The second quarter was docile compared to the volatile first quarter of the year—that is until the surprising results of Britain’s EU membership referendum began to roll in on June 24th. When Britons voted to leave the 28-member economic block to which they had belonged for 43 years, market volatility spiked, causing investors around the world a weekend of indigestion. But as is usually the case with equity markets, fear-driven overreactions mostly right themselves after a short spell as soon as investors get used to the idea that going forward things will be a bit different.
Even though equity markets have mostly recovered from the shock of ‘Brexit’, this vote will likely have future implications for investors in two respects. First, this vote has injected uncertainty into the minds of corporate executives (and investors) that will likely result in a slowing of global growth. Decisions about building factories, moving corporate offices and hiring more workers are likely to be delayed until such time as there is some clarity on the path that Britain will take with regard to its EU exit. Europe, of course, will bear the brunt of this economic uncertainty in the coming months. But the murky environment in Europe also matters to large U.S. companies, which derive about 40% of their revenues from overseas. Companies with significant exposure to Britain and the pound will feel particular weakness.
Second, opponents of the EU throughout Europe are emboldened in the wake of the U.K. result and will be seeking to have their own referendums in their own countries. If Britain’s exit is somehow pulled off with alacrity and minimal pain, then the clamoring will only increase. As things look now, however, there seems to be no avoiding an extended period of uncertainty in Britain and in Europe overall.
Meanwhile, U.S. stocks have shrugged off the Brexit worries, and have in fact recouped the entire post-referendum decline and today, as I write this letter, sit at fresh all-time highs. There are three main reasons for optimism on the part of U.S. equity investors.
First, our economy continues to do quite well, particularly when compared with other developed countries. While the very poor job additions number of 30,000 for May was way below expectations, the June figure (reported just last Friday) was 287,000 job additions—the strongest month since October of last year. No single month report matters that much, however, as the data is far from perfect and subject to significant future revisions. That being said, our job market seems to be reasonably healthy.
Second, manufacturing in the U.S. is also strengthening. The ISM Manufacturing Index has topped 50 for the last four months in a row, indicating growing customer orders and factory production. (A reading above 50 indicates expansion while a reading below 50 indicates contraction.)
Finally, the leadership vacuum in Britain and the political upheaval in Europe over Brexit will likely keep the Federal Reserve from raising interest rates for some time. In a ‘lower-for-longer’ interest rate scenario, riskier assets like stocks stand to benefit as growth-oriented investors see little to like in bonds.
Bonds around the world have also benefitted in the wake of Brexit as more risk-averse investors seek safety. The U.S. ten-year Treasury note currently yields 1.53%–not far from its all-time low yield of 1.375%, reached last week. European government bonds are also at record-high prices (and record-low yields) reflecting the uncertainties of the time. While it is impossible to pinpoint the precise causes of low and even negative interest rates in Europe, one factor certainly has to be demographics. Europe is an old continent and getting older. No level of rates will be able to stoke economic demand from a populace that is beyond their peak spending years and is understandably concerned about the future. This factor is also applicable to Japan, which has an aging population and shrinking workforce. Central banks in Europe and Japan are simply pushing on strings.
U.S. stocks remain somewhat expensive compared to their history, but are still attractively priced relative to bonds. Consider that the dividend yield on the S&P 500 stands at 2.17%, which is quite a bit higher than the ten-year Treasury’s 1.53% yield. Stocks yielding more than bonds is an unusual occurrence in the U.S.
Amid the creeping uncertainty around the world, the U.S. still appears to be on relatively solid economic footing. This country continues to act as a safe haven for investors around the world who are looking for a solid currency and reliable markets in which to invest. Brexit may, in the end, turn out to be a bad move for Britain, but for the moment it highlights the solidity of U.S. markets and the U.S. dollar.
Please do not hesitate to contact me if there is anything about the markets or your portfolio you would like to discuss.