At first blush, Britain’s vote Thursday on whether to leave the European Union may not seem like a big deal, especially to folks on this side of the pond.
After all, we’re talking about just one European country—whose economy is only slightly bigger than California’s—thinking about ending a partnership with other European nations, right? And Britain never fully embraced that partnership in the first place, as evidenced by its refusal to adopt the euro.
Still, the economies of the European Union are collectively almost as large as that of the United States. And at a time when the global economy is so fragile that the Federal Reserve refuses to raise interest rates even by a quarter of one percentage point, a British exit–or “Brexit”–vote could have ripple effects that American investors will feel first hand:
1. The stock market will get shakier.
“Brexit has the potential to be a big deal because it’s a source of volatility,” says Mark Freeman, chief investment officer at Westwood Holdings Group. You’re already seeing that play out in the stock market.
Since the start of the month, the CBOE S&P 500 Volatility Index, which gauges investor fear, jumped from a below-average level of 13 to above 20. Not only is volatility back above normal, it’s back to where it was in January, when the stock market experienced a big selloff; and last September, when the dip was almost as bad.
That’s not to say that we’re in store for another big selloff. But fear creates a headwind for both the stock market and the actual economy. “It’s human nature: When you don’t know what’s going to happen, you tend to pull back,” Freeman says. “You don’t just charge ahead.” And that’s true for investors deciding whether to plow new money into the market, or business executives deciding whether to invest more into expanding their payrolls or plants.
This may explain why U.S. stocks are down more than 2% since early June while foreign stocks are off nearly 7%. If Brits actually vote to leave the EU, “expect a decline across almost all global equity markets, simply on the economic uncertainty created,” says Burt White, chief investment officer at LPL Financial.
2. The dollar could rise, which is bad news for U.S. stocks.
Both sides of the Brexit debate argue that their cause will ultimately benefit the U.K. economy. In the near term, though, “it is safe to assume Brexit would cause an initial sharp decline in the pound against the euro, and that both would decline relative to the U.S. dollar,” says White, as global investors look for shelter from the European storm.
In the lead-up to the Brexit vote, the dollar has gained about 2% against a basket of foreign currencies, after falling around 6% earlier in the year.
Why does this matter? A strong dollar makes it harder for U.S. companies to export their goods abroad. That’s because a rising dollar increases the costs of U.S. goods for foreign buyers. If foreign sales are hurt by an even stronger buck, this could prolong the earnings drought that companies in the S&P 500 stock index have been in for more than a year. And that could spell trouble for stocks. “The markets are going to follow the path of earnings,” says Westwood’s Freeman.
3. Already low interest rates could be driven lower, which isn’t great news for the economy.
“The risks surrounding Brexit have clearly had an impact on the U.S. Treasury market,” says Brian Belski, chief investment strategist for BMO Capital Markets. Just in this month, the yield on 10-year Treasury securities has fallen from 1.85% down to 1.61%, which is fast approaching the all-time record low of 1.46% in 2012.
Normally, low rates are good for the economy because that means lower borrowing costs for businesses and mortgage rates for would-be home buyers. But low rates can also be a sign of underlying trouble in the economy. If the recovery were going well, the cost of borrowing money would rise as demand for money grows and investors and business owners seek to take on greater risks.
But bond yields move in the opposite direction of bond prices. So today’s falling interest rates are a sign that worried investors covet the safety of hum-drum bonds, no matter how little they yield. It’s even worse overseas, where both 10-year German and 10-year Japanese bonds are paying negative interest rates.
4. The global economy could brake for this slowdown.
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Last week, after the Federal Reserve voted not to raise short-term interest rates, Fed chair Janet Yellen conceded that the upcoming Brexit vote factored into the central bank’s decision. She noted that a British exit of the EU could have negative consequences to the U.S. economy.
How? For one thing, “the U.K. would need to re-negotiate its trade agreements, and, although gradual, this could have adverse effects on economic growth,” notes Jason Pride, director of investment strategy at Glenmede. At the very least, some market observers fear a Brexit vote could make global leaders rethink how to position their European assets, which could delay investment plans in the region.
“Potential Brexit brings a litany of risks along with it, including currency, trade, and economic growth,” Pride says.
5. It could feed into a dangerous narrative for the bull market.
The bull market is already vulnerable because it’s so old. Most bull markets last around four years, but this one is already more than seven, making it the second-longest rally in history. Making matters worse, the economic expansion is also older than average.
As a result, investors are almost looking for a reason to lose faith. Last summer, a slowdown in China’s economy nearly pushed the U.S. stock market into a bear market. In January, falling oil prices nearly did the same. While Brexit itself wouldn’t have as big of an economic effect, it’s market psychology you have to fear.