All eyes were on the latter half of the month with the referendum on Britain’s membership and markets were range-bound leading up to the vote. Given all the volatility and uncertainty, it may be surprising that global markets were generally positive for the month. The Dow Jones Industrial Average and the S&P 500 were both up just under 1%. The tech-heavy NASDAQ Composite was down 2.13%.Globally, the MSCI Europe Index was down -4.68% while Asian markets were mixed with the Japanese yen surging to its strongest level in over two years and the Nikkei 225 Average off a staggering 9.63%. China’s Shanghai Composite was up 0.45% for the month. Here are some of the highlights in this month’s commentary:
Brexit Fallout: There is still a great deal of uncertainty surrounding the future of markets in the Eurozone. Banks and other financial stocks were among the hardest hit with the industry entering a bear market. European financial companies were down nearly 30% for the year before rebounding slightly.
Next Steps: Britain will likely take its time in officially starting the separation process while the European Union will attempt to speed things up and solidify the remaining member states.
Credit Spreads: The spreads between higher quality US Treasuries and relatively lower corporate debt widened in response to the Brexit vote, indicating that investors were in a “risk-off” mood.
Brexit Ramifications
Now that some of the dust has settled, investors are recalibrating their market expectations and looking ahead. In the aftermath of the vote, European banks were the among the hardest hit. Many European financial institutions house their trading operations, especially foreign currency trading, in London so as to serve clients across the European Union (EU). Investors, concerned over the fallout of a Brexit, drove banks and other financial companies down sharply. Of particular importance to the markets is how economic treaty negotiations play out and whether EU-based banks are able to continue their operations effectively and efficiently in a country no longer associated with the European Union. The MSCI Europe Financials Index, which measures the performance of large and mid-size financial companies, including banks, was down over 14% on Friday following the results of the referendum and down nearly 20% two days after.
Given the results of the Brexit Vote, we would anticipate the Federal Reserve holding off raising rates during its next meeting until the future of global growth becomes clearer. Furthermore, the strength of the US dollar has been an issue for the Fed and the flight to treasury assets has only contributed to the upward pressure.
Source: Morningstar Direct
Next Steps…
Looking ahead, Article 50 of the Lisbon Treaty gives the UK between 24 and 36 months to complete its separation from the EU. However, only the UK can invoke Article 50 and they have indicated that they will take some time before starting the clock. Member states, clearly unhappy with Britain’s referendum, are calling on the country to start the process sooner rather than later. Given the geopolitical grumblings and increased uncertainty, we expect prolonged and sporadic bouts of market volatility as investors continuously digest new information and progress on trade negotiations and changes within the UK’s political structure.
The EU has the unenviable task of making the separation quick so as to reduce risk as much as possible all while discouraging other countries from leaving as well. However, the Brexit just might be the catalyst other countries needed to start their own referendums. Indeed, according to a number of polls, a majority of French and Italian citizens want a Brexit-like referendum. In fact, if French Front National Leader Marine Le Pen wins her presidential bid next year, she has promised to hold a French referendum. Could we see a “Frexit”? Only time will tell but, like the UK, France pays more into the EU than they get back and that alone may be a big enough issue given the success of the Brexit campaign. Should France leave, the future of the EU would appear more and more in doubt. As it stands right now, Germany is on the hook for an additional 3 Billion Euros to the annual EU budget once Britain leaves. At some point, even Germany’s citizens may call for a referendum as the system becomes even more unsustainable.
Reexamining Credit Spreads
We have reviewed credit spreads in the past but the current environment presents a good opportunity to reexamine spreads and how they reacted to the results of the Brexit vote. Credit spreads are useful in determining the market’s “risk on” or “risk off” attitude by looking at the differential between yields on riskier corporate bonds and less risky US Treasury securities. When investors take on more risk, yield spreads tend to tighten as they sell lower risk US Treasury bonds and buy relatively higher risk corporate debt. The selling pressure on US Treasuries pushes the prices on those securities down and the yields up. The buying pressure on corporate debt has the opposite effect, all else being equal. When we start to chart the daily changes in the yield spreads, we can see how the market’s appetite for risk changes over time.
