The dawn of globalization began on the day the Allied forces claimed victory in World War II. It became a 70-year experiment bringing together dozens of countries under a common central governing body. Then of course we all watched the Berlin Wall go down and the golden age of capitalism had begun.
From that moment in 1989, capital, people and ideas all moved freely throughout Europe. It seems the great EU experiment was working perfectly coming to a climax with the introduction of the Euro binding all these nation states together through a common currency. It sounded like a great idea but it took the Europeans seven decades to realize what our founding forefathers figured out 200 years ago: A confederacy does not work; It was the basic reason why the 'Articles of Confederation' were dropped for a masterpiece we call 'The Constitution'! Brexit was inevitable.
Forget the reasons, let's just get down to facts. Britain and Europe now face a protracted period of economic and political uncertainty, as the British government tries to understand the new role it will have with the single European market and with Europe in general. This is a huge undertaking which includes new deals which must be brokered and negotiated with all the other 27 countries, their individual parliaments and the European Parliament. Every economy in Europe will suffer.
In the immediate aftermath of Brexit, global equites lost almost $2 trillion in value, the CBOE Volatility Index rose 49.3 percent and fixed income, even with the ridiculously low or even negative yields, saw a strong rally. So where do we go from here?
Let's be absolutely clear, the world has entered uncharted territory. The earthquake felt out of London last week was only the beginning. The process, the Europeans tell us, can play out for a couple of years. A couple of years? What can be worse for equities than the unknown? Brexit is a historic event in Europe and from here on the entire story will be one of disintegration not integration. The next few sessions will see investors and money managers repricing assets in order to reach a level where there is an appropriate price for those heightened risks.
Aside from the likelihood of the Brits going into recession and the plunging currencies, there are three very important ancillary effects caused by the historic events in the U.K. which will determine the direction of the markets for the next few months:
- First, the strength in the dollar will force multinationals to readjust earnings expectations. Remember, the currency exchange rate is a big factor in bottom line numbers and a strong dollar has proven to be a headwind for the last few quarters. Both the Euro currency and the British Pound are in for some rough times ahead while the U.S. dollar and Japanese Yen become safe havens along with gold.
- The second problem is the multiple in the market. If we agree that prior to the Brexit vote stocks were trading at the upper end of historic valuations with a 19 or 20 P/E on the S&P 500, then one must conclude that a contraction of earnings caused by dollar strength will be yet another headwind for equities. It seems it's only a matter of time before we see a readjustment of the multiple.
- Finally, confidence: As a student of the markets one must conclude that the action last week will do very little to instill confidence. We have reached a point in the aging economic cycle where the U.S. electoral process is certifiably insane, the Fed has done all it can do with no real fiscal stimulus in sight until 2017 and uncertainty has become deeply embedded in every market. This has far reaching implications from the appetite for risk on through corporate Cap-Ex.
As someone who has found themselves in the capital markets my entire adult life I can only remember a handful of times in which I thought that 'Cash was King'…This is one of those times. As Larry Kudlow has taught us all, "Earnings are the lifeblood of stocks" and it seems as if the blood is being sucked out of the market by forces beyond our control. The next few weeks should not be a time to be a hero but rather the time to look for ways to preserve capital until the dust settles. Remember, all this uncertainty will eventually pass and the global landscape will be a bit different. Unfortunately no one knows the timetable but I would recommend staying liquid through the election in November. When that time comes, U.S. corporations will do what they always do; they will be at the forefront of creating the new world order, whatever that might look like!
