However, the Brexit vote increases the possibility of a global recession. A policy mistake in a slow growth in deflationary world could be particularly damaging. The early 2016 economic slowdown and market correction provides an appropriate framework in considering how a policy action proved disruptive to the global economy. By raising interest rates and diverging U.S. monetary policy from that of the rest of the world, the U.S. Federal Reserve’s actions strengthened the dollar and sparked a chain reaction of unintended consequences: capital outflows from emerging markets, lower oil prices, wider high yield spreads, concerns about risk to the global banking system, and ultimately fears of a looming global recession. That transpired over the span of many months. A similar phenomenon is now likely to play out in a matter of days as investors seek the perceived safe haven of U.S.-dollar denominated assets. Once again the yield curve is flattening and corporate borrowing costs are rising. The strong dollar will again prove a headwind to U.S. exports and corporate profitability.
Make no mistake: This is a shot directly at the globalization boat. Every international market is perceived to be riskier and investors now require a higher risk premium to be exposed to international markets and currencies.
The global economy is now back to where it was in 2010 and 2011, when economists have been debating the efficacy and sustainability of the European Union, the Eurozone and its common currency. Ultimately, much like European Central Bank President Mario Draghi’s response to the 2011 crisis when he decided to do whatever it would take to save the euro, central banks will do whatever is necessary to limit the fallout from the Brexit referendum and provide support to the global economy.
As always, volatility in markets ultimately creates buying opportunities and already there are extreme divergences in the performance of certain sectors, industries and companies. All told, investors should expect volatility to persist and returns to be weaker as markets deal with this uncertainty.
