Joseph SchwSDWIA Bridgearz, CFA 612.355.4365

Stephen Dygos, CFP® 612.355.4364

Benjamin Wheeler, CFP® 612.355.4363

Paul Wilson 612.355.4366

www.sdwia.com

JULY 2016
Market Update
(all values as of 04.30.2020)

Stock Indices:

Dow Jones24,345
S&P 5002,912
Nasdaq8,889

Bond Sector Yields:

2 Yr Treasury0.20%
10 Yr Treasury0.64%
10 Yr Municipal1.44%
High Yield8.04%

YTD Market Returns:

Dow Jones-14.69%
S&P 500-9.85%
Nasdaq-0.93%
MSCI-EAFE-18.62%
MSCI-Europe-20.55%
MSCI-Pacific-15.39%
MSCI-Emg Mkt-17.02%
 
US Agg Bond4.96%
US Corp Bond1.42%
US Gov’t Bond5.64%

Commodity Prices:

Gold1,693
Silver15.08
Oil (WTI)19.58

Currencies:

Dollar / Euro1.08
Dollar / Pound1.24
Yen / Dollar106.57
Dollar / Canadian0.71
 

Macro Overview
The British vote to exit the EU was essentially a validation that a disintegration process of the EU is possibly underway, causing destabilization for countries throughout the EU. Britain’s vote may lead to other similar referendums, particularly with the Netherlands and France where populist sentiment is growing.

The British pound fell to a 30-year low versus the U.S. dollar following the outcome of the referendum. Conversely, the fall in value for the British pound can be beneficial for the country as Britain’s exports become cheaper worldwide and tourism increases as stronger foreign currencies come into the country.

The unraveling of Britain from the EU is not expected to be automatic or immediate and may take years for it to finalize. Britain would need to execute a divorce clause titled Article 50 of the EU agreement in order to move forward with the separation from the EU. Several member EU countries, including the IMF, are eager to have Britain expedite the exit in order to minimize uncertainty.

In the wake of the refeEU Mapflagrendum’s outcome, international equity markets tumbled as uncertainty led the course. U.S. financial markets were incredibly resilient following the days after the British EU vote, with U.S. equity and bond prices all propelling to higher levels.

The Fed’s plan to further increase rates this year took a different course as the repercussions from Britain’s EU vote are expected to lead to slowing economic growth and a sustained low interest rate environment. Some Fed watchers even believe that the Fed may ramp up its stimulus efforts again with lowering rates should the EU and Europe’s economy falter.

Overshadowed by the Brexit news, the U.S. Census Bureau reported data that may help solidify the Fed’s wait to raise rates. Durable goods orders fell 2.2% in May, worse than anticipated. Such data is an indicator of whether inflationary pressures are present and if inconsistent expansion exists in the economy due to less capital spending.

In the midst of the Brexit turmoil, the Federal Reserve announced that 33 selected U.S. banks passed an imposed stress test to see how well they’d perform under severe circumstances, such as high unemployment, recession, and falling asset prices. The stress test revealed that the 33 banks tested had nearly twice the amount of required capital needed, up significantly from the last stress test conducted.

Sources: Eurostat, Bloomberg, Federal Reserve, U.S. Census Bureau

 

 
Twenty eight countries represent the European Union, abiding by various rules and policies.

 

What Britain Leaving The EU Means
The EU (European Union) was established following the end of WW II in order to offer financial and structural stability for European countries. Since its establishment, the EU has grown to a membership of 28 countries, abiding by various rules and policies set forth by the EU Council.

One of the responsibilities of member EU countries is to accept and honor immigrants and citizens from other EU countries as part of the human rights initiatives recognized by the EU. Immigration has been a topic of contention among various EU countries for sometime. This was a decisive factor for Britain leaving the EU since its economy and cities have been inundated by foreign-born immigrants seeking jobs and a better quality of life.

The markets have reacted negatively to the announcement, pushing down stocks, the British pound, and bond yields as investors

brexit blue european union EU flag on broken wall and half great britain flag, vote for united kingdom exit concept

brexit blue european union EU flag on broken wall and half great britain flag, vote for united kingdom exit concept

seek the perceived stability of bonds as markets worldwide acclimate.

Since Britain has been part of the EU since 1973, it is expected that the unraveling of British ties from the EU could take years. Contracts, employees, and laws will all have to be revised, reshuffled, and rewritten in order to accommodate the divorce between the two.

Now that the British have decided on leaving the EU, many believe that another referendum could possibly be presented in France and other EU countries. The concern of a domino affect is very realistic, as several other EU members are experiencing similar frustrations as Britain.

Expected effects in the U.S. include: Prolonged low interest rates More assets flowing into the U.S. from abroad U.S. companies altering European contracts Stronger U.S. dollar versus the British pound and euro
Sources: EuroStat, EU Council, Europa.eu

 

Emerging Markets Excel – EM Update
Emerging market equity indices advanced towards the end of the second quarter, excelling past larger cap international counterparts. Companies within emerging economies reacted negatively to Britain’s vote to leave the EU as the question of what contracts and employment agreements may become null once the exit occurs.

