When the British voted in June to leave the European Union after 43 years of membership, many investment strategists painted a gloomy picture for what lay in store for the markets during the summer and for the balance of 2016. Some predicted the imminent demise of the EU and a global recession. In recent weeks, however, the volume and intensity of such predictions from financial pundits has diminished.
The Brexit vote is an excellent example to investors of how difficult it is to forecast near-term movements in financial markets. There are many good reasons why stock and bond markets should have declined in the wake of the British vote: weaker economic growth in Europe due to Brexit concerns, possible Federal Reserve interest rate hikes in 2016, the U.S. Presidential election uncertainty, high valuations of both stocks and bonds, growing populist and anti-trade sentiment in Europe and the U.S., as well as (still) declining corporate profits in the U.S. Summer trading can also be light and fluky, as historically most of equity markets’ gains have come from the November to May stretch.
But stocks have shrugged off these worries to work their way gradually higher through the summer. Several broad U.S. stock indexes reached their all time highs just in the last week amid muted volatility and low trading volumes—some might say investor apathy. U.S. stocks, it seems, may have benefitted from the turmoil in Europe by becoming a relatively safer and more predictable place for global investors to put money to work. Also, the second quarter earnings season in July was pretty constructive overall, with technology companies in particular continuing to post solid growth. Finally, this summer markets have enjoyed a respite from those one-off (but regularly-occurring) unpredictable events that can have many investors reaching for their Pepto-Bismol and the “sell” button.
A final reason why stocks have continued to perform relatively well is that the U.S. economy continues to expand—but at a modest pace. It’s the old “Goldilocks” scenario of growth that is strong enough to maintain healthy job levels, but not so fast that it spurs the inflation that brings the Fed back into the picture to hike rates quickly. Brexit caused the Fed to blink in June and leave rates unchanged, but our central bankers will likely have to raise rates before the end of 2016. The current state of our economy is probably strong enough that it will not deserve the support of near-zero interest rates.
U.S. stocks continue to trade a bit on the rich side, with the S&P 500 fetching a price-to-earnings multiple of 18.5 times expected earnings for 2016. Both the financial and energy sectors posted improving earnings in the second quarter, and if they continue to improve these recent earnings-laggards may help to turn the tide of declining aggregate corporate profits in the coming couple of quarters.
Please do not hesitate to contact me if there is anything about the markets or your portfolio you would like to discuss.