Second-Quarter Market Update & Outlook

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  • The Brexit vote in late June 2016 created renewed concerns regarding global economic growth, but it’s expected to only have a modest impact on the U.S. economy.
  • Stocks drifted upward throughout most of the second quarter, until the Brexit vote sparked significant declines in late June. Despite this, U.S. stocks finished with gains, and international stocks were flat for the quarter.

  • Bonds produced better than expected results once again, as the 10-year Treasury note yield dropped from 1.79 percent to 1.48 percent during the quarter.
  • Volatility has been the most consistent 2016 investment theme, but portfolio diversification has been effective in weathering market turmoil and preserving capital.

Economic Environment

The top global economic news of the quarter was Britain’s decision to exit (Brexit) the European Union (EU) in a referendum held June 23, 2016. Despite the populace voting to leave, the withdrawal will take a minimum of two years, given the Lisbon Treaty’s provisions governing