Quarterly Economic Review Second Quarter 2016
As if making up for lost time, a quarter that initially distinguished itself for tight trading ranges and a lack of volatility ended on a completely different note. The catalyst for what can only be described as gut wrenching volatility was the June 23 U.K. referendum to leave the European Union. The vote, otherwise known as Brexit, drove foreign exchange markets to their most volatile single day in history. British sterling, for its part, had its greatest one-day decline ever. Global stock markets lost $3 trillion over the course of two days, and worldwide government bond yields plumbed unprecedented lows. The S&P Global Broad Markets index had its most significant two-day decline in history and $12.7 trillion (36%) of global sovereign debt traded at negative yields by quarter end â€” an 80% jump from the amount at the start of the quarter.
Cooler heads rapidly prevailed and markets did an about-face. Stock market declines nearly evaporated over the next four days. The U.S. stock market experienced its greatest weekly gain of the year. As a matter of fact, by the time of this writing, the U.S. stock market has not only regained pre-Brexit levels, it has reached a new all-time high.
For now, Brexit seems to be reasonably discounted by markets, and investors will digest new information as it comes. In the meantime, U.S. fundamentals are reasonably positive, and a strong June payrolls report laid to rest the largest concern for both investors and the Federal Reserve. Thus, the labor market remains healthy and continues to advance. The consumer is in good shape as well. Confidence is strong, and inflation adjusted wage gains have been on the rise for years. The savings rate hit a low for the year in May, driving retail sales to the largest two-month jump in over two years. Housing remains a key driver of economic growth and is likely to only improve with the dramatic drop in mortgage rates this year. Manufacturing has improved from weakness that began late in 2015, and inflation (presently desired) is on the rise. Modest dollar weakness will also be a positive for exporters, manufacturers, and multinational companies.
International fundamentals are more of a mixed bag. The World Bank and the International Monetary Fund (IMF) acknowledged a stabilization and rebound in China. They suggest the nation’s situation has become less dire. China’s exports are increasing again, imports are down (in value but not volume), and the consumer is holding up well. Unfortunately, the same cannot be said of Japan, which has experienced unfavorable developments. Deflation is once again a problem and economic growth remains a challenge. A Brexit induced flight to quality has also driven the yen dramatically higher. This negatively impacts inflation, exports, and corporate earnings. Of course, Europe is likely to be negatively impacted as the region works its way through Brexit and related challenges.
In light of broad global weakness, and despite a preponderance of negative and low rates already, central banks are expected to accelerate stimulus measures. The Bank of England, Bank of Japan, European Central Bank, and People’s Bank of China have all announced a willingness and inclination to do more, in many cases as early as this month. For now, the belief in “muddle through it” economies and confidence in accommodative central banks to the rescue have appeased investors. Indeed, many global stock and bond market indexes are at or near all-time highs. Considering tepid growth, elevated valuations, and low interest rates, go-forward return expectations should be modest.
Economic Review And Outlook
Key Economic Fundamentals
Following the pattern of the past two years, acceleration in second quarter growth is expected to compensate for a slow start to 2016. Key drivers to the improvement include a modest pullback in the dollar, an uptick in manufacturing activity, and a seemingly reinvigorated consumer.Â As with the second half of 2015, growth in the first three months of 2016 was driven exclusively by the consumer. Outside of continued favorable growth in housing, investment spending was a drag. Of particular note, business spending on equipment had its worst showing since the height of the financial crisis.
Directionally speaking, economic results came in a bit weaker than expected in Q2, particularly for the U.S. That said, forecasts were fairly accurate relative to previous periods and the trends in both Europe and the U.S. were positive. Brexit related uncertainty will no doubt drive greater forecasting error, and market volatility, in coming periods.Â Dollar weakness early in the year reversed modestly over the past two months. That said, the dollar’s net decline through the first half of 2016 has been a welcome respite for manufacturers, multinational companies, U.S. policymakers, and globally diversified investors.
Through April, weakening trends in leading economic indicators seemed to have stabilized. Rebounding commodity prices, currency stability, and aggressive central banks have no doubt been key factors. Going forward, Brexit uncertainty, currency wars, and a worldwide epidemic of negative interest rates will be key economic drivers.
Economic growth in the four largest economies (Euro zone, U.S., China, and Japan) is expected to slow in 2016. Forecasts of a net deceleration in advanced economies is expected to be offset by emerging nations. Strong and accelerating growth in India would be a key driver as would “less bad” results out of Russia and Brazil.
