Last week the citizens of the United Kingdom voted to leave the EU.
First some history. The predecessor of the EU was called the European Economic Community which started in 1957. The original EEC consisted of Belgium, France, Italy, Luxembourg, the Netherlands and West Germany. In 1963 and in 1967 the UK tried to joining the EEC but their applications were vetoed by Charles de Gaulle. After de Gaulle was out of office the U.K. applied again and was accepted in 1975.
Politics in the U.K. being what it is in January 2013 Prime Minister Cameron announced that there would be an in or out referendum on EU membership before the end of 2017. That vote was what was held last week. The Brexit yes vote does not mean that U.K.’s withdrawal from the EU is a done deal. There are several steps which still must happen. How this will actually unfold is unclear. The actual withdrawal should take at least 2 years and politicians could very well suggest that another referendum asking “Do you really, really want to leave the EU.” I suspect that people in power: politicians and others will try to talk voters into another referendum taking back Brexit.
While the sharp drop in equities last Friday was a normal reaction to massive uncertainty the size may well have been a consequence of so many people having speculated on the outcome of the referendum and been wrong. Many market shocks are due to the unforeseen. The earthquake/nuclear accident in Japan was not foreseen. The Nikkei fell 16% during the next two trading days but recovered fully in 4 months.
The problem with assessing markets reaction to Brexit may be that this is different in the sense that if the U.K. had left the EU the day after the vote, or even started the Article 50 process markets could start to react and eventually settle somewhere. Instead we are faced with markets trying to seek prices based on something which has never happened before and may happen sometime after 2 years from now. If EU members wanted quick market normalization post-Brexit the sensible choice would be to find a way to make it happen quickly rather than slowly. I believe that the fact is that political leaders see that as the beginning of the end of the EU. In a very real sense what is happening is a struggle between the extremes of world government and individuals perception as to what is best for themselves.
There is one thing which is always true of markets: when there is uncertainty investors flee equities and seek safety in U.S. Treasuries.
In the longer run the question is how will this effect the economy of the U.K. members of the E.U. the U.S and the rest of the world. My simple answers is that this is in fact good for the U.K. bad for the E.U. and neutral for the U.S.
The problem is that this is happening at a time of massive global economic uncertainty. Things were already sluggish and this never before seen event occurred and the natural reaction is to flee for safety. Safety = gold and U.S. Treasury debt. Equity markets do not like uncertainty and as the exit of the U.K. from the E.U. takes time to unfold this nagging uncertainty will continue to drive money to U.S. Treasuries and, by implication, drive down mortgage rates.
Brexit is not a catastrophe. It is the result of the corrective force of voters telling government what direction it wants the U.K. headed .
What we will likely see this week is the usual campaign of misinformation by economic media trying to convince individuals that everything is OK and equities are a great buy.
My belief is that we will continue to see safe haven buying of Treasuries even though the yields are low. I see the possibility that the 10-year U.S. Treasury yield could fall into the range of 1.00%-1.25%.
In case you were wondering Fed hikes are off the table indefinitely