Bad Time for a Market Shock

June 27, 2016

The British referendum result delivered bad news and not merely because it defied street expectations or the widely held view of investors, economists, world leaders, and central bankers that the British, European and world economies would be poorly served by a verdict to take Britain out of the EU.  No time is good for bad news, but this development landed on a global economy that hasn’t shown much resilience since the financial crisis and especially this year.

The initial two post-referendum trading days have confirmed a negative market reaction with lots of contagion to other countries, as the Remain proponents had forecast.  Sterling’s tumble against the dollar of 12% since Thursday’s high far exceeds the immediate decline when it left the ERM in mid-September 1992 and is only a third as much as the fall between the high in 1975 and low in 1976.  The Ftse’s fall of slightly less than 5% over the past month is not terribly large.  However, considerably larger share price declines elsewhere in the European Union reveal a deep possibility that the Brexit vote may mark the start of the final unraveling of the EU itself, or if not that, then the common currency experiment.  Compared to a month ago, stocks are down at least 9% in Europe as a whole, France, Germany, Denmark, Spain, Italy, Belgium, and Portugal.

The European Monetary Union not long ago experienced a severe attack related to the perceived unsustainability of a single monetary policy, disparate and uncoordinated fiscal policies, members with widely different levels of trade competitiveness, debts and deficits among some members that proved far larger than thought, wholly different cultures and governance between creditor and debtor nations, and deepening animosities shared by government leaders and voters between the nations of the north and south.  Beyond that, there’s been voter remorse in much of Europe over what EMU delivered in jobs, wage growth, and in providing a stronger presence with nations outside of Europe relating to security from the job dislocation caused by technical innovation and globalization, the invasion of migrants, and in basic protection from global terrorism.  Tensions also arose between different generations within countries.  The Common Currency Union’s original sin was too proceed without a sufficient popular mandate.  All signers of the Maastricht Treaty upon which it was based were required to ratify it, but only a couple put the issue to a direct vote of the people, and the most important of those referendums in France squeaked through by the narrowest of margins — 50.8% for to 49.2% against.  That was way too small to constitute a mandate for a change in sovereignty so great, and France indeed now 24 years later is one of the top candidates to test if it’s time to leave as well.

Economically, the EU is saddled with chronically meager growth, socially excessive levels of unemployment, negative interest rates, and deflation.  There is no plan for a broad Euroland-wide break-up, and and the tooth-extracting pace by which a series of past crises have been handled points to excessive delay in straightening out the present mess.  It’s safe to believe that the future is likelier to hold bad news than unexpectedly good developments.  The loss of Britain’s voice, moreover, will be sorely missed in providing balance to EU-wide policy-making.

The world faces other threats in the second half of 2016.  If the Trump revolution is completed in November, the U.S. role in global diplomacy will undergo its biggest change in over 75 years.  Such a development in the long arc of history could far exceed the fallout that Brexit will bring.  Political leaders virtually everywhere, and that significantly includes Japan, have shirked their policy responsibilities, forcing central banks to shoulder an unreasonable burden of keeping growth moving forward and inflation safely above zero.  When the dot-com bust hit in late-2000, Fed stimulus got to work from a federal funds rate level of 6.5% and cut such to 1.0% by mid-2003.  When the sub-prime mortgage loan crisis surfaced in August 2007, the fed funds target was at 5.25%.  The FOMC is isolated compared to other advanced economy central banks in managing to implement an initial rate hike, but like their colleagues elsewhere, Fed officials are caught in a trap of not finding the U.S. economy in a position to handle more normalizing steps.  Negative interest rate experiments have yielded very disappointing side effects.

A new global economic shock will have to be handled by tools other than central bank measures if it’s to be successful.  A different country patron would be also needed.  Pump-priming by China served that role in 2009, but China’s got its own serious problems now as well as a leader with different priorities than his predecessor.

Whether its because of the complexity of big economic problems or the lack of competent political leadership or the failure of political institutions that pick political leaders or the corruption of well-funded interest groups bent on putting the desires of the few before the common good of the many, the end result has been a surge in nationalism virtually everywhere.  Historically, that’s seldom led to good outcomes.  Brexit presents world markets with a new accelerator of fear, and a bad backdrop of pre-existing tensions gives one little reason to be optimistic.

Currency markets can be an excellent venue to showcase investor concerns.  1976 comes to mind when a diving Italian lira in the earliest months of the year spawned trouble on a string of other intra-European currency relationships including the French franc and pound, which exploded downward in March after sliding under support at $2.00.  Sterling weakness is the trigger this time, and the yen, Swiss franc, dollar and gold are the objects of the stampede into safety.  It’s being said by some pundits that being primarily a political event, the fallout of the Brexit vote is likely to simmer down pretty quickly.  As a rule in the past, political shocks tend to be more quickly self-limiting than true economic shocks.  But an observation lately is that economic data is not the straw that stirs the forex drink in quite the same way.  The Fed’s been talking a long time about data-driven policy and has managed just one rate hike despite progress in cutting unemployment and pulling away from a deflationary threat.  Brexit has enormous policy implications, even greater uncertainty regarding how these changes will play out, and it directly involves one of the major storage mediums of off-shore paper currency wealth.

The pound’s 12% decline since Thursday may be just the beginning.

Copyright 2016, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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