Second Quarter 2016 Market & Economic Summary

The defining moment of the second quarter came when the United Kingdom voted on June 23rd to leave the European Union, or Brexit, as it is commonly called. Polls and bookmakers had been predicting the opposite, and markets rallied for several days up to the vote. When the surprising result was announced overnight on the 24th, markets plummeted. Losses were severe on Friday and continued through Monday. The Europe STOXX 600 index fell by 10.85% in two days of trading, while the British pound dropped to a 31-year low against the U.S. dollar. British banks were especially hard hit on fears that London would lose its position as Europe’s premier financial center. Barclays Bank stock fell 40% in two days.

Then markets rallied strongly over the final three trading days of the quarter as central bankers around the world promised additional stimulus. The Dow Jones Industrial Average lost 870 points, or 4.8%, in the aftermath of the Brexit vote, but recovered 90% of the decline before the end of the quarter, closing just 400 points below its all-time high reached in May 2015. The STOXX 600 average rallied nicely, as well, but gained back just 60% of its post-Brexit losses.

Domestic Equity Markets

With the strong rally at the end of the quarter, the S&P 500 and Dow Jones Industrial Averages moved back into positive territory for 2016. The S&P gained 1.9% in the quarter and is up 2.7% for the year, while the Dow increased by 1.4% during the last three months and is ahead 2.9% for 2016. The Nasdaq Composite Index, already down for the year after the first quarter, fell fractionally and finished the first half of 2016 down 3.3%.

Investors continued to favor higher-yielding sectors such as utilities, real estate investment trusts (REITs), and consumer staples as interest rates fell. The Utilities Select Sector SPDR ETF, the best-performing sector ETF in the first quarter, continued on a tear and is now up 21% for the year.

The price of oil recovered further in the second quarter as did other commodities, and energy stocks were strong performers. The Energy Select Sector SPDR ETF, which stabilized in the first quarter, gained 10.3% in the last three months and is 13% higher for the year.

International Markets

Developed international stocks, as measured by the MSCI EAFE index, fell nearly 10% after the Brexit vote and recovered less than 6% in the subsequent rally. That left those stocks in the red by 2.6% for the quarter and 6.3% for the year. Fears ran through international markets that Britain’s vote to leave the EU would result in a wave of anti-EU referenda in other European countries, possibly leading to an end to the union. However, the leaders of the Brexit campaign were unprepared for victory and began backtracking on their previous claims of savings to British taxpayers from leaving the EU. It is now unclear whether Britain will, in fact, follow through and leave the union.

Emerging markets, which turned around in the first quarter after several years of losses, fell just 5% in the post-Brexit slump and regained almost all of the loss by the end of the quarter. The MSCI Emerging Markets index was basically flat with a 0.3% decline in the second quarter and held on to a 5% gain for the year.

Bond Markets

After ending the first quarter with a yield of 1.77%, the U.S. 10-Year Treasury Note traded in a narrow band until June 3rd, when a Labor Department payrolls report came in much weaker than expected and the probability of a June rate hike by the Federal Reserve fell sharply. The yield decreased from 1.8% to 1.7% on June 3rd and then fell further in the final days of June after the Brexit vote and two-day market sell-off. However, the yield did not increase as the stock market rose. In fact, on July 1st, the 10-Year Note briefly fell below the previous record low of 1.38% before finishing at 1.44%.

Internationally, expanded stimulus programs by central banks in Europe and Japan as well as fears of slower global growth due to the Brexit vote drove yields down. At the end of June, over 30% of all government debt carried negative yields, and, on July 1st, all Swiss government bonds went negative.

The Economy

Data on the U.S. economy continue to give mixed signals. The ISM Manufacturing Index rose almost two points to 53.2 in June, its fifth increase in six months, and the highest level since February 2015. Also, after two sluggish quarters, consumer spending surged in April and May.

On the other hand, the May employment report showed the slowest pace of job growth in more than five years. In addition, construction spending fell 0.8% in May, its second straight decline. On a year-over-year basis, construction spending is growing at a 2.8% rate, the slowest pace since November 2011.

Conclusion

The U.S. economy is still growing at a modest rate and there are few signs of recession on the near horizon. Nevertheless, it is unclear what effect the Brexit vote will have on the world economy, although exports make up just 12-13% of the U.S .economy. Fed-funds futures recently reflected a 16% chance of a rate hike by the Federal Reserve by the central bank’s December meeting, down from 40% in early June. Continued low interest rates could be supportive of the stock market.

From a technical standpoint, the market’s sharp rebound from the post-Brexit losses is a positive for future gains, but it is certainly not conclusive, and falling interest rates may be signaling a slowdown in world growth. As always, we will closely monitor all developments affecting your investments and keep you advised.