On Thursday the United Kingdom voted to leave the European Union by a 52%-48% (1.3 million vote) margin, catching pundits and financial markets by surprise. When the polls opened, implied odds of remaining in the E.U. sat at 90%, but as the outcome began to take shape early Friday morning, global risk assets began a steep, violent decline. The British pound fell by as much as 11% versus the dollar to its lowest level since 1985. The U.K.'s benchmark index, the FTSE 100, tumbled 9%, its largest decline since the 2008 financial crisis. In the U.S., the Dow fell more than 600 points with the 10-year U.S. treasury yield falling as low as 1.43% before settling for the week at 1.56%. Gold at one point rallied by more than 8%. Investors also fled to the relative safe haven of the yen, further complicating Japanese officials' plans to devalue out of their current deflationary spiral.
The greatest damage took place in markets most vulnerable to the potential domino effect of a broader E.U. breakup. Spain's IBEX index fell 17% while Greece's banking sector crashed 25%. A Brexit is expected to soon plunge the UK economy into a recession with global banks already mobilizing the relocation of jobs to other E.U. financial centers like Dublin or Frankfurt. The U.K. Treasury projects housing prices to fall as much as 18% as a result of the Brexit, with IHS economics projecting a 10% depreciation in U.K. real estate by 2017. Goldman Sachs revised its 2017 U.K. GDP estimate lower by 1.8% to 0.2%.
Only three weeks ago we wrote about the Federal Reserve priming the market for a summer rate hike. At that time implied odds of a monetary tightening by the end of July exceeded 50%. Now, Fed Funds Futures say there is only a 10% chance of any move at all in 2016. Bank of England (BOE) President Mark Carney isn't letting disappointment over the result get in the way of doing his job. The BOE pledged a record 250 billion pounds ($345 billion) of liquidity for the financial system, promising further measures if needed to deal with a "period of uncertainty and adjustment."
So how did we get here?
"Remain" campaigners, including Prime Minister David Cameron, focused on messaging that the U.K. is "stronger, safer and better off" in the E.U. while "Leave" advocates focused on the need to "take back control" of issues like immigration. Older white voters in smaller Northern cities heavily favored leaving. For example, in the homogeneous Northeast city of Hartlepool, which is most famous for hanging a monkey suspected of being a Napoleonic spy, 70% of voters opted to leave. Younger voters and those in cosmopolitan London voted decisively to stay.
Perhaps Cameron's biggest mistake, though, was calling such a referendum in the first place. Three years ago, facing a split in his own party between pro- and anti-E.U. officials, Cameron sought to foster unity by promising a referendum on E.U. membership if he won re-election. While anti-Europe sentiments were rising at the time, polls suggested the British people still overwhelmingly favored remaining in the bloc. "Remain" continued to hold around a 10-point lead in the polls until early this year. A major turning point was the defection of Cameron's long-time friend and popular former London Mayor Boris Johnson to the "Leave" camp. Johnson gave "Leave" a popular, credible face for its movement, and he is perhaps the greatest beneficiary of a Brexit victory as the odds-on favorite to replace Cameron as Prime Minister.
Now, it's important to understand the referendum result does not result in the U.K.'s immediate departure from E.U. It simply, Under Article 50 of the Treaty of Lisbon, sets in motion a negotiation over the terms of Great Britain's transition out of the bloc. Among the things that need addressing are the status of 3 million E.U. workers in the U.K., $575 billion of annual trade between the U.K. and continental E.U., terms for U.K. corporations accessing the E.U.'s $14 trillion single market and rules for banks U.K. banks conducting business with the rest of the E.U.
Experiencing the immediate repercussions of their decision to leave the E.U., many "Leave" voters are already experiencing buyer's remorse and confusion over what they voted for. An online petition for a re-vote has already garnered millions of signatures. The U.K. has long sought a "British exception" whereby it could exercise greater control over immigration, but E.U. officials have resisted such overtures. Already Boris Johnson is distancing himself from some of the more nationalistic tones of the "Leave" campaign. In fact, many speculate the U.K. may not leave the E.U. at all. The affirmative Brexit vote could simply give U.K. leaders a stronger mandate to negotiate a more equitable relationship with the continent. A decidedly pro-Remain parliament will have to approve the transition terms, as will 20 of 27 E.U. member states.