A broadly used and recognized index of emerging countries, the MSCI Emerging Markets Index, declined to include Chinese stocks in its broad array of emerging market equities. The reason cited was the continued difficulty of getting money in and out of the country without limits, a prerequisite for inclusion into the index.

Sources: MSCI

 

 
Gov. bond yields turned negative throughout Europe and rates droped in the U.S. and Asia.

 

Equity Update – Domestic & Global Stock Markets
U.S. stocks fared better than international stocks following Britain’s announcement on leaving the EU. U.S. equity markets were resilient once the surprise of Brexit unfolded, with the S&P 500 Index and the Dow Jones Industrial Index both positive for the year.

Domestic equities are more insulated from global developments and any other major equity markets since American companies generate 70% of the revenues from the United States. Japanese companies generate 50% from within their economy only and European companies generating a mere 49% from Europe only.

U.S. equities are considered attractive relative to negative yielding government bonds in Asia and parts of Europe, even as the U.S. 10-year note finished below 1.5% in June. The S&P 500 index currently carries 60% of its stocks with a dividend yield higher than the 10-year treasury bond yield.

The primary British equity index, the FTSE 100, tumbled in June following the Brexit vote. Companies within the index generate about 75% of their revenues outside the U.K., with many maintaining contracts and arrangements with other companies based in other EU countries. Since the actual extraction of Britain from the EU may take years, decisions for capital spending and expansion by European companies may be hindered.

Certain equity sectors are becoming increasingly sensitive to what the presidential candidates are proposing. Concerns lie with those sectors where newly enacted regulatory policy can inhibit growth and profits. Other sectors are being adversely affected by low rates, such as banks whose earnings are hindered by low rates, which limits the amount of profits they can earn as deposits fall and loan rates drop.

The Department of Labor reported that average hourly earnings grew by 2.5% over the past year, thus placing pressure on corporate earnings as wages move up. Many analysts believe that wages will continue to increase as unemployment rates remain below 5%, enticing companies to keep performing workers and paying them more.

Sources: Department of Labor, S&P, Bloomberg

 

Federal Reserve Changes Its Tune – Monetary Policy
The events in Europe along with an IMF report released in June indicating that U.S. economic growth would fall short of expectations, prompted the Federal Reserve to subdue its pursuit of any additional rate increases this summer.

Britain’s vote on the EU exit sent U.S. government bond yields to new multi-year lows as well as dimmed trade growth prospects between Europe and the U.S. The dollar’s recent rise is also a headwind for the U.S. since a rise in the dollar’s value drags on U.S. exports and puts downward pressure on U.S. inflation, which is well below the Fed’s 2% target for inflation.

 

 
Gov. bond yields turned negative throughout Europe and rates droped in the U.S. and Asia.

 

Concurrently, the International Monetary Fund (IMF) report released in June suggested that the U.S. faces economic “headwinds” and “pernicious” trends including a shrinking middle class that could slow growth in the long term. Labor’s share of U.S. income is about 5% lower today than it was 15 years ago, while the middle class has shrunk to its smallest size in the past 30 years. Demographic changes are slowing potential growth and that in turn is affecting business investment and leading to a less dynamic labor force. The IMF is estimating that U.S. GDP will grow 2.2% this year, down from 2.4% in 2015.

Economists believe that both of these occurrences will foster an elongated low rate environment throughout the domestic and international fixed income markets.

Sources: IMF, Bloomberg, Federal Reserve

Bonds Worldwide React To Brexit – Global Fixed Income Update

As government bond yields turned negative throughout Europe, rates overseas in the U.S. and in Asia also dropped to new lows. The U.S. Treasury 10-year bond yield stood at 1.49% at the end of the June, a level not seen in a very long time. The concern with ultra-low yields as well as negative yields is when rates eventually do increase, the affect would have adverse consequences for bond prices. The surreal phenomenon of negative yielding government bonds is becoming more of a norm among global fixed income markets.

The U.K. was stripped of its AAA credit rating by Standard & Poor’s, lowering the rating to AA. Such a change may make it more difficult for the British government to issue inexpensive debt. S&P cited the downgrade due to increased risk because of a less predictable, stable, and effective policy framework in the U.K. S&P also noted that the U.K. has the highest financing needs among all of the 131 countries it follows and rates. The U.K. now has a worse rating from S&P than the U.S., whose rating was famously lowered by the credit-reporting firm in 2011, even after the downgrade was adamantly contested by the U.S. Treasury and government.

The S&P downgrade may lead to other rating companies to reconsider the U.K. in light of the EU referendum, resulting in possible economic and political repercussions. Moody’s lowered its outlook on the country to negative from stable in late June.

With the decline in yields around the developed markets, the flight to quality and safety of the U.S. Treasury market seems to be attracting global buyers even at lower yield levels. U.S. fixed income markets solidly outperformed U.S. equity markets as of the end of the second quarter, with corporate, municipal, and government fixed income sectors all advancing. An oddity as it is, bonds kept pace with rising commodity prices from gold to oil, whereas bonds tend to lose value as commodity values increase.

Sources: Moody’s, S&P, US Treasury, Federal Reserve