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Is the Post-Brexit Routing Over? Markets Recovering But Will They Hold?

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June 28, 2016

(Tuesday Market Open) The Brexit boomerang on the markets appears to have come to an abrupt halt as U.S. markets moved solidly higher in the early going, following the lead of European and Asian markets overnight. Is this a floor to the routing after the Brexit vote for the United Kingdom to leave the European Union? If it’s real, can it last or is this the market’s dead-cat bounce?

If it’s lasting, it would be a welcome relief after Monday’s market meltdown. Despite government leaders’ efforts to calm the masses early on, the three major benchmarks wiped out any gains, however small, they’ve made since mid March. Both the Dow Jones Industrials (DJIA) and the S&P 500 (SPX) slipped below their 200-day moving averages, key technical support levels.

The closely watched SPX dipped below 2,000 early Monday and stayed there for much of the day before crawling up ever so slightly before the close. On the way down, the index took out what many analysts saw as key technical support levels at 2,030 and 2,000. SPX ended the session at 2,000.58, off better than 36 points, but appears to be recovering strongly in the early going. Can SPX hold above 2,000 and perhaps take a run at 2,030?

Financial stocks continued to falter, falling nearly 3% on the session. Many analysts believe the financial sector may have the most to lose if Britain departs from the European Union, in part because of the possible impact on trade, and also because a potential Brexit-triggered recession may put continued pressure on interest rates.

But financials weren’t alone in walking the plank Monday. Materials, energy and industrial stocks also dropped sharply with materials sinking 3.4%. Of all the S&P sectors, only the defensive utilities sector made a small positive move of less than 1%.

DJIA lost 334 points at the session’s lows and finished at 17,140, off 260. The Nasdaq Composite Index (COMP6) took another nosedive, settling at 4,549, down 113 points.

Ahead of Monday’s open, U.S. Treasury Secretary Jack Lew attempted to reassure investors that a financial collapse was not in the making. “Obviously this is a change in policy that has implications which change the decisions investors make, so I’m not saying there’s not an impact in the markets,” he said in a CNBC interview. “The challenge is for leaders in the U.K., in Europe, around the world, to manage through a time of change, to provide as much continuity, stability and the foundation for strong economic growth as possible.” Are his remarks effective today?

As the markets swooned, volatility rose even above last week’s high levels, with the VIX index, a widely-followed measure of market fear, rising above 25 for the first time since mid-February, when the market was down near its 2016 lows. It closed at 23.85.

The British pound got, well, a pounding on Friday, dropping in its worse single-day dive ever, and continued to do so on Monday to hit a 31-year low to the dollar. In early trading, the currency was at $1.34 to the dollar. Still, at least one analyst is predicting that the pound could hit parity with the dollar by the end of this year or early 2017. “Investors should be prepared for the risk of [pound] weakness extending quite significantly in the next few months, while uncertainty surrounding how the U.K. moves forward persists,” said Shaun Osborne, chief currency strategist at Scotiabank, according to MarketWatch.  

Crude oil prices have gotten a beating too, winding down the session at $46.65 but adding $1 in early trading. And, as to be expected in times of turmoil in the markets, the yield on the 10-year Treasury toppled to 1.44%, a place it hasn’t seen in four years. That, too, saw a bounce early on. 

S&P 500

FIGURE 1: OUCH!

The S&P 500 (SPX), plotted through Monday's close on the TD Ameritrade thinkorswim platform, dipped below the key 2,000 level in a down day of trading across the board, but managed to edge up slightly by the close. Can it stay higher today? Data source: Standard & Poor’s. For illustrative purposes only. Past performance does not guarantee future results.

How Bad Was It S&P? Not so bad after all. Friday’s 3.6% and Monday’s 1.8% declines in the SPX were about average when it comes to market reaction, or over reaction, to major shocks, according to S&P Global Market Intelligence, which studied how such shocks affected the market over the last 75 years. After events ranging from Pearl Harbor to the Sept. 11 terrorist attacks to the Lehman bankruptcy, the market declined an average of 3.5% on the first day for all observations, followed by a total decline of 10.3%, before bottoming over the next 32 days. The worse pullback was the Crash of 1987, what has become known as Black Monday, when stocks markets across the world tanked and the SPX plummeted 20.5%. On average, it takes SPX 113 days to get back to breakeven, but after Oct. 19, 1987, it took 368 days to recover. Will that happen this time?

“Investors can take encouragement that Friday’s decline was very close to the average for all of these market shocks since World War II,” S&P Global said in a note yesterday. “In addition, the S&P 500 fell 300 basis points more in 2011, following the downgrade of U.S. debt. Market shocks, in general, tend be short and shallow as investors quickly come to the conclusion that the event will not throw the U.S., or the world, into recession.” That said, the firm does believe Brexit may slow economic growth in Europe by a yet-to-be determined amount.

Meanwhile, at the Fed… Federal Reserve Chair Janet Yellen looks prescient now, after noting last week that the Brexit vote would be “significant for the United Kingdom and Europe,” and staying out of the fray. But we might get a little Fed insight into Brexit tonight, when Fed Gov. Jerome Powell speaks on recent economic developments, monetary policy considerations and longer-term prospects. The futures market now forecasts no chance of a Fed rate hike until December, and even then prospects appear low. Futures have begun to price in small chances for the Fed to actually lower rates at meetings between now and December. Yep, lower rates.

Epoch Event Leads to Downgrades. As promised, Standard & Poor’s cut the United Kingdom’s credit rating Monday and Fitch followed with a downgrade of its own after Friday’s vote count to leave the European Union. “In our opinion, this outcome is a seminal event, and will lead to a less predictable, stable, and effective policy framework in the U.K.,” S&P said in a press release after lowering the nation’s rating two notches to “AA” from “AAA.” “We have reassessed our view of the U.K.'s institutional assessment and now no longer consider it a strength in our assessment of the rating.” Fitch said much the same after slicing its rating to “AA” from “AA+” and revising down its real GDP projection gains to 1.6% from 1.9%. “Uncertainty following the referendum outcome will induce an abrupt slowdown in short-term GDP growth, as businesses defer investment and consider changes to the legal and regulatory environment,” Fitch said in its press release. Remember that the U.K. vote was an advisory one, not law.

Good Trading,
JJ
@TDAJJKinahan

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