‘Brexit’ Doesn’t Stop New Highs
Initial reaction to this summer’s surprising decision by voters from the United Kingdom (UK) to leave the European Union (EU) initiated a sharp selloff in global equity markets. Following the vote that made this exit or “Brexit” official, the US based S&P 500 Index dropped nearly 5%, and the broad STOXX Europe 50 Index plummeted downward in excess of 10% in just two days trading.
It is interesting to note, however, that the UK equity market (represented by the FTSE 100 Index) dropped by barely 3.4% over the same time period. Since then, the S&P 500 has more than regained what was lost during the initial selloff, and the FTSE 100 Index has rebounded to levels higher than prior to the vote. The STOXX Europe 50 index has also rebounded to pre-Brexit levels. Dr. Scott Brown, Ph.D., Chief Economist for Raymond James Financial Services, indicated that the majority of the financial markets had been expecting to see a “remain” vote; hence, the resulting vote to “leave” was a major shock. The key economic concern related to Brexit is uncertainty.
What isn’t uncertain, however, is that ahead of the vote, there were already signs that business investments were being restrained, residential and commercial real estate transactions were being delayed, and consumers were postponing big-ticket purchases. Additionally, Prime Minister David Cameron has since resigned, effective in October, at which time negotiations with the EU will begin, covering a multitude of aspects regarding the U.K.’s exit. This process is expected to take a minimum of two years due to specifics stated in Article 50 of the Lisbon Treaty which went into effect on December 1, 2009. The Lisbon Treaty is an international agreement which forms the constitutional basis of the European Union.
The controversy regarding the “Brexit” situation isn’t the only issue facing the people of the U.K. Shortly after the “leave” vote was acknowledged, First Minister of Scotland, Nicola Sturgeon, said that a second referendum granting Scottish independence was now “highly likely.” This comes as no real surprise considering that Scots voted by 62 percent to 38 percent to remain in the EU. Further complicating the matter is that there have been talks of other countries (France, the Netherlands, and Sweden) making a push to exit of the EU as well. Clearly, the U.K. economy will face a long period of uncertainty, which could negatively affect business investments on a global scale.
It isn’t uncommon for investors to overreact during selloffs, especially in times of uncertainty and unrest. Campbell Harvey, a finance professor at Duke University and expert on the European Union and the Euro, commented during the onset of the downturn that, "The markets are overreacting. The long process required before the U.K. can leave the EU will mean countries have time to renegotiate trade treaties.” Regardless of this, the vote to leave appears to be a call to reclaim national sovereignty, and it definitely adds uncertainty to an already fragile European economy. The vote also raises the potential for other member nations to consider their status in the EU.
However, the International Monetary Fund (IMF) earlier predicted that leaving the EU would cause a severe economic impact to the U.K. which may give other countries pause before they take a similar path.
Brexit and general weakness in the European economies has impacted world currencies. The American dollar has strengthened against the Euro and the British pound as investors moved to greater relative safety in American assets. In fact, the pound is trading at historic lows relative to the dollar. U.S. exports have become more expensive in the European region which will be a drag on the U.S. economy; and conversely, imports are cheaper for U.S. consumers. Goldman Sachs Chief European Economist, Huw Pill, estimates that “Brexit” will reduce GDP for the Eurozone by 0.2% to 1.5% in the second half of 2016 and that Britain will “flirt” with recession in 2017. However, the European Central Bank remains accommodative and European consumers and companies continue to benefit from lower energy prices.
James Paulsen, Ph.D., Chief Investment Strategist for Wells Capital Management, Inc. calls Brexit “a fairly wimpy crisis.” Dr. Paulsen stated that, “the Brexit crisis, at least from an economic standpoint, is far less serious than is suggested by the public rhetoric.” It is not expected that any economic damage in the U.K. will have much impact on the U.S. economy. Despite the concerns in Europe, the U.S. economy remains relatively healthy outside of the energy sector. The consensus estimates for Real GDP growth for 2016 and 2017 are steady but unremarkable: 2.00% and 2.30% respectively. Jan Hatzius, Chief Economist of Goldman Sachs Research, stated that, “The U.S. economy is more like a healthy tortoise than a sickly hare.” Any impact on the US economy from “Brexit” should be minimal as the U.K. accounts for less than 4% of U.S. exports and less that 3% of US imports. However, it will be important to monitor other members of the European Union and their potential for following the U.K.’s lead in the coming months. Also, it is important to note that there could very possibly be a second referendum on the U.K. leaving the European Union around the end of 2016 or the beginning of 2017. Volatility in global markets will likely remain elevated for a time. The “Brexit” vote makes it more unlikely that the US Federal Reserve will increase rates during the remainder of 2016 due to the added uncertainty. Also, the Fed’s preferred measure of inflation (the headline personal consumption deflator) remains below the target 2% rate which supports deferring a rate hike.
Employment numbers are another important economic indicator. The U.S. unemployment rate edged up in June by 0.2 percentage points, increasing to 4.9 % as labor force participation improved. Non-agriculturally related payroll employment was well-ahead of expectations for the period, adding an impressive 287,000 jobs. Of course this number is subject to future revision, but it helps to offset a very disappointing report of a revised 11,000 additional jobs for the previous month. Due to the volatile nature of the monthly reports, it is important to focus on longer-term averages. Economists surveyed by the Wall Street Journal earlier this year estimated that the US needs to add 145,000 jobs each month to be in line with workforce growth. Even with the strong June number, the average for the second quarter was 147,000 compared to 196,000 in the first quarter. Unemployment has declined over the past year in all industries except for mining (includes oil and gas) and manufacturing – durable goods. Industrial production was down (1.4%) year-over-year (through May). Laggard market groups included Materials (-2.7%) and Business Equipment (-1.4%). Construction led market groups, increasing 1.2% year-over-year.
Domestic equity markets were positive for the second quarter and year-to-date through June. The S&P 500 Index was up 2.5% for the quarter and 3.8% year-to-date. The Russell Midcap Index was up 3.2% and 5.5% for the same periods. The Russell 2000 Index (small cap stocks) was up 3.8% for the quarter and 2.2% year-to-date. Value stocks continued to outperform growth stocks in the quarter as investors extended their search for income and more reasonable valuations. International equity was mixed with developed markets declining (1.5%) and (4.4%) and emerging markets increasing 0.7% and 6.4% for the quarter and for the first six months respectively. The large-cap S&P 500 was led by income-producing Telecom and Utilities sectors and a rebounding Energy sector while laggards were Financials and Technology.
Domestic equity markets continue to look near fully valued based on 2016 earnings estimates but look more reasonable based on 2017 earnings estimates. The question is how reasonable are the estimates for 2017. A 14+% earnings growth rate will be required to achieve the current consensus estimate. With a 2% GDP backdrop it appears unlikely that this estimated level of growth will be attained even with implementation of greater efficiencies and ongoing share buyback programs. Estimates are continually being revised downward, however even if the actual growth rate is reduced by half it is still likely enough to provide support and allow the markets to move higher.