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.
This 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.
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.