Brexit Reignites A New Phase Of Risk-Off Sentiment

The shocking news that the UK voted to leave the European Union has triggered a new phase of risk-off sentiment around the world. It’s anyone’s guess how this all plays out, but the initial reaction is deeply bearish. Yes, it could all be overblown, but the crowd is inclined, once again, to run first and ask questions later. “This is the biggest shock to European politics since the fall of the Berlin Wall,” Rob Ford, professor of politics at Manchester University, tells Bloomberg.

World equity markets are tumbling today, but the real test will probably come next week, after the world digests the news over the weekend. Meantime, the appetite for safety has soared.

The 10-year German Bund yield is back in negative territory, dipping to -0.08% (as of 6am NY time), as investors rush back to a safe haven. Futures trading for US stock indexes are down sharply in early trading, following routs in Europe and Asia on Friday. Suffice to say, the notion of a Fed rate hike is dead in the water for the foreseeable future.

The main question is what impact will all of this have on the real economy? No one knows, although the initial view is that Brexit comes with a price tag. Exactly how much a macro haircut awaits, if any, is to be determined. Ground zero, of course, is Britain. Economists have been warning that a vote to exit the EU would take a bite of Britain’s GDP, perhaps leading to a mild recession in the months ahead. Europe, too, would suffer a degree of blowback. The bigger unknown is whether there are ramifications for the US and elsewhere?

Lots of questions, but few answers at the moment. For the moment, it’s all about sentiment, which has turned sharply negative. Markets are discounting trouble, and there’s sure to be no shortage as the ugly details of how the UK will disentangle itself from the EU emerge in the months ahead.

As for the US stock market, the crowd as recently as yesterday (Thurs., June 24) was feeling jovial. The S&P 500 surged 1.3%, approaching its highest level in months. But if the rally this week was predicated on Britain staying in the EU, a major attitude adjustment is scheduled for Friday.

In the short run, nothing much, if anything, will change in terms of fundamental adjustment of regulations, trade, etc. Implementing Brexit will take time, several years, in fact. But it’s coming and because markets are forward-looking machines there will be a constant discounting process underway for some time, perhaps with turbulent results.

The blowback from Brexit probably won’t be as bad as the pessimists think, but it won’t be trivial either. As the markets struggle to find out where equilibrium lies, there will be substantial risk and opportunity… and lots of volatility. Separating the wheat from the chaff isn’t going to get any easier, and it may be a whole lot tougher. But for good or ill, it seems that regime change has arrived… again. Now comes the hard work of figuring out what it means, or doesn’t.

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