Equity markets advanced in July, as investors were heartened by the relative stability across global financial markets in the immediate aftermath of Brexit. Sentiment was also likely buoyed by the significant pick-up in hiring during June following a very weak May jobs report. While we too share the view that certain risks have diminished, we question whether stocks should be at all-time highs given generally weak global growth conditions and monetary policies which may be losing their effectiveness.
In recent weeks, several international governments and central banks took policy actions which we view as meaningful for capital markets. In certain cases, we were left wondering whether the measures implemented were the most prudent to ensure long-term economic stability; others we felt might have illustrated the limitations of how impactful monetary policy can be in reinvigorating economic growth. In China for example, second quarter GDP growth came in at a respectable 6.7%, modestly ahead of expectations. However, much of this was driven by a pick-up in bank lending, potentially at the insistence of the government. To the extent that lending decisions are being made at least in part due to political considerations, we are concerned that capital is not being optimally allocated throughout the economy. Moreover, we believe that this is reflective of a government prioritizing short-term growth over longer-term reform.
Elsewhere, the Bank of Japan (BOJ) boosted its stimulus program via an increase in its ETF purchases. Despite this expansion, markets appeared to be underwhelmed, as we believe that many investors were hoping for an increase in the central bank’s purchases of Japanese government bonds as well. In our view, the idea that the BOJ took only a modest incremental step may be an implicit reckoning on its part that there is only so much that monetary policy can accomplish on its own. The Japanese government perhaps endorsed this view by announcing new fiscal stimulus initiatives to help support the BOJ’s efforts to bolster the economy. In Europe, countries including Spain and Portugal were not penalized despite having budget deficits exceeding thresholds agreed upon in the European Union’s Fiscal Stability Treaty. This is concerning to us as we view it as another example in which government officials appear to be putting off reforms necessary for longer-term stability.
Also in Europe, regulators completed their latest round of bank stress tests. The results were uneven in our view. While most banks fared well, there were some notable exceptions. Italy’s Banca Monte dei Paschi di Siena was found to be the most vulnerable, as it was shown likely to have all of its Tier 1 capital wiped out in an adverse economic scenario. Perhaps more troubling, other larger and in our view more systematically important institutions, including Deutsche Bank, Barclays, and Unicredit fared poorly as well. Our takeaway from these tests is that more needs to be done to shore up Europe’s financial system and enable it to better withstand future economic fluctuations.
In the U.S., recent economic data releases have sent mixed signals about the health of the domestic economy. While the consumer sector appears to be relatively healthy, much of the rest of the economy remains challenged. Indications of strong consumption include retail sales, which have come in at robust levels in recent months. Personal spending too was a key driver of second quarter economic activity, growing by over 4%, the fastest rate since 2014. Housing was another area of strength. In June, both existing and new home sales hit record levels for the current expansion.
Despite a seemingly healthy consumer, overall GDP growth was lackluster during the second quarter, coming in at just a 1.2% annualized rate. Business sector capital spending was once again a drag on growth, at least in part due to excessive inventories which were drawn down during the quarter. In our view, the inventory build may be symptomatic of uncertain business conditions. We believe that management teams may be delaying investment decisions until they have a better handle on certain outstanding issues, including Brexit’s potential impact on the global economy and the outcome of the U.S. presidential election. One positive takeaway from this weaker than expected data is that the Federal Reserve appears unlikely to be raising rates anytime soon.
Corporate earnings reports were likely another factor driving the market higher in July. Earnings declined again in the second quarter but the falloff was less than expected, and we believe that profits are likely to improve in the coming quarters. Additionally, while in some cases there were UK-specific impacts from Brexit on business activity, there was little contagion noted in Continental Europe.
We have incrementally upgraded our view on the market, but remain somewhat cautious in our outlook. The immediate fallout from Brexit has so far been less problematic for equities than many feared. We believe that this has at least been in part a function of the quick resolution of UK national leadership, and also because the UK appears to be in no rush to formally commence its exit from the European Union. In addition, the U.S. consumer, a key cog of the domestic economy, has shown encouraging signs of strength. If sustained, this should continue to support economic growth and provide a boost to corporate earnings.
Negative factors which give us pause include the upcoming U.S. election. We believe that the uncertainty surrounding this event, in addition to continuing fears over possible medium and longer-term effects of Brexit, have negatively impacted corporate decision making and capital spending plans. In our view, the less than stellar financial condition of the European banking system increases the continent’s vulnerability to any potential Brexit related fallout, particularly given its tight links to the UK. Finally, oil prices have weakened again recently. This could potentially have negative effects not only on energy companies, but also the industrial suppliers which service them. Banks too may feel the impact of further oil price declines should they trigger a wave of energy sector loan defaults. Overall, while there are reasons for optimism, we find it difficult to justify a market making all time highs despite elevated levels of political and economic uncertainty across much of the world.
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