As we enter the third quarter, economic conditions in the U.S. generally point to continued expansion. Importantly, consumer spending has been increasing at a solid pace after a winter slowdown, supported by stronger wage growth and a falling unemployment rate which currently stands at 4.7%. Personal spending rose 0.4% in May, which followed a 1.1% increase in April, the largest gain in nearly seven years. Overall, economist expect second quarter GDP growth to rebound from a weak first quarter. Second quarter estimates are generally ranging between 2.5% and 3.0%.
Hindering a strong consumer are slowdowns in hiring, automobile sales, and business investment. Much of the recent economic weakness can be traced to the effects of low oil prices and a strengthening dollar. Most affected by the low oil/strong dollar regime have been industrial production and corporate profits. Overall industrial production, as tracked by the Federal Reserve, has declined on a year-over-year basis for the past nine months. Similarly, U.S. corporate profits have declined on a year-over-year basis since late 2015.
Despite near-term economic weakness, Federal Reserve Chairwoman Janet Yellen stated during a June 21st congressional testimony that the chances of a recession this year are “quite low”. Although Yellen conceded that slowing productivity growth due to weak private-sector investment could hamper the expansion, her focus on a strong consumer cast a positive light on the Fed’s outlook for the remainder of the year.
Global markets were significantly impacted in late June by the United Kingdom’s referendum vote to leave the European Union (EU). The somewhat surprising “Brexit” vote caused the pound to sell off to its lowest level in 30 years and investors to flock to safe-haven assets. Unlike some EU member countries, the U.K. has its own separate currency and its own central bank, removing some of the disruptive risk potential. Nevertheless, investors will ponder the potential for a ripple effect that spurs other countries to leave the EU in the months ahead.
The Brexit vote will undoubtedly serve to energize the anti-globalization movement in the U.S. and around the globe. The referendum’s key takeaway may be that sovereignty and nationalism now rival economics as drivers of voter sentiment. In response to the vote, The U.K.’s Prime Minister David Cameron stated that he will resign, with the new prime minister expected to take over in October. On the domestic front, Donald Trump, the Republican presumptive nominee for president, cheered the vote, standing in contradiction to Democratic rival Hillary Clinton.
From a U.S. perspective, the Brexit vote will promote further strengthening of the dollar, weigh on business confidence, and tighten financial conditions, particularly for those companies with a strong presence abroad. Positively, American households should see some benefit from cheaper imports. Although Britain’s ability to trade with the U.S. will be somewhat hampered, the effect on our domestic economy is likely to be muted. Imports and exports to and from the U.K. account for less than 5% of America’s total trade in goods and services.
A flight-to-quality that pushed bond prices up (and yields down) was evident in the waning days of June in response to the British vote to leave the EU. The 10-year U.S. Treasury Bond finished the month yielding about 1.5%, down from approximately 1.8% at the start of the second quarter and marking its lowest yield since 2012.
Worries of a financial panic similar to the bankruptcy of Lehman Brothers or the Greek default appear unfounded for now. Yields on British government bonds went down, not up, evidence of strong buying demand and a muted exit of foreign capital. In fact, the yield on the 10-year British bond fell below 1% for the first time in late June.
Overall, fixed income sovereign debt yields in the Eurozone took on a bifurcated flavor as June came to a close. Yields on German, French, Dutch, and Belgian sovereign bonds were pushed lower by investors looking for safer assets. Conversely, yields on the debt of certain countries—namely Italy, Spain, Portugal, Ireland, and Greece—rose precipitously as investors cast a discerning eye towards the less-than-stellar financial and fiscal picture of the Eurozone periphery.
After seven years of holding short-term interest rates near zero percent, the Fed moved to increase the benchmark rate by a quarter of a percent in December of 2015. Following the first rate increase in nearly a decade, the market has been speculating on the timing and magnitude of any future rate hikes. Despite the Fed’s initial guidance of up to four additional hikes throughout the current year, the modest growth experienced so far in 2016 coupled with the Brexit vote makes it doubtful that any further rate increases will occur for the duration of the year. As evidence, the futures-implied odds of the Federal Reserve raising its target-rate range plummeted from approximately 60% to effectively 0% in the wake of the exit vote. Fixed income investors appear to be predicting a benign global rate environment for the remainder of the year with the Bank of England, European Central Bank, and Bank of Japan likely to ease policy.
