pound fell 8% against the dollar–which made U.K. consumers 8% poorer when they go to buy, say, an iPhone or anything else priced in dollars.
How many of these dominoes fall will depend on the reaction by other European Union members–a desire to punish the United Kingdom so nobody else tries to leave will make things worse. (At a minimum such a stance will indicate that Brussels doesn’t understand how much the structure and attitudes of the European Union bureaucracy are a big part of the problem.) And on how quickly and how far growth falls in the United Kingdom after the vote and how many economies in the European Union it takes down with it. It’s not like the problems in Greece and other European economies are a thing of the past.
Second, the fall of these U.K./European Union dominoes will affect the tumble of dominoes in the rest of the global economy.
Remember that when it decided not to raise interest rates back on June 15, the U.S. Federal Reserve gave uncertainty over the Brexit vote as a reason to wait. Now that Brexit is a reality as opposed to just an uncertainty, I can’t see the Fed being anxious to increase U.S.interest rates. Higher U.S. interest rates would put more pressure on the pound and the euro. It would slow the U.S. economy at a time when the global economy as a whole looks likely to slow as the force of Brexit hits the economies of the United Kingdom and the European Union. Recognizing this, the futures market has virtually dismissed the possibility of an interest rate increase at the July 27 meeting. In fact, the CBOE calculations show the market now pricing in a 7.2% chance that the Fed will cut interest rates in July and a 12.7% chance that the central bank will cut interest rates at its September 21 meeting. It’s not until the December 14 meeting that the odds include a significant–18.1%–chance of an interest rate increase–and even then the market is still pricing in a 10.2% chance of an interest rate cut.
Much of the Fed’s course will be determined by how the global currency dominoes fall. The pound, of course, is forecast to move lower. The currency, which closed at $1.3679 agains the dollar on June 24, is already down 13.3% in the last ten months. Some currency analysts are forecasting a drop to $1.20. The euro is likely to fall on Brexit uncertainty. On June 24 it moved down to $1.1117 against the dollar. The 52-week low is $1.0524 and I’d be surprised if we don’t revisit that level, especially since the European Central Bank is unlikely to move to strengthen the euro after working so hard to weaken it to accelerate growth. The off-shore yuan–that is the Chinese currency traded in Hong Kong–fell 0.8% against the dollar on June 24.
A stronger dollar carries two risks. First, it will create a drag on U.S. economic growth as it cuts into U.S. exports by making them more expensive in other currencies. Second, it puts pressure on emerging market currencies, which are already feeling the effects of the usual cash outflows in times of uncertainty. Both the Mexican peso and the Brazilian real, for example, fell against the dollar on June 24. This kind of concerted downward move in the yuan and in emerging market currencies conjures up memories of the emerging market sell off of last summer.
The world’s central banks are determined to arrest the fall of as many dominoes as they can. Every bank from the Bank of London to the Federal Reserve issued statements promising to provide liquidity even before the Brexit votes were counted. It’s not clear to me, though, that stretched as they are by near-zero or below-zero interest rates, how much leverage central banks have to affect exchange rates or national economies. The Bank of Japan is in an especially tight spot because the yen’s role as a safe haven currency keeps pushing the yen higher at a time when the Bank of Japan wants to see the yen move lower to encourage economic growth in Japan. The currency appreciated briefly to 100 before weakening at the close to 102.22. A close at 100 is likely to bring intervention by the Bank of Japan–and more currency market turmoil–currency analysts forecast.
Before Brexit the general worry among central bankers was that the world would face another crisis before the global financial system fully recovered its equilibrium from the last crisis. In the wake of the Brexit vote that worry has gained in focus and immediacy.
As the next few days progress, I’ll try to post some concrete moves to take in this period of uncertainty.
By a surprisingly large margin of 52% to 48% the United Kingdom voted to leave the European Union in Thursday’s Brexit referendum.
Global financial markets plunged in a decline all the more dramatic because traders and investors had decided on Wednesday that the United Kingdom would decide to stay in the European Union. On that day, for example, the pound rallied.
