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posted on 04 July 2016

Brexit Was Just The Beginning - Here's What's Coming Next

by Shah Gilani, Money Morning

Special Report from Money Morning

Brits voting on June 23, 2016, to exit the European Union wasn't a "Lehman" moment.

Sure, global equity markets lost a combined $2.08 trillion on Friday June 24 and Monday, June 27, the first two trading days after the votes were tallied.

And the Dow Jones Industrials Average lost 870 points in those two days, falling almost 5%.

But the vote wasn't a so-called Lehman moment (a reference to the infamous September 15, 2008 bankruptcy filing by Lehman Brothers that triggered the global financial crisis) because equity markets have already bounced back.

The Dow's soared almost 4.5% from Tuesday through the close of the market on June 30.

U.S. equity benchmarks are again a couple of percentage points from their all-time highs.

So, it's safe to get back into stocks, right?

Not so fast...

Brexit Wasn't a "Lehman" Moment - It Was a "Bear Stearns" Moment

If you don't know what a "Bear Stearns" moment is, let me explain.

On March 16, 2008, Bear Stearns sold itself to JPMorgan Chase for a paltry $236 million. Bear Stearns was the first glimpse of the rot beneath the surface of the U.S. economy, which would be exposed six months later with the collapse of Lehman Brothers.

Bear Stearns was the harbinger, the canary in the coalmine of the 2008 financial crisis.

Those that couldn't see Bear Stearns for what it was continued to buy into the market rally after Bear collapsed, and didn't see Lehman's demise coming, either. Those folks are probably still reeling from the financial crisis and the Great Recession.

If you're among them, and you don't want to be victimized by all that again, take a moment to consider what actually just happened, why the markets are bouncing, and what's going to happen six months from now.

The world changed with the Brexit vote. And if the world's changed, you better believe markets are going to have to adjust to future realities.

It's the Economy, Stupid

For all the talk about the British not wanting to be dictated to by political hacks running the European Union from Brussels, all the talk about the British not wanting to have their immigration policies decided by the continent, the mostly unspoken truth is the Brexit vote was also a repudiation of the marriage of globalization and the manipulation of free markets by central banks, especially the ECB.

The initial idea of a European "commonwealth" where borders would give way to free trade made sense and was the origin of what became the European Union.

But free-flowing, multilateral trade across a bloc of independent states with different currencies wasn't easy. When currencies appreciate and depreciate against each other, it's hard to get cross-border financing and hard to manage constant free-flowing trade.

Hence, the birth of a common currency, the euro.

European Union members who abandoned their home currencies to adopt the euro found it easy to get cross-border financing since banks in Germany, for example, would be more inclined to lend to E.U. member countries, businesses, and governments if there was no currency risk when they were repaid in the same currency. So banks bent over backwards to lend in.

Lending flourished and trade was a lot easier.

But lending, no matter how much credit is made available, doesn't guarantee profitability or economic growth.

The answer across the E.U. to slowing growth has been to make more money available.

When that didn't spur growth, when businesses and countries that deficit-financed lavish spending on social services and unprofitable economic endeavors struggled into insolvency, the answer was to lavish credit and liquidity across countries and banks by means of the European Central Bank's manipulation of interest rates down to zero, then into negative territory, and of course massive "quantitative easing."

Those misguided policies haven't spurred growth. But they have spurred massive dislocations of capital. They have harmed savers and pensioners. They have hijacked free markets' commonsensical and practical allocation of capital to deserving businesses and countries.

The Brexit vote - mostly by older Brits who better understand the difference between free markets and free stuff from governments financed out of central banks' fantasy factories - amounts to a repudiation of central planning by central socialist authorities and their central bank financiers.

The UK Is Just the First Domino

The world will now look at Britain and see how it fares unyoked from what amounts to a failed experiment, and will look at what's happening to the rest of the European Union.

And they'll eventually see that markets selling off on the Brexit vote was, in fact, a Bear Stearns moment, a harbinger of the brewing crisis, the next meltdown, and another super market crash.

What's about to happen is the European Union is going to disintegrate.

It's not about trade, it's about European banks, the ones that lent hand over fist, that aren't getting paid back, that will increasingly have to rely on fewer countries backing a central bank that's grossly over-leveraged already and will have to keep inflating its balance sheet buying the underwater assets of failing E.U. banks and the sovereign obligations of failing states.

Italian banks are a prime example of what's happening across Europe.

According the Bank of Italy, banks there are sitting on $396 billion of non-performing loans that are "unlikely to be repaid in full."

In April the Italian government forced Italy's three largest banks and a handful of private financial services companies to pony up $5.5 billion to backstop a bailout fund they named Atlante, or Atlas, after the mythological figure who holds up the heavens.

A private fund was convened because the government isn't supposed to directly bailout failing banks. But they're planning on guaranteeing securitized bad loans Alante wants to sell to speculators. We'll see how well that goes.

If it doesn't fly and banks begin to fail, that will be your Lehman moment.

As far as the ECB coming to the rescue, they're not exactly the Rock of Gibraltar.

With only $12.2 billion in hypothecated capital and a balance sheet north of $3.5 trillion, which is being added to monthly to the tune of $67 billion worth of government, corporate and junk bond purchases, belief in the stability of the ECB, as the E.U. potentially shrinks - taking away sovereign backers - is going to face its own Lehman moment.

Smart Brits saw all that happening and wanted out before the biggest bubble in history pops.

There's no stopping it. And markets will start realizing that in the weeks and months ahead.

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