In
an historic move, Great Britain voted to leave the European Union. This
decision caught global markets somewhat by surprise and increases uncertainty
in several ways, resulting in an adjustment in global securities prices.
As
this is written, markets are reacting, and the Dow Jones Industrial average is
off more over 600 points with the S&P 500 Index down 3.6%. Gold is up
nearly 5%, oil is down, and the dollar is up. The EAFE international
Index is down over 8% while the emerging markets index is off about 6%.
U.S. 10 year Treasury rates are 1.55% (0.19% lower on the day).
What
does all this mean? The biggest near term economic impact will likely be
transmitted through adjustments in foreign currency exchange rates. A
weaker British Pound and a weaker Euro mean a stronger U.S. dollar. The
economic impact of a stronger dollar is an increase in the costs to foreign
buyers of U.S. exports and a decrease in the costs to U.S. buyers of imported
goods. Other things being equal, these price changes reduce U.S. exports
and increase U.S. imports. Fewer U.S. exports somewhat reduce U.S.
economic activity while cheaper imports tend to reduce U.S.
inflation.
Intermediate
term implications may be political. UK Prime Minister David Cameron is
stepping down in the fall, the EU will be weaker, and Scotland may reconsider
leaving the UK. France or other states may be encouraged by this
departure and could consider their own exit from the EU. More broadly,
this may be a boost to other populist, nationalist, or anti-bureaucracy
movements and a general backlash against the status quo. Geopolitically,
a more fragmented Eurozone may encourage more opportunism on the part of
Russia.
Perhaps
the most important economic trend Brexit may bolster is the backlash against
free trade. Free trade is an important component to a healthy,
unencumbered economy. But with the presumptive presidential candidates of
both U.S. major political parties having staked out the most anti-free trade
positions of any candidates for quite some time, this additional international
anti-trade momentum could hurt earnings growth.
Clearly,
the UK’s separation from the EU will not occur for some time, and in the
interim, there could certainly be other free trade agreements negotiated
between Great Britain and the European Union that might mitigate the impact of
this vote. On the other hand, the EU may also seek to punish Britain for
leaving and move them “to the back of the line” as our president had suggested
the U.S. would do, which would not be a good outcome.
Overall,
uncertainty has increased in several areas, and that could take a while to play
out. What is not uncertain, however, is that stocks are a little cheaper
today and bonds generally a little more expensive than yesterday. Market
volatility creates an opportunity for those with a long-term view to benefit by
rebalancing, and that will be our reaction.
Given
the origin of this market dust storm, we’ll close with advice in the form of an
aphorism generally connected to British character: Keep calm and
carry on!