As markets opened today on the actual results it was a very different story with the pound sinking to its lowest level since 1985 and the European STOXX 600 index showing its biggest drop since 2008 and the global financial crisis. Around the world money moved away from risk and toward perceived safety. Emerging markets tumbled with the iShares MSCI Emerging Markets ETF (EEM) down 5.38% as of noon on Friday, June 24. The Standard & Poor’s 500 stock index was off 2.8% after an early morning drop in the S&P 500 index futures triggered a trading curb at the Chicago Mercantile Exchange. The U.S. benchmark for crude, West Texas Intermediate, dropped by as much as 6.8% to $46.70 a barrel. Cash looking for safety flowed into the Japanese yen, which climbed 3.5% against the U.S. dollar, and into gold, which climbed 8.1% to $1358 an ounce.
In the short term volatility itself will bring more selling as computerized trend-following strategies designed to limit risk create more selling. When the price trend turns negative–as it has today after four previous days had left the S&P ahead by about 2%–these strategies say sell in order to keep up with index volatility and to limit the size of future losses. Markets saw this pattern at work last August when volatility that started in China led to volatility in U.S. markets that led to selling that finally took the S&P 500 down 11%. The bigger the drop today, June 24, the more selling these strategies will generate next week, Rebecca Cheong, head of Americas equity derivatives strategy at UBS told Bloomberg today. Total sales, she estimates, could reach $150 billion should volatility persist in the S&P 500 next week.
The Standard & Poor’s 500 Volatility Index (VIX) was up 40.46% as of 1:10 p.m. New York time, up from a climb of just 33.51% as of an hour earlier.
If you have volatility trades on the VIX–such as the ones I suggested on April 28 on the ProShares VIX Short-Term Futures ETF (VIXY) up 21.6% today or the ProShares VIX Mid-Term Futures ETF (VIXM) up 7.67% today–I’d suggest leaving them on into next week as this risk-strategy rebalancing plays out. (For that original post on my paid site see http://jubakam.com/2016/04/time-to-trade-volatility-with-the-vix-again/ For a summary of that post see this free site on that date. )
In the slightly longer-term, through, I’d look to exit these trades. Fear and volatility spike in the immediate aftermath of an event like this and then recede–even as the long-term effects just start to play out. I’ll try to sketch in some of those long-term effects in my next post this afternoon.
Despite torrential rains in London and the southeast of England, polling places are reporting long lines for today’s Brexit referendum vote.
Before the actual vote, a BMG Research poll for the Electoral Reform Society found that 67% of people said they would definitely vote. That would put turnout even with the 66% in last year’s national election.
A high turnout is thought likely to favor the “stay” side in the vote–all things being equal.
But polls are also showing that all things aren’t equal. Polls show that 79% of voters over 65 say they will definitely vote but only 54% of 18-24 year-old voters say they will definitely vote. That could be critical since in polls older voters have favored “leave” in the referendum while younger voters come down on the side of “stay.”
At 10:20 a.m. New York time the S&P 500 volatility index (VIX) had plunged 14.5%, giving back all of yesterday’s pre-voting jump as traders hedged their anxiety over the possibility of a vote to leave the European Union
To anyone getting all warm and cozy with the polls showing that voters will decide to stay with the European Union in Thursday’s Brexit vote, I’ve got just one word of warning: Michigan.
Remember the Michigan primary between Hillary Clinton and Bernie Sanders this year? The polls had Clinton ahead by double digits. Nate Silver’s 538.com, one of the most thoughtful poll crunchers had her up by 21 percentage points. In what the media saw as a startling upset, Sanders won by 1.5 percentage points.
The polls were so wrong in Michigan because of problems with past vote weighting. And the same problems should make you regard all the current polls in the United Kingdom with extreme skepticism.
Polls don’t survey every voter in the electorate. They take a sample and then weight that sample based on the way that different kinds of voters turned out in the last election. In the Michigan primary, because of some extremely odd history–one year the state wasn’t allowed to hold a meaningful primary as punishment for violating Democratic Party rules, for example–there wasn’t a recent election to use in weighting those samples. And it turned out that the participation by different classes of voters was radically different than it had been in the last, very distant, primary.
So the polls were really, really wrong.
