Fed setting the stage
Although the Fed (and the market) took a more dovish stance following the weak May jobs report, it still appears that the goal is to raise interest rates at least once this year; possibly as soon as July or September.  This is far from suggesting that monetary policy will be “tight” in the near-term; while the trajectory of future rate hikes is highly likely to be of the gradual variety.  Regardless, the potential summer of discontent could be further fueled by Fed-induced volatility.

Brexit: a one-sided risk
Another more immediate sign of discontent will likely come from across the Atlantic Ocean. In the first half of the year, investors kept a watchful eye on political developments in Europe, including the refugee crisis and negotiations over Greece’s bailout. Europe’s political risk may be approaching the 2016 peak with the June 23 “Brexit” referendum as the U.K. decides to exit or remain a member of the European Union (EU). We see this as a one-sided risk to the markets given the likelihood of a sharp stock market sell off in the event of a vote to leave, while only a modest relief rally may result from a vote to remain in the EU.

While it may simply be a coincidence,  the pattern taken by global stocks in the run up to the Brexit referendum is similar to the pattern seen in the run up to the 2014 Scottish referendum (when Scotland voted to stay or leave the U.K.), as you can see in the chart below. If the pattern continues, we could be due for a short-term dip in the next two weeks as the referendum becomes top of mind for investors.

Stocks have followed a pattern ahead of the Brexit referendum that is similar to the 2014 Scottish referendum

Source: Charles Schwab, Bloomberg data as of 6/6/2016.

Past performance is no guarantee of future results.

Fortunately, it looks like the U.K. may vote to remain in the EU, based on polling data. As you can see in the charts of 2016 Brexit poll results, online polling shows a tight vote, but telephone polling shows about a 10% advantage to remaining in the EU. Telephone polling is statistically sampled and historically tends to be more accurate than online surveys. We are not political analysts and the vote could go either way, but 10% is a pretty wide margin—not quite a landslide, but enough to put the issue to rest for some time if the vote ends up reflecting what we are seeing in the telephone polls.

Brexit: online versus telephone polls

Source: Charles Schwab & Co., Inc., Financial Times, ComRes, ICM, Ipsos MORI, ORB, Pew Research Center, Survation, Financial Times, BMG Research, Greenberg Quinlan Rosner Research, Harris, ICM, Lord Ashcroft Polls, Opinium, ORB, Panelbase, Populus, Survation, TNS, YouGov. Data as of 6/6/2016.

The 10% margin is similar to what we saw in both the 2014 Scottish referendum and the 2015 general election in the U.K.. In the 2014 Scottish referendum, the online polls were similarly tight; but ultimately the Scots voted in their economic best interest and remained part of the U.K. by a 10% margin. A similar pattern was seen in the run up to the 2015 general election in the U.K.; where polls showed a tight race between the Conservative and Labour parties, but the Conservatives winning by a 7% margin.

In the case of a Brexit result
If the U.K. were to leave the EU, it seems likely the EU would raise tariffs and take actions to encourage the movement of trade back within the EU. The U.K. would have less influence to block or negotiate these regulations. With trade making up 40% of gross domestic product (GDP), keeping favorable trade agreements in place is critical to the UK economy. The financial sector is likely to suffer most—over time, London would likely lose its place as Europe’s financial hub to Paris or Frankfurt as new EU rules are written. The uncertainty of what newly-crafted trade deals would look like between Europe’s second-largest economy and the rest of the EU would limit capital spending across the channel in both directions, as well as weigh on trade in the interim.

Global stocks may react to the concern the Brexit could result in a wave of similar votes across different countries in the EU. Today, half the voters in eight EU countries believe their own governments should hold votes on staying in the EU, according to polls conducted by Ipsos Mori. The Brexit result could renew the debt crisis of 2011, when bond yields of southern European countries soared on fears they would be forced to exit. The euro would also likely to slide on fears of a breakup of the Eurozone. Investors may favor perceived safety and move to assets considered more defensive such as the U.S. dollar and gold. Lastly, a Brexit would be likely to raise global economic uncertainty, perhaps enough to prompt the Fed to push out U.S. interest rate expectations.

In the case of a Remain result
Global stocks may not see much of a relief rally following a vote to remain in the EU. The global stock market is near the high for the year and does not appear to have priced in the consequences of a vote to leave, so there is little room to rally on the news. Also, since stocks have been following a similar pattern to the 2014 Scottish referendum, it is worth noting that there was no relief rally after the referendum results. Stocks in the U.K. and around the world, as measured by the MSCI United Kingdom Index and the MSCI AC World Index, fell 8% over the month following the referendum as an unrelated slide in oil prices began.

While we see the Brexit vote as a one-sided risk to the markets, we believe economic considerations will favor the U.K. remaining within the EU despite how much the British may resent bailed-out banks and bureaucrats in Brussels.

So what?
This isn’t a comfortable time for investors, which isn’t a bad thing from a contrarian sentiment perspective. We urge investors to stick with their asset allocations, but use volatility to tactically rebalance. Economic data shows signs of improvement, and the Fed continues to be cautious about tightening policy too quickly, which could aid stocks in the second half. Internationally, the “Brexit” vote will likely be the focus for the near term—we expect the U.K. to remain in the EU, but there is a risk that the leave camp will prevail.

Liz Ann Sonders is senior vice president and chief investment strategist at Charles Schwab & Co.
 
Brad Sorensen is managing director of market and sector analysis at the Schwab Center for Financial Research.
 
Jeffrey Kleintop is senior vice president and chief global investment strategist at Charles Schwab & Co.
 
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