By: Gene Walden July 01, 2016
The first 12 weeks of the 2nd Quarter were nearly as prim, proper and unruffled as a royal tea party. Then came Brexit, which sent the crumpets flying like fists at a Manchester soccer brawl.
It didn’t take long for the fall-out to begin once United Kingdom citizens voted to opt out of the European Union (EU). On June 24, the morning after the vote, the Dow plunged more than 500 points in the opening minutes of trading. The price of gold soared to a two-year high and oil dropped by about 6%. By the end of the second day of trading, Monday, June 27, the global equity market had lost about $3 trillion in market capitalization – and the British pound had dropped to a 31-year low relative to the U.S. dollar.
However, the equities markets quickly rebounded, regaining much of the lost ground from the Brexit sell-off in the final three days of the month.
We believed that the market’s initial knee-jerk reaction was somewhat premature since Britain’s exit from the EU may take up to two years to complete. But Brexit may have long-term implications for the economy and the markets, and much of the brunt of those implications may be reserved for the UK itself. For instance:
- 51% of Britain’s exports go to the EU while only about 7% of the EU’s exports go to Britain. UK exports to the EU comprise 12.6% of UK GDP, while EU exports to the UK comprise just 2.6% of EU-27 GDP. Clearly, Britain would miss the EU a lot more than the EU will miss Britain.
- The UK will lose access to about 50 third-party trade agreements, and is unlikely to secure better terms of trade since it has less negotiating power than the EU.
- The UK needs to replace many EU laws and regulations, including in the financial markets, heightening business uncertainty.
- The UK could stand to lose thousands of jobs if international companies decide to move operations to the EU in order to fall under EU trade agreements.
- The UK has a large (5%) current-account deficit, which requires financing from abroad. While a weaker pound could boost exports over the longer-term, it would serve to raise the cost of imports in the short-term, exacerbating the current-account deficit.
- Uncertainties in the UK financial sector will persist on risk of loss of EU passport rules (under which banks, asset managers and other financial firms in one EU member state may serve customers in the other 27 without setting up local operations). Germany and France might view Brexit as an opportunity for their own financial sectors, potentially making it difficult for the UK to negotiate retention of passport rights.
Only time will tell how severe the impact will be for the UK. After being a member of the EU since 1973, the UK will undoubtedly face some difficult challenges in breaking from its European trading partners.
As for the rest of the investment market, after two days of turbulence in the wake of Brexit, things seemed to be returning to normal. The stock markets recovered most of their lost ground and oil prices moved back up closer to $50 a barrel. However, gold prices remained near their peak level and yields on 10-year U.S. Treasuries continued to hover under 1.5% as the month came to a close.
Here are some of the other key developments from the 2nd Quarter that are covered in more detail later in the report:
- Oil prices continue to rise
- Shoppers keep spending, but department stores still suffering
- Fed declines to raise rates as economy remains sluggish
- Employers are still hiring but at a slower pace
- Negative interest rates in Europe and Japan fail to boost economies
Brexit takes S&P 500 on a Wild Ride
After a relatively flat 12 weeks in the market, due in part to declining employment growth and sluggish GDP growth, the final week of the 2nd Quarter turned into a Brexit roller coaster ride. The S&P dipped from 2113 to 2000 in the first two days of trading after the vote, then moved back up to finish the period at 2098.86, which is a 1.9% gain for the quarter and a 2.7% gain for the year. For the month of June, the market ended nearly flat, up about 2 points after ending May at 2096.96.
Consumer spending aids economy
Although retail sales have been far from robust, sales volumes have been moving up this year, particularly online sales, according to the June 15 U.S. Census Bureau Advance Monthly Retail Trade and Food Services Survey.
U.S. retail and food services sales for May showed an increase of 0.5% from the previous month, and 2.5% above May 2015, adjusted for seasonal variation and holiday and trading-day differences. Total sales for the March 2016 through May 2016 period were up 2.4% from the same period a year ago.
Sales for non-store retailers (primarily online retailers) were up 12.2% from May 2015, while Health and Personal Care Stores were up 8.3% from last year.
But while those two segments of the retail market have been strong, department store sales continue to drop. Department store sales were down 0.9% for the month in May and down 5.8% year-over-year. Many of the nation’s largest department chains reported weak first quarter earnings (including Macy’s, Kohl’s, Nordstrom, Gap, and JC Penney).
