Post Brexit musings - Bullish vs Bearish.

As markets struggle to adjust to the post Brexit bloodbath,  many analysts and experts are looking backward, juxtaposing the event to past crises and modeling their responses accordingly. There are many who see it as the seeds of doom, and believe that it is time to cash out of the market. There are others who vehemently argue that not only will markets bounce back but that it is a buying opportunity. The sentiments in India on Brexit also fall in the same binaries, along with some out of the box witty tweets.

Here are some of the major global economic effects of Brexit:

1. Government bond rates in developed market currencies (the US, Germany, Japan and even the UK) have dropped, gold prices have risen, the price of risk has increased and equity markets have declined.
2. If this is a battle, the British Pound is on the front lines and taking heavy fire, plummeting to 10% over the last week against the US dollar and approaching three-decade lows, with the Euro seeing collateral damage against the US dollar and the Japanese Yen.
3. The Pound is expected to go down further as predicted by various rating agencies.                                 
   
                                                  Source: Bloomberg
4. The damage is greatest in the EU, but even within the EU, it is the old EU countries (primarily West European, that joined the EU prior to 2000) that have borne the biggest pain, with sovereign CDS spreads rising and stock prices falling the most. The new EU countries (mostly East European) have been hurt less than Britain's other trading partners (US, Australia and Canada) and the damage has been damped in emerging markets. At least for the moment, this is more a European crisis first than a global one.
5.  Many people have opined that financial sector companies are being hurt more than the rest of the market by Brexit and that smaller companies are feeling the pain even more than larger ones,what I have observedis that the evidence is not there for either proposition at the global level. At more localized levels, it is entirely possible that it does exist, especially in the UK, where the big banks (RBS, Barclays) have dropped by 30% or more and mid-cap stocks have done far worse than their  large-cap counterparts.
   

   Contradictory advices from 'experts'

    At one end of the spectrum, some experts are suggesting that Brexit could trigger a financial crisis similar to 2008, pulling the global economy into a recession, and that investors should therefore reduce or eliminate their equity exposures while they have the time. At the other end of the spectrum are those who feel that this is much ado about nothing, that the UK will renegotiate new terms to live with the EU and that investors should view the market drops as buying opportunities.
   
   Going the way experts have failed miserably in the past, I am skeptical to trust either side and decided to study the basics to understand how the value of stocks could be affected by the event and perhaps pass judgment on whether the pricing effect is understated or overstated. The value of stocks collectively can be written as a function of three key inputs:
   a) the cash flows from existing investment,
   b) the expected growth in earnings and cash flows, and
   c) the required return on stocks (composed of a risk free rate and a price for risk).
   

   Ending Note

   I see the effects as falling midway to the two extreme 'expert advice'. I think that doomsayers who see this as another Lehman moment have to provide more tangible evidence of systemic risks that come from Brexit. At least at the moment, while UK banks are being hard hit, there is little evidence of the capital crises and market breakdowns that characterized 2008.Like in India the markets have stablilized and the Brexit shock absorbed. It is true that Brexit may open the door to the unraveling of the EU, a bad sign given the size of that market but buffered by the fact that growth has been non-existent in the EU for much of the last six years.
   If the European experiment hits a wall, it will accelerate the shift towards Asia (look East) that is already occurring in the global economy.
   I also believe that those who believe that is just another tempest in a teapot are being too naive. The UK may be only the fifth largest economy in the world but it has a punch that exceeds its weight because London is one of the world's financial centers. I think that this crisis has potential to slow the 'new mediocre' global economy further. If that slowdown happens, the central banks of the world, which already have pushed interest rates to zero and below in many countries will run out of ammunition. Consequently, I see an extended period of political and economic confusion that will affect global growth and some banks, primarily in the UK and the US, will find their capital stretched by the crisis and their stock prices will react accordingly.