Brexit Vote (What happened and What to do)

/in /by

brexit-shutterstock2

Around 7 p.m. last night those of us watching markets knew we had a problem.  The results from Sunderland came in massively for “Leave,” and they were expected to only show a marginal “Leave” victory.  Immediately the pound dropped 4% on the news and global markets moved sharply lower.  It was the first clue there was going to be a surprise.

By midnight it was official:  The markets, betting odds and private pollsters were all wrong.  “Leave” was declared the winner, and at 1 a.m. last night the British Pound was down 10% vs. the dollar (at a 35 year low) and S&P 500 futures were down 100 points.  So, as shocking as it may seem, things have actually gotten a touch better since then.

From an analysis standpoint I want to focus on immediate takeaways and trying to answer questions you may have (or questions you may get from your clients regarding this event):

The Markets are Clearly Down Big But It’s Actually Not that Bad.  First, US stocks and the Pound are off the overnight lows, and European markets actually haven’t violated last week lows.  The S&P 500 did break down through 1940 but 1900 is acting as decent support this morning.  Bottom line, the numbers are messy but it could be worse.

Europe is now toxic from an investment standpoint:  First, I will be selling half my  HEDJ this morning and waiting to sell other half solely because I hate selling all of a position into a panic.  But, it’s understandable if anyone wants to unload it all into this decline.

For Great Britain, a messy 2 year “divorce” will begin from the EU and a massive cloud of uncertainty will descend on that economy.

Whether the Brexit will be good or bad for Britain or the EU economy remains unclear (and will stay that way for years). But, the bottom line is that businesses and people will become substantially more risk averse amidst all this uncertainty, and that sapping of risk taking and capital expenditure (which is the key to economic acceleration) will be a headwind on economic growth in the region.

Finally, get ready for more “Exits.”  Scotland actually voted to “Remain” in the EU last night, so there will almost certainly be another Scottish referendum, and it’s very possible last night’s outcome will result in the dissolution of Great Britain over the coming years.  For Europe, talk will start on a new kind of “Grexit.”  Only this time it will be a “German Exit.”  I’m not saying it’s likely, but last night’s decision will embolden all the nationalist parties across Europe, and the EU as a whole will now be under attack at the polls over the coming year.

MW-EQ064_sadin0_20160624011734_ORThis Is Not a Bearish Game Changer for the US Yet, But is A New, Material Headwind and Makes Us Cautious but Not Outright Bearish.  I am not wholesale reducing US equity exposure on this news because the direction of US stocks is more tied to the economy and valuation than Europe right over the medium and longer term.

But, there will be real world impacts for the US:  Earnings for the commodity producers, banks and multi-national exporters will all get hit and that further calls into question the $130 2017 EPS figure (which creates a valuation problem).  Economically, obviously the recent uptick in manufacturing activity is at risk, and the broad uncertainty isn’t helpful given we need to see further economic acceleration to power stocks higher.

Market Winners and Losers:  As mentioned in our preview yesterday, losers are exporters, banks/financials and commodity sensitive companies.  “Winners” are Treasuries (which will continue to surge as they and Japanse Government Bonds are now the safe have destination of choice), and domestically focused US stocks sectors.  If I were to buy anything today, it would probably be US investment grade corporate bonds (if we see a dip) because US balance sheets remain incredibly well capitalized.  LQD is one of the easiest ways to do this.

Do I Buy the Dip in US Stocks?  I don’t think so, at least not here.  Stocks aren’t cheap enough to buy the dip given the uncertainty.  At current levels the S&P 500 is trading just under 16X $120 EPS, and that’s not cheap enough for me.  I would look to potentially add some light longs between 1800-1850 so more towards 15X $120 EPS, with 1725 still representing compelling valuation (that’s 15X a $115 S&P 500 EPS).

What Makes This a Bearish Game Changer?  You will hear the term “Lehman Moment” a lot over the coming days but that’s a bit aggressive (at least so far).  As always, contagion is the risk here and the first signs of that will appear in British and European banks, so we will be watching the price action in the SX7P.  It that continues in free fall well into next week, that’s a major  warning sign.

Wildcard to Watch: The Yuan.  If the dollar continues to surge then we will have to worry about Chinese officials devaluing the yuan in retaliation.  That is one wild card to watch over the coming weeks if we see the dollar move higher towards par.

Bottom Line

This is not a bearish game changer for US stocks yet, but clearly the surging dollar and massaive uncertainty will be a renewed headwind.  We obviously remain cautious on stocks here but would not wholesale dump equities at this point.  Despite the hysteria, the outlook for stocks over the next year really hasn’t changed that much, as US economic growth remains the determining factor in whether stocks move materially higher from current levels.

