Why Brexit Fears Are Far from Over for Investors

Why Brexit Fears Are Far from Over for Investors

© Neil Hall / Reuters

Friday's post-"Brexit" market wipeout was one for the record books: The $2.08 trillion decline was the worst single day ever.

The CBOE Volatility Index (VIX), Wall Street's "fear gauge," posted its fifth largest gain after trading in U.S. equity futures was halted overnight. The Nasdaq Composite suffered its largest rout since 2011 and is now down nearly 6 percent for the year. The plunge at the open was the U.S. market's worst since 1987, a sign of fragility and lack of liquidity. Gold's 4.7 percent surge was its biggest day since Lehman Brothers failed in 2008.

The fear was palpable ­— and it's set to continue as Britain's repudiation of top-down economic elitism cuts to the core of what's been sustaining financial markets over the last seven years: Low volatility and relative political stability. With a contentious U.S. presidential election ahead — and GOP contender Donald Trump's anti-immigration tendencies closely aligned with Brexit sentiments — the turbulence could well last through November.

Related: Why 'Brexit' Is the Biggest Threat Yet to This Bull Market

The political fallout is just beginning, with pro-remain British PM David Cameron resigning and "Article 50" — the EU's exit clause — yet to be invoked by the British government. The Brexit process is likely to take years.

The only example we have was Greenland's 1982 decision to exit the EU's predecessor after a popular referendum voted for independence. After much wrangling over fishing rights (an industry responsible for the vast majority of the country's economy), the island nation finally left in 1985 under the Greenland Treaty.

It took more than 100 meetings and three years to extricate a frozen island of 56,000. What of a well-developed island of 65 million?

In the years to come, nervousness, uncertainty and copycat independence movements in other countries will reign. Anti-EU politicians in Italy, France and the Netherlands have already called for referendums while similar calls were made by anti-immigration parties in Sweden and Denmark.

Related: In the Aftermath of the Brexit Vote, the Bluffing Continues

Should Brussels take a hard line in the trade negotiations to come, the British economy and the pound sterling will suffer as traders price in a larger economic drag from Brexit, destabilizing markets. Should Brussels make the process as painless as possible, it will embolden pro-independence movements elsewhere and hasten the collapse of the EU project altogether.

It's a no-win situation for the European Union elites. Deutsche Bank analysts noted the difficultly in a note to clients, saying policymakers must strike the right balance in exit negotiations between preserving existing trade and investment links with Britain while sending a strong signal to other EU countries that an exit isn't going to be easy or desirable.

No wonder then that it wasn't British stocks that were hit hardest on Friday (although British banks suffered their largest one-day decline on record) but peripheral Euro area stocks. Greek stocks lost nearly 16 percent, while Italian stocks were down 12.5 percent. A breakdown in the European Union would threaten Greece's bailout programs, since a smaller Euro area would put the rescue burden on a smaller number of countries. In Italy, the euro-sceptic Five Star Movement recently won a decisive victory in the second round of municipal elections.

Related: How the Brexit Affects Your Retirement

As for financial market volatility, keep an eye on the currency markets. By virtue of the sheer volume of trading in foreign exchange, and the buildup of popular currency carry trade positions in which investors borrow currencies at low rates to buy up stocks and other risky assets they expect will bring a higher return, volatility here will spill into other areas of the financial system. Remember the selloff last August? That was driven by Chinese currency volatility.

Consider that another area of the global financial system that was hit hardest on Friday was Japan — half a world away from Europe — as safe haven inflows into the yen forced the closure of yen carry trades. The yen ended the day up 6.6 percent against the euro, slamming the Nikkei average down 7.9 percent on worries over the impact on export competitiveness.

Another drag will come from the surge the U.S. dollar is enjoying in all this.

The greenback surged to levels not seen since March in mid-day trading on Friday. A strong dollar has been one of the main reasons for an ongoing corporate earnings recession, with S&P 500 earnings down four quarters in a row. Expect the strong dollar to be blamed for another batch of weak results when the second quarter earnings season starts in a couple of weeks.

Related: What the Brexit Vote Means for the US Economy

In an example of a classic negative feedback loop, a stronger dollar will also unwind some of the recent strength in crude oil prices — which, in turn, was one of the main motivators for the powerful stock market rally out of the February low. West Texas Intermediate fell 5.1 percent after testing below its 50-day moving average for the first time in four months.

For the bulls, all hope rests in the rising odds of an interest rate cut by the Federal Reserve later this year. But as experiments with negative interest rates in Europe and Japan have revealed, at this point, lower interest rates are doing more damage (by weakening bank profitability) than anything else.

In short: The three years of low volatility investors have enjoyed since the Dow Jones Industrial Average first hit the 18,000 level in 2014 is ending. And thus, allocations to safe havens like cash and gold should be reconsidered.