Great Britain voted to leave the EU on June 24 sparking market volatility and uncertainty
Global monetary policy saw an increase in negative interest rates as investors ran to safety
While U.S. interest rates are near all-time lows with the 10-year rate falling from 1.78% to 1.49%, the positive yield remains attractive to international investors
S&P 500 returned 2.5% for the quarter with largest gains coming from energy as commodity prices continued to rebound from first quarter lows
The British are going! The British are going! Out of the European Union, that is. The headlines of a generally positive quarter, like a British weather forecast, turned dark and gloomy on June 24 with the vote to exit the EU. This surprising result caused financial, political and economic shockwaves around the globe. Perhaps England’s seemingly early elimination from the 2016 Euro Championship soccer tournament was a bit of foreshadowing. At least the U.K. had tennis great Andy Murray to lift its collective spirits with his second Wimbledon championship.
In the immediate aftermath of the vote, British Prime Minister David Cameron announced his resignation, global markets declined 6% to 11%, and the British Pound fell to its lowest valuation against the U.S. dollar in 30 years. The forecasted medium- to long-term impact of the first country exiting the EU range from minimal to extraordinary, meaning the truth is somewhere in the middle.
In the short term, the break-up will hurt the U.K., as investors may exercise caution in future investments. It is uncertain how the commercial relationship with the EU will pan out. This is significant because as part of the EU, the U.K. has significant trade advantages with other member nations. As a trade partner, the British may need the EU more than the EU needs them. This is uncharted territory that will surely cause more market uncertainty as the exit process and terms are formalized. More than likely, other countries within the EU will be paying close attention to this activity and drawing their own conclusions on if they should break ties as well.
This story is just beginning. The MSCI EAFE (Europe Australasia Far East) Index contains just shy of 20% exposure to the U.K. market, and the MSCI ACWI (All Country World Index) has 6.42% exposure to the U.K. The overall impact in the U.S. financial markets should be minimal, as the U.K. only makes up 4% of the total global GDP. As we have seen in the past, however, U.S. markets are susceptible to global shocks regardless of the overall impact the event has on the economy.
Global monetary policy remains in focus as the concept of negative interest rates has turned from a desperate measure to common practice. As of quarter-end, 35% of the Citi World Global Bond Index is trading at a negative rate.1 Japan, which has the second-largest bond market, has negative rates across the yield curve from the ultra-short duration bonds all the way out past the 15-year bond. In Switzerland, the entire yield curve is negative. Though rates are near historic lows in the United States, competition has heated up across the globe to purchase bonds with a positive yield.
Domestically, general economic conditions continued to improve. GDP growth was revised upward to 1.1% annualized during the first quarter. Second quarter numbers are not tabulated as of the publication of this article, but estimates have second quarter GDP at around 2.5% annualized, plus or minus 0.5%. Unemployment remains below 5%, and jobs continue to be created with an additional 287,000 added in June. Aggregated corporate profits that have been on the decline since mid-2014 are projected to rebound to all-time highs by year-end according to S&P consensus analyst estimates. The energy sector saw its first improved earnings per share valuation in the first quarter of 2016, and is expected to turn positive in the second quarter for the first time since the fourth quarter of 2014.
Equity returns in the United States were positive across the board during the second quarter. The theme of value outperforming growth continued, with mid value leading the way (4.8% return). The S&P 500 returned 2.5% during the quarter, while large growth saw the smallest gains at 0.6%. These returns put each U.S.-style box in positive territory year to date. The exception was small growth, which took a huge hit during the first quarter but recovered nicely in the second quarter. The energy sector – which has been under substantial stress as commodity prices fell dramatically throughout 2015 and into the first few months of 2016 – has bounced back and was the best performing sector during the quarter at 11.6%, bringing its year-to-date return to 16.1%. That total only trails the more defensive telecom and utilities sectors with year-to-date returns of 24.8% and 23.4% respectively.
International developed markets (as measured by the MSCI EAFE Index) continued to struggle in 2016, adding to the losses of the first quarter. The index returned -1.46% during the second quarter, putting the year-to-date losses at over 4% in U.S. dollar terms. While Brexit shook the global markets in late June, poor continued financial performance (which comprises nearly one quarter of the MSCI EAFE index) contributed to the loss. Emerging markets, however, continued to improve as most emerging market countries rely heavily on the commodity markets, up 0.66% during the second quarter after returning over 5% during the first quarter.
Interest rates on the 10-year U.S. Treasury bond declined even further during the second quarter, as many investors around the world flocked to safety. The 10-year rate began the quarter at 1.78% on March 31 and ended the quarter at 1.49% on June 30. While we continue to hear about how low interest rates are in the United States, the fact is that even with these low numbers, the United States still has some of the highest rates when compared to other developed countries; some notable developed countries (e.g., Japan and Germany) are experiencing negative interest rates.
The Barclays Aggregate Bond Index, a measure of investment grade debt, returned 2.2% for the quarter and is already up over 5.3% year-to-date due to lower interest rates across the yield curve (remember, there is an inverse relationship between interest rates and bond prices). High-yield debt and TIPS have also done very well for the first six months of the year, returning 9.3% and 6.2% respectively.
A diversified asset allocation portfolio is meant to smooth out returns over the long term without having huge positive or negative swings. Diversification is a topic that we stress to plan participants through communication and education meetings.
1 MFS Q3 Market Insights webcast July 12, 2016
2 Source: Barclays, Bloomberg, FactSet, MSCI, NAREIT, Russell, Standard & Poor’s, J.P. Morgan Asset Management