InnOvation Capital & Management, LLC
LAW – POLICY – FINANCE – MARKETS
INFORMATION FOR THE ENTERPRISE AND INVESTOR
JULY 12, 2016
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Last week, we discussed political aspects of the “Brexit,” the prospective divorce of the U.K. from the European Union. Today, we’ll discuss finance and markets. Later in July, IntelDigest will have global Debt on the agenda, as well the prospects for Gold.
Uncertainty is the primary product thus far of the U.K. vote to leave the European Union. Investors hate uncertainty! In the immediate aftermath of the referendum, global equity markets and the British Pound Sterling took giant steps down; the Euro and related currencies fell; many investors fled to the supposed “safe havens” of precious metals and U.S. treasuries. Gold and silver, in particular, rallied by more than 5% in two days.
In the following week, markets settled down and many equities regained their previous footings. But, gold and silver have not retraced, and Sterling remains down more than 10%, at its lowest level in decades. Gold and silver are likely to continue making great gains over the next two years, while the British Pound is likely to continue lower.
In the U.K., six fund managers have halted redemptions from their U.K. property funds in the last two weeks. This is stifling almost 50% of the real property markets. The fund managers fear that sellers will overwhelm the market, forcing fire sales of U.K. property.
The market uncertainty hastened by the Brexit vote will have long-lasting ramifications, but that does NOT necessarily mean a market crash, or even a bear market, IN THE SHORT TERM. There is a high probability that central banks around the world will move to counter downturns in the markets with new rounds of monetary easing.
The Bank of England, European Central Bank, and the People’s Bank of China have all indicated that they are ready to provide liquidity, if needed, to ensure global market stability. The Federal Reserve stated that it is “carefully monitoring developments in global financial markets, in cooperation with other central banks, following the results of the U.K. referendum on membership in the European Union.” And, it is “prepared to provide dollar liquidity through its existing swap lines with central banks, as necessary, to address pressures in global funding markets, which could have adverse implications for the U.S. economy.”
Impact on the U.K.
It is likely that Brexit will lead to lower GDP growth in both the U.K. and the E.U. over the next two years as the separation progresses.
The long-term outlook for the U.K. economy is actually better, once it is free from E.U. regulations and has completed new trade agreements with the E.U. and the rest of Europe. The old saying is that “capital goes where it is treated best,” and a nimble, re-formed U.K. economy should make the country appealing to investment capital. However, that is a couple of years down the road.
In the meantime, the British economy is fragile, whether it leaves the European Union or not. The United Kingdom has a high chance of plunging into a recession, and the Bank of England would be left with a difficult choice. The BOE could lower interest rates in an attempt to mitigate the risk of recession, which would hurt its currency even more and create inflation concerns. Or, it could raise rates to support the currency, thereby choking choke off growth.
Impact on the E.U.
The European economies have more to lose from the Brexit. For example, consider that Britain is Ireland’s largest trade partner, accounting for roughly 14 percent of Irish exports. Depreciation of the British Pound will make it more difficult for Irish exporters to sell goods to Britain. The Netherlands, Luxembourg, and Belgium send 9% of their respective exports to the U.K. All E.U. economies will be at a disadvantage versus a depreciated British Pound.
A large part of the problem pre-dates the Brexit vote; even before the referendum, Debt has been the biggest economic problem in the world; this will be the primary topic of IntelDigest next week. The global economy is drowning in debt. Corporate debt in emerging markets has jumped five-fold over the past decade, and companies in the U.S., Europe, and Japan have been taking advantage of ultra-low interest rates to amass TRILLIONS of dollars of new debt. U.S. corporations are carrying twice as much debt on their books as they did six years ago.
The situation is worse in Europe, where the banking system never fully recovered from the 2008 financial crisis. Brexit will severely test the banks of Europe, placing greater constraints on the already fragile union, which will lose financial support from Britain, which may then be in a position to operate in a more nimble and dynamic fashion as it competes against the union.
Impact on the U.S.
The oasis in the desert of the world economies has been American dividend-paying stocks, mostly in the utility, telecom, specialty REIT, and consumer staples sectors. Fear and upheaval drive investors to essential and basic goods and services offering reasonable yields (3-5%). As noted above, capital will go to where it is treated best.
This is the reason that there is less probability of a bear market or recession in the U.S. during this year. Capital flees from upheaval and uncertainty, and cash from around the world continues to prop up U.S. stock markets.
Looking Forward
The economic consequences of the Brexit will play out over time. The financial crises of 1998 and 2008 actually started over a year before the Crisis Dates, so the Brexit consequences could ramp up to a Crisis Date over a year or more in the future.
We are likely to see more spirited intervention by central banks, opening the floodgates of Easy Money even wider. Although the quantitative easing programs of the Federal Reserve ended two years ago, the Fed could come up with QE4 if a recession looms. The European Central Bank buys $90 billion per month of both government bonds and corporate debt in order to keep Europe afloat. And, the Bank of Japan has become the largest shareholder in just about all Japanese companies, and will probably begin buying American equities soon.
We must be cognizant of the potential for another financial crisis in 2017 or 2018. Financial systems around the world are still fragile after the 2008 crisis, and have been propped up by massive interventions by central banks. The level of debt all over the world is unprecedented. And, both the U.K. and European Union will likely be at their weakest as they progress through the separation process over the next two years.
IntelDigest will continue to address these issues and many others, on a weekly basis, as we go forward.