Global Markets Recoup $2T After Brexit, Street Looks to 2016's Second Act

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Global equity markets through the first half of 2016 were, in a word, resilient.

Put through the paces of one macro-economic shock after the next, including worries about global growth, uncertainty surrounding the Federal Reserve’s path of monetary policy, and an unexpected Brexit vote, markets across the world ended the first six months of trading mostly in the green.

Many on Wall Street believed the latest hurdle, the United Kingdom’s decision late last week to sever its more than 40-year membership in the European Union, would cripple upward momentum and perhaps even trigger a global recession.  As a result, investors ripped $3.01 trillion out of global markets in the wake of the vote.

In keeping with 2016 trends, the sentiment tide quickly reversed by Tuesday after two straight-sessions of losses as investors rushed back into risk assets, sending $2.07 billion in value back into the global marketplace by the close of trade Thursday. The moves capped a volatile first half of the year on an unexpected high note.

Despite the Brexit tumult, the broader averages ended the second quarter in the green with the Dow Jones Industrial Average adding 1.4%, and the S&P 500 gaining 1.9%. Meanwhile, the Nasdaq Composite slipped 0.5% for the period.

On a year-to-date basis, both the Dow and the S&P are up more than 2.6%, while the Nasdaq is 3.3% lower.

Jim Paulsen, chief investment strategist at Wells Capital Management, called the short-lived Brexit freak out “a wimpy crisis” in economic terms.

“It should be encouraging to investors that there’s been a muted response. The stock market now is essentially at the same place it was the Friday before [the Brexit vote],” he said. “A real possibility is that the U.K. left the EU, but what will happen is they’ll simply renegotiate how to interact with the EU and it’ll be a similar partnership. I’m not sure that even means much to the economy.”

"The single most important thing to analyze, watch, and take note of in the next 12-18 months is the dollar."

- Chris Hyzy

While investors clearly moved into risk assets like equities, the CBOE’s VIX Index, known as Wall Street’s fear gauge, plunged. But traders didn’t necessarily ditch their positions in safe havens like gold and U.S. government debt. For the quarter, gold jumped 6.82% to $1,318 a troy ounce – notching the biggest two-quarter gain since 2007. Meanwhile, the yield on the 10-year U.S. Treasury bond, which moves inversely to price, extended one month of declines to two as it fell 1.492% in the second quarter. It’s the biggest two-quarter yield decline for the 10-year since 2011.

The reason for the unusual move into equities but not out of safety plays is because investors aren’t completely sure risk has melted out of the market, according to Chris Hyzy, chief investment officer for Bank of America’s Global Wealth and Investment Management division.  He attributes part of the risk-on rally to short covering as investors make good on bad bets for stocks they expected to move lower after the Brexit vote.

Hyzy also noted the other part of the equation has been “relatively tame” action in currency markets as investors became more confident. Ahead of the U.K. referendum, investors expected the dollar to strengthen, but as of late Thursday, the dollar index gained 0.27% against a basket of global currencies.

“The single most important thing to analyze, watch, and take note of in the next 12-18 months is the dollar,” Hyzy said. “If it’s stable or slightly weak, then the rally continues, economic pain is not as large, and global trade doesn’t have pressure on it.”

He warned, though, if the greenback strengthens materially, it will have a range of implications including increased pressure on central banks, including the Federal Reserve, trying to normalize policies. That would create more difficulty for trade, export, and manufacturing sectors around the world to produce needed growth to drive investors into equity markets.

Despite the warning, Hyzy said he doesn’t expect the dollar to strengthen in the second half of 2016 because he sees both headwinds and tailwinds keeping the currency trading along its current value.

“The dollar will be stronger to sterling because the U.K. will have 2% of its growth wiped out in 18 months, but with the Fed on hold for longer, the realization is taking hold that they won’t normalize quicker versus other central banks, and interest-rate parity won’t be as wide. The dollar will hang on,” he explained.

The not-too-strong, not-too-weak nature of the greenback is likely to help corporate earnings in America by removing a significant headwind that’s pressured profits for several quarters as it becomes less expensive for other nations to buy American goods.

Despite the surge in equities in the back half of the week, Paulsen said buying opportunities are still plentiful in the market for those waiting to dive back in.

“The right thing to do right now is buy,” he said. “Ultimately, economic fundamentals [of the U.S.] will force investors away from selling. A week from now, we could be setting new highs…that’s going to be part and parcel of Brexit not being bad economically and the realization that we’ve had a bad earnings situation that’s turned up a bit.”

Paulsen added, though, the markets are also likely to re-test the lows – but said those pullbacks should signal buying opportunities for investors.  In that case, he recommends unloading safe havens and buying more cyclical sectors.