Job growth weakens
Employment continued to move up during the quarter, but at a greatly reduced pace. With the addition of just 38,000 nonfarm jobs for the month of May, according to the U.S. Department of Labor Employment Report issued June 3, that was the second consecutive month of sub-par job growth, following the addition of just 123,000 new jobs in April. In the past 12 months prior to April, job growth had averaged about 230,000 new jobs per month.
The May increase of just 38,000 new jobs was the lowest total since September 2010. While the unemployment rate dropped by 0.3% to just 4.7% – the lowest rate since November 2007 – the decline was due to the fact that 458,000 people dropped out of the workforce and were no longer counted among the unemployed.
For the year, three S&P 500 sectors have dramatically outperformed the rest of the market. Energy has climbed 16.1% for the year as the oil market recovered. Telecommunications and Utilities, which are both strong on dividends, have moved up significantly as investors sought to enhance their income as fixed income yields have lagged. Telecommunications was up 24.85% through the first half of the year and the Utilities sector was up 23.41% for the year. Financials has been the worst performing sector this year, down 3.05% for the first six months, although it did rebound a little in the second quarter, up 2.12%.
The table below details the quarterly and year-to-date performance of each of the 10 S&P 500 sectors:
Bond Market: Fed Declines to Raise Rates Again
Sluggish employment and GDP growth figures reported during the 2nd Quarter once again dissuaded the Federal Reserve from instituting a long-awaited rate hike when the board met on June 14 and 15.
In her report, Fed Chair Janet Yellen said, “Considerable uncertainty about the economic outlook remains. We cannot rule out the possibility expressed by some prominent economists that slow productivity growth seen in recent years will continue into the future.” She added, however, that “the U.S. economy is doing well. My expectation is that the U.S. economy will continue to grow.”
Following the uncertainty over Brexit, the Fed may decide not to raise rates for several more months.
The bond market reacted strongly to Brexit, as investors snapped up 10-year U.S. Treasuries, sending yields to a four-year low of 1.46% in the days following the vote.
The yield on 10-year Treasuries ended the month at 1.47%.
Market yields for 10-year U.S. Treasuries have been trending down for most of the year after ending 2015 with a 2.27% yield. The main impetus for the declining yield has been negative rates in Europe and Japan, which have prompted more investors to buy U.S. bonds. The leading issuers of negative rate bonds are Germany, Japan and Switzerland, where central banks have issued a wave of government bonds that yield less than 0%. (Negative interest rates refer to a monetary policy in which bank deposits and government bonds actually return less than the investor deposits.) In all, more than $10 trillion in (non-U.S.) government bonds now carry “negative interest rates.”
Equity Earnings Projections Declining
The consensus 12-month forward aggregate earnings for the S&P 500 was almost the same on June 30 as it was as the year began – slipping just three cents from $126.91 at the close of 2015 to $126.88 at the end of June. That would represent an aggregate earnings growth rate of about 8.5%. We believe that projection is somewhat optimistic, and that the actual earnings growth numbers will be slightly lower.
Forward Price/Earnings Ratio and Earnings Yield
The forward 12-month P/E ratio for the S&P 500 ended the 2nd Quarter at 16.4, up slightly from the 16.1 P/E at the start of 2016.
While the 16.4 P/E level is still within a reasonable range based on historic levels, we are skeptical of further expansion in light of the sluggish growth rate of corporate earnings and the eventual prospects for higher interest rates.
The forward 12 months earnings yield for the S&P 500 ended the quarter at 6.0%, which was unchanged for the quarter. The forward earnings yield had been declining slowly since 2011 when it reached a high of 7.4%.
At their current level, these three fundamental factors (12-month forward earnings, P/E, and earnings yield) tell us that projected earnings growth is sluggish and that the P/E ratio is somewhat above the historic average (which is 14.5). While the P/E often drops during periods of lower earnings expectations, historically low interest rates in the fixed income market are helping to keep investors in equities. Although the equity earnings yield is at a relatively low level of about 6%, it is still significantly higher than the market interest rate for 10-year Treasuries, which dropped to under 1.5% in the wake of Brexit – the lowest yield in four years.
