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Economic & Market ReviewSecond Quarter 2016
Economic & Market Review
ECONOMIC REVIEW
Brexit Unsettles Global Investors, Boosts the DollarBritain’s vote to break with the European Union rattled markets and opened up tough questions about the economic bloc’s future.
The outcome sparked worries over a downturn in Europe, but any impact on the United States appears muted for now.
• Markets convulsed in response to the vote, with many surprised by the Leave campaign’s success. Reacting with their
typical aversion to uncertainty, equity markets worldwide fell in the days after the referendum, though they’ve since largely
recovered their losses.
• Long-term political and economic effects will become clearer with time. Negotiations between the UK and EU could last
two years or more, and new trade agreements and other key policies may not get finalized until then. It remains unclear
whether Brexit prefigures a wider, more decisive shift against European integration. Despite media speculation, no other EU
country looks poised to leave.
• News of the vote bolstered the dollar as the pound took a dramatic fall, hitting a 31-year low against the greenback. The
euro also dropped against the dollar following concerns over post-Brexit fallout on the continent, especially given the UK’s
status as a top trade partner to other European countries.
ECB Keeps Focus on Inflation, Expands Monetary Easing
• The euro bloc’s performance was respectable, if unremarkable. The European Central Bank (ECB) upped its 2016 growth
forecast from 1.4% to 1.6%, following a first-quarter that saw surprisingly strong expansion. Meanwhile, unemployment ticked
down to 10.1% in May. That’s high compared to the US, but still a much-welcome improvement from a jobless rate that stood
near 11% this time last year.
• The ECB added new methods to its stimulus toolkit, introducing the purchase of investment-grade corporate bonds as the
latest stage of its asset-buying program in its continuing effort to combat weak inflation.
Second Quarter 2016
Economic & Market Review
US Outlook Positive Despite Conflicting DataWhile some indicators are sending off mixed signals, overall the U.S. economy continued to press ahead and deliver strong
results on crucial measures like consumption.
• GDP growth from the first quarter was revised upwards from 0.8% to 1.1%. Estimates for Q2 GDP expansion are pegged
closer to 2%—somewhat better, but nothing spectacular. Elsewhere the housing sector looked fairly secure, with home sales
still growing moderately.
• The election cycle lurched ahead following the confirmation of Clinton and Trump as the two presumptive nominees.
Markets seem to have digested the news without much fanfare, and it remains unclear how investors will react to the two
possible outcomes facing the country in November.
• Job numbers puzzled observers with a set of conflicting results. May’s labor report was far weaker than expected, with
payrolls expanding by only 11,000. Yet numbers roared back in June, when the economy added 287,000 new jobs.
• Consumer spending climbed a healthy 0.4% in May after lifting 1.1% in April, putting Q2 consumption numbers on a
much stronger footing compared to last quarter’s tepid results. In addition, consumer confidence rose to a new high for the
year. With household spending comprising around 70% of national economic activity, any gains here will be critical to continued
U.S. momentum.
Fed Pauses on Rate Hikes
• The Fed left short-term interest rates unchanged. Minutes from recent meetings suggest that mixed jobs data and a lack
of momentum on inflation, along with persistently slow growth abroad, have made officials less confident about changing
current policy.
• Economic uncertainty has tempered expectations for more rate hikes later this year. While the Fed still expects
ongoing economic expansion at a moderate pace, noting promising trends in spending and credit availability, the recent
caution exercised by policymakers has left many Fed watchers predicting just one more rate increase for 2016, not two.
Second Quarter 2016
Economic & Market Review
Signs of Relief for Emerging Markets?
• Emerging markets received hopeful news last quarter, after getting battered the past year by a strong dollar and weak
demand for raw goods. Oil prices appear to be stabilizing, which could brighten prospects for commodity exporters such as
Nigeria and Russia. Meanwhile, the dollar’s rally seems to have cooled, reducing pressure on nations like South Africa and
Turkey that have struggled to service their high volume of dollar-denominated debt.
• China is benefitting modestly, though meaningfully, from fiscal stimulus. Improved sentiment boosted home prices, and
non-manufacturing activity ticked upwards in June, while manufacturing largely held steady. Any progress should benefit
emerging markets that rely on Chinese commodity consumption to fuel their growth.
