Madison Weekly Market Wrap June 27, 2016

Market Snapshot

Brexit Brings Pain

In what some are calling the single-most momentous day in British politics since WWII, on Friday the United Kingdom voted to leave the European Union. The impact of this result has been far and wide, with global markets hit and U.K. Prime Minister David Cameron announcing his resignation. The vote was widely split across the U.K., suggesting that Scotland may well seek independence and Northern Ireland may seek reunification with the Republic of Ireland. Other countries may seek to leave the EU as well, perhaps starting with the Netherlands. European banks will be asked to weather a big storm and may not be up to the challenge. However, the vote must still be ratified by Parliament and may take years to implement fully.

Risk assets around the world suffered one of their worst days of the decade, as Brexit reactions rippled across the globe. Stocks in particular felt the brunt of the fallout, alongside the British pound. The British pound fell to 30-year lows while the Japanese Nikkei fell nearly 8 percent before recovering into the close. The Stoxx Europe 600, a pan-European benchmark, and London's FTSE 100 both tumbled more than 8 percent in early Friday morning trading, though they began to recover as the trading day came to an end. Germany's DAX fell the most since the 2008 global financial crises.

Banks got hit especially hard with the U.K. Barclay's down over 20 percent at one point while American banks including Goldman Sachs, JPMorgan Chase, and Citigroup also saw significant losses. The major safe havens for world traders were U.S. Treasuries, gold, and the Japanese yen.

Here at home, Wall Street followed global markets lower, erasing significant gains made earlier in the week (see the Market Snapshot above). The tech-heavy Nasdaq performed moderately worse than the other benchmarks, losing over 4 percent. The declines brought the S&P 500 (-3.59 percent), the Dow (-3.39 percent), and the small-cap Russell 2000 (-3.81 percent) near or into negative territory for the year-to-date, alongside the Nasdaq.

The Brexit vote dominated market sentiment throughout last week (and not just Friday). U.S. stocks reached their highs for the week on Thursday, when many wrongly concluded that the U.K. would vote to remain in the EU. Futures plunged in overnight trading, however, after it became clear that the vote had gone the other way. The major indexes plummeted at the open, recovered a bit, but then fell back to new lows in afternoon trading.

Last week's U.S. economic data were mixed. Existing home sales rose 1.8 percent in May, while new home sales fell 6.0 percent. The smaller sample size used in the new home sales data often results in volatility in the reading. Durable goods orders fell 2.2 percent, with core capital goods orders falling 0.7 percent. The data pointed to a lack of business investment and concerns over productivity, but the numbers also reflected a recovery in export orders.

The yield of the benchmark 10-year U.S. Treasury note rose marginally through last week, only to plummet to its lowest levels in nearly four years as bonds rallied after the release of the results of the vote. The favorable macro backdrop created a firmer tone in the investment-grade corporate bond market, but it sold off sharply following the Brexit news. The high yield market was also volatile.

As I have noted, the impact of the Brexit vote will likely be very substantial for Great Britain and for Europe. Rating agency Standard & Poor's has already confirmed that the U.K. is likely to lose its highest-level AAA credit rating. The EU referendum is tearing the U.K. in half. London, Scotland, and Northern Ireland voted strongly to stay in the EU while the north of England, the Midlands, and Wales wanted out. The young and the educated wanted to stay while the old and the uneducated wanted to leave. Meanwhile, radical parties are making inroads at every level of government around the continent of Europe. 

However, I don't expect long-term negative consequences in U.S. markets to any significant degree and, as the above chart suggests, the markets appear to have overreacted given the magnitude of what happened today relative to other major events. If the U.K. experiences something like the predicted 3.5 percent decline in GDP then it will be bad for the U.K, but it will mean little globally. Remember, the U.K. represents just 4 percent of global GDP. Even in a worst case scenario it is not large enough to derail the global economy on its own. 

A stronger dollar will likely lower U.S. GDP somewhat and push interest rates a bit higher, but there is no reason to expect a recession at this point. Brexit gives the Fed more reason not to move on interest rates. But if we do suffer a correction, remind yourself that this is why diversification matters and that volatility is the price you pay for higher returns. There is no reason to alter a good financial plan or change one's asset allocation on this news.

Chart of the Week

Good Reads

The following recent articles are well worth your time.

Simple Financial Advice for New Grads (Morgan Housel)
Do You Pass the Financial Stress Test? (Bloomberg)
The Importance of Asset Allocation vs. Security Selection: A Primer (GestaltU)
When Winners Fail (Basis Pointing)
Simplexity (Michael Batnick)
The Market's Buyback Yield is not a Timing Tool (Patrick O'Shaughnessy)

Book of the Week

Daniel Kahneman, winner of the Nobel Prize in Economic Sciences for his work in psychology challenging the rational model of judgment and decision-making, wrote this insightful memoir about his life and work, Thinking Fast and Slow. In it, he tells his story, summarizes his life's work. He also reveals when we cannot trust our intuitions and how we should use the benefits of slow, deliberative thinking. His work (and this book) challenged and ultimately transformed the way I think about thinking.

Fact of the Week

A new report from Berenberg research projects that life expectancy will keep increasing and fertility will keep decreasing on a global scale. The number of countries with high life expectancies (over 75 years old) and low birth rates has been steadily increasing since the mid-20th century, and it will keep rising. Berenberg projects that over 75 percent of countries will reach this by 2050. Taken together, long lives and low birth rates mean the percentage share of older people in these countries -- and in the world -- will increase as well. The number of countries with a higher percentage of citizens older than 65 is set to skyrocket within a few years, as will the number of countries with negative population growth. That means the demographic problems that have almost crippled Japan in the past few decades (such as fewer and fewer people available to fund senior programs) will affect 40 percent of all countries by 2050.

Quote of the Week

"Friendship is like money, easier made than kept."

-Samuel Butler

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