Falling interest rates have again resulted in risk-adjusted outsized gains for intermediate and longer-term bond holders. Government and investment-grade corporate bonds have returned 6% over the last twelve months as measured by the Barclays Capital US Aggregate Index. In addition, high yield bond holders have recouped earlier losses on the back of the improving financial condition of energy-related companies due to a recovery in oil prices.
Treasury yields of selected maturities for recent time periods are displayed below.
|Treasury Bill||Treasury Notes & Bonds|
|3 mo.||2 yr.||5 yr.||10 yr.||30 yr.|
The total return numbers for various fixed income indices over the last twelve months are displayed below (data from Bloomberg).
|12 Month Returns (as of 6/30/16)|
|Barclay Capital US Aggregate||6.00%||Merrill Lunch US High-Yield||1.71%|
|Merrill Lynch US Treasury Int-Term||3.97%||Merrill Lynch US Municipal Index||8.00%|
|Dow Jones Corporate||9.10%||JP Morgan Embi Global||10.32%|
U.S. markets were initially roiled by the British referendum to leave the EU before recovering in the last three trading days of the quarter. The Dow Jones Industrial Average and the S&P 500 Index erased more than three months of gains in the two days following the exit vote but recovered at quarter end and are up 4.3% and 3.8%, respectively for the year. The technology-heavy NASDAQ Composite Index posted a strong June return but remains down year-to-date, largely due to first-quarter earnings misses for the three largest constituents, Apple, Google parent Alphabet, and Microsoft.
Stock markets in countries sharing the euro were obviously at the forefront of the steep fall in global markets. On the Friday following the vote, the Euro Stoxx 50 index closed down 8.6% while Spain’s IBEX and Italy’s FTSE MIB indices plunged more than 12%. Even Germany’s DAX index, the stalwart of the Eurozone, closed down almost 7%. European financial stocks were particularly hard hit as investors worried about the strong link between Eurozone countries’ sovereign risk and the health of their banks. The London-traded shares of Barclays, Royal Bank of Scotland Group, and Lloyds Banking Group lost about one-third of their market value in the days following the Brexit result.
Safe-haven currency strengthening also applied additional pressure to export-dependent companies tied to the U.S. dollar and Japanese yen. Stronger currencies tend to make a country’s exporters less competitive as the effective prices of their goods increase. The U.S. dollar appreciated 2.7% in the two days following the U.K. decision according to the WSJ Dollar Index, which measures the greenback against 16 other currencies. More pronounced, the Japanese Yen was up a staggering 14% against the dollar at quarter end. As a consequence, Japanese shares were pummeled with the Nikkei Stock Average falling 8% in the aftermath of the EU exit vote. Emerging market economies are also feeling the negative effects of a strong dollar as it is making their dollar-denominated debt and commodities they sell more expensive. The MSCI Emerging Markets Index of 23 countries fell approximately 5% in the two days following the exit vote.
Following 2015 in which growth stocks were by far the best performing style category, the first two quarters of the year were witness to a shift in leadership from growth stocks to value stocks. Higher dividend-paying stocks continue to attract the favor of investors searching to replace falling fixed-income yields, although valuations are starting to appear stretched. As large-capitalization stock prices increase, we are finding the valuation of small-capitalization stocks becoming more compelling. Domestic small-cap stocks, as depicted by the Russell 2000 Index, were up a strong 3.8% for the quarter.
Below is a table which displays various equity index returns for the past quarter.
|Equity Indices||2nd Qtr. 2016|
|Dow Jones Industrial||2.07%|
|S&P 500 Growth||1.01%|
|S&P 500 Value||3.96%|
|Russell 2000 (small-cap)||3.79%|
|MSCI/EAFE (developed international)||-1.23%|
|MSCI/EM (emerging markets)||0.78%|
Looking at sector performance within the S&P 500, there was once again a wide dispersion of returns. The Energy sector posted positive second-quarter returns after a difficult 2015, as oil prices increased and appear to be showing signs of stabilization. Financial sector shares were pressured in similar fashion to their European counterparts, but rallied in the last few trading days of the quarter. Telecom and Utilities, two smaller sectors of the market known for defensive characteristics and higher dividend yields, again outpaced the overall market return.
The following table details S&P 500 sector returns for the quarter (price only).
|Return by Stock Sector||2nd Qtr. 2016|
|4. Health Care||6.27%|
|5. Consumer Staples||4.63%|
|9. Consumer Discretionary||-0.91%|
|10. Information Technology||-2.84%|