US and Europe

Brexit: Stock markets sanguine, but a rough ride is still likely

Monday July 04, 2016 Mark Cox

The immediate reaction of pundits in the financial world to the Brexit vote in the UK was one of shock, quickly followed by near-panic. Share prices had been buoyant just before the vote, in the belief that a Remain result was assured. But they fell sharply on the day the result was announced, and they fell further on the following trading day. The general view was that Brexit would lead to significant economic disruption and, in all probability, recession.

 

However, the mood on stock exchanges around the world changed extraordinarily quickly. Just one week after the Brexit vote, prices had more or less recovered to the levels they reached on the day of the vote. And, for the most part, they were higher than they had been a week before the vote.

 

The table below shows the leading global stock indexes, and it adds New Zealand’s NZX50 and Australia’s ASX200 for reference.

 

The table shows that all three of the most commonly quoted stock indices (the Dow Jones, the FTSE 100, and the Nikkei 225) climbed during the week before the vote, fell sharply immediately afterwards, and then recovered to finish higher than they were one week before the vote. Remarkably, the FTSE 100 was at a significantly higher level one week after the vote than it was one week before. By comparison the NZX 50 and the ASX 200 indices moved less dramatically, but this might have been a reflection of different considerations at play, such as the Australian General Election.

 

brexit table

 

Note: the % changes are from the previous level shown in the table, not from the previous day’s trading.

 

It is generally believed that stock indices foreshadow future economic conditions.  If this is so, the implication is that Brexit will not harm the UK economy, and other economies will not be affected.  One way of looking at it is that Brexit might weaken the political integrity of the European Union, but not its economic integrity: the British, Germans and French will want to carry on selling goods and services to one another.

 

However, it is worth noting that the currency markets have told a different story, at least in the case of Sterling.  The GB pound strengthened from US$1.40950 one week before the vote, to US$1.49036 on the day of the vote. It then plunged to US$1.31808 two days after the vote, before recovering slightly to US$1.32629 a week after the vote.  The collapse is thought to be because it became clear that the base rate in the UK would need to stay lower for longer to stave off a recession, and because the international agencies down-graded the UK’s credit rating.

 

So, what to make of these conflicting signals?  There are a number of possible interpretations, but one of the most plausible is that the currency markets have got it right.  The UK economy is in for a rough ride, and the FTSE 100 presents a false picture because it reflects international economic prospects more than it reflects UK economic prospects.   This might also mean that the other major international stock indices present an over-optimistic outlook.  There is still major uncertainty and this, in itself, is enough to hold back global economic growth.