How Brexit Will Move Markets (Stocks, Bonds & the Dollar)

/in /by

 

brexit-800x500

Many subscribers to the Sevens Report have been asking:

  • What Will Make Brexit Good, Bad and Ugly
  • Why a “Remain” Vote May Not Be A Positive for Stocks
  • How Stocks, Bonds and the Dollar Will React Depending on the Vote
  • How to Protect Portfolios and Seize Opportunities Regardless of the Outcome.

Brexit Preview: Good, Bad & Ugly

First, let me start by saying that any remain win will result in a relief rally, one that likely will take European stocks through the pre-Brexit highs of late May, and the S&P 500 through 2,100 to test recent resistance at 2,120. But for Brexit to become a material positive (and in that regard be totally removed as a macro headwind), style points will matter with regards to “by how much” the remain camp wins.

Conversely, the size of a leave victory is unimportant.  Whether Great Britain votes to leave by a one-vote majority or a 10% majority, the result in markets will be the same—pain!

 

The Good: Remain Wins by > 10%. This is the best outcome for the bulls. The reason for that is because a greater-than-10% victory likely means that, at least for the foreseeable future, the idea of Brexit politically will be dead—and that means we don’t have to worry about another vote in the future.

Likely Market Outcome: Risk On. Stocks: Sharply higher and led by Europe, although the US will be up big also. Resistance at 2,120 will likely be tested in the S&P 500. Sector Winners: Anything with UK or European exposure will outperform (and the more the better, HEDJ and VGK are obvious winners), US global industrials like GE/HON will also benefit from the reduced international uncertainty. Financials (XLF), banks (KBE) and basic materials also will outperform (thanks to a weaker dollar and rising bond yields). Bonds: Treasuries and bunds will drop (likely sharply) and yields will rise (likely sharply). Commodities and Currencies: Gold will drop (support at $1,250 will be important) while industrial commodities will rally (oil, copper, etc.). The dollar and yen will get hit, likely hard, and support at 93.50 in the dollar will likely be broken on a short-term basis, but as long as there isn’t a close below 92.52 it’s not too bearish. Finally, the pound and euro will surge short term (although we don’t see this outcome as starting a new material move lower in the dollar or move higher in European currencies beyond the short term).

 

The “Bad”: Remain Wins By <10%. I put “bad” in quotation marks because risk assets will still rally on this outcome, but the market reaction should be substantially muted compared to the “Good” scenario. Here’s why.

If remain wins by a slim margin, we will likely have another Brexit vote, potentially in late 2016 or early 2017.  The reason for that is politics: If the remain win is tight, the ruling Conservative party’s mandate will be called into question and a general election will likely be called later this year. The minority parties (Labour and others) will use another potential Brexit vote as a carrot to try and seize power in that general election.

Bottom line, if this victory is slim, Brexit will be put on the back burner from a macro risk standpoint, but it won’t be removed.

Likely Market Reaction: Basically a scaled-down version of the “Good” outcome, with moves in the same direction, just in smaller percentages.

The Ugly: Leave Wins. If leave wins by just a single vote it will be a material negative for Europe and Great Britain (at least for the short and medium term).

Likely Market Reaction: Risk Off. Stocks: Europe would drop like a stone (3%-5% is not out of the question). US stocks would also drop (2,050 would be important support for the S&P 500). Sector losers: Banks, financials, global industrials and basic materials will drop sharply. Bonds: Treasuries and bunds would surge, and I would expect the respective low yields for the year in each to be taken out on a leave outcome. Commodities and Currencies: It would be typical risk-off trading: The dollar and yen will surge, the euro and pound (and to a lessor extend commodity currencies) will drop sharply. In the dollar, resistance at 95.50 and 95.90 would likely be tested in the coming days. Looking at commodities, gold would rally big (another break of $1,300 would be likely) while oil and copper would drop sharply.

Bottom Line

From an opportunity standpoint, I’ve never been a fan of guessing binary events with which I have no special insight or edge, so tomorrow we will not be positioning ahead of the result Thursday night. I will leave that adventure to those much smarter and more intrepid than I.

But, from a broad, macro-allocation standpoint, unless we get a shock and leave wins, this won’t change my opinion on US stocks broadly. I have looked at Brexit largely as a mid-summer distraction, and I hope to be proven right on that by this time tomorrow. Beyond potentially creating a buying opportunity for HEDJ (as we mentioned last week) or a Great Britain ETF, the only other likely legitimate market reaction from this will be a move lower in Treasuries and bunds (i.e. higher yields).

To that point, if remain wins and we do not see a material move in Treasury and bund yields over the coming week or two, I will take that as a big negative signal on the economy and markets—because absent Brexit protection buying, those yields should be substantially higher than they are, if we are to believe the economic data.

And while the S&P 500 will likely surge on a remain victory, nothing about it will make us more inclined to get bullish on stocks, because the issues of 1) valuation, 2) lackluster economic growth, 3) troubling profit margin trends in corporate America and 4) lack of Fed clarity will “remain” (pardon the pun).