- Britain leaves, stocks plummet. In a surprise move, the United Kingdom has voted to leave the European Union. Global markets are awash in red this morning, exacerbated by the last few days’ risk-on posture as a “remain” vote became viewed as consensus. After touching the 1.50 level against the dollar after yesterday’s close, the pound is now below 1.4 and briefly made a 30-year low. Overnight, Japan’s Nikkei Index was among the worst hit, closing down 7.9%, while in afternoon trading the German DAX is down more than 7%, France’s CAC is down more than 8%,the U.K’s FTSE is lower by approximately 4%, and Spain’s IBEX down more than 12%. Safe-haven assets are rallying as expected, with the yield on the 10-year note down to 1.53%, and COMEX gold up 5%. WTI crude oil is falling sharply and below $48.00, while the dollar index is up over 2.5%.
- U.K. surprises markets, votes for Brexit. The U.K. voted to leave the EU in a very close vote yesterday, leading to Prime Minister David Cameron’s resignation and sending markets fleeing to safe havens amid the political uncertainty. The U.K. and EU will work over the next several years to determine the terms of the U.K.’s economic separation from the EU, essentially beginning the reversal of many decades of integration in the region. The political uncertainty, related impact of tightening financial conditions, and impact on U.K. trade are collectively causing investors and markets to price in greater odds of recession in the U.K. and Europe. The market’s extreme reaction reflects partly an unwinding of “remain” trades over the last week or so that were observable, in particular, in strength in European stocks and global financials.
- We believe U.S. economic impact from Brexit will be manageable. After the U.K. vote to the leave the EU, the odds of a recession in the U.S. have moved higher, but are still well below 50% in our view. Tighter financial conditions and a stronger dollar may be a slight drag on our exports. And lower commodity prices, market volatility, and lower interest rates may have some negative impact on corporate profits. But the U.S. economy is very resilient, and the direct impact of economic conditions in the U.K. and EU may be limited.
- Not another Lehman moment. While Brexit was unexpected and is likely to cause some near-term and perhaps even some longer-lasting financial market volatility, we do not believe Brexit will turn into another Lehman Brothers-type event. The U.S. economy, banking system, and consumers are in far better shape today than in 2008.
- We reiterate our 2016 equity market forecast.* We continue to expect mid-single-digit returns for the S&P 500 in 2016, driven by better U.S. economic growth and an earnings rebound in the second half of the year.
- Fed rate hike turns into rate cut probability. Futures show a small (15%) chance of a rate cut at one of the Federal Reserve Bank (Fed) meetings over the next few months and a rate hike has been priced out by the end of 2016. This morning the Fed already announced it is monitoring markets carefully and ready to provide unlimited U.S. dollar liquidity via existing swap lines.
- Treasury yields closer to record lows on flight to safety. The 10-year Treasury yield fell nearly 0.20% in early trading but is now off the overnight low yield of 1.49%. High-quality bond prices broadly are higher but are unlikely to match the pace of Treasury gains. The all-time low on the 10-year Treasury yield is 1.39%, reached in July 2012, and remains within striking distance. The 2-year Treasury yield, at 0.6%, is at its lowest level since October 2015 (and not far from the overnight borrowing rate), just prior to moving higher in anticipation of Fed rate hikes. Lower-rated bonds, such as high-yield bonds, are weaker as is typical during such episodes.
- Bigger bond moves occurring in Europe. The 10-year German yield is down to a record low of -0.08%, with the U.K. 10-year leading the way down -0.25%. Peripheral European government bond markets (Spain, Italy, Portugal, Greece) are weaker, but movements are slightly more subdued compared to those at the peak of the European debt crisis in 2011 and 2012.
- Banks pass tough stress tests. The Fed announced the first round of results from its stress tests last night and all 33 banks passed. Collectively, despite tougher scenarios, the banks maintained higher capital levels under stress than last year. This result is good news and validates the improved capital positions of the banks since the financial crisis, but will be overwhelmed by the extreme market volatility today following the U.K.’s surprising decision to leave the EU. Next week (June 29), the Fed will announce the results of its review of the banks’ plans to return capital to shareholders (dividends and share buybacks). In light of the Brexit vote, we would suggest caution toward financials given tightening financial conditions and low interest rates (and related flat yield curve).
Historically since WWII, the average annual gain on stocks has been 7 – 9%. Thus, our forecast is in-line with average stock market growth. We forecast a mid-single digit gain, including dividends, for U.S. stocks in 2016 as measured by the S&P 500. This gain is derived from earnings per share (EPS) for S&P 500 companies assuming mid-to-high-single-digit earnings gains, and a largely stable price-to-earnings ratio. Earnings gains are supported by our expectation of improved global economic growth and stable profit margins in 2016.
- Durable Goods Orders and Shipments (May)
- Germany: Ifo (Jun)