by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] In a major shock, U.K. voters chose to exit the EU in yesterday’s referendum.  The vote, which ran roughly 52/48 in favor of Brexit, defied polls and, for the first time in our experience, the betting pools as well.  In the U.K., this is the second straight polling miss; pollsters also missed the Labour loss in the last elections.  As expected, PM Cameron, who promised a referendum to quell a backbencher revolt, resigned.  His political ploy clearly backfired.  One half of our macro team, Kaisa, is in London this week.  The mood on the ground there is calm, but confused.  Many voters felt that they did not have enough details to make an informed decision.  The turnout for the referendum was the highest in any U.K. election since 1992.  England and Wales voted strongly in favor of leaving, while Scotland and Northern Ireland voted for remaining in the EU.

It will take some months to completely determine what this historic vote means, but here are our initial thoughts:

Financial and commodity markets: As one would expect, market volatility is historic.  Part of the reason for the massive volatility is that the markets were surprised by the outcome.  With polls mostly leaning toward remain going into the vote, we had seen a rather impressive rally in the GBP and global equities over the past few days.  So, with the unexpected outcome, reverse market action is accentuated.  Flight to safety instruments have all rallied strongly.  Treasury yields plunged across the board, with the 10-year T-note dipping under 1.50%.  Perhaps even more shocking, the two-year T-note fell over 20 bps, approaching the 56 bps level.  This T-note is very sensitive to Fed policy and the plunge in yield suggests that no tightening will occur for the rest of the year and perhaps longer.  The JPY penetrated the 100 ¥/$ rate and it appears the BOJ did intervene to prevent further strength.  Gold prices have soared, with the nearby futures price hitting $1,362.60, a rise of nearly $100 per ounce.  The rise in gold occurred despite a strong dollar.  On the flip side, global equities are all lower, with most major markets off around 7%.  Bank stocks were especially vulnerable, with most dropping double digits.  Outside of gold, most commodity prices are lower, with oil down over $3.00 per barrel at the lows.  The GBP fell below $1.3300.

In the ensuing hours, we have seen markets stabilize and, in most cases, they have lifted off their worst levels of the overnight session.  However, thus far, we haven’t seen anything that would suggest a recovery is in the offing.  Going into 2016, there were two major concerns, Fed tightening and Brexit.  The first concern is now off the board, but the second, unfortunately, has occurred.  The BOE has already indicated it will take steps to stabilize markets but there will be limits to what it can do.  Usually, major market dislocations such as this one tend to create buying opportunities; we suspect this one will as well, but it will take a few days to sort out where we go forward.

The question of Europe: The EU and the U.K. will begin the process of splitting up.  The official process creates a two-year period where negotiations take place for exit.  Thus, nothing happens immediately.  We suspect EU officials have two goals; first, they want to quell panic, and second, they want to greatly punish the U.K. for its actions to make it abundantly clear to the remaining members of the EU that exiting isn’t a viable option.  Already, EU officials have indicated that there will be no further concessions made to the U.K.  Unfortunately for the EU, the populist trend appears to be gaining strength and other nations in the EU are going to consider an exit.  Already, Geert Wilders, a right-wing populist political leader in the Netherlands, applauded the British outcome and suggested his nation should consider a referendum as well.  Scottish leaders have indicated that Scotland will be exploring its options, which may include devolution.

An EU without the U.K. will become more German-centric.  France will struggle to dilute German dominance.  As we noted in last week’s WGR, the entire EU project is now in question.  The goal of the EU was to offer peace and prosperity as an alternative to nationalism.  When the Soviet Union was a threat and the U.S. was willing to fund European security, the EU worked reasonably well.  But, absent the communist peril, with the U.S. less interested in Europe and with prosperity lagging for the masses, nationalism is gaining strength.  Although we don’t expect Europe to become a threat to global security for the foreseeable future, one cannot fully discount history.  Simply put, we have seen two world wars spawned by European nationalism.  If it returns, it is reasonable to expect that this threat will return.  Again, this isn’t an immediate concern but the risks will rise over the next two decades.

The growing threat of populism: We have been discussing this issue for some time.  Sluggish economic growth and widening income inequality has led to a growing backlash against globalization and deregulation.  Numerous right- and left-wing populist movements have been rising in Europe and the remarkable primary campaigns of Donald Trump and Bernie Sanders show that similar sentiment is occurring here as well.  At heart, populism is anti-globalization and, at some point, will also push for protective regulation.  Such policies threaten price stability and, if implemented, will lead to inflation.

The fact that the polls and betting pools in the U.K. completely missed this outcome suggests that populism is growing.  Think of it this way: although there were no official exit polls in the referendum, there were a couple private ones that were calling for remain to win 52/48.  So, how does this happen?  Assuming that there was a random sample, the only explanation is that responders probably lied to poll takers.  In other words, people may say they deplore populist positions, but in the voting booth they are voting for populism.  If we are correct, it means that pollsters and the elites are greatly underestimating the strength of populism.  The European establishment has been left looking very much like the Republican establishment in the wake of Trump’s primary campaign: befuddled and completely wrong about the public’s passions.  It also means that the polls here may be underestimating the impact of the Trump general election campaign.  Historians may pinpoint yesterday’s referendum as the turning point where globalization began its retreat.

We will have more on this issue in the coming weeks.  For now, expect markets to remain under pressure.  We would not expect this event to trigger a recession in the U.S., but we are confident that U.S. monetary policy will not tighten further this year.

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