The Brexit has been such a destabilizing force for global markets because it adds a great deal of uncertainty to an already fragile ecosystem. Will E.U. officials seek to make an example of the U.K. as warning to other countries contemplating an Eur-exit, or will they prioritize short-term stability? Will the E.U. survive, with popular political figures in France, Italy, Spain, Denmark and the Netherlands now calling for referendums on E.U. membership? The E.U. is less popular in many of those countries than it is in the U.K. A recent French poll found the percentage of citizens with a favorable view of the E.U. is 38% percent, down from 69% in 2004. In Spain that number has fallen from 80% to 47%
The U.K. could also break apart. Scottish First Minister Nicola Sturgeon is calling for a fresh referendum on Scottish independence after 62% of Scots voted to "Remain." Similar calls have come from pro-"Remain" Northern Ireland. As a result of rising instability across Europe, investors will likely continue flocking to the relative known commodity of U.S. stock and bond markets. After all, U.S. GDP exceeds that of the entire E.U.
The U.K. appears to have cut off its nose to spite its face. George Soros correctly predicted the pound's fall post-"Brexit" would be more disruptive than "Black Wednesday." Investors should expect heightened volatility through the rest of the year.
Tesla does the electric slide
Tesla Motors this week offered to acquire SolarCity Corp in an all-stock deal valued at $2.8 billion. The merger of an electric-car company and solar-panel company might not look all that unnatural on the surface, but the intrigue lies in the fact Elon Musk is the largest shareholder in both companies. Musk has grown accustomed to hero worship from analysts and investors, even his most outlandish comments and audacious bets met with wonder. However, even Musk is finding it hard to escape criticism for the optics of this deal involving two companies that rely heavily on government subsidies. Tesla shares fell by more than 10% following announcement of the acquisition, the company's market cap falling by more than the value of the entire deal.
Musk, who is also the CEO and largest shareholder of rocket maker SpaceX, has long creatively shuffled assets among his three companies. For example, in 2014 SpaceX was the largest buyer of $214 million in bonds offered by SolarCity. However, attempting to combine two of the entities is his boldest, most brazen endeavor yet. That's because for the past year, amid increased competition within the solar-panel installation business, SolarCity has been hemorrhaging money, with some of its bonds yielding only 20 cents on the dollar. SCTY shares have fallen by nearly 75% since early 2014.
Jim Chanos, who has revealed shorts bets against both firms, shredded the deal, calling it a "brazen Tesla bailout of SolarCity" and a "shameful example of corporate governance at its worst." Much of the outrage stems from the fact Tesla tendered a $1.4 billion secondary offering of shares only last month, money that was immediately used to rescue a company burning through hundreds of millions of dollar every quarter.
Musk obviously, or at least outwardly, doesn't see it that way. He called the merger a no-brainer and envisions the combined entity as having the potential to be a trillion-dollar company (Tesla is currently valued at $28.5 billion). He envisions the new Tesla as a one stop shop for clean-energy enthusiasts, one where they can get electric cars, solar panels and batteries for storing energy, powering homes and charging vehicles. However, skeptics believe the move will just serve as a distraction as Tesla attempts one of the greatest production ramps in history to meet pre-orders for its new Model 3.
While Musk will recuse himself from internal discussions over the deal at both companies, helping its chances of going through is the fact 45% of Tesla shareholders also own shares in SolarCity. Because the proposed merger is an all-stock deal, valuing the two unorthodox companies will also lead to some late nights for a few lucky Wall Street investment bankers.
One thing is for sure, the deal is a dangerous risk that could very well pay off.
China grapples with dollar volatility
The headline is Wal-Mart struck a deal to sell its Chinese e-commerce business to JD.com, but the most interesting part of the transaction is the new partnership that will result from the transaction. Wal-Mart, like Apple and many other U.S. companies, has been frustrated in its attempts to make inroads in the communist country. Rather than try to beat competitors, Wal-Mart, like Apple did with its investment in Didi Chuxing, is choosing to join them.
Perhaps overshadowed by the Brexit, concerns about a looming Chinese economic crisis dissipated early in the week, owing largely to the Fed's more dovish about-face on interest rates that slowed the dollar's ascent. However, given the dollar strength that emerged as a result of Brexit, China could once again come into focus as markets ponder the potential for a yuan devaluation.
The People's Bank of China (PBoC), perhaps in response to its latest rejection from MSCI's benchmark emerging markets index, announced plans to welcome foreign equity listings.
Brazil's Olympic bailout
After the governor of the Brazil's Rio de Janeiro state declared a financial emergency only a month before the beginning of the 2016 Olympic Summer Games, the government announced a $849 million bailout of the region. The federal government will also offer state governments $15 billion in debt relief over the next three years to allow them time to shore up public services. The moves should help ease short-term economic pressures in the beleaguered country, which this week included a record-setting $19 billion bankruptcy for leading telecom company Oi.