2016 Second Quarter Report: The Shadow of Brexit

Written on August 3, 2016

The first half of 2016 has been quite tumultuous, with the dismal first few weeks of the year, the surprising “Brexit” vote in the United Kingdom, and increased volatility across the board. So it may come as a surprise that the second quarter of 2016 eked out positive returns for many of the United States market indices; most of them are showing positive—though hardly exciting—gains over the entire first half of the year.

On the first day of July, the Dow, S&P 500 and NASDAQ indices were all higher than they were before the Brexit vote took investors by surprise. This suggests that, yet again, the people who let panic make their decisions lose money while those who keep their heads sail through. There will be plenty of other opportunities for panic in a future where terrorism, a continuing mess in the Middle East, a refugee crisis in Europe and premature announcements of the demise of the European Union will deflect attention away from what is actually a decent economic story in the U.S.

The Wilshire 5000 Total Market Index—the broadest measure of all U.S. stocks—was up 2.84 percent for the quarter and is now up 3.69 percent for the first half of the year. The widely-quoted S&P 500 index of large company stocks posted a gain of 2.46 percent in the second quarter and is up 3.84 percent for the first half of 2016.

When you look at the global markets, it’s clear that the U.S. has been a haven of stability in a chaotic world. The broad-based EAFE index of companies in developed foreign economies lost 1.46 percent in dollar terms this quarter and is now down 4.42 percent for the first half of the year. In aggregate, European Union stocks lost 7.60 percent in the first half of 2016. Emerging markets stocks of less developed countries, as represented by the EAFE EM index, gained 0.66 percent for the quarter and are sitting on gains of 6.41 percent for the year so far.

Meanwhile, interest rates have stayed low, once again confounding prognosticators who have been expecting significant rate rises for more than half a decade now. Treasury yields remain near the bottom of historical rates; three-month notes yielded 0.26 percent at the end of the quarter, while 12-month bonds were yielding just 0.43 percent. Go out to 10 years, and you can get a 1.47 percent annual coupon yield. Low? Compared with rates abroad, these yields are very generous.

The American economy is on track to grow at a 2.0 percent rate this year, which is hardly dramatic, but it is sustainable and unlikely to overheat different sectors and lead to a recession. Manufacturing activity is expected to grow 2.6 percent for the year based on the numbers so far, and the unemployment rate has fallen to 4.7 percent, which is actually below the Federal Reserve target. Inflation is also low, running around 1.4 percent this year.

The unemployment statistics are almost certainly misleading in the sense that many people are underemployed, and a sizable number of working-age men are no longer participating in the labor force. However, for many Americans, there is work if you want it. Historically low oil prices and high domestic production have lowered the cost of doing business and the cost of living across the American economic landscape.

Despite all this good news, the market is struggling to keep its head above water this year and questions remain. The biggest question in many people’s minds is: WILL the European Union break up now that its second-largest economy has voted to exit? There is already renewed talk of a Grexit, along with clever names like the dePartugal, the Czechout, and the Big Finnish. With active political movements in at least a dozen Eurozone countries agitating for an exit, it is possible that someday we will view the UK as the first domino.

You will continue to see dire headlines, if not about Brexit or the Middle East, then about China’s debt situation and the Fed either deciding or not deciding to raise rates in the U.S. economy. Oil prices are going to bounce around unpredictably. The remarkable thing to notice is that with all the wild headlines we’ve experienced so far, plus the worst start to the year in U.S. market history, the markets are up slightly here in the U.S., and the economy is still growing.

The rest of the year will most certainly bring surprises, but investors need to remain calm and understand that making short-term decisions based on panic usually negatively impacts long-term returns.

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