The United Kingdom’s (U.K.) unexpected decision to leave the European Union (EU) sent markets reeling on Friday (June 24, 2016). The S&P suffered a 3.6% decline, its worst day of 2016. But that loss was muted in comparison to the 8.6% drop in Europe’s EURO STOXX 50 Index—its biggest one-day loss in 30 years—or the nearly 9% drop in the British pound versus the U.S. dollar to a 31-year low. Investors fled to safe havens such as U.S. Treasuries, the U.S. dollar, and gold amid the political uncertainty. These moves were exaggerated by the unwinding of “remain” trades that were made in the days leading up to the vote, when global equities, European markets, and banks in particular, had risen.
Perhaps the most surprising market reaction was in the U.K. stock market. The FTSE 100 Index in the U.K. fell just 3% (in local currency), slightly outperforming U.S. stocks, and ended last week (June 20–24) up 2%, for its best week in the past 10. U.K. stocks likely benefited from the potential export boost from the weaker pound. Plus, these are global companies that generate most of their revenue outside of the U.K. In U.S. dollars, however, U.K. stocks suffered double-digit losses.
This week we look at the potential U.S. economic, earnings, and market implications of this historic event—the first reversal after many decades of European integration.
*Historically since WWII, the average annual gain on stocks has been 7-9%. Thus, our forecast is roughly in-line with average stock market growth. We forecast a mid-single digit gain, including dividends, for U.S. stocks in 2016 as measured by the S&P 500. This gain is derived from earnings per share (EPS) for S&P 500 companies assuming mid-to-high-single-digit earnings gains, and a largely stable price-to-earnings ratio. Earnings gains are supported by our expectation of improved global economic growth and stable profit margins in 2016.
Additional disclosure on page 1:
U.S. Treasuries, the U.S. dollar, and gold may be considered “safe haven” investments but do carry some degree of risk. Treasuries include interest rate, credit, and market risk. They are guaranteed by the U.S. 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. Precious metal (gold) investing involves greater fluctuation and potential for losses. The potential for fast price swings in currencies may result in significant volatility in an investor’s holdings.
POTENTIAL ECONOMIC IMPACT
As discussed in this week’s Weekly Economic Commentary, we expect minimal impact on the U.S. economy from the Brexit. Although the odds of a U.S. recession in the next 12–18 months may have risen slightly, we believe they remain well below 50%. The stronger dollar from tightening financial conditions will be a slight drag on U.S. exports, but exports only represent about 15% of U.S. gross domestic product (GDP), and the U.K. composes just a small fraction of that. Even the much larger EU, which will see some negative economic impact from breaking trading ties with the U.K., comprises just 17% of U.S. exports.
The wild card is how this vote affects other countries considering leaving the EU. Should other countries leave over time and the EU unravel (though not our view), the economic and financial market implications could be quite significant and resemble the European debt crisis in 2012. This political uncertainty could be with us for some time as negotiations between the U.K. and EU (which cannot begin until new British leadership is in place) may be very tough and could take more than the prescribed two years. Anti-integration leaders in several countries, including France, have already called for their own referenda.
POTENTIAL EARNINGS IMPACT