• Brazil faces a much tougher outlook. Severe recession has sent unemployment soaring past 10%, while deficits continue to
mount. Political turmoil has only compounded the crisis, with suspended leader Dilma Rousseff facing an impeachment trial.
MARKET REVIEW
US Stocks Shake Off Brexit Worries to Finish Higher
• Despite initial selling pressure after a surprise “leave” vote, US stocks moved higher on the quarter, thanks in part to a
strong post-Brexit rally at quarter-end. The S&P 500 stock index finished the period up 2.5%, and has gained 3.8% for the
year. While far from spectacular, US stock market returns continue to show resilience amidst a variety of economic pressures
both at home and abroad.
• Mid and small cap US stocks outpaced large caps, with the Wilshire 4500 stock index gaining 4.1% in the second quarter
and 4.0% for the year. Generally speaking, smaller US companies were less exposed to the strong US dollar and the post-
Brexit international weakness, compared to the large cap global conglomerates that derive much of their revenues abroad.
• Market volatility was mostly subdued in the second quarter. The VIX volatility index started the quarter around 14 in early
April and maintained a modest range between 13 and 16 into June, before briefly jumping as high as 26 the morning after the
surprise “leave” vote. Despite the initial shock, markets quickly digested the news and within less than a week, the VIX index
was back below 16 to finish the quarter.
Second Quarter 2016
Economic & Market Review
International Stocks Fail to Keep Pace with US
• International developed stocks succumbed to Brexit pressures, with the MSCI EAFE index dropping 1.2% in the second
quarter. The index now stands 4.0% lower than it did at the start of the year. Markets have priced in the low expectations for
global growth, however, so even a small improvement in the international outlook could have a big impact.
• Despite some volatility, emerging markets stocks finished modestly higher on the quarter, rising 0.8% for the period. For
the year, emerging markets have risen 6.6% as they continue to rebound from a dismal 2015 in which they declined 14.6%.
The stabilization of oil prices is helping the outlook, but a variety of issues continue to present challenges for many of the BRIC
countries (Brazil, Russia, India and China).
Bonds Post Strong Gains as Interest Rates Fall Lower Still
• Nearly all bond investments rose on the quarter as yields finished at new lows for the year. The benchmark 10-Year US
Treasury yield started the quarter at 1.78%, but quickly retreated to 1.49% by quarter-end as Brexit-weary global investors
looked to the safety and stability of US dollar denominated debt.
• US taxable bonds performed well in this environment, rising 2.2% as measured by the Barclays US Aggregate Bond Index,
which has now gained 5.3% year-to-date, a rather remarkable result considering the modest expectations many had for bonds
at the outset of 2016. Municipal and foreign bonds were also strong performers, rising 2.6% and 4.0%, respectively, in the
second quarter. For the year, munis are up 4.3% and foreign bonds an astounding 13.5%, with the latter a reflection of yields
pushing toward zero (and in many cases into negative territory) throughout the world.
Alternatives Impress
• Major alternative asset classes posted strong gains in the second quarter. Commodities (up 12.8%) and energy stocks (up
11.6%) led the charge, while REITs and gold both posted gains of 6.8%. The figures are even better when looked at year-to-
date, with energy stocks up 16.1%, commodities up 13.3%, REITs up 13.6%, and gold up 24.6%. While we generally only
recommend small allocations to these rather volatile asset classes, their performance thus far in 2016 illustrates some of the
diversification benefits of their inclusion in portfolios.
Second Quarter 2016
Market Summary
Past performance is not a guarantee of future results. Indices are not available for direct investment. Index performance does not reflect the expenses associated with the management of an actual portfolio.
Market segment (index representation) as follows: US Large Cap (S&P 500 Index), US Mid/Small Cap (Russell 4500 Index), International Developed (MSCI Europe Australasia Far East Index), Emerging Markets (MSCI
Emerging Markets Index), US Bond Market (Barclays US Aggregate Index), and US Dollar (Trade Weighted US Dollar Index: Broad).
