The surprise decision of Great Britain's voters to leave the European Union has sent ripples into the global markets resulting in significant equity market volatility and currency market losses. The truth in the matter is that no one really knows what will happen regarding this unprecedented move to break up a 23 year old union. Per the European Union bylaws, there are still at least two years of work involved before any exit actually occurs. As we have witnessed in the recent UEFA Euro Cup tournament, anything could happen in that two year window – like England being knocked out by the small nation of Iceland.
Moving past the two day market route, which has been well documented, we can step back and realize that for major benchmark indexes, the UK leaving the EU has very little impact in terms of security inclusion and benchmarking. Eurozone specific indexes, which are focused on the countries with a common Euro currency, already exclude the UK, while broad based global country indexes will continue to keep the UK as a component. From an index administration perspective, Brexit has very little impact on the day to day of index membership and index rules. Nasdaq will continue to classify the UK as a country and continue to include it part of our Developed Markets Index family.
With Brexit having little to no index impact, it is now time to focus on its impact on the broader markets. Global equity markets have nearly recovered from their initial knee-jerk reaction though it is a different story for the currency markets. The pound has already tumbled dramatically and likely to remain weak as investors try to quantify the implication of the vote
Brexit’s short term impact is certainly not clear, and the long term impact on the United Kingdom exiting the EU are simply too controversial at this point in time.
It is fair to say that Brexit is not responsible for the German 10 year bond rate moving to negative territory or the US 10 Year Treasury moving below 1.5%. The reality is that global markets have been flirting with slower growth prospects and global uncertainty well ahead of this vote. Brexit certainty led to a rough Friday and Monday in the equity markets but those markets have now largely recovered. The long-term trend in global rates continues lower, despite any recovery or any speculation following Brexit.
The Brexit uncertainty has forced strong bidding for US Treasuries. Just as important at monitoring the absolute level of yields is monitoring the spread between yields on different points on the yield curve. The spread between 10 year and 3 month rates, is typically a barometer of economic health and a narrowing spread could mean trouble ahead. Although the spread, has been distorted due to unprecedented Fed intervention following the economic crisis, it is at multi-year lows.
The above chart depicts short and mid-term rates along with the spread between the two. Historically when the spread narrowed or went negative (10 year minus 3 months) the economy was doing poorly, perhaps even in a recession. With the spread at nine-year lows, this is not about Brexit as it is more about weakening growth expectations, lack of inflation, and monetary policy.
The questions around the impact of Brexit are important and wide ranging. They have to be addressed to help frame currency policy, expectations of economic growth and regulatory concerns.
For now, the biggest question is not how Europe, a continent that has been lacking significant GDP growth for the past decade, will handle the UK exiting. The biggest questions are: What will actually cause rates to rise, economic growth to occur and inflation to hit the markets? How can bonds continue their leading place in performance when rates are bouncing into negative territory in Europe?
As one piles through the data, it is clear that Brexit was not the root cause for the weak trends in equity markets or the compression of global yields but rather quite the contrary. It is more likely that the trends of the market – low growth, low rates, and low inflation were the influencers of the Brexit outcome.
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