Are Financial Markets Over-Exaggerating The Brexit Effect?

By Bryan Rich 

June 28, 2016, 4:00pm EST

We’ve talked about the Brexit effect the past couple of days.  And we’ll continue on that theme today, as people continue to digest the results and come to grips with potential outcomes.

The knee-jerk reaction in markets has suggested that there is considerable fear of another global financial crisis.  But as we’ve said, things today are very different than they were in 2008.  The failure of Lehman triggered a global credit freeze.  That brought global banks to their knees and, therefore, even massive Fortune 500 companies couldn’t access capital needed to operate.

Again, this time is different (typically dangerous words to say, but true).  The financial system remains well functioning.  Most importantly, central banks are pro-actively maintaining stability and confidence by offering liquidity to banks and have made it well known that they stand ready to act where ever else needed (i.e. intervention).

So now we’re seeing some projections of the economic implications of the Brexit coming in.  The ECB thinks it will shave “as much as” ½ percentage point in GDP growth in Europe.

Here’s a look at euro area GDP…

euro gdp
Source: Tradingeconomics.com

You can see the damage to the economy in the global financial crisis.  While Europe is still emerging from stagnation, lopping off ½ percentage point is far from a “Lehman moment.”  Plus, if the euro weakens, as it should, on the outlook, that economic hit will be softened dramatically.  When we think about the broad Brexit implications, Europe is probably the first place everyone should be looking, and the ECB’s projection doesn’t look so bad at all.  With that, the market volatility we’re seeing seems to be over-exaggerating the Brexit effect.

Still, the biggest risk associated with the Brexit is that it becomes contagious.  As we said on Friday, the potential Grexit (of last year) and the Brexit are most different for one simple reason.  The British vote doesn’t involve a country leaving the common currency — the euro.

The British, of course, have their own currency, and among all of the EU countries, the British have probably retained the most sovereignty.  It’s a fracturing of the euro, the second most widely held currency in the world, that would trigger a global financial and economic crisis.  That’s the big danger.  If other EU countries that are also part of the common currency (the monetary union – the EMU) took the lead of Britain, then it gets very ugly.

Perhaps the first place to look for that potential spillover, is in the sovereign debt markets of Spain and Italy — the two big EMU constituents that were close to default four years ago.  When those countries were on the brink of collapse in 2012, the 10-year government bond yields were trading north of 7% (unsustainable levels).

111spain yield
Source: Reuters, Billionaire’s Portfolio

111italy yield
Source: Reuters, Billionaire’s Portfolio

Today, Spanish and Italian 10-year debt is yielding just 1.3%.  In a post-Brexit world, where the real risk is contagion, both of these important market barometers are indicating no contagion danger.

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