Thursday, August 25, 2016

Global Markets and London Overreact to the British Vote to Secede from the E.U.: Missing the Bright Spots

The world’s financial sector may be excessively sensitive to increasing uncertainty associated with major changes—that is, changes that impact how large institutions, including governments, relate to each other. In such cases, so much is at stake that forces (i.e., the major powers) tend to manage the large-scale change with a minimum of disturbance. In short, the status quo has too much at stake for the market’s feared uncertainty to actualize. The British referendum on whether the E.U. state should secede is a case in point.

On the day after the vote to leave the Union (51.9% versus 48.1%), global stocks fell. The Nikkei 225 fell nearly 8 percent, and the German DAX closed down 6.8 percent. The STOXX Europe 600 Banks index had its worst day on record (going back to 1987) with a decline of more than 14 percent. U.S. stocks fell more than 3 percent. The Dow closed down 610 points to close at 17,400 (its eighth-largest point-loss), and the S&P 500 closed down 76 points at 2,037. The Nasdaq declined 4.1 percent, 202 points, to nearly 4,708. Closer to home, the UK FTSE 100 closed nearly 3.2 percent lower, while sterling fell more than 10 percent against the U.S. dollar.[1] With all of that re-pricing of risk, given an assumed increased uncertainty, an observer might have assumed that the U.K. would head into a severe recession without any trade to speak of. I submit that investors and stock analysts rather severely over-reacted. Put another way, their reaction says more about them than what was likely in store for Britain and the E.U.

The FTSE 100 recouped the losses by June 29th, closing at 6,360.[2] Wall Street recouped all of the losses by July 9th, when the S&P 500 closed near 2130, just shy of its record. The Dow hit 18,147, its highest level since May 2015.[3] At that point, the previous market declines could only be reckoned as over-reactions.

By late August, British retail sales reversed much of any fallout immediately after the referendum.[4] Before the vote, the State’s finance ministry had warned that a vote to secede from the Union would mean higher mortgage rates. “However, nearly half of mortgage borrowers look set to gain from the Bank of England’s interest rate cut” on August 4th.[5] We can conclude, therefore, that Britain dodged the economic bomb that the former Prime Minister, David Cameron, had warned would go off; the feared uncertainty was overblown.

American companies, too, dodged a blow that global investors had been anticipating. In fact, the vote helped some of the companies. “We believe that the weakening of the pound has made London a more attractive tourist shopping destination,” Mark Aaron, Tiffany’s director of investor relations told investors in late August.[6]

There is no excuse for the overblown risk-assessments. For one thing, the uncertainty should have been downgraded when new Prime Minister, Theresa May, said she would not trigger the E.U.’s Article 50 (on secession from the Union) in 2016; instead, she would begin formal talks with the E.U. to negotiate terms for future trading.[7] She would also lose no time negotiating on trade with another Union, the U.S. That Britain would obvious have plenty of say in the trade deals, including perhaps how many E.U. regulations the former State would have to retain to retain free-trade, suggests that Britain could come out of the transition better off for Britain. That the path forward would be prudent could easily have been incorporated into the political and economic risk assessments just after the vote, given the British culture. Investors and financial analysts should have had greater faith that the State’s business sector could indeed handle the uncertainty involved.

As for the E.U., the “Eurozone” was by the end of August “quite healthy,” according to Jason Pride, director of investment strategy at Glenmede.[8] PVH, an apparel maker, reported that the slowdown in its European business was “short-lived.”[9] Furthermore, the secession of the foremost anti-federalist State could actually be seen as strengthening the Union politically; no longer a house divided on the most basic assumptions of what the E.U. is—a confederation or a modern federation—the way was cleared for enough federalized fiscal policy to match the extent of federal monetary policy. That is to say, the E.U.’s competencies could reach the point at which the Union could handle its existing responsibilities. The federal system could move closer to being in balance with respect to the federal level and the State governments such that neither would dominate the other. This is a crucial feature of a viable federal system, which neither the E.U. nor U.S. had mastered.

In short, the secession could be viewed as good both for the State and the Union. I submit that very little of this scenario received airplay in the wake of the “shocking” vote. Instead, the market listened to exaggerated doomsday scenarios without any internal check. Even in mid-August, bearish bets against the British pound reached the highest level on record. On August 12th, the Bank of England’s currency exchange-rate index was at its lowest level since 2010, down 12 percent since the referendum. The next Monday, the pound dropped to $1.2880, down 13 percent since the vote.[10] To be sure, the U.K.’s large current-account deficit (the value of imports greater than exports) was putting downward pressure on the currency. Even so, it would not be unlike the market to over-estimate the propensity of the British economy to weather secession. The news that the break would not be quick and thus without discussions and thorough planning should have indicated that the British would see to it that the process would not threaten their economy. Yet speculators tended to get out of hand without realizing it, and the gullible world took the assessments as indicative rather than as possibly over the top. The vote “was really a non-event,” according to Catherine Lesjak, the chief financial officer at HP.[11] The participants in the global financial markets erred most fundamentally not just in missing the “non-eventness,” but even more importantly in missing how the secession of the anti-federalist State would strengthen rather than weaken not only Britain, but the E.U. as well. In other words, global markets were two-degrees of separation from this wider perspective in the wake of the vote.

[2] Alistair Smout, “Britain’s FTSE Makes Up All It’s Post-Brexit Losses,”, June 29, 2016.
[3] Adam Shell, “Bye, Brexit Blues: S&P 500 Near High, Dow Up 251,” USA Today, July 8, 2016.
[4] Andy Bruce, “British Economy Escapes Brexit Blow, For Now,” The World Post, August 26, 2016.
[5] Ibid.
[6]Matt Krantz, “Some U.S. Companies Capitalizing on Brexit,” USA Today, August 30, 2016.
[7] Andy Bruce, “British Economy Escapes Brexit Blow, For Now,” The World Post, August 26, 2016.
[8] Matt Krantz, “Some U.S. Companies Capitalizing on Brexit,” USA Today, August 30, 2016.
[9] Ibid.
[10] Mike Bird, “Bets Against Pound Clime to New High,” The Wall Street Journal, August 16, 2016.
[11] Matt Krantz, “Some U.S. Companies Capitalizing on Brexit,” USA Today, August 30, 2016.