Early “Brexit” impact was localized, but tail risk persists.

When the U.K. voted to leave the European Union, I happened to be in the thick of it, on a business visit to London. When I turned in on the night of June 23, the opinion polls showed the race to be neck-and-neck, but financial markets were increasingly confident that a “Remain” vote would be returned. The comment we published the next morning was not the one we’d anticipated.

You had to be there to get a good sense of the shock the “Leave” vote caused. It has set off the U.K.’s biggest political and constitutional upheaval in 70 years. But what do markets make of it all?

Large-Cap Equities Erase Losses

Our initial response was to convey our view that fears of a “Lehman moment” were overblown. The vote hadn’t changed the fact that we are in a slow-growth, low-inflation, low-interest rate environment. Sure enough, the FTSE 100 Index powered back through its pre-Brexit level at the end of last week. The S&P 500 Index has also been reversing its losses. Global risk assets were recovering even before Bank of England Governor Mark Carney boosted them by hinting, last Thursday, at “some monetary policy easing” over the summer. It looks like our first instinct was a good one.

We have now experienced a handful of these V-shaped moves in markets over the past two years, over which time both the price and the earnings of the S&P 500 have remained virtually unchanged. Indeed, it’s the “slow, low, low” background that is both stagnating earnings and allowing specific or localized shocks to cause outsized short-term volatility; it makes the margin of error for investors so thin.

And there is no shortage of additional potential shocks coming our way. The U.S. still has to choose between two (at least publicly) anti-trade Presidential candidates in November, and Spain’s latest general election kicked off an 18-month cycle that will include Germany, France, Italy and the Netherlands. But as long as the underlying fundamentals remain unchanged, volatility from these events can create opportunity, which is why we stress the importance of focusing on fundamentals rather than news headlines. Amid the noise of last week, for example, the Atlanta Fed raised its forecast for U.S. Q2 real GDP growth to 2.7%, while the Eurozone printed a positive headline inflation number and its lowest unemployment in five years.

The Impact Has Been Localized

This is not to say that the vote hasn’t inflicted damage. At the end of last week, the FTSE 250 Index, which better represents the U.K. economy than the global, often U.S. dollar-earning companies of the FTSE 100, was still some 5% short of pre-Brexit levels. European stocks remained down by a similar amount. This is as challenging for the E.U. as for the U.K. itself: Standard & Poor’s downgraded both entities last week.

And then of course there is the pound sterling. Its 8% one-day drop against the U.S. dollar on June 24 was the biggest since the end of Bretton Woods. A recovery last week was stopped in its tracks by those comments from Mark Carney.

So far, so rational. Global markets in general have recovered, with those most exposed to the longer-term implications of “Brexit” re-priced for weaker performance.

Still “Slow, Low, Low”—But More So

Where the vote has had a broader impact, it’s “more of the same”. “Brexit” hasn’t changed the “slow, low, low” dynamic, but may have amplified it. Fed Funds futures now forecast that the U.S. central bank will be on hold at least into next year. The prospect of monetary tightening disappearing over the horizon has driven bond yields lower. The two-year U.K. Gilt yield went negative for the first time last week, the entire Swiss curve is dipping in and out of negative territory and the German Bund yield has sunk to uncharted depths. And now the 10-year U.S. Treasury yield is also flirting with historic lows.

This puts banking-sector profits under more pressure: at the end of last week European banks were still down 15%-20% since the vote, but U.S. banks remained down 4%-5%, too. But does it forecast similar gloom for non-financial corporate earnings? This is something Joe Amato discussed a couple of weeks ago, and we still think bonds are being pushed by technical pressures rather than fear of an outright collapse in growth and earnings—and so far equity markets appear to agree.

Nonetheless, we believe this is a time for caution, not complacency. If the U.K.’s voters have articulated a cry of rage against trade and globalization that is heard and echoed further afield, we could see more than a localized effect on growth prospects. In Spain a week ago the electorate responded to “Brexit” by moving back towards the center, but there are still many more occasions for political risks to spill into global economic fundamentals—and for markets to hit bumps that are much harder to overcome.

In Case You Missed It

  • U.S. 1Q 2016 GDP (final):  +1.1% annualized rate
  • Case-Shiller Home Prices:  April home prices increased 1.1% month-over-month and increased 5.4% year-over-year (NSA); +0.5% month-over-month (SA)
  • U.S. Consumer Confidence:  +5.6 to 98 in June
  • U.S. Personal Income & Outlays:  Personal spending increased 0.4%, income increased 0.2%, and the savings rate decreased to 5.3% in May
  • ISM Manufacturing Index:  +1.9 to 53.2 in June
  • Eurozone Purchasing Manager Index:  +0.2 to 52.8 in June

What to Watch For

  • Wednesday 7/6:  ISM Non-Manufacturing Index
  • Wednesday 7/6:  FOMC Minutes
  • Friday 7/8:  U.S. Employment Report

– Sonia Mukherji, Investment Strategy Group

Statistics on the Current State of the Market – as of July 1, 2016

Market Index WTD MTD YTD
Equity      
S&P 500 Index 3.3% 0.2% 4.1%
Russell 1000 Index 3.3% 0.2% 4.0%
Russell 1000 Growth Index 3.2% 0.4% 1.7%
Russell 1000 Value Index 3.3% 0.1% 6.4%
Russell 2000 Index 2.7% 0.4% 2.6%
MSCI World Index 3.3% 0.4% 1.5%
MSCI EAFE Index 3.5% 0.8% -3.3%
MSCI Emerging Markets Index 4.5% 0.6% 7.3%
STOXX Europe 600 3.4% 0.9% -4.9%
FTSE 100 Index 7.2% 1.1% 7.8%
TOPIX 4.3% 0.7% -18.0%
CSI 300 Index 2.6% 0.0% -14.6%
Cash & Fixed Income      
Citigroup 2-Year Treasury Index 0.1% 0.0% 1.3%
Citigroup 10-Year Treasury Index 1.1% 0.3% 8.3%
Barclays Municipal Bond Index 0.2% 0.1% 4.4%
Barclays US Aggregate Index 0.8% 0.2% 5.5%
Barclays Global Aggregate Index 0.8% 0.3% 9.2%
S&P/LSTA U.S. Leveraged Loan 100 Index 0.4% 0.1% 5.5%
BofA Merrill Lynch U.S. High Yield Index 1.1% 0.4% 9.7%
BofA Merrill Lynch Global High Yield Index 1.1% 0.4% 9.0%
JP Morgan EMBI Global Diversified Index 2.1% 0.5% 10.9%
JP Morgan GBI-EM Global Diversified Index 3.2% 0.1% 14.4%
U.S. Dollar per British Pounds -2.6% -0.8% -10.0%
U.S. Dollar per Euro 0.1% 0.2% 2.5%
U.S. Dollar per Japanese Yen -0.5% -0.1% 17.2%
Real & Alternative Assets      
Alerian MLP Index 1.3% -0.6% 14.1%
FTSE EPRA/NAREIT North America Index 4.7% 0.2% 13.3%
FTSE EPRA/NAREIT Global Index 4.3% 0.3% 9.1%
Bloomberg Commodity Index 3.1% 0.9% 14.3%
Gold (NYM $/ozt) Continuous Future 1.3% 1.4% 26.3%
Crude Oil (NYM $/bbl) Continuous Future 2.8% 1.4% 32.3%

Source: Factset, Neuberger Berman LLC.