Uncertainty and financial markets are inexorably connected. Every market situation has those elements of risk that cannot be measured with precision—a fact that is equally disconcerting and exhilarating at once. We have been lamenting the uncertainties around economic growth and earnings too weak to lift markets, while also regarding with interest the embryonic evidence of a slightly steeper growth path emerging in this quarter. The Atlanta Fed’s GDPNow estimate of 2Q GDP is reading 2.8% as of June 14, a significant improvement on the less than 1% growth rate seen in 1Q of this year. Several more hurdles have appeared, however, and markets will need to digest them before we can see any reliable forward movements. Unlike many elements of uncertainty that have little definition, the implications of the following events can be absorbed quickly.
The Federal Reserve’s June meeting
As the Fed meeting has taken place and members passed on raising rates, it might seem like a “one and done” event in which we have already cleared any hurdles the event may have presented. We include it because it casts a long shadow and the Fed’s views offer important forward-looking perspectives. Deciding to pass on a policy move at this time reflects changing Fed sentiments, with six of its committee members now expecting only one rate hike in 2016 and one member going so far as to not expect any hikes in the next few years. We recognize that these sentiments are not well anchored as we suspect that the recent weak employment report for May had a lot to do with this shift. This puts next month’s employment report into a very bright light, which is why we think markets are not likely to move much until we see where that report leads us.
The “Brexit” Vote on June 23
While the U.S. presidential election may be top of mind for many people, a close second could be the upcoming United Kingdom referendum in which it votes whether to remain a part of or exit (“Brexit”) the European Union.* As shown in Figure 1, up until only a week ago, polling had suggested that the decision will be very close, but had “exit” coming out on top. The betting odds had the “remain” camp favored by roughly two to one, although this was recently down from three to one. With roughly 10% still undecided—and in light of campaigning having been marred in the wake of Member of Parliament Jo Cox’s murder last week—the vote could go in any number of directions. Many are looking to the recent Scottish referendum about a potential withdrawal from the U.K. where the polling had suggested an exit would be in the offing, but the final outcome tipped in favor of staying, and we think that will be the case here as well. The U.K.’s “exit” camp points to issues such as immigration and the sovereignty of Parliament, while the “remain” camp is relying on fear as a reason to stay put. Markets have been feeling the weight of this vote with the recent rally in Treasuries and German bunds considered part of a flight to safety. The move in German bunds has been particularly noteworthy as yields have dipped below 0%, helping to put the global total of debt instruments with negative yields up to around $10 trillion.
Regardless of which way the vote goes, markets seem destined to react. A decision to stay in the EU will likely spark a relief rally that should help equity markets, particularly in Europe, while fixed income markets could be feeling an opposite reaction as the need for safety fades. An exit vote opens an entirely different can of worms, which seems likely to lead to difficult markets. The actual process of leaving may take up to two years and will include many efforts to renegotiate new arrangements between the U.K. and the continent. One near-certainty in our view is that this will be a very bitter divorce. Like many break-ups, what is beneficial for one party is detrimental to the other and that would be no less true in this case. The stakes for the EU are high. If the United Kingdom is seen as having exited without experiencing any downside, the very rationale for the union’s existence could begin to fray, possibly prompting other countries (most notably France and Finland), to leave.
The June employment report
Another potential obstacle involves the June employment report, due to be released on July 8. One bad report does not a trend make but then again, a trend has to start somewhere and making that determination will be front and center with the next jobs report. As noted earlier, the weak report for May turned into a significant pivot point for the Fed, raising questions about the continued U.S. expansion. The good news is that the data released since the employment report have not corroborated the poor employment report. Initial U.S. Jobless Claims have averaged 269,000 the past four weeks which is right in line with the average for all of 2016. Reports on Job Openings have continued to move higher, indicating that businesses are still looking to add talent. Retail sales advanced by 0.3% in May which, given the high sensitivity of consumers to job prospects, would seem to indicate that consumers are not harboring employment fears. However, while anecdotal reports appear favorable, markets will still need to see evidence in the June report.
Over the next month, 2Q earnings will begin to be reported, and they are expected to resemble 1Q, with overall earnings down and negative results showing up well beyond the energy patch. The bigger story is that the pattern is expected to change in 3Q so look for releases to try and verify that this upturn is on the horizon. If this comes to pass and the other aforementioned events are received well by markets, we could be poised for an interesting and perhaps profitable second half of 2016.
* The European Union (EU) is a federation of nations that was created to foster economic and political cooperation. It has become a “single market” where goods, services, and people can essentially be treated as if they were all part of one country. Of the 28 EU members, a subset of 19 is referred to as the eurozone, which uses the euro as its currency.
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As of June 19, 2016
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Formerly the Lehman Aggregate Bond Index, this index tracks investment-grade bonds traded in the U.S.; the securities are weighted according to their market size.
Citigroup Economic Surprise Index
A measure for various regions, which shows how economic data are progressing relative to consensus forecasts of market economists. The weighted, historical standard deviations of data surprises are calculated daily in a rolling three-month window. A positive reading suggests economic releases have on balance been beating consensus estimates.
Dow Jones Industrial Average
Index that shows how 30 large, publicly owned U.S. companies have traded during a standard trading session in the stock market.
HFRX Global Hedge Fund Index
One of the family of 75 HFRX Hedge Fund Indexes, the global industry standard for performance measurement across all aspects of the hedge fund industry.
MSCI EAFE Index
Largely recognized as the preeminent benchmark in the U.S. to measure international stock performance; it comprises indexes that represent developed markets outside of North America: Europe, Australasia, and the Far East.
MSCI Emerging Markets Index
Designed to measure stock market performance in the global emerging markets; it covers over 800 securities across 23 markets and represents roughly 13% of world market capitalization.
NASDAQ Composite Index
Index of common stocks and similar securities listed on the NASDAQ Stock Market Index, which has over 3,000 components. The Composite is considered an indicator of stock performance for technology and growth U.S. and non-U.S. companies.
Used to evaluate the likelihood of default by a bond issuer. Independent rating agencies analyze the financial strength of each rated issuer. Moody’s ratings range from Aaa (highest quality) to C (lowest quality). Bonds rated Baa and better are considered “investment grade.” Bonds rated Ba and below are “speculative grade” or “high yield.” Similarly, Standard & Poor’s ratings range from AAA to D. Bonds rated BBB– and better are considered “investment grade” and bonds rated BB+ and below are “speculative grade.”
Russell 1000 Index
Measures the performance of the large-cap segment of the U.S. equity universe. It represents approximately 92% of the U.S. market, is a subset of the Russell 3000 Index, and includes approximately 1,000 of the largest securities based on a combination of their market cap and current index membership.
Russell 2000 Index
Measures the performance of the small-cap segment of U.S. stocks and is a subset of the Russell 3000 Index, which encompasses the 3,000 largest U.S.-traded stocks.
Russell 3000 Index
Measures the performance of the largest 3,000 U.S. companies representing approximately 98% of the investable U.S. stock market.
Russell Midcap Index
Measures the performance of the mid-cap segment of U.S. stock and is a subset of the Russell 1000 Index. It includes approximately 800 of the smallest securities based on a combination of their market cap and current index membership.
S&P 500 Index
U.S. stock market index based on 500 large companies’ market capitalization (total value of the outstanding shares); widely regarded as the single-best gauge of large-cap U.S. stocks.
S&P Municipal Bond Index
A broad, market value-weighted index that seeks to measure the performance of the U.S. municipal bond market.
WTI, or West Texas Intermediate
A classification of sweet, light (low-density) crude oil from Texas, used as a major worldwide benchmark for oil prices.