Index Returns
US
Large Cap
US
Mid/Small Cap
International
Developed
Emerging
Markets
US
Bond Market
US
Dollar
2Q 2016 STOCKS BONDS / DOLLAR
2.46% 4.13% -1.19% 0.80% 2.21% 1.80%
Since Jan. 2001
Avg. Quarterly Return 1.6% 2.5% 1.3% 2.6% 1.3% 0.1%
Best 15.9% 21.4% 25.8% 34.8% 4.6% 5.9%Quarter Q2 2009 Q2 2003 Q2 2009 Q2 2009 Q3 2001 Q4 2008
Worst -21.9% -23.7% -20.5% -27.6% -2.4% -5.4%Quarter Q4 2008 Q4 2008 Q3 2008 Q4 2008 Q2 2004 Q2 2009
World Stock Market Performance
Graph Source: MSCI ACWI Index. MSCI data © MSCI 2016, all rights reserved.
It is not possible to invest directly in an index. Performance does not reflect the expenses associated with management of an actual portfolio. Past performance is not a guarantee of future results.
MSCI All Country World Index with selected headlines from Q2 2016
170
180
190
200
Apr May Jun
“Mortgage Refis
Return as Interest
Rates Plummet”
“US Budget Deficit
Expands In First Half
of Fiscal Year”
“US Jobless
Claims Fall
to Four-Decade
Low”
“Fed Signals
No Rush to
Raise Rates”
“Anemic
Wage Growth
Restraining Economy”
“Eurozone Economic
Recovery Gathers Pace”
“Greece Passes Austerity
Measures as Creditors
Remain Deadlocked over
Bailout Terms”
“US Treasury Yield
Curve Is Flattest
Since 2007”
“Eurozone Slides
Back into Deflation”
“US Consumer
Spending Climbed at
Fastest Pace in Nearly
Seven Years”
“Weak Hiring
Pushes Back
Fed’s Plans”
“US Stocks Rise
to Cap Rocky
First Half”
“Brexit Vote
Pushes Britain
into Uncharted
Waters”
2.46
4.13
-1.19
0.80
1.19
US Large Cap Stocks
US Mid/Small Cap Stocks
International Developed Stocks
Emerging Markets Stocks
Global Stocks
Past performance is not a guarantee of future results. Indices are not available for direct investment. Index performance does not reflect the expenses associated with the management of an actual portfolio.
Market segment (index representation) as follows: US Large Cap (S&P 500 Index), US Mid/Small Cap (Russell 4500 Index), International Developed (MSCI Europe Australasia Far East Index), Emerging Markets (MSCI
Emerging Markets Index), and Global Stocks (MSCI All Country World Index). World Market Cap represented by Russell 3000 Index (US Market), MSCI World ex USA IMI Index (International Developed Market), and MSCI
Emerging Markets IMI Index (Emerging Markets). Russell data © Russell Investment Group 1995–2016, all rights reserved. The S&P data are provided by Standard & Poor's Index Services Group.
US stocks shook off Brexit worries to finish higher in the
second quarter, while mid and small cap stocks outpaced
large caps.
International markets failed to keep pace with the US, as
developed markets declined and emerging markets rose
modestly.
World stock market capitalization stands at $41.2 trillion.
StocksSecond Quarter 2016 Index Returns
World Stock Market CapitalizationPeriod Returns (%) * Annualized
Asset Class YTD 1 Year 3 Years* 5 Years*
US Large Cap Stocks 3.84 3.99 11.66 12.10
US Mid/Small Cap Stocks 3.98 -3.29 9.42 9.84
International Developed Stocks -4.04 -9.72 2.52 2.15
Emerging Markets Stocks 6.60 -11.71 -1.21 -3.44
Global Stocks 1.58 -3.17 6.60 5.95
Returns for the Quarter (%)
53%US Market$21.9 trillion
36%International Developed Market$14.9 trillion
11%Emerging Markets$4.4 trillion
2.21
0.98
6.55
2.61
1.11
1.71
4.04
US Total Bond Market
Short-Term Investment Grade Bonds
Long-Term Investment Grade Bonds
Municipal Bonds
Mortgage-Backed Bonds
Treasury Inflation-Protected Bonds
Foreign Bonds
Past performance is not a guarantee of future results. Indices are not available for direct investment. Index performance does not reflect the expenses associated with the management of an actual portfolio.
Market segment (index representation) as follows: US Total Bond Market (Barclays US Aggregate Index), Short-Term Investment Grade (Barclays US Govt/Credit 1-5 Year Index), Long-Term Investment Grade (Barclays US
Govt/Credit Long Index), Municipal (Barclays Municipal Index), Mortgage Backed (Barclays US MBS Index), Treasury Inflated-Protected (Barclays US TIPS Index), and Foreign (Citi World Govt Bond Non USD Index). 10-Year
Treasury Bond yield data obtained from Federal Reserve Economic Data.
