1 July 2016

It’s hard to remember a more tumultuous week in the UK. There has been a lot of noise about the financial market reaction to Brexit and no doubt that it has been painful, particularly in parts. However, it is far from complete chaos and is markedly different to what we saw as the financial crisis descended in 2008 following the collapse of Lehman Brothers. In that it stands apart from UK politics.

Looking at the UK market reaction to the news that the UK had voted to Leave the EU there is no doubt that it sparked a few crazy hours overnight on Thursday and when markets opened on Friday. But speaking to people involved it becomes clear that markets resumed their normal functioning fairly quickly. Markets fell sharply and the impact was painful – see chart below (via the WSJ), the FTSE 250 in light blue is still down around 3.6%, while the FTSE AIM (yellow) is down 1.4% and the more globally diversified FTSE 100 (dark blue) is now up about 6%.

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Despite this, it was still different from the crisis following the collapse of Lehman Brothers. Back then the market was marred by indiscriminate selling, lack of liquidity and sheer panic. This time around, while there have been broad declines in markets across Europe, the focus of the selling and pressure has been on specific equities which investors believe will be hit hard by Brexit. Of course, the currency has also come under significant pressure, but even that has stabilised in recent days.

This is how you would expect markets to function in the wake of such a tumultuous event. Financial stocks, house builders and those exposed to UK consumer demand have been hit hardest – as the chart via the WSJ below captures. This suggests that selling has not been indiscriminate but targeted and rational. Furthermore, after a couple of days of sharp declines in both equities and the currency, buyers moved in and the situation stabilised.

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It’s too early to tell how the market will react over the longer term; this will depend firstly on the short term economic impact of Brexit and then the longer term relationship between the UK and the EU. The initial signs on this front and the prolonged uncertainty are not great – investment declines and consumer spending falls are expected – but at least markets have shown they can continue to function properly.  Ultimately, economic indicators such as business surveys and consumer confidence will be more important to watch in the coming months.

This is maybe less true for European markets, where the panic was more palpable and the initial widespread declines harder to explain. But even here the concerns were led by the banking sector. This is not entirely surprising given the banking sector in many parts of Europe remains undercapitalised, inefficient and unprofitable. Furthermore, the Eurozone’s banking union is far from complete and the new rules on bank bail-ins continue to make investors skittish. Add the fact that the ECB has little room for significant further easing without coming up against almost impossible political hurdles and it becomes a bit clearer why European markets were so startled by Brexit.

This all stands in contrast to the UK political scene, which seems to have imploded and turned in on itself. At a time when the country needs leadership neither party and precious few politicians have shown any. Somewhat ironically after a campaign categorised by politicians warning of financial and economic doom, it is the political system not the financial or economic system which has shown itself to be frail. Of course, if politics continues to fail to show any clear direction of travel for the UK’s exit from the EU, markets may well yet become more chaotic.