The surprising outcome of the British election over succession from the European Union rocked global financial markets on Friday. The selling continued into Monday, but markets quickly bounced back on Tuesday, Wednesday and Thursday. Now with Brexit a full week in the rear view mirror, most stock markets around the world have nearly or fully recovered their losses. But in bond markets, particularly in the US, the historic gains in prices (and drop in bond yields) remain largely intact. Moreover currency markets have also retained their post election gains (or losses).
Immediately following the large declines in world stock markets on Friday, investment advisors for major banks were all over the media advising investors of the bargains the stock market had provided. They cautioned investors that the markets were overreacting, throwing the proverbial baby out with the bathwater. Investment strategists were quick to point to beaten down US stocks, like Southwest Airlines with virtually no British of european exposure. The argument being, that these stocks were being unfairly punished by an indiscriminate market inclined to sell, sell, sell.
In reality, the market reaction to the Brexit vote had very little to do with the implications for corporate earnings or weakened economic activity in the UK. It had everything to do, first and foremost, with the excessive risk-on positioning of portfolio managers who were betting strongly on a remain vote. Many pointed to the odds at British bookie parlors, the "in the know" folks who were treating Brexit as a one in six probability. The torrid selling on Friday and into Monday was largely driven by fund managers scrambling to get back onside.
There is, however, a much more significant and lingering issue that underlies these moves. This, is the implication for currency markets. Friday saw the greatest one day selling of the Great Britain Pound (GBP) in history. While the Euro also sank, the US dollar rose. And, in far more dramatic fashion, the Japanese Yen soared.
And herein lies the problem for US stock markets. The Bank of England announced earlier today that they will be likely adding to QE to stimulate the post-Brexit economy. As one might expect, the GBP is down another 1.5% against the dollar on the news. Further QE by the ECB would predictably have a similar reaction in currency markets. This being said, it is the Yen and the Chinese Yuan that pose the greatest risk to devaluation and the greatest implications for a further rise in the dollar, as these countries desperately struggle to invigorate their own exports. A stronger dollar would pressure sales and earnings of US multinational companies, already suffering not insignificant profit declines and poses a great challenge to US stock prices going forward.