Bonds posted strong gains as interest rates reached new
lows on the year.
The 10-Year US Treasury yield started the quarter at
1.78%, but quickly retreated to 1.49% at quarter-end
following the surprise Brexit results.
Longer duration fixed income performed best, but nearly
every bond asset class finished the quarter higher.
BondsSecond Quarter 2016 Index Returns
10-Year Treasury Bond YieldPeriod Returns (%) *Annualized
Asset Class YTD 1 Year 3 Years* 5 Years*
US Total Bond Market 5.31 6.00 4.06 3.76
Short-Term Investment Grade Bonds 2.60 2.63 1.92 1.77
Long-Term Investment Grade Bonds 14.33 15.72 9.33 9.18
Municipal Bonds 4.33 7.65 5.58 5.33
Mortgage-Backed Bonds 3.10 4.34 3.76 3.01
Treasury Inflation-Protected Bonds 6.24 4.35 2.31 2.63
Foreign Bonds 13.50 13.85 2.36 0.311.0%
1.5%
2.0%
2.5%
3.0%
Jun-15 Sep-15 Dec-15 Mar-16 Jun-16
Returns for the Quarter (%)
6.81
11.62
12.78
6.77
US Real Estate Investment Trusts
US Energy Stocks
Commodities
Gold
Past performance is not a guarantee of future results. Indices are not available for direct investment. Index performance does not reflect the expenses associated with the management of an actual portfolio.
Market segment (index representation) as follows: US Real Estate Investment Trusts (MSCI US REIT Index), US Energy Stocks (S&P 500 Energy), Commodities (Bloomberg Commodity Index), and Gold (London Bullion
Market Association Gold P.M. Price). Gold spot price data obtained from Federal Reserve Economic Data.
Major alternative asset classes posted strong gains in the
second quarter and are also up substantially on the year.
US energy stocks and commodities were among the best
performers on the period, as oil prices showed more
signs of stabilization.
Gold continues to shine.
AlternativesSecond Quarter 2016 Index Returns
Gold Spot PricePeriod Returns (%) * Annualized
Asset Class YTD 1 Year 3 Years* 5 Years*
US Real Estate Investment Trusts 13.56 24.10 13.51 12.53
US Energy Stocks 16.10 -3.92 -1.27 0.77
Commodities 13.25 -13.32 -10.55 -10.82
Gold 24.60 12.78 3.48 -2.59
$1,000
$1,100
$1,200
$1,300
$1,400
Jun-15 Sep-15 Dec-15 Mar-16 Jun-16
Returns for the Quarter (%)
Gross Domestic ProductSecond Quarter 2016
Source: JP Morgan Asset Management
Even as the economy continues to expand for the 7th consecutive year, the pace of this recovery is slower than the average growth rate of
the past half century. Second quarter GDP is forecast to be around 2.0%, with the consumer (which accounts for more than 2/3 of GDP)
continuing to be the bright spot in the economy.
Labor MarketsSecond Quarter 2016
Source: JP Morgan Asset Management
The job market has been strong, adding 14.4 million new jobs to the economy during the current recovery. However, the labor force
participation rate (which measures the percentage of people employed or looking for work) has been declining due to an aging population
and other factors such as outsourcing and job automation.
Negative Interest RatesSecond Quarter 2016
Source: JP Morgan Asset Management
As interest rates fall worldwide, negative interest rates
are becoming more commonplace. In this upside-down
arrangement, bond buyers (the lenders) effectively pay
interest to the bond issuers (the borrowers). An
estimated $12 trillion of worldwide debt now carries a
negative yield, most of it representing government
bonds.
Special Report: Some Thoughts on Brexit
Voters in the UK took markets by surprise on June 23, passing a
referendum calling for Britain to withdraw from the European Union
(EU)—the so-called “Brexit.” In the lead-up to the vote, investors
showed increasing confidence that the motion would be rejected,
bidding up both stocks and the pound sterling. Equity markets and
sterling thus plunged when the referendum carried, partly based on
fears about the economic impact of Brexit, but also in large
measure due to the shock of the outcome—a sort of panic selling
response.
