There are plenty of perspectives on the Brexit vote as media outlets bombard the airwaves and internet with how this all will play out. Seeing so many perspectives speaks loudly as to why we are seeing an immediate surge in volatility. Uncertainty creates volatility and opposing viewpoints adds to the unpredictability. Clearly the markets had an immediate reaction but this short-term affect is still largely based on speculation of how this will play out. The long-term consequences are unknown for now and will likely be quite different depending on which perspective you’re considering.
The short-term reaction of uncertainty is a flight to quality, in this case, U.S. Treasuries and gold. This is a continuation of what we were experiencing before the announcement but with a whole lot more momentum. The volatility has been amplified but is nothing new. Treasury prices rallied on the news (yields down). Product spreads have widened, reflecting a broad “risk off” trade. The probability of a rate move by the U.S. central bank (Fed) has actually shifted from a hike to perhaps a more accommodative stance, although the probability of any move is very low all the way through February, 2017. The U.S. markets are tied to the global markets and therefore we may continue to see volatility based on the collective flight to quality; however, the markets are clearly watching and digesting what the next steps may be.
Equity markets took hits across the globe. Europe was down >10% in a single day. The DOW opened down 200 points and continues its anticipated day weakness. From a fixed income perspective, momentous events such as Brexit emphasize the importance of “Knowing What You Own”. With interest rates continuing to fall, investors, more than ever, need to allocate assets appropriately and not find unsuited replacements that don’t substitute for the known cash flow and income taken with fixed income holdings. Substantial pullbacks of 5% or 10% of wealth could take long periods to recover. From a relative basis, U.S. Treasury yields are much higher than global rates and typically investment-grade assets provide much desired credit protection in volatile times.
Many of the global central banks have expressed their willingness to level off market reactions if need be. The Fed is monitoring the markets and will provide liquidity if necessary. U.K. officials will likely enact measures to ease any market turmoil. Bank of England Governor Mark Carney has stated that policy makers are ready to pump 250 billion pounds ($345 billion) into the system, although he believes the U.K. banks will withstand the disorder.
From Britain’s perspective, things will clearly change, but wasn’t that the point? Giving credit to their awareness, the British people were certainly mindful of the potential consequences of their vote. Perhaps the British vote to exit reflects a belief that the benefits of independence from the EU will offset any risks of financial consequences? As Americans, we should be aware that freedom of choice may outweigh financial concerns. Even so, there may be positive financial fallout as well. Certainly, direct taxation via European Union membership will go away. There will be certain trade-offs between negotiating as a combined state to negotiating on their own. It can be argued that it will be more costly to negotiate alone but the counter is that they will be negotiating for the sole benefit of their people, not other nations that happen to be part of the EU.
What we can conclude now is that the short-term affect is a flight to quality. Volatility is likely to remain for the short-term as long as uncertainty prevails. And now, more than perhaps any period in recent history, it is important to know what you own and why you own it. Appropriate asset allocation is essential.
The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.