How Brexit Threatens the Stock Rally

While U.S. stock investors seem to understand the risks of a China trade war, they may be completely overlooking the grave danger of a “hard Brexit.” Such an event would "almost certainly" throw the UK into a recession and weigh heavily on the eurozone area, one of the world's largest economies where U.S. companies have heavy exposure, according to Randy Frederick, vice president of trading and derivatives at Charles Schwab, as outlined by Business Insider.

"The Brexit issue is, I think, a bigger issue than a lot of people realize," said the market watcher. "I think retail investors on our side don't really get how big that is and how much of an impact it could have. I think everybody understands the China issue, and I think it's just because it's the stuff that they interact with on a daily basis."

The Road To Brexit

• March 12, 2019: UK lawmakers vote on a new deal outlining terms of the UK’s departure from the EU.
• March 13, 2019: If deal is rejected, lawmakers vote on whether to leave the EU without an agreement.
• March 14, 2019: If lawmakers reject a no-deal Brexit, they vote on whether to seek a delay to the U.K’s separation from the EU.
• March 15, 2019: Two-day summit begins. EU leaders meet to consider the state of the Brexit process.
• March 21, 2019: Without an extension, the U.K. is scheduled to leave the EU.

'Worst Possible Outcome' No-Deal Looks More Likely

The Schwab analyst made his comments as Great Britain moves toward a "no deal" Brexit on March 29. While on Monday, the Labour Party said it would support a second referendum to postpone the deadline, Frederick is skeptical that ill will come to fruition, increasing the odds of the “worst possible outcome.” In the case of this no-deal Brexit, a sharp decline in the European economy would increase the likelihood of an economic recession in the US by 2020, said the Schwab analyst.

The problem is, many investors have become “immune” to Brexit headlines, hardened by the past two years’ uncertainty. “If you had said to people a year ago that as we go into March 2019 there is still going to be no clarity on what is going to happen at the end of the month, people would have been horrified,” said John Wraith, who covers U.K. rates strategy and economics at UBS, per The Wall Street Journal.

Now only would Brexit serve as a powerful negative force in itself, but it would also amplify headwinds such as China-US trade wars, the China-Korea breakdown, weakening corporate earnings and a slowdown in economic growth. All of these factors put US equity prices at risk. Schwab's Frederick notes that a breakdown in talks between the US and China is ass equally risky a factor as a no-deal Brexit. So far, he indicates that manufacturing in both countries are showing signs of strain under new tariffs.

The Waiting Game

It’s important to note that it's not just a "hard Brexit" that could destabilize stocks, but also the risk of nail-biting uncertainty extending beyond the March 29 deadline.

People are just kind of waiting,” said David Zahn, head of European fixed income at Franklin Templeton, in an interview with the WSJ. “What the market is really having problems with is the uncertainty, and once we have certainty we will be able to move forward.”

In the meantime, investors such as Zahn have kept their portfolios neutral in terms of exposure to the pound, and duration, a measure of bonds’ sensitivity to movements in interest rates.

Looking Ahead

Some market watchers suggest that a US-China trade truce is already being priced into the market due to recent commentary from the White House. Meanwhile, US investors, seemingly unaware of the negative pressures that a hard Brexit could impose, may end up sucker punched. On the flip side, a resolution of both issues could offer more clarity on future earnings potential, lifting equity prices higher as they rebound from a rocky 2018.