Brexit – Risk Becomes Reality
The major market indices finished the week lower after the UK’s vote to exit the European Union (EU) roiled the global markets.
June 27, 2016
| By Mike Schwager
Performance for Week Ending 6/24/16:
The Dow Jones Industrial Average (Dow) fell 1.56%, the Wilshire 5000 Total Market IndexSM (Wilshire 5000SM) lost 1.53%, the Standard & Poor’s 500 Index (S&P 500) finished off 1.64% and the Nasdaq Composite Index (NASDAQ) shed 1.92%. Sector breadth was negative with 9 of the 10 S&P sector groups finishing lower. The Materials sector (-2.55%) led the way lower followed by Financials (-2.44%) and Industrials (-2.40%).
||Closing Price 6/24/2016
||Percentage Change for Week Ending 6/24/2016
||Year-to-Date Percentage Change Through 6/24/2016
*See below for Index Definitions
MARKET OBSERVATIONS: 6/20/16 – 6/24/16
The major market indices finished the week lower after the UK’s vote to exit the European Union (EU) roiled the global markets. Strong gains earlier in the week would suggest that the global markets were not positioned for this outcome. Safe haven assets were the major beneficiaries as witnessed by the sharp drop in Treasury yields (price and yield move in opposite directions), a surge in the price of gold and strong gains in the US dollar and Japanese Yen. Central bankers over the past few weeks have sounded the alarm over the potential for Brexit, with leaders from the Federal Reserve, Bank of Japan and Bank of Canada all citing the vote as a potential disruption to the global economy. Fed Chair Janet Yellen recently said the decision could have consequences for financial markets, and “in turn for the U.S. economic outlook.” The “risk-off” mentality is likely to remain in place for the foreseeable future until more clarity on the situation emerges. At this point there seems to be more questions than answers.
So what's next after Brexit? Thursday’s vote likely marks the beginning of the end for the U.K.’s 43-year involvement in European Union. The vote isn’t legally binding, so Parliament now must pass laws to make Britain’s exit happen. Article 50 of the Lisbon Treaty will be invoked to begin the formal process for leaving the EU. That would start a series of negotiations for how to separate the U.K. which could take up to 2 years. The problem is that there is no clear road map as the vote marks the first departure from the modern-day EU. For the UK, clearly the near term outcome is not good – the separation process could take years, economic activity will be disrupted materially (at least in the near-term), and Britain has a difficult political road to navigate.
Pandora’s Box? The question now emerges whether the Brexit decision is limited to Britain or does it reflect a broader view of frustration that similar outcomes should be expected going forward in other countries – elections are coming up in Spain (6/26), Australia (7/2), Japan (7/10), Italy (October), and the US (11/8) while Europe’s two most important countries hold national elections next year (France in April/May and Germany as early as August). Following the Brexit vote politicians in several European countries (including France, the Netherlands, Italy, and elsewhere) are calling for referendums similar to the one just held in the UK.
In terms of the US markets, S&P 500 companies generate a minimal amount of sales and earnings from the UK, although the indirect impact from the likelihood of a stronger dollar and weaker overseas growth could come into play. While headline risk and elevated uncertainty may be a near term headwind to the financial markets, when the dust settles the US markets may be viewed as a good buying opportunity. The US economy continues to grow, the likelihood of a recession remains low, the Fed is likely to hold interest rates steady for the foreseeable future, and sentiment is extremely negative (a contrarian indicator). While a larger drawdown in stock prices cannot be ruled out, fear should eventually give way to fundamentals.
The Week Ahead: Second quarter earnings season will begin to gear up with 11 members of the S&P 500 scheduled to release results. The data calendar will be relatively busy. Economic reports of interest include the final revision to first quarter GDP, the April Case-Shiller Home Price Index, June consumer confidence, May personal income and spending, June motor vehicle sales, the June ISM Manufacturing Index and May construction spending. Several Fed Heads will be out and about and investors will be looking for their thoughts on the Brexit vote and how it impacts forward rate policy. Fed Chair Yellen speaks on Wednesday followed by St. Louis president James Bullard on Thursday and Cleveland president Loretta Mester on Friday.
The Dow Jones Industrial Average is a price-weighted average of 30 blue-chip stocks that are generally defined as the leaders in their industry. It has been a widely followed indicator of the stock market since October 1, 1928.
Wilshire 5000 Total Market IndexSM represents the broadest index for the U.S. equity market, measuring the performance of all U.S. equity securities with readily available price data. The index is comprised of virtually every stock that: the firm's headquarters are based in the U.S.; the stock is actively traded on a U.S. exchange; the stock has widely available pricing information (this disqualifies bulletin board, or over-the-counter stocks). The index is market cap weighted, meaning that the firms with the highest market value account for a larger portion of the index.
Standard and Poor's 500© Index is a capitalization-weighted index of 500 stocks. The index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
The NASDAQ Composite Index is a broad-based capitalization-weighted index of stocks in all three NASDAQ tiers: Global Select, Global Market and Capital Market. The index was developed with a base level of 100 as of February 5, 1971.
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