Just two weeks ago, stocks took a nasty beating in the wake of the surprise Brexit vote. But life in the EU goes on, and there hasn’t been any meaningful headlines coming out of Europe recently.
Historically, U.S. investors have always returned to the U.S. fundamentals, absent major overseas events. For now, the pattern has repeated itself.
The latest catalyst to spark gains was the strong June payrolls report, which pushed the S&P 500 Index to within one point of a new high.
I seriously doubt the economy is as strong as June’s 287k rise might suggest, but taken together with May’s paltry rise, the economy is still generating jobs and doesn’t seem set to stall.
The immediate fallout from the Brexit vote was a steep selloff in stocks. But when cooler heads prevailed, buyers stepped in.
Despair turns to jubilation? Well, that’s a stretch on both sides.
But jittery short-term traders that hit the sell button are realizing economic activity between the UK and the EU won’t stop simply due to a nonbinding referendum (that will likely be binding).
Risks aren’t going away and more volatility may occur as investors price in the uncertainties of Brexit. But the strong rally last week was encouraging.
Moreover, much of the recent data heading into Q3 has been encouraging, too.
Weekly jobless claims are near a cyclical low, the Challenger layoff report was one of the lowest readings of the last two years, and both the ISM Manufacturing and Non-Manufacturing Indexes exceeded expectations.
Rock bottom yields in Europe bear watching, and we may see some additional aftershocks that could create volatility in our markets. However, an improving US economy is likely to lessen risks to the profit outlook.
The fallout from the Brexit vote continued for a second day, with another round of selling in most major equity markets and another advance among risk-off assets. If you are keeping score, S&P’s Howard Silverblatt tweeted that Friday’s selloff lopped $2.1 trillion off global equity values, the largest one-day drop ever.
The political earthquake in Europe has already claimed the career of British Prime Minister David Cameron. And, if it already hasn’t been said, I’ll say it: the British pound has gone on a crash diet, falling to the lowest level against the dollar in over 30 years. It’s going to be a big plus for British exporters, but it will likely stoke inflation in the U.K.
But as the political fallout continues, many at home are asking how this will affect our financial markets and our economy. No one has a crystal ball. But before I take a stab at it, let me explain the short-term rout in stocks.
Political pundits and analysts had expected the Remain camp to squeak out a win. In anticipation, markets rallied as the vote approached. But Thursday night’s “surprise” was analogous to a swift and unexpected kick in the gut. Hence, we seeing a re-pricing/re-adjustment of risk.
In other words, investors are surveying the new economic landscape and trying to settle on a new value for the market as a whole. It is uncharted territory for the markets, which creates volatility.
It’s not that a recession in the U.K. (if it were to occur) would, by itself, sink the U.S. economy. It won’t. But fears and uncertainty swirling around the referendum have raised concerns that other nations might find Britain’s path to be an attractive one. Then, there are renewed worries that the euro itself might eventually collapse.
One thing that’s certain: equity markets hate heightened uncertainty, and that’s what’s been playing out over the last couple of days, especially among the financials.
So back to the question: how will this affect the U.S.? It’s hard to see how this alone becomes a Lehman moment that crashes into the credit markets and destroys liquidity.
Banks in the U.S. are in much better shape today, and the consumer is healthier than in 2008. Yes, there are weak spots, such as business spending, but when Lehman Brothers imploded, the U.S. was already in a modest recession. Today, the economy is expanding, albeit modestly.
A better question for long-term investors
Will this impact your portfolio five or ten years from now? Again, no one has a crystal ball, but I suspect the answer is no.
Historically, the U.S. economy and corporate profits hold the biggest sway over the medium- and long-term direction of U.S. stocks, not what happens around the globe.
Whether the tragic earthquake in Japan, the Arab spring, the 2011/12 eurozone debt crisis, chaos in Iraq and Syria, or Russia’s invasion of Ukraine, the spotlight normally returns to domestic events.
Let’s face it, the Fed is just plain reluctant to boost interest rates.
The April meeting of Fed officials has come and gone and there were few hints a more aggressive posture is in the offing.
Yes, the labor market continues to improve, the jobless rate resides at 5.0%, and inflation has been showing signs of gradually ticking higher. But that doesn’t seem to be making an impression on Janet Yellen.
I can only speculate but I suspect there are several factors that are in play right now.
Moderation in Q1 economic activity
A PCE Price Index that remains below target
A reluctance to go against the grain of other major central banks
Fears of creating global instability and/or rocking U.S credit markets
A resumption of an upward trend in the dollar
Yellen’s dovish tilt
Brexit worries – the vote occurs one week after the Fed’s June meeting
Election year – the Fed would deny it, but it doesn’t operate in a political vacuum.
Investors will continue to parse and dissect the Fed’s statement over the next couple of days. But with no specific language that illustrates a more receptive mood (or significantly better economic data), a June rate hike remains only a distant possibility.
Maybe the Fed is waiting for all the storm clouds to recede. But that will never happen.
Oil hit a bottom on February 11, and notably, so did stocks and spreads on junk bonds. Who says oil isn’t driving psychology!
Look at the close relationship between stocks and oil in the chart below.
More importantly, in my view, look at how the tightening in high-yield spreads are moving lockstep with the bump in oil prices.
Rising junk bond spreads have historically been a sign of tighter financial and credit conditions. Tighter credit conditions can choke off the supply of needed capital to businesses, and poof, there goes the recovery.
If spreads have peaked, it’s a very encouraging sign for the economy in the second half of 2016.
