This is a significant market and economic event that opens up major new pathways for political change, market reactions and central bank actions. Determining actual economic impacts for companies, labor, trade, etc. may be impossible for quite some time. It seems politics, rather than the economy, could have a more important impact on the markets in the near term. The possibility of other countries exploring exit from the E.U. could further anti-establishment/nationalist campaigns both in Europe and the U.S.
While the economic linkage is important, including how much trade the U.K. does with the E.U. and with the U.S., there is a broader risk. After decades of expanding the E.U. membership, the union has had one of its four most important members decide to leave. The E.U. can’t afford another of the remaining three key members to leave and expect to keep the union or the currency intact.
The vote could easily set off a market correction. However, we don’t think this is equivalent to a “Lehman Moment” that ushered in the Great Recession. We believe the impact on the financial sector will be most severe, as falling interest rates could hit financial institution operating revenue. Bank stocks in the U.K. and E.U. reflected this, ending down 1.06% and 17.75%, respectively, for the quarter. U.S. bank stocks fared better up 1.02% for the quarter.
We expect central banks will have a coordinated response, which could soften market outcomes. The U.K. is likely to cut its rate, the E.U. and Japan may add to their quantitative easing programs, and the U.S. will likely back off its rate rising rhetoric for this year and maybe longer. While the central bank actions can help, politics will likely trump central banks for attention and impact on the markets and global economy.
Bonds performed very well in the quarter with the Barclays U.S. Aggregate Bond Index rising 2.21%. Interest rates in the U.S. were falling before the Brexit vote, which drove U.S. fixed income yields even lower and briefly approached the all-time low for 10-year U.S. Treasury yields of 1.4%. Even prior to the vote, yields on European government bonds fell further below zero, responding to the European Central Bank (ECB) policy of buying corporate investment grade and high yield bonds. U.S. yields followed Europe’s as many E.U. and Asian investors increased holdings of U.S. corporate bonds.
We think that U.S. bond yields could go even lower. While long term U.S. yields are already near all-time lows, the U.S. market looks attractive compared to negative yields in Europe and Asia. Corporate bond spreads, while immediately rising in reaction to the Brexit vote, are likely to narrow in the medium term. European and Japanese investors are likely to return to the safety and yield of the U.S. bond market over the coming quarters as their markets offer little if any positive-yielding bonds.