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Wednesday, July 13, 2016

Edward Jones' Financial Focus - Five Post-Brexit Takeaways

As the dust began to settle a bit last week following the outcome to the Brexit vote, markets found a bit of footing. We’re still in the early stages and plenty of questions remain, but there is some comfort to be taken in the market’s reaction.  We’d offer the following five takeaways:

It doesn’t pay to panic – The magnitude of Brexit shouldn’t be dismissed. But the sky isn’t falling, despite the immediate reaction in the stock market treating it as such. In the two days following the vote, global markets dropped sharply, with the S&P 500 falling about 5% and the Dow losing 800 points. But as is typically the case, keeping perspective and a level head was rewarding, with stocks rebounding nicely, recouping most of those losses as the week progressed. This was a very similar path to the China-driven panic selloff of last August when markets dropped more than 5% on Monday and Tuesday of that week, only to post sharp gains over the following few days. Stocks went on to rally more than 5% in the next 4 months. This is not to say the current path ahead will be similarly strong, but it is an important reminder that there’s more to the market than just Brexit or China. Knee-jerk reactions are driven by emotion, longer-term performance is driven by fundamentals.

The volatility isn’t over – Last week’s rebound was most welcome, but it won’t be smooth sailing from here. The execution of the U.K.’s exit is unlikely to be smooth and will take time, leaving the cloud of Brexit overhanging global sentiment and markets for a while. It will take time for the direct economic impact to be realized in Europe. It’s likely that the U.K. economy could slide into recession, but at less than 4% of world GDP, we don’t think the U.K. will drag the global economy into contraction. Of perhaps most concern is the potential for other EU members to seek similar referendums, splintering the union. We don’t think this is the likely outcome, but regardless, Brexit now joins the line of prominent market risks that includes China, Fed tightening and sluggish global growth. Each is likely to take its turn in the spotlight as the year progresses. We don’t think this is the beginning of a bear market, but prepare for ongoing volatility in the second half of the year.

Global interest rates will stay low for longer – We expect one of the important responses from the Brexit fallout will be additional stimulus measures from central banks around the world, most notably the European Central Bank (ECB). More than $11 trillion in global sovereign bonds currently carry a negative yield, a condition that is likely to persist as central banks look to support growth. Global interest rates and currencies are likely to remain under pressure. The Fed took a pass on hiking rates in June, which looks to be the prudent choice given the Brexit outcome. Nevertheless, we expect the Fed to continue to evaluate opportunities to get a rate hike in at some point this year. The markets are fixated on the precise timing, but the broader view shouldn’t be lost. The Fed is considering rate hikes because the U.S. economy is in a position to handle them. While nearly all other central banks are looking for ways to provide additional stimulus, the Fed is taking its foot off of the accelerator (note: it’s not slamming on the brakes) because economic trends in the U.S. warrant it. This divergence in monetary policy will show up in ongoing low (and negative) interest rates around the world as well as continued currency volatility.

Diversification works, even toward markets in the center of the fray – The U.K. economy was already slowing this year, likely reflecting uncertainty around the anticipated Brexit vote. The outcome’s negative impact on confidence and investment could certainly drive Britain into recession in the near term, but other core EU economies (Germany, France, Italy, Spain, et. al.) have seen modest improvement in recent quarters, suggesting growth in Europe is not solely dependent upon the strength of the U.K. economy. To be clear, Europe’s economy is unlikely to shrug Brexit off unscathed, but we don’t think a euro recession is inevitable. Lower unemployment, improving credit trends, and room for rising profit margins suggest that economic and corporate earnings trends might be able to come in ahead of current pessimistic expectations. In that event, given notably lower valuations (P/E), international developed-market equities look particularly attractive. Consider this: the FTSE (U.K. stock market) is actually at a 10-month high and EAFE (European and Japanese large cap equities) was up about 3.5% last week. 

Our economy is still on sound footing – The focus on Brexit has overshadowed the more positive story here at home. The upcoming release of the second-quarter GDP report will likely show that the U.S. economy grew faster than it did in the first quarter, putting it on track to post solid growth of 2%-2.5% this year. Unemployment is at cyclical lows (below 5%), consumer spending and confidence is up, and the housing market is improving nicely. This economic base, along with stabilization in oil prices and the U.S. dollar, should support better earnings growth as we move through the year, which in turn offers fundamental support to the markets to help offset skittishness from the ongoing Brexit drama. 

This article was written by Edward Jones for use by your local Edward Jones Financial Adviser, which in Prescott is Neal Robinson at 1400 N. Acres Rd. Suite 55.

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