3 Lessons from Brexit

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Jun 30, 2016 1:38:57 PM

and tagged In the News

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brexitWith all the initial panic over the Brexit vote—and the subsequent relief as markets recovered—it’s been easy to lose sight of the bigger-picture lessons. Here are three that we should keep in mind.

1. The world did not end.

We have seen multiple crises around the European Union; Brexit is the most recent, and Greece in 2011 was perhaps the most severe. Each time, when signs of a breakup appeared, we worried they would lead to a Lehman moment, taking the world economy back to 2008. With Greece in 2011, a deal was cut and a breakup averted. But the possibility remained that, if a deal had not been made, disaster might have ensued.

This time, we do have a breakup on our hands, and the world still hasn’t ended. There have been adjustments, to be sure, and some negative consequences are likely. So far, though, it looks like Brexit will be one more thing we muddle on through.

Were the fears irrational? No, they weren’t. It’s possible that the Brexit crisis could become systemic, but if it does, it will be for political reasons rather than economic ones. With the initial rational, reasonable reactions to the vote from both the British and European governments, markets returned to focusing on economic fundamentals, which don’t look all that bad.

2. The global economy is solid.

Had the political turmoil of Brexit piled on top of a weak economic underpinning, the results for markets probably would have been much worse than what we’ve seen. The fact that markets didn’t drop into bear territory on one of the most significant and feared political developments since the Greek crisis suggests that the economic foundation is much stronger than generally appreciated.

Here in the U.S., for example, consumer confidence and spending continue to improve, and despite the recent weak jobs report, most other indicators remain strong. Growth in Europe also continues to increase in many countries. Emerging markets are showing signs of improvement as well, and their stock markets have actually moved up in aggregate, despite Brexit. Even with a massive shock, the fundamentals remain sound, and after the initial panic, markets are responding to that.

3. The global financial system appears healthier.

Another recent story has been the outcome of the Federal Reserve’s stress tests for large banks. These tests impose hypothetical severe shocks to see how well the banks’ business would do under difficult conditions. Thanks to recent improvements in their capital provisions, almost all U.S. banks passed unconditionally. Here in the U.S., the financial system is clearly safer than it was, and the stress tests help prove that.

Bigger picture, the Brexit vote (and the subsequent reaction and recovery) has served as a similar, real-world stress test for the global economy and financial system. Despite all the fears—and the very real potential risks—the economy and financial system have proven robust enough to survive a severe shock. This is the good news to take away from the volatility of the past couple of days.

I’m not saying there’s no risk going forward, only that the risk is primarily political, not economic. It’s possible that, if politicians manage to keep their cool, the current recovery will continue.

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