Jul 01, 2016
Stocks completed a near 6% round trip in a rousing final week of the second quarter, leaving most of the broad equity averages at slightly positive levels for the three months. The U.K. vote to leave the European Union clearly caught investors leaning the wrong way, triggering panic across global markets. The abrupt recovery that followed was almost equally surprising.
Earlier in the quarter, the U.S. markets had appreciated to levels close to the previous high set in the spring of 2015. The catalyst for this stealth rally had come from a familiar place – poor economic news that put the Fed’s plan to raise interest rates on hold, thereby providing more short-term monetary fuel for financial markets.
For the quarter, the S&P picked up 2.5%, the Dow gained 2.1%, while both the NASDAQ and most non-U.S. markets lost ground. Value stocks and related strategies continued to perform better than Growth this year. Small and Mid-Cap stocks outperformed Large cap stocks, reversing last quarter’s trend. Fixed income returns were also broadly positive as global events pressured bond yields lower around the world.
The outcome of the Brexit referendum (Britain’s vote to leave the European Union) was a surprise to both sides of the issue. Investors initially scrambled to comprehend what this meant, resulting in the largest single day loss of global capital on Friday, June 24th. The relief that came several days later reflected a more circumspect view on the ultimate impact of the split, allowing that it might just be a positive in the long-term.
Understanding how this unexpected result came about shines a light on issues that extend beyond the political and economic ramifications of this decision. Experts were surprised that the voters’ positions on identity and national security mattered more than what was supposedly in their own economic interests. In reality, this was less an issue for many as the economic interest of being part of the EU was not equally distributed among the electorate.
The risk of a further fragmentation of Europe is real, but at this stage, it is virtually impossible to know how all this will play out. The frustration and discontent in Britain shares common elements with the rise in populism elsewhere in the world. Closer to home, we have seen greater unrest around our free trade and immigration policies. This is a dynamic and complex development. It is not our intent to be ambiguous, but there are too many moving parts to know how these issues get sorted out and how they will impact the investment side. The rejection of establishment politics and the pushback against the privileged and elite have the capacity to create challenges for the capital markets, but we don’t discount the possibility that new opportunities and more efficient governing can arise from this as well.
Amidst talk of unconventional monetary tools (negative interest rates) and reshaping the economies of Europe, the fundamental story for U.S. investors has not changed. Growth rates in corporate earnings and revenues have been negative for four consecutive quarters (see charts below), yet stock prices have remained at historically high levels. Future support for higher stock prices is importantly tied to an improving earnings outlook. Favoring that is the reduced impact of year over year comparisons from the beleaguered Energy sector. Also, prior to Brexit, the U.S. dollar had pulled back from the 2015 high, which benefits multi-national company earnings translation. Last, U.S. corporations continue to employ “financial engineering” techniques including a record level of stock buybacks, which produce higher earnings per share by reducing the share count. As a result, some strategists are projecting earnings to turn more positive later in the year.
These estimates seem optimistic, given the absence of factors that would normally be associated with rising earnings – accelerating revenues, higher margins, and increased productivity. With the market’s current valuation at a relatively high level, it is a stretch to expect stocks to move meaningfully higher without stronger reason to believe these fundamental drivers will improve sometime soon. In our macro analysis process, we do not as yet see a pick-up in the kind of economic activity that would drive sales and give corporations the confidence to invest capital in their businesses (as opposed to financial engineering) and hire new workers.
We expect highlighting these economic challenges will be a key recurring theme in the general election rhetoric through November. Our view is that unless and until there is a political will to reestablish the principles of sound economic policy, we will likely continue to experience a slowly deteriorating, deflationary U.S. and global economic environment. That, in turn, may support modest positive financial market returns for a while longer, but as we have indicated before, it may become difficult for financial markets once again should this gradual deterioration culminate in another credit restrained recession. The good news is that this outcome is not preordained. Much of the economic malaise we are experiencing is of our own doing. As such, the opportunity to chart a different course and create a better outcome can also be of our own doing.