Remember Brexit? The markets didn’t seem to as the languid summer rolled along into mid-August.
The days immediately following the June 23 vote by a majority of Britons to extract their country from the European Union was like an investment Armageddon where the British pound got pounded, major global stock indexes fell through a trapdoor, and yields on U.S. Treasurys and other bellwether developed-market bonds tumbled in the risk-off environment. But the markets—particularly equities—quickly reversed course as the mind set toward Brexit shifted from apocalypse to apathy.
This much we do know: The Brexit aftermath will have have both short-term and long-term consequences. What we don’t know is what exactly those longer-term consequences will be. Brexit was yet another jolt to global markets that seem ever more connected and volatile, and more tumult is likely to come (whether or not they’ll be Brexit-related). For investors, that means being mindful of protecting their portfolios against the next shoe to drop.
“Brexit doesn’t mean a lot in and of itself, which is why there was a sharp bounce back in the markets,” says Ben Hunt, chief risk officer at Salient, a diversified asset management firm. But it could be a harbinger of things to come.
The way he sees it, Brexit is a Bear Stearns moment, not a Lehman Brothers moment. In other words, both the Brexit vote and the collapse of investment bank Bear Stearns in March 2008 were viewed as idiosyncratic events that the markets shrugged off. As it turned out, Bear Stearns was a prelude to the systemic problems of the global financial system symbolized by the bankruptcy and demise of Lehman Brothers six months later.
“I think Brexit is a big deal, the same way Bear Stearns was a big deal, because it is the first car on this train of anti-globalization, anti-status quo, anti-trade political movement that’s growing around the world,” Hunt says. “The Lehmann Brothers to Brexit’s Bear Stearns that I’m looking ahead to are the political events that can’t be papered over.”
The first item on the worry parade is Italy, where there’s an October referendum on a constitutional overhaul proposed by Prime Minister Matteo Renzi that he says will stabilize that country’s chronic political instability. He has promised to quit if the referendum is defeated. Part and parcel to that is the sorry state of debt-laden Italian banks. Italy is negotiating with the EU to recapitalize its banks, arguing that flexibility is needed to prevent bank failures that could ultimately cause a contagion that could take down Europe’s banking system.
The Italian vote in October is seen as a referendum on how Italians feel about their participation in the euro zone, and the fear is that political instability caused by a “No” vote on Renzi’s constitutional overhaul could cause financial instability in its banking sector that could set off bad outcomes across the continent.
After that comes the U.S. election in November, with GOP nominee Donald Trump’s stances on trade and tariffs stirring concerns about negative domino effects across the globe. Ben Hunt says if Trump threatens a trade war with China, the Chinese would likely respond by floating their currency, resulting in devaluation.
That, he argues, would be destabilizing to the European banking system because their banks don’t fund themselves in the same way that U.S. banks do. U.S. banks are funded by depositors, while European banks are funded by securitizations and by essentially being merchant banks, making them intertwined with—and levered to—global trade finance.
“So when a country as important to global trade as China devalues its currency, it means that existing loans based on the old value of the Chinese currency become unglued,” Hunt explains. “That’s when you get a credit freeze, akin to the 1997 Asian credit crisis. This is a potential earthquake 20 times greater than what happened when Thailand devalued its currency in 1997.”
Further out is the 2017 presidential election in France, a country where EU-skepticism is greater than what existed in Great Britain before the Brexit vote. If far-right populists gain the upper hand in that vote, there’s a fear that France will bolt the EU—a scenario known as “Frexit.”