Brexit | Market Uncertainty Ahead

Whoa! That election result certainly came out of the blue. If you ever needed proof that markets hate uncertainty, consider that the S&P 500 dropped nearly 6% in two days and then rallied 6% over the next three. We ended June at just about the same level we entered Brexit.

What gives?

Brief EU history The European Union was created by the signing of the Maastricht Treaty in 1992. The underlying thought was that countries that trade with each other are less likely to go to war against each other. After the devastation of two world wars last century, this idea had plenty of support. Because countries would share a common currency (except for UK ironically who chose to keep the pound), rules were put into place to ensure economic prudence. Member countries would maintain “sound fiscal policies, with debt limited to 60% of GDP and annual deficits no greater than 3% of GDP.”

Nobel Prize winning economist Milton Friedman said a common currency with individual country’s budgets couldn’t last. He may finally be proven right. Nearly all member countries have cheated on these agreed upon standards. The so called PIIGS (Portugal, Italy, Ireland, Greece and Spain) countries were in such bad economic shape after the great recession that the ECB had to repeatedly bail them out. Austerity demands by the ECB led to riots in Greece and fears of a complete collapse of their financial system.

The Bad

Free and fair trade is good for global economic growth. This basic tenant of economics helps explain the concern investors realized when the UK voted to leave the European Union. All other things being equal, less trade should lead to less economic activity, lower incomes and less demand for goods and services.

Furthermore, the lower economic activity results in lower tax revenues, which results in larger deficits and.. well you get the picture. After the Brexit vote, former Fed chief Alan Greenspan claimed we entered “the worst period I recall since I’ve been in public service”. A prominent London trader claimed, “this is as big as 2008 and has the potential to be even bigger.”

The Good

How can Brexit be good for the global economy. A group in Brussels currently negotiates all trade between countries in the EU. The Committee for International Trade passes rules that apply to all member nations. If the Brexit vote leads to new, and better trade agreements with an independent Great Britain, other countries may respond in kind.

Success could embolden the EU to take a similar tack to remain competitive. The resulting economic activity could be just the tonic the global economy has been waiting for ever since the economic crisis of 2008. Pollyannaish? Perhaps, but this result is certainly possible and interesting to consider.

Conclusion

Markets hate uncertainty and we have that in spades today. With an election on the horizon, uncertainty will likely continue. Buckle your seat belt.