Dollar Rallies after Brexit Vote
The Dollar rallied strongly versus the Pound after the Brexit vote. But for the year, the Dollar has dropped steadily versus the Yen, reversing a trend the previous two years when the Dollar gained in value versus all of the world’s leading currencies. The Dollar has also slipped slightly versus the Euro this year. A declining Dollar should help American companies regain competitiveness overseas.
Oil and Gold
Oil prices continued to rise throughout the quarter, although prices dipped 6% in the wake of Brexit. But they quickly moved back up to over $49 a barrel in the days following the Brexit vote before settling at $48.33 a barrel (West Texas Intermediate) to close the month. The recent price is nearly double the low mark for the year set on Feb. 11, when the cost of a barrel of oil dropped to slightly under $27.
We believe the recent strength in the oil market is due to global supply moving in line with demand after many months of overproduction. Production has slowed as prices dropped, with the higher cost producers forced to curtail production. We believe that supply and demand will likely be nearly in balance by the end of this year. With shale producers and other suppliers waiting to jump back into the market at the right price, we expect that the lid on oil prices will be at about $70 to $80 a barrel over the next couple of years.
Gold prices, meanwhile, jumped to a 2-year high after the Brexit vote, finishing the month at $1320 per ounce, a 24.5% increase over the $1060 per ounce price at the start of 2016.
The global equities market was pounded briefly by concerns over Brexit, with the MSCI EAFE Index dropping from 1687 to 1546 (-8.4%) in the first two days of trading after the Brexit vote. It rallied to finish the quarter at 1608, although that still represented a decline of 0.56% for the quarter, and a drop of 6.28% for the year.
Fast-Forward: Outlook for the Markets
Even with the Brexit fall-out, the S&P 500 has experienced a fairly flat year – which is in line with our expectations for the year due to the sluggish economy. Going forward, here are some of the key issues facing the market:
Corporate earnings continue to weigh on the market. If wage gains accelerate, we could see a further drop-off in earnings expectations. Manufacturing output levels have been declining throughout the year. Although oil prices have improved, the U.S. oil industry remains in a slump, and the banks and financial institutions that had helped fund some of the recent oil projects continue to face the possibility of delinquencies and defaults.
Consumer spending has begun to show signs of life, particularly in the automotive, online and big box retailer areas.
Despite the fact that the oil industry is still in a slump, prospects look far better now than they did at the first of the year when oil dropped to under $30 a barrel.
Employment levels had been one of the strengths of the economy until the 2nd Quarter when the new job level tapered off significantly. Although new workers continue to be added to the job market each month, the recovery in the jobs market – which was already slower than we had expected – has slowed down even further. We believe that there is still substantial room for improvement in labor conditions.
In the wake of Brexit, we believe that the Fed will be reluctant to raise rates any time soon, so that may give the economy a little room to expand without further economic pressures.
With government bonds yielding less than 1.5% in the U.S. and negative rates in Europe and Japan, the U.S. equities market still looks attractive on a relative basis to many investors.
Through the second half of 2016, we continue to have modest expectations for the stock market and the economy. We expect GDP growth to be lower this year than it has been the past few years. The consensus among analysts for GDP growth for this year is 1.8%, according to the Blue Chip Economic Indicators, but we project GDP growth in the range of about 1.0 to 1.5%.
Globally, over the next 12 months, we believe that China will have GDP growth of about 6% and Japan will have negative growth. We are relatively optimistic regarding growth prospects for Europe, despite its sluggish economy. We believe Europe will experience growth of about 2.6% and the UK will experience GDP growth of about 3.6%, although that may change somewhat in the wake of the Brexit vote.
While the continued employment expansion has been one of the major themes of the recovery, we believe there is still considerable opportunity for improvement in several key areas. We expect gross domestic product (GDP) growth this year to be below the rate of the past several years (but not negative), and employment is likely to remain soft, as well.
Based on current economic conditions, we are not projecting a recession in the near term, considering that consumer spending is still at a reasonable level and the job market is still improving (albeit slowly). Even if the economy does slip into a recession, we would expect it to be fairly modest and short-lived. On the other hand, we are not projecting a strong economy or a strong stock market through the second half of 2016.
Media contact: Callie Briese, 612-844-7340; firstname.lastname@example.org
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