Steven Major, HSBC Holdings’ head of fixed-income research, calls Brexit a mere “sideshow.” Howard Marks says Brexit isn’t likely to have a meaningful effect on the economies of the U.K. or the European Union. George Soros thinks Brexit has unleashed a 2008-sized debacle. Larry Summers views Brexit as the worst shock to Europe since World War II. Paul Krugman predicts that Brexit will make Britain substantially poorer.
I don’t belong on the same list as the worthies noted above, but last week -- before Brexit happened -- I questioned how much EU membership actually boosted the U.K.’s GDP or productivity after joining the group in 1973. I thought dismal currency and market outcomes had already been baked into the U.K.'s performance going back years. How much worse could it really get, I wondered?
Stock markets haven’t answered those questions yet and it's far too early for them to offer definitive guidance, anyhow. We’ve had just four trading days since the Brexit vote. Global stock markets were down sharply the first two trading days following the vote, and then abruptly reversed course, posting strong gains over the subsequent two days.
There appears to be agreement, however, on at least one point: While uncertainty lingers in Europe, investors are seeking safety in the U.S. The dollar has gained on every G10 European currency since the vote. And while the MSCI Europe Index is down 5.3 percent since last Thursday, the S&P 500 Index has given up only 2 percent of its value since then.
So rather than predicting the economic fate of the U.K. and Europe just yet, I'm going to pivot to a different issue: Just how safe is the world's most highly-regarded economic and financial safe haven? (Sorry China, but you don’t qualify yet. Japan, Germany -- you two don't compare to the U.S. or China in the GDP league tables.)
The U.S.’s economic might and relative stability make it an intuitively appealing place to hide. But the U.S.’s popularity may ultimately be just as destabilizing as Brexit.
The potential for trouble starts with a rising dollar. A stronger dollar, of course, makes U.S. goods more expensive for overseas buyers, which in turn puts a dent in the earnings of U.S. companies that are export-dependent (about 13 percent of the U.S.'s GDP derives from exports). The impact of that isn’t trivial. The U.S. Dollar Index has advanced 20 percent since March 2014, while at the same time “as reported” earnings per share for the S&P 500 have declined by 10 percent.
That isn’t a coincidence. The correlation between the U.S. Dollar Index and U.S. earnings, as measured by Robert Shiller’s historical earnings for U.S. stocks, has been a negative 0.54 from 1967 to 2015 (the longest period for which data is available for the U.S. Dollar Index). A note: A correlation of 1 implies that two variables move perfectly in the same direction, whereas a correlation of negative 1 implies that two variables move perfectly in the opposite direction.
This negative correlation between the dollar and U.S. earnings implies that when the dollar rises, there is a real risk that earnings will get dinged.
As earnings go, so do stock prices. According to Shiller’s data, the correlation between U.S. stock prices and earnings has been a whopping 0.96 from 1871 to 2015. In other words, continued enthusiasm for U.S. investment may set in motion a chain reaction that starts with a stronger U.S. dollar and ends with declining U.S. stocks –- not exactly what investors hope to achieve by seeking refuge in the U.S.
This risk to U.S. stocks is particularly acute today because U.S. stocks have been a safe haven for some time and they are very, very richly-valued already (particularly the tech-heavy Nasdaq). Brexit is just the latest in a long line of European hiccups in recent years, from the EU’s struggle to revive growth to the ongoing Greek bailout drama to the wobbly solvency of Southern Europe’s banks, and so on.
Ben Carlson, who writes the blog "A Wealth of Common Sense," nicely laid out the outperformance of U.S. stocks relative to European stocks over the last several years and draws a compelling case for the latter's valuation when compared to its more expensive cousin.
According to Shiller’s data, the cyclically adjusted price-to-earnings ratio, or CAPE, is now 26. The CAPE has only been higher three times –- on the eve of the Great Depression, during the Internet Bubble, and just before the Great Recession –- none of which were, ahem, auspicious occasions.
So it’s not at all clear to me that the U.S. is actually any less risky than Europe right now. But one thing is clear: If investors continue to insist on the U.S. as a safe haven, they may be helping foment the same weakness in the U.S. that they hope to avoid by fleeing Europe.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
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Nir Kaissar in Washington at firstname.lastname@example.org
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