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Eye on BREXIT

June 25, 2016

The final poll of BREXIT decided the fate of Britain existing the EU. Although the event has been long before in discussion, and it will take at least 2 years for the actual exit. It is inevitably worth every attention of market participant.

 

If it looks and barks like a dog….


In every market situation, we want to be aware of potential Black Swan situation, this one has its unique potential.

 

Market Reaction

 

In financial markets, wall street dislikes surprises, and the current event on BREXIT is a text book example of surprise.

 

The BREXIT poll result points to one way or the other during the whole day Thursday during the US market session. And the market shown optimistic sentiment toward the closing and saw buyers rushed into the market near the closing. On Friday, the US stock market opened down and followed the overnight Europe and Asian market weakness. At the end of the day, markets closed near the low, Dow Jones Industrial closed down 610 points, or -3.39%, S&P 500 index closed -3.59%, rested at a very sensitive level of 2,037.41, less than 0.5% above the critical support level of 2020, which was formed since late March 2016.

 

These large movements in the US equity market are rare, and we have not seen this kind of intraday drop for a few years. However, over the weekend, as investors dig into the matter, their mind will be more clear. I always believe market is right, so Monday will tell a better story.

 

Beside the equity market movement, more importantly, British pound dropped more than 10% overnight, it was the biggest drop in 35 years.

 

Combined with these orchestrated large movement in both equity and currency markets, caution is warranted.

 

What is the big deal?

 

The BREXIT can potentially be a big deal. First of all, the original idea of EU is about “single market” and unity. This idea had affected the rest of the world to follow suit, we have seen every effort toward market globalization in the last 10 years or so. The concept of “Globalization” is an extension of EU manifested in the rest of the world. BREXIT is a contrarian to this holy grail idea.  Potentially it will affect many business practice of current modern world.

 

Why does Britain exist EU?

 

Britain’s decision is a reflection of the civil desire. By existing EU, Britain can cater more effort to its own situation, sort of mind its own problems. In addition, it saves Britain about $8.5 bil membership and contribution a year, money talks. Britain was unhappy its less than desirable influence level within the EU, and BREXIT ends its dismay, although it comes with other consequences.

 

What impact does it have in Britain, EU and the rest of the world?

 

In the short term, the currency upheaval is apparent, coupled with speculative forces that will keep the pound unsettled, 15% drop in the currency is what has been expected.

 

By exiting EU, the negative impact will drag on Britain, it is projected to be 3.8% to 7.5% of shrinkage in the Britain economy in the long term. By not trading with counterparts, the cost of goods can rise to induce inflation within the nation, and overspill to its sooner to be former EU members. Cost induced inflation is not a positive force, it can put more obstacle in economic growth and survival as Britain is climbing out of a recession with slow recovery.

 

How does it affect China?

 

China trades with Europe and EU through its relationship with Britain, if Britain is out of the picture, it will change the game plan for China’s international policy, and the roadmap to Reminbi domination can be surely altered.

 

Also, the China’s economy has its own struggle. While dealing with the aging population; structural transition from labor intensive reliance to technology intensive model can be slowed and interrupted due to BREXIT.

 

This will bring negative impact on the economic recovery for China.

 

How US will be affected?

 

 This US economy is the strongest among all, relatively speaking. US was the first nation went into recession in 2008, and the first one got out of trouble. The US is the first come into this credit tighten cycle by way of increasing interest rate. While all other nations are still in the expansion mode with interest rate stepping downward.

 

There are many indicators showed that leading economic data does not support the growth argument of the US economic. The latest decision of FED decided to less the frequency and upcoming rate hike is another validation of the health of the US economic at this stage.

Timing wise, the BREXIT event can push the nerve of the US stock market which is already consolidating near its 7 year high.

 

In response to the current market reaction and consider the sensitive timing we are in, we should view the BREIX event with great caution.

 

Conclusion on Investment Strategies

 

About 2 years ago we have been preparing to deal with potential impetus like BREXIT which can cause imbalance of the market place, which can often be a trigger and turning point of the market place.

 

Giving the market situation, if S&P 500 index breaks below 2000 level, we have every reason to scale back our equity exposure. (see figure 1 below for detail).

 

 Figure 1, source stockcharts.com

 

There are three independent effective strategies to defend our portfolio:

  1. Selling stock/equity positions; and sell puts to scale back into the market, the desired result will be buying stocks on discounts. We called this a hybrid strategy

  2. Utilize our US Tactical Sector ETF model can be an ideal market timing methodology to react and follow the stock market trends

  3. By reducing equity exposure and seek out higher yield fixed income investments can be a prudent defense against market downtrends

Let us engage into a conversation to customize your portfolio to fit into the volatile market situation.

 

Regards,

 

 

Daniel Wu, Chartered Market Technician

Pair Lending, LLC

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