A weak payrolls report for May gave investors pause and stayed the hand of a Federal Reserve otherwise inclined to tighten monetary policy. A dramatic rebound in June, however, suggests an aberrant May result. Absent Brexit uncertainties, it would seem the Fed could get back to the task of rate normalization. Meanwhile, other statistics confirm steady labor market improvement. Weekly jobless claims continue to impress and the labor force participation rate seems to be stabilizing, albeit at a disappointing level. The unemployment rate, already below the Federal Reserve’s target, is widely expected to fall further, and labor market slack continues to improve as well. Lastly, an absurd, if not comical, amount of ink has been spilled of late to extol the nearly imperceptible uptick in nominal wage gains (see red line below) in recent months. In truth, far more impressive, and meaningful, inflation adjusted wage gains have been taking place dating back to the middle of 2011!
Low interest rates, housing market gains, favorable labor market dynamics, and cheap gasoline have all contributed to the U.S. consumer remaining resilient and confident. Balance sheets are strong, debt levels are reasonable, and household net worth continues to hit new highs. Considering positive fundamentals, particularly cheap gasoline, the rise in household savings rates from May 2015 through March 2016 has baffled economists. Fortunately, consumer behavior, of late, has been more in line with logical expectations. The savings rate has dropped, and retail sales in April and May grew at the fastest two-month pace in over two years. Auto sales, while somewhat off earlier highs, also continue at a robust pace.
As shown by the ISM graph on the following page, the service sector is in reasonable shape and manufacturing activity continues to improve following a contraction that began late last year. Dollar strength and low energy prices had been key culprits behind manufacturing weakness and a stunning 16 month decline in the utilization of U.S. manufacturing, mining, and utility infrastructure. Recent dollar weakness, particularly in the first quarter, and a jump in energy prices have helped to stabilize the manufacturing sector. That said, industrial production has still experienced year-over-year declines for the past 10 out of 12 months and capacity utilization, while possibly stabilizing, shows no signs yet of improvement. The dollar’s recent rebound and continued weak global growth (both likely accentuated by Brexit fallout) do not bode well for manufacturing or exports.
The two pillars of U.S. economic strength, of late, have been the consumer and housing. As a contributor to GDP, investment in residential housing has grown at an annualized rate of 8% or better for the last seven out of eight quarters. Over half of these quarters registered annualized gains in excess of 10% and growth in Q1 clocked in at 15.6%! Building activity has steadily increased in recent years, home builder sentiment hit new post-crisis highs in recent months, and annual home price gains have accelerated over the past year. Mortgage rates, already attractive, have plummeted in 2016 to the lowest level since May 2013. Provided buyers are not priced out of the rising market, and builders manage to find adequate labor and land (increasingly a challenge), housing should continue to be a positive.
Capital Markets Review
Fixed Income Markets
This commentary was written by Robert W. Lamberti, CFA, VP and Co-Chief Investment Officer of Summit Financial Resources, Inc. and Summit Equities, Inc., 4 Campus Drive, Parsippany, NJ 07054. Tel. 973-285-3600, Fax: 973-285-3666. Securities and Investment Advisory Services offered through Summit Equities, Inc. Member FINRA/SIPC, and Financial Planning Services offered through Summit Equities, Inc.â€™s affiliate Summit Financial Resources, Inc. Sources of Performance: MorningstarÂ®. Indices are unmanaged and cannot be invested into directly. The investment and market data contained in this newsletter is not an offer to sell or purchase any security or commodity. Standard & Poor’s 500 Index (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. The Wilshire 5000 Index is a market capitalization-weighted index of the market value of all stocks actively traded in the United States. The index is intended to measure the performance of all U.S. traded public companies having readily available price data. The MSCI Emerging Markets Index is an index created by Morgan Stanley Capital International (MSCI) that is designed to measure equity market performance in global emerging markets. Emerging markets are considered risky as they carry additional political, economic, and currency risks. Real Estate Investment Trusts, REITs, are securities that invest in real estate directly, either through properties or mortgages. REITs receive special tax considerations and typically offer investors high yields, however, have liquidity constraints. The Barclays Capital U.S. Aggregate Bond Index is a market capitalization-weighted index comprising Treasury securities, Government agency bond, Mortgage-backed bonds, corporate bonds, and some foreign bonds traded in the U.S. Fund Category Performance is not inclusive of possible fund sales or redemption fees. Investment grade bond analysis included bonds with ratings of AAA, AA, A, and BBB. Municipal and Corporate Bonds are backed by the claims paying abilities of the issuer. TIPS are inflation-indexed securities issued by the U.S. Treasury in an effort to widen the selection of government securities available to investors. Past performance does not guarantee future results. Information throughout this Newsletter, whether stock quotes, charts, articles, or any other statement or statements regarding market of other financial information, is obtained from sources which we, and our suppliers believe to be reliable, but we do not warrant or guarantee the timeliness or accuracy of this information. Neither we nor our information providers shall be liable for any errors or inaccuracies, regardless of cause, or the lack of timeliness of, or for any delay or interruption in the transmission thereof to the reader. Opinions expressed are subject to change without notice and are not intended as investment advice or a guarantee of future performance. Consult your financial professional before making any investment decision.