The story does not end here. After the tumult unleashed last Friday with the UK referendum indicating a desire to exit from the European Union, the financial markets experienced more gyrations. The equity market decline globally that started on Friday continued on Monday. The British pound (GBP) also continued its slide falling near 1.32 USD/GBP before stabilizing around that level. Then, on Tuesday risk assets started to recover. At this point, the S&P 500 is just a few points below the level it was at the close of Thursday June 23rd before the results of the vote were known. The United Kingdom equity index (FTSE 100) is almost 4% higher than Thursday’s close…in local currency terms. Meanwhile, European stocks remain about 4% below the pre-referendum level, the GBP is 10% lower relative to the US Dollar, and gold is 6% higher.
Despite the significant moves in major financial markets, it appears to us looking beneath the surface that most of the price action is based on reasonably logical premises. For example, rate sensitive equities have performed well as expectations that rates will be lower for longer. European energy companies performed well as revenue in selling oil is mostly USD-based while costs are denominated locally. The UK equity index has also performed relatively well in local terms since almost 80% of the revenue is from outside of the UK. The GBP should be lower as it is rational that the Bank of England will be moving towards easing as its leader Mark Carney confirmed in a speech this past Thursday. High yield bond spreads in the US stayed stable and crude oil prices stayed resilient. That is not to say that the all clear sign has been given on the market. We continue to think that there are more questions than answers from here and the start to the process has already been messy as Boris Johnson, the former top contender to succeed David Cameron as Prime Minister, had his political support fail. This is not a quick story, but a saga with many twists and turns likely to come. In the words of the German Chancellor, “Don’t’ delude yourself.”
We are keeping a close eye on a couple of “contagion” indicators that might create concern in the future. Included in this list are bank stocks. It is natural for financial institutions to be challenged as they battle low (and in many places negative) rates and risk management as major currencies continue to have multi-standard deviation moves, but they are also the most likely to transmit those challenges elsewhere. Also on the list is the Chinese yuan. With renewed strength in the USD, Chinese policy makers are again faced with the choice of whether to devalue the currency to maintain appeal to European customers and support exports. The devaluation process last August spooked the market and we are have an even more fragile global growth sentiment today.