The results of the UK referendum, in which the nation’s citizens voted to exit the European Union, impacted capital markets around the world. European stocks were hit hard, with the Stoxx Europe 600 index falling by approximately 7%, its worst one-day decline since 2008. Ten-year government bond yields in Germany and the UK tumbled to all-time lows, while U.S. Treasury yields approached their lowest levels in years. Perhaps the most violent moves were found in currency markets, specifically the British pound sterling, which collapsed to its lowest level versus the dollar since 1985.
In our view, whether or not the UK follows through on its referendum and exits the EU, the odds have increased that the country will enter into at least a mild recession. We expect that businesses have pared back on investment plans due to the economic and political uncertainty currently enveloping the nation. We also believe that European economic activity may be adversely impacted as a result of reduced trade with Britain, as well as a similar pause in investment decision making. We see the U.S as more insulated, however, as sales to the UK represent a small percentage of total American exports. Moreover, exports are not a major driver of the U.S. economy. That being said, we do see the potential for the shares of U.S. multinational companies to be impacted, primarily due to the recent strengthening of the dollar.
The risk that we are most concerned with in the aftermath of Brexit is the potential for political contagion, should it galvanize nationalist sentiment in other countries and encourage them to follow Britain’s lead in leaving the EU. We believe that this could create shockwaves throughout the global economy. In this regard, we are keeping a close watch on the upcoming Italian constitutional referendum. While this is not a vote to leave the EU, our concern is that it could ultimately lead to one.
There are reasons to believe that longer-term impacts to U.S. capital markets from a British exit may not be so severe. To begin with, the referendum was nonbinding, so there is a chance that the UK may not ultimately leave the EU. While this is not our expectation, it is a possibility. Secondly, the country maintains its own central bank and currency. This should make the potential separation relatively less onerous, as compared with a Eurozone country which would have to manage the logistics, and consequences, of a currency transition. Finally, banks in the U.S. are well capitalized, as evidenced by the healthy results from the most recent round of Federal Reserve stress tests. This is important, as we view financial institutions as the most likely sources of capital market contagion. We therefore think that a severe shock to the U.S. domestic economy as a result of Brexit is unlikely.
The Federal Open Market Committee held its most recent meeting earlier in June, and it was noteworthy in that officials reduced their interest rate projections. The committee cited the upcoming British referendum and the slowdown in the pace of domestic hiring as reasons for their downgraded assessment. It also noted weak productivity gains, unfavorable demographics, and lingering impacts from the financial crisis of 2008 as factors which are depressing the neutral interest rate, defined as the rate required to keep growth on trend and inflation stable. These viewpoints marked a stark contrast from just several weeks before, when Fed Chair Janet Yellen articulated her view that a near-term rate hike was likely. At this point, it appears that any remaining chances for a near-term rate hike were likely dashed with the results of the UK referendum, and the Fed will likely hold rates steady perhaps into next year. We believe it is highly unlikely that the Fed would tighten policy until it has greater clarity with regards to Brexit’s impact on the domestic and global economies.
Domestic consumption was a bright spot during the quarter. Personal spending jumped 1.1% in April, the best pace in nearly seven years, while retail sales topped expectations with strong gains in both April and May. Perhaps consumers are feeling more positive due to recent wage increases. In this regard we note that unit labor costs during the first quarter grew by a solid 4.5%, and wage growth during May came in at a relatively healthy 2.5% clip. We were also pleased to see the savings rate continue to tick lower with the latest reading down to 5.3%, meaningfully below its recent peak of 6%. Should wages continue to firm, and consumers maintain their willingness to spend, the results could be quite positive for economic activity moving forward.
There are many cross currents to consider in assessing today’s market outlook. In our view, the political and economic uncertainties plaguing many of the world’s major economies justify a guarded outlook and a certain degree of defensiveness. We have long invested with the philosophy that economies in low growth phases tend to be most vulnerable to exogenous shocks. In this regard, despite the meaningful pickup in GDP growth which looks to be in the 2.5%-3% range for the second quarter, the economy still appears to be stuck in the lower gear which has persisted for several years now in the wake of the financial crisis. In this context, despite the aforementioned reasons to believe that Brexit need not be a calamitous event for domestic stocks, we still view it as an exogenous shock, albeit an indirect one, to a U.S. economy which remains mired in a below trend growth phase.
Many capital market indicators are also flashing signs of caution. Gold recently hit a multi-year high, and a number of government bond yields are trading at all-time lows. We view these as signs that markets are cautious as investors flock to safe havens. In a similar vein, both the U.S. dollar and Japanese yen have seen strong demand of late. We find it unusual that U.S. equities have held up rather well alongside these other more defensive investments. Our view is that this confluence will not persist, and that either equities or safe haven assets are likely to give up some of their recent gains. Given the uncertainty encompassing capital markets in the aftermath of Brexit, we would expect that stocks are more likely to be the decliners than other more defensive assets.
Still, reasons for some optimism remain. The rebound in consumption during the second quarter was quite encouraging, and if sustained would go a long way towards supporting future economic activity. The labor market will likely be a key determinant of this. In this regard, it remains to be seen whether May’s anemic job growth was an aberration, or the start of a downturn in hiring. Continued wage growth and relatively low levels of unemployment claims are supportive of a still healthy job market, but all eyes will be on the upcoming June labor report to get a better sense of this. We also continue to be bullish on the housing market. Positive trends have continued in recent months, with existing home sales for May notching their best results in nearly a decade. Moreover, the market may get another boost as mortgage rates follow interest rates to lower levels.
We are a bit more guarded in our assessment of the corporate sector. We think that the strong dollar post-Brexit will be a challenge for U.S. based multinationals, as it is likely to present a headwind to exports and profits. However, the energy and industrial sectors should benefit from the rebound in oil prices in recent months. We note that rig counts have stabilized, and expect that this should bode well for industrial capital spending moving forward.
In summation, there are strong pockets in the U.S. economy and reasons to believe that domestic stocks can hold up reasonably well to Brexit-induced financial turbulence. However, it remains to be seen to what extent the UK referendum will impact the economies of Great Britain and Europe. More importantly in our view, is how this event will affect populist movements in other European countries, perhaps encouraging them to follow Britain’s lead. Coupled with political uncertainties in the U.S. leading up to the presidential election, we conclude that there is enough risk in the current market environment to justify a guarded outlook. As always, we maintain our risk-conscious approach to seeking long-term growth.
This information is intended solely to report on investment strategies and opportunities identified by Roosevelt. Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. This material is not intended as an offer or solicitation to buy, hold or sell any financial instrument. References to specific securities and their issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Please contact us at 646-452-6700 if there is any change in your financial situation, needs, goals or objectives, or if you wish to initiate any restrictions on the management of the account or modify existing restrictions, or if you would like to request a copy of our Code of Ethics. Our current disclosure statement is set forth on our Form ADV Part II, available for your review upon request, and on our website, www.rooseveltinvestments.com.