The S&P 500 and global markets came under historic pressure on Friday after voters in the United Kingdom surprised the world with a decision to leave the European Union after more than 30 years of membership.
By all accounts, the pressure is set to continue as the eight-year-old bull market faces its most serious existential threat yet.
The political fallout is just beginning, with pro-“remain” British Prime Minister David Cameron resigning and “Article 50” — the EU’s exit clause — yet to be invoked by the British government. The Brexit process is likely to take years. During which nervousness, uncertainty and copy-cat independence movements in other countries will reign. Anti-EU politicians in Italy, France and the Netherlands have already called for referendums while similar calls were made by anti-immigration parties in Sweden and Denmark.
In the end, the Dow Jones Industrial Average lost 3.4%, the S&P 500 lost 3.6%, the Nasdaq Composite lost 4.1% and the Russell 2000 lost 3.8%.
Financial stocks led the decline, falling 5.4%, followed by materials and technology. Defensive telecom stocks limited their decline to 0.9%. JPMorgan Chase & Co. (JPM) fell nearly 7% to collapse out of its three-month consolidation range and put an end to its five-month uptrend, benefiting the July $60 puts recommended to Edge Pro subscribers.
Brexit Ripples Throughout the World
Overnight, the smell of panic was in the air.
The British bound dropped to levels not seen since the mid-1980s. U.S. equity futures went “limit down” as circuit breakers kicked in. European bank stocks — the epicenter of all of this because of their European bond holdings and exposure to the local economy — were crushed by the most on record. A surge in the Japanese yen smashed popular currency carry trades and torpedoed the Nikkei 225 index to a loss of 1,286 points, or a stomach-churning 7.9%.
Greek stocks lost nearly 16% while Italian stocks were down 12.5%. A breakdown in the European Union would threaten Greece’s bailout programs, since a smaller euro area would put the rescue burden on a smaller number of countries.
The policy elites are in a serious bind with a situation that looks, in some ways, worse than the 2008-09 financial crisis.
For one, all the obvious policy easing levers have already been pulled.
The Federal Reserve has only raised interest rates just one this cycle, leaving the Federal Funds rate in a range between 0.25% and 0.5%. Aggressive asset purchase programs have already been deployed, with the Fed holding nearly $4.5 trillion in assets vs. $900 billion back in 2008.
The Bank of Japan is buying stocks via exchange-traded funds. The ECB is buying corporate bonds. Both have deployed negative interest rates with calamitous effect as this has pressured bank profitability by narrowing net interest margins.
Two, this comes at a time of global economic vulnerability.
Here in the United States, we’re in the midst of an outright earnings recession, with S&P 500 earnings down for the last four quarters in a row. Deflation is a real threat, made worse by elevated public debt-to-GDP ratios in the developed world. Spain, Poland, Greece, Italy, Switzerland and the euro area as a whole are all in outright deflation. France, the Netherlands, Ireland, Germany, the U.K. and Finland all have inflation rates near 0%.
In Asia, China is contending with a slow-burn credit crisis by attempting to manage down its currency in an effort to bolster exports. A collapse in the British pound and the euro threatens that. Japan is a mess, with a 229% debt ratio, a 6% budget deficit, deflation and an economy on the verge of contraction as officials obsess over keeping the yen weak in a similar effort to bolster exports.
And three, any policy response is likely to only deepen the problem.
If central bankers support markets here — keeping stocks in the low-volatility sideways crawl of the last three months, capping a three-year consolidation near Dow 18,000 — it will prove all the pre-Brexit fear mongering hollow and will encourage pro-independence votes in Italy and elsewhere.
But if they let markets fall, volatility will beget volatility as one of the few bright spots in the global economy darkness. Years of central bank intervention and easy gains have encouraged risk taking and leverage accumulation. The collapse could be swift and severe. The opening gap down move this morning was the worst since 1987, pointing to the fragility of markets.
Already, the Friday’s decline pushed all the major averages into the red for 2016: The Dow is down 0.1% while the Nasdaq is down nearly 6%.
In response, I am continuing to recommend defensive positions to by subscribers including a focus on volatility — which one of the few assets that provide some diversification benefit in this environment. The CBOE Volatility Index (VIX) enjoyed its fifth best daily gain ever returning to mid-February levels. That boosted the Credit Suisse AG – VelocityShares Daily 2x VIX Short Term ETN (NASDAQ:TVIX) recommended to Edge subscribers to a 41% gain.