Same problem is making the accuracy of the Brexit polls in the United Kingdom even more questionable. In a very interesting podcast on 538.com, Tom Clark, chair of the editorial board at the Guardian newspaper, notes that the last referendum on Europe that poll takers might be able to use for weighting took place in 1975. Since then the electorate has shifted–there’s the rise of the far right, Euro-skeptic, anti-immigant UKIP party, for example. And perhaps even more important the decline of the number of people with landline phones and the rise of Internet polling have changed response rates to polls and have resulted in considerable self-selection by poll participants. Absent a recent referendum vote to use as a model, pollsters have to fall back on weighting from more recent national elections–and no one really knows if voters behavior is the same in national elections and in referendums.
No one knows what the exact result of any shifts in the electorate have been–or how accurate or inaccurate those shifts might make current polls. (And as tempting as it is to extrapolate betting odds from bookmakers to referendum results, no one really knows how that sample of voter opinion relates to the opinions of the entire electorate.)
In other words, it’s quite possible that the Thursday results will bear very little relationship to the polls as they now stand. I think it’s likely that the trends that seem to be moving toward a win by the “stay” in the European Union position are real trends. But there is certainly a non-zero chance that all these numbers are rubbish.
Which, of course, would give a surprise result–one that went against the market’s current belief in the polls–real power to move the markets. And which might be one reason that the Standard & Poor’s 500 Volatility Index (VIX) soared 14.56% to 21.17 on June 22.
Just as British bookmakers are soothing some of our financial market angst over the results of Thursday’s Brexit vote, Federal Reserve chair Janet Yellen is turning up the anxiety meter.
Bookies in the United Kingdom–and the cash being placed with them as bets–now give “stay” with the European Union an 82% chance of winning the referendum. According to big U.K. bookmaker Ladbrokes, 95% of the bets placed Monday were wagers on a failure of the “leave” position in the referendum. (Official polls remain split on the results of the vote.)
You might have expected a big rally–like yesterday’s–on the continued shift in the odds but the markets aren’t seeing it. As of 3:30 p.m. New York time, the Standard & Poor’s 500 stock index was up just 0.37% to 2091.04 as it continues to lag both resistance at 2100 and the 2135 all-time high. West Texas Intermediate was off 1.05% to $48.85 a barrel; the Brent crude benchmark held up better, dropping just 0.19% to stay above $50 a barrel at $50.46.
What’s the matter markets? Afraid to feel the joy of a likely defeat of the Brexit side in the vote? (Granted, it’s never over until the fat lady sings.)
Give credit to a subtle but none the less profoundly negative shift in the testimony that the Fed’s Yellen delivered to the Senate today. (She’ll complete her semi-annual Congressional tour with the House tomorrow.)
Basically what Yellen said today is that the Fed is on watch to see whether the U.S. economy will show signs of improvement in growth. That’s a significant shift from last week when Yellen talked about watching to see when the economy showed signs of improvement.
“Proceeding cautiously in raising the federal funds rate will allow us to keep the monetary support to economic growth in place while we assess whether growth is returning to a moderate pace, whether the labor market will strengthen further, and whether inflation will continue to make progress toward our 2% objective,” Yellen said.
Odds of a U.S. recession remain low (Whew!) Yellen told the Senate Banking Committee, but a slowdown in hiring in May, and weak growth in first quarter GDP have made the Fed much more cautious.
And it’s not just Yellen. James Bullard, head of the St. Louis Fed, and until recently one of the strongest voices arguing for an interest rate increase, published a paper last week suggesting that the U.S. economy could be stuck in a rut for the next two to three years.
Two to three years? Okay delaying the next interest rate increase until 2017 does send a thrill through parts of the financial markets (especially the bond markets) but I don’t think there’s anyone out there rooting for two to three years of economic growth so slow that the Federal Reserve can’t raise rates by even a quarter of a percentage point.
I still suspect that an actual win for the “stay” forces in Thursday’s Brexit vote would produce a surge in the markets. But Yellen’s remarks have certainly primed market for a major rethink after the vote.
And I wouldn’t make too much of a single minor data points like this but I wouldn’t totally ignore it either. On a day when the odds for a major market upheaval from Brexit have retreated, the S&P Volatility Index, VIX, has actually inched ahead rising to 18.47, up 0.54%.
Seems like not everybody is swigging the happy juice today.