Bexit Vote Keys Sell-Off

7/4/2016


Spurred by Britain's vote to exit the European Union, stocks suffered a panicked sell-off. Over two trading days, the Dow Industrials slumped 4.8% while the Dow Transports dropped 7.5%. Both indexes then recouped more than half those declines over the next two days as investors reassessed the potential fallout.

While near-term volatility seems likely, we see little reason to adjust our equity exposure. For now, our buy lists have 82% to 84% in stocks, with the remainder in a short-term bond fund. With a rally above 18,096.27 in the Industrials and 8,109.19 in the Transports, we would view the primary trend as bullish.

Contagion risk

Global equity markets lost $3 trillion in the two days following Britain's vote — the worst two-day decline in the history of the S&P Global Broad Market Index, according to S&P Dow Jones Indices. In percentage terms, it was the worst two-day decline since 2008.

While Britain's vote was momentous, its impact on the global economy and corporate earnings seems unlikely to be as severe as implied by the market's initial reaction. The European Central Bank estimates the vote could shave as much as 0.5% from Europe's year-ahead economic growth — hardly an earth-shattering calamity.

The biggest danger is the risk of contagion, with other European Union nations following Britain's lead. If a country that uses the Euro currency decides to exit, the risk of unintended consequences would certainly rise.

Also, if Britain and the European Union cannot reach an agreement on their future relationship, the potential for trade disruptions could weigh on business investment in all of Europe. But both Britain and the EU have incentive to maintain trade ties, so a deal seems likely unless domestic politics gets in the way.

Meanwhile, the uncertainty is expected to delay an interest-rate hike from the U.S. Federal Reserve until 2017, and central banks in Europe are widely expected to introduce fresh stimulus efforts.

Yields on 10-year Treasury bonds are below 1.5%, near four-year lows. Lower bond yields, while bad for profits in the banking sector, are spurring an increase in mortgage refinancings — and helping sustain demand for rate-sensitive products like automobiles.

Conclusion

Britain's vote has major implications for Britain and globalization, but the impact on U.S. corporate profits seems unlikely to be a game-changer. As a partial hedge, subscribers should keep 16% to 18% of their equity portfolios in a short-term bond fund. For new buying, Laboratory Corp. of America ($129; LH) offers a timely pick.


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