TO LEAVE OR NOT TO LEAVE
That was the question answered by the United Kingdom in an historic referendum vote to leave the European Union. The 52% to 48% vote to “Leave” was a shock to the markets which had heavily priced in a “Remain” vote in the days leading up to it. A rise in populist sentiment against the trade and importantly the lax immigration policies enforced upon the U.K. by the European Union were the foundations of the “Brexit” movement. Upon the announcement of the voting results, extreme volatility returned to the markets after what had been a slow grind higher during the second quarter. Global stock markets cratered, interest rates dropped and currencies fluctuated wildly, following a steep drop in the British Pound (£). Equity markets quickly regained their post-Brexit losses, however, interest rates remained at their very low levels reflecting a flight to safety.
So where does the UK go from here? While it isn’t likely that elected officials would go against the will of the public, the referendum itself is not legally binding. It will be up to Parliament to invoke ‘Article 50’, which would begin the separation process. Former Prime Minister David Cameron announced his resignation, leaving the task of leading negotiations with each of the European Union nations to establish new trade agreements to the new Prime Minister Theresa May. These negotiations may take more than two years to complete. From the market’s perspective, the fact that the U.K. did not adopt the Eurodollar (€) currency is a positive. Untangling a country from a shared currency and instituting its own is a much taller task than what the U.K. and Europe are faced with now. Therefore, it is widely believed that E.U. officials will fiercely negotiate the terms of the U.K.’s exit in order to discourage other member countries from following Britain’s lead.
Markets & Economic Data
The S&P 500 earned 2.5% in the second quarter, similar to the Dow Jones 2.1% return, while the NASDAQ lagged and was -0.2%. The MSCI EAFE index was down -1.5% in the quarter, while emerging markets continued to outperform their developed counterparts in 2016 by posting a 0.8% gain (MSCI Emerging Markets Index). One theme that has continued to play out over the course of the year is investors’ hunt for yield as it simply is not available in the fixed income markets without delving into the risky high yield sector. As of June 30th, the 5 year U.S. Treasury yielded 1.00% and the 10 year yielded 1.47%.
Value stocks, in particular high dividend paying stocks, greatly outperformed their growth counterparts. Low and falling interest rates around the globe are causing investors to turn their sights to other sources of income, driving the highest yielding sectors of the stock market to lofty valuations. We believe this to be another effect of the negative interest rate policy (NIRP) adopted by the European Central Bank and the Bank of Japan. Over 30% of the world’s sovereign debt traded at a negative interest rate as of June 30. The ramifications of this NIRP experiment are still unknown although the policy has yet to bear fruit in the way of increased inflation or productivity.
|Market Indicies (Total Return as of 6/30/2016)|
|MSCI Emerging Markets**||0.8||6.5||(11.8)||(1.2)||(3.5)|
|Source: Bloomberg Finance L.P; *Annualized; **USD|
U.S. economic data has been a mixed bag and is generally supportive of slow but steady growth. Manufacturing remains a weakness, though activity picked up in the second quarter. Housing data continues to improve (benefitted by low mortgage rates), evidenced by an increasing number of home sales and prices which have risen 5.4% over the last 12 months as measured by the Case-Shiller home price index. Monthly employment reports have been choppy but the three-month average of 147,000 jobs created and the 2.6% annualized growth in wages are indicative of a still improving labor market. In addition, the more timely weekly jobless claims figures remain at low levels indicating that people who are looking for work are finding jobs. Corporate earnings are lackluster but may be poised to improve fueled by energy companies coming out of the downturn. In addition, the pause in the strengthening of the U.S. dollar should benefit U.S. multinational companies’ earnings.
Continuing to Watch Central Banks & Overseas Developments
For the time being, Janet Yellen and the Federal Reserve are on hold for increasing interest rates and it is clear that the Committee’s projection of four hikes this year made at the beginning of 2016 was far too ambitious. Adding to the confusion of market participants are the mixed messages that the members of the FOMC are sending by way of their public statements that seemingly contradict each other. In particular, St. Louis Fed President James Bullard’s abrupt shift from ‘hawk’ to ‘dove’, now favoring only one interest rate increase over the next three years after weeks earlier publicly supporting multiple hikes this year and next. Against the backdrop of slow global growth and increased uncertainty due to Brexit and the upcoming U.S. Presidential elections, we believe that the Federal Reserve will be hard pressed to justify more than one rate increase in 2016.
International central banks remain accommodative as their economies are in a continued state of low to no growth. The European Central Bank announced additional easing and is now including corporate bonds in its asset purchases, pushing the borrowing costs for some European firms to nearly 0%. Japan decided that its economy was too fragile and further delayed a sales tax increase; an action that Prime Minister Shinzo Abe had repeatedly said would only happen in the case of a major economic shock or earthquake. China mostly stayed out of the headlines and appears on track for a ‘soft landing’ with projections of around 5% growth in 2016.
The Wealth Management officers at Old Second work with clients to craft investment strategies that fit their objectives of growth and income. Particularly in volatile markets, ensuring that clients’ exposure to risk is appropriate for their situation is of the utmost importance. Challenges in the markets must be met with diligence and care. Our team of experienced professionals is available to help guide you along the path toward achieving your financial goals.
Rich Gartelmann CFP® – (630) 844-5730 firstname.lastname@example.org
Jean Van Keppel CFA® – (630) 906-5489 email@example.com
Brad Johnson CFA®, CFP® – (630) 906-5545 firstname.lastname@example.org
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