Brexit Dust Is Still Settling

What, Me Worry?

The shock from last week’s surprise Brexit vote has dissipated fairly quickly. US stocks, based on the S&P 500, have regained about 3/4 of the post-Brexit loss, while European shares have only recovered about half of their losses. Japanese stocks have hit the 61.8% retracement of the Brexit decline as of Thursday. UK stocks, based on the FTSE 100, improbably have regained all their lost ground and are now higher than pre-Brexit levels (nearly 123.6% retracement of Brexit plunge). Go figure.

But all is not well according to other market indicators of risk sentiment. US Treasuries’ yields are still down sharply and the US Dollar index, Japanese yen, and gold are holding on to most of the gains from pre-Brexit levels, suggesting safe haven demand is still elevated. The British pound is similarly significantly weaker and unable to rebound.

Global stock markets have begun to differentiate between markets as suggested in last week’s update, with the US stocks outpacing European and Japanese rebounds. UK shares are the surprise and probably represent an overabundance of bargain hunting by local investors. The chart below provides a nice visual of the relative bounces among major stock markets.

Where to Next?

The retracements in global shares are most likely only a short-term rebound following the initial Brexit jolt, in my view. While safe haven assets (US Tsy’s, USD, JPY and gold) remain elevated, I would be extremely cautious in chasing this bounce. If safe havens begin to fall more sharply, then I’m wrong and the first scenario from last week’s report (Much Ado About Nothing) is playing out. That would be based on the notion that markets have concluded the fallout from Brexit won’t materialize for quite some time and that asset values post-Brexit represented bargains.

More likely, in my opinion, we may have seen most of the bounce we are going to get, and sellers may become more active in the weeks ahead. We are also entering a new financial quarter and it will be interesting to see how asset managers adjust their allocations. This may lead to pronounced reductions in allocations to the UK and Europe, given the longer-term uncertainty and negative outlooks for those regions.

I would continue to favor US and Japanese stocks over European and UK shares, only looking to enter the latter on significant renewed weakness. Japanese shares are lagging somewhat mainly due to the strength of the JPY, which I suspect will shortly be addressed by additional government stimulus and possible Bank of Japan (BOJ) intervention to weaken the JPY.

Remain Calm. Carry On.

In the bigger picture, the fallout from Brexit has further darkened the global economic outlook, leaving central banks with no choice but to keep rates extremely low for years ahead. Such an environment is typically risk asset (stocks & commodities) positive, as investors struggle to find returns. And it’s also an environment that should limit the upside potential for those same risk assets.

Taken together, I would continue to follow a ‘buy on dips” strategy, as well as taking money off the table on rebounds. The Brexit drama has only just begun and promises to keep markets jumpy throughout the summer, which should provide more active investors with a series of opportunities to buy dips/sell rallies.