Since the June 25 market lows, stock markets have more than
recouped the early post-vote decline, in some cases reaching all-
time record highs. The pound sterling, however, remains below its
pre-Brexit levels, and UK property funds have also come under
serious selling pressure. Prime Minister David Cameron, who led
the effort to defeat the referendum, resigned in the wake of the vote
and has been replaced by cabinet minister Theresa May, who has
vowed to proceed with the exit from the EU.
Brexit raises many questions, but offers few answers at this
time. Among the questions:
• Will the UK actually exit the EU? The referendum is non-binding,
a heavy majority in Parliament favors remaining in the EU, and
there seems to be some “voter’s remorse” in the air.1 New Prime
Minister May promises to stay the course on Brexit, but that’s
surely the path of least political risk for a brand new PM.
• If Brexit happens, when? Under the Treaty of Lisbon (which
functions as the EU’s constitution), a two-year negotiation
window opens only when the UK invokes the treaty’s exit clause.
There’s no sign of that happening anytime soon, and many
observers believe the two years could expand into a much
longer timeframe.
• If and when Brexit happens, what will the terms of the divorce
look like? The UK will want the trade advantages of EU
membership, without the obligation to accept the free movement
of EU residents across its borders. Understandably, the EU says
you can’t have one without the other.
• What about Scotland and Northern Ireland? Both of these UK
members voted strongly pro-EU. Will they seek to secede from
the UK in order to remain in the EU? And would that cause UK
leadership to reconsider Brexit, despite the vote?
• If Brexit happens, will this mark the beginning of the EU’s
unraveling? Anti-EU sentiment has been rising across the
continent.
• And if the EU comes apart, what are the geopolitical
implications? Will the Eurozone lose its power and status in
international affairs? Might this embolden Russia’s Putin further?
(continued on next page)
Second Quarter 2016
Special Report: Some Thoughts on Brexit
While much is unknown, we can make a few initial
observations:
• Brexit introduces uncertainty into the UK economic picture,
lowering both consumer and business confidence, and
consequently reducing UK economic growth expectations.
• Any adverse impact on the UK economy will have ripple effects
in Europe and beyond.
• The pound sterling is down about 6% from its level one week
prior to the Brexit vote, which is a tangible confirmation that
markets view Brexit as a negative for Britain, but not a huge
one.2
• Interest rates in the UK, Europe and US are meaningfully lower
than pre-Brexit, which is consistent with the expectation that
Brexit poses another headwind for global growth.
Finally, as we always counsel when trying to make sense of
big headlines that generate market volatility, try to keep things
in perspective.
• While Brexit is expected to dampen UK economic prospects in
the near term, it does not fundamentally change the nation’s
long-run economic potential. Likewise, it won’t necessarily alter
the demand for UK goods and services, notwithstanding
potential trade frictions in the nearer term.
• The UK never adopted the euro currency; this likely reduces the
disruption that would result from the UK leaving the EU.
• It is very much in the financial interests of both the UK and the
remaining EU states to continue to do as much business
together as possible. Whether financial incentives outweigh the
political remains to be seen.
• The UK economy functioned long before the EU existed. It will
continue to function, with or without the EU. The UK could
compensate for Brexit by shifting its economic game plan from
Euro-centric to “global-centric.”
• In the final analysis, the long-term economic impact of Brexit is
unknown. In terms of financial market impact, from this point
forward the developments are as likely to be positive as
negative.
In closing, here’s an intriguing thought to consider. The EU
leadership opposed Brexit; the UK leadership overwhelming
opposed Brexit; and voters in Scotland and Northern Ireland
opposed Brexit. Meanwhile, Brexit carried the UK popular vote by a
52-48 margin, but it’s not at all clear that the referendum would
carry today, considering market and other reactions since the vote.
Given that the terms of Brexit will be negotiated by parties, all of
whom oppose the idea, perhaps it’s not far-fetched to envision a
Brexit that results in something that looks very much like the status
quo. In other words, an agreement that permits free (or mostly free)
movement of goods, services and people between the EU and the
UK. Stay tuned.
1 Those of you old enough to remember the whimsical protest write-in campaign for comedian Pat Paulsen in 1968 might liken the Brexit vote to the aftermath of a Paulsen victory. “I never would have voted for the guy if I thought he had a chance of winning!”
2 As a result, the cost of an American’s vacation in London has moved from outrageous to merely very expensive.
Second Quarter 2016
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