Economic & Market Review - gouldasset.com · Economic & Market Review ECONOMIC REVIEW Brexit Unsettles Global Investors, Boosts the Dollar Britain’s vote to break with the European

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


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


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


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


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


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


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


6.81

11.62

12.78

6.77

US Real Estate Investment Trusts

US Energy Stocks

Commodities

Gold


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


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


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


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


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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Economic & Market Review - gouldasset.com · Economic & Market Review ECONOMIC REVIEW Brexit Unsettles Global Investors, Boosts the Dollar Britain’s vote to break with the European