For example, the chart below shows how investors reacted to the Federal Reserve’s Open Market Committee and its concerns over the impending Brexit vote pushed spreads higher. A week later, polls indicated that the “Remain” camp was surging ahead right before the vote. Markets started pulling out of US Treasuries and moving back into riskier assets, including corporate bonds. The selling pressure on Treasuries nudged those yields higher while the buying pressure on corporate debt brought those yields down, effectively narrowing the yield spread. Once it was clear that the Brexit vote had enough steam to pull ahead, investors poured back into the relative safety of Treasuries, effectively widening the spreads and also highlighting the fact that markets had not priced in the “Leave” camp winning the referendum.
Source: Morningstar Direct
Concluding Thoughts
As we have mentioned in our previous commentaries, uncertainty is abhorred by the markets and the results of the Brexit referendum have certainly given investors reasons to doubt global growth. We believe volatility will likely continue at a higher pace for the foreseeable future as the markets recalibrate their expectations. While this may be disconcerting for investors, we continue to believe the best remedy for those concerns is a comprehensive wealth plan that focuses on long-term objectives combines with prudent risk management.
This newsletter was written and prepared by CWM, LLC. Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. Government bonds and Treasury bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value.
DJIA
The Dow Jones Industrial Average is comprised of 30 stocks that are major factors in their industries and widely held by individuals and institutional investors.
NASDAQ COMPOSITE
The NASDAQ Composite Index measures all NASDAQ domestic and non-U.S. based common stocks listed on The NASDAQ Stock Market. The market value, the last sale price multiplied by total shares outstanding, is calculated throughout the trading day, and is related to the total value of the Index.
S&P 500 INDEX
The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
NIKKEI 225 AVERAGE INDEX
The Nikkei 225 Average Index is a Japanese index that tracks the top 225 companies listed on the Tokyo Stock Exchange. It includes the most liquid Japanese stocks listed in the first section of the Tokyo Stock Exchange. It is price-weighted and yen-denominated.
SHANGHAI COMPOSITE INDEX
The Shanghai Composite Index is a market index of all stocks (A shares and B shares) that are traded on the Shanghai Stock Exchange. It tracks the largest publicly traded companies in China.
MSCI EUROPE INDEX
The MSCI Europe Index is a market capitalization weighted index which consists of stocks from 15 developed market countries within the European region.
MSCI EUROPE FINANCIALS INDEX
The MSCI Europe Financials Index captures large- and mid-cap companies across 15 developed markets countries in Europe. All securities in the index are classified in the Financials sector as per the Global Industry Classification Standard (GICS).
BARCLAYS US TREASURY INDEX
The Barclays US Treasury Index measures US dollar-denominated, fixed-rate, nominal debt issued by the US Treasury. The index includes all public obligations of the US Treasury with at least one year until final maturity, regardless of optionality.
BARCLAYS US CORPORATE INDEX
The Barclays US Corporate Index measures the investment grade, fixed-rate, taxable corporate bond market. The index includes senior and subordinated debt with at least one year until final maturity, regardless of optionality. It includes US dollar-denominated securities publicly issued by industrial, utility and financial issuers.
Pew Research Center, June 2016. http://www.pewglobal.org/2016/06/07/euroskepticism-beyond-brexit/pm_2016-06-07_brexit-01/
Financial Times, February 2016. https://next.ft.com/content/807750a4-d984-11e5-98fd-06d75973fe09
Financial Times, 2016. https://next.ft.com/content/e8b14d60-3a36-11e6-9a05-82a9b15a8ee7
Armstrong Economics, June 2016. https://www.armstrongeconomics.com/international-news/europes-current-economy/five-more-countries-want-referendums-to-exit-eu/
Zero Hedge, June 2016. http://www.zerohedge.com/news/2016-06-26/civil-uprising-escalates-8th-eu-nation-threatens-referendum