Will Brexit Crash the Stock Market?

After a difficult two days, there’s a serious question on many investors’ minds: Is this the big one, the next crash? It's a reasonable concern. After all, haven’t we been hearing about all the damage Brexit could do? And haven’t we sort of been down this road before, with the Greek crisis in 2011?

It's been a bad couple of days, no doubt, but I don’t think Brexit will bring on a financial crash. As I write this, markets are bouncing back around the world, and U.S. markets are positive as well. 

Fundamental change or just a drop in confidence?

This goes back to our recent discussions of confidence-based pullbacks versus fundamentally driven pullbacks. Confidence-based pullbacks can be sharp, but they tend to be less severe overall and to recover much more quickly. The most recent example, in the first quarter of this year, showed just that behavior. The question about Brexit is whether the turbulence we’re seeing reflects a fundamental change or just a drop in confidence.

I would argue that, so far, nothing has fundamentally changed. Yes, there's certainly the potential for significant change. At the same time, both the British government and major players in the European Union (notably, Angela Merkel of Germany) have gone out of their way to avoid doing anything drastic. Given David Cameron’s decision to postpone starting the exit process, not to mention the second thoughts among the British leadership, it’s possible they may end up changing their minds.

Markets already recovering

From a legal perspective, nothing irrevocable has happened yet. It may, and confidence has taken a hit. With reduced confidence, markets have been reacting for the past two days as if things will worsen. But a confidence-led pullback, as we have seen, typically isn’t as bad as a fundamental one, and markets are now recovering. Let's take a look:

• In Britain itself, the FTSE 100, which tracks major international companies, is back to mid-May levels, largely reversing the recent drop.
• The FTSE 250, made up of smaller companies that are much more exposed to the U.K. itself, is still down at levels from February, but it is up more than 3 percent today.
• The DAX, the German index, never made it down to February levels and is moving back up as well.
• The CAC 40, the French index, is doing pretty much the same.

In short, the global market reaction points to a real but limited impact, nothing like a crash.

From a U.S. stock market perspective, the damage should be even more limited. The S&P 500 dropped from around 2,100 to around 2,000 over two days, or about 5 percent rounded. With S&P 500 revenues of around 3 percent from the U.K. and 7 percent from Europe, this is a rational adjustment that incorporates both substantial potential risk from a recession there and some systemic risk.

To repeat, this is a rational adjustment, not a panicked one. As of now, markets are processing the real risks rather than running scared. Arguably, we haven’t seen a real confidence-driven pullback here in the U.S., just a reasonable response to new information.

What could take this pullback to the next level?

If politics in the U.K. or Europe gets more toxic, which is certainly possible, that could do it. So far, however, everyone is behaving in a responsible fashion. If the U.S. economy continues to weaken, that could also do it for us, but recent data is showing continued (though slow) growth.

The thing to watch for over the next couple of weeks will be signs that fundamentals, both political and economic, are eroding. Right now, that doesn’t seem to be happening, indicating that a deeper pullback, while possible, is unlikely to turn into a crash.