QUARTERLY MARKET UPDATE as of July 2016
Just when the market seemed to be calming down for a less volatile summer it was rocked by controversy when British voters passed a referendum to leave the European Union. The last week in the quarter saw stocks fall by the most in any two-day period this year, then rebound to recover most of the decline. Central banks around the world orchestrated announcements that would provide liquidity if needed, which helped bring back investor confidence. A move towards safe haven investments pushed Treasury yields lower. The ten-year treasury yield dropped down to 1.50%, surprising investors who have been expecting higher interest rates. The market never likes uncertainty and the questions raised by the Brexit vote and its ramifications increase that level of the uncertainty significantly.
Sorting out what will happen is an exercise in itself. After the vote, Prime Minister Cameron and several cabinet members from opposing parties resigned, putting the government in disarray. There is a possibility that a second referendum is held to vote again on exiting the EU, or that the first referendum, which is not binding is not followed. Leaving the EU is not official until Britain invokes Article 50, the exit clause of the European Union. This will not take place until there is more discussion within the new government, sometime in the fall after the Prime Minister plans to leave office. Once it is invoked, the process for leaving can take up to two years. In the meantime opposition politicians in several other EU countries, most noteworthy being Italy and France, have also started the process for their own referendums to leave the EU.
Global markets are increasingly interconnected. The concerns in the U.K. and E.U. had an immediate impact on currencies, interest rates, and forecasts for the future. Funds flowed out of the British Pound and Eurodollar, and into the US dollar and Japanese Yen. Interest rates moved lower throughout the world, and some growth forecasts were adjusted downward. The stronger dollar then prompted China to devalue their currency, which raises additional concerns over countries using their currency to compete for growth. The Federal Reserve Board will now likely put off raising interest rates in the U.S. until next year. The increase in uncertainty in turn causes some business decisions on hiring and capital investments to be put on hold.
Forecasts for 2016 growth in the U.S. as measured by GDP from “The Economist” poll were revised downward again this last quarter from 2.0% to 1.8%, and that has not factored in the new element of business uncertainty coming out of Europe. We expect some small downward revisions to GDP forecasts across the globe, with greater downward revisions in Europe. This may start the dollar off on a renewed strengthening trend this quarter, which is counterproductive to U.S. exports.
Domestically, the U.S. economy has shown stability and has a higher yet moderate growth rate compared to the economies in other developed countries. Consumer confidence is at the highest level for the year. The labor market continues to improve, while changes in consumer spending and income have been uneventful. Inflation remains benign and below the Fed’s 2% target. Data on housing has been up and down this year, but the overall growth trend has been a bright spot for the economy. Second quarter growth is expected to climb versus the first quarter, but the outlook for the third quarter is cloudy due to Brexit.
The market P/E ratio using earnings one year forward is at 17.5, up from 16.8 in the last quarter. This slightly higher market valuation is reasonable given the lower interest rate environment. Corporate earnings are expected to be higher in the third and fourth quarters and that may increase next year’s estimates. But with the recent global political events and increased uncertainty, we raise our level of caution this quarter. We will continue to look for better values in U.S. centric investments and move away from U.K. and European investment exposure.