The Empire Strikes Back
Orwellian trends toward creating bulge governing bodies such as Oceania, Eurasia and Eastasia have run into a Brexit wall of conservatism. For decades a new world order toward federalism and globalized governance has metastasized. Fears of terrorism and socialist regulatory oversight over private decision making has galvanized conservatives. In Austria and France and now Trumpian America as well as England have shocked the utopianism of the Liberal establishment. One man’s utopia is another’s dystopia. The Left views bigger as better: Big Brother removes decision making from the individual to the wiser State, from the State to the Federalists and from the Federalist to International Governance. Spurred by the rise of unmitigated immigration, regulation and terrorism in an environment of secular stagnation has fueled anger among traditionalists. The UK rule by referendum vs representative governing has blown open the loophole in the Left leaning playbook. The empire of nationalism strikes back!
Referendum Rule vs Representative Democracy
Recently we have posited that a Brexit would lead more to a short term shock wave vs a major recession. We could be wrong, but the real risk would arise from any additional countries leaving the EU beyond the UK. Such new threats to established political infrastructure would certainly hasten economic and investment chaos. The UK exit from Europe has raised perhaps excessive fears of rising inflation, interest rates and job reduction. Job losses related to the contraction of the financial hub of London are real as is the Sterling depreciation of 10 to 30% inflating import prices. However, import inflation can also be deflationary in this era of stagnant income and aging demographics as it retards GDP. Any inflation will be temporary and countered by currency infused export growth in a deflationary slow growth environment. What forecasters also fail to account for is that “Old England will not allow interest rates to rise” if their economy begins to contract. In fact they will ensure that yields fall to new historic lows along with record central bank asset purchases to encourage investment and consumption. Investors should also consider that the UK divorce from Europe will take 2 to 4 years during which a cheaper currency and major stimulus can offer a competitive advantage. Nobody is certain of the Brexit ramifications as it is still evolving, but the UK will not be falling off the cliff anytime soon.
Sentiment Foretasted A June Top
With a surging US Dollar, depreciating Sterling and enormous political uncertainty in the US, there would seem to be little reason to increase investment exposure in our stock market. However, it’s also during such lame duck periods of financial turmoil that bargain opportunities appear. The next chart from a few weeks ago gave a projected June topping zone above 2105 SP and over 17,800 in the Dow followed by a short term correction. A “Remain” vote would have sent prices to the upper part of our window while we expected a “Leave” vote to cause an immediate 5 to 10% pullback.
Stock indices poked their heads twice into the Sell territory we identified before violently correcting overnight upon the surprise Brexit vote. A 6% intraday drop is notable, but not alarming at this point. Without a domino secession of other countries from the EU, it’s likely financial markets will find equilibrium over the next month. The 2nd half of 2016 will be a time to look for new buying opportunities for the longer term while Brexit penalties and stimulus are discussed and election uncertainty keeps investors subdued. With this confirmed top we will await new Buy signals before investing new capital into equities.
A new phrase we are applying to the Brexit risk is “ceteris paribus” or “as long as other things remain unchanged”. Brexit, ceteris paribus, is not a serious long term risk. The UK leaving the EU on a Brexit creates fear of the unknown leading to higher risk discounts on future investment valuations. The real concern is the “risk off” panic selling that could result from a far more serious Frexit (French exit from EU), Scexit (Scottish exit from UK) or any other country leaving the UK or European Union. The mere uncertainty of a realizable campaign to break up these unions would create a tsunami of “risk off” investment flows and a severe shortage of vital capital investment. This would cause a serious Global Recession. To prevent such a panic will require Germany and the EU striking the perfect balance of enacting a significant financial penalty upon the UK that scares remaining EU members into “Remaining”, while not pushing the UK into a trade war or recession. The UK will also have to be aggressive with fiscal and monetary stimulus to counter the coming London financial contraction and increasing stagnation in coming quarters.
Brexit and US elections during a sluggish economy is not a great fundamental environment to invest new funds. However, technically, instead of selling into this panic, expect further price erosion to create new investment opportunities in coming months. The caveat emptor warning we will be assessing that could trigger a reduction of equity exposure would be the Dow falling into 15,000’s as a result of more countries leaving the EU or the UK. Thus far this market panic has been mild, but the British Pound may have further devaluations that will test market mettle before we find an oversold zone to Buy. Watch the 1.27 – 1.31 zone for the British Pound to mark a potential proxy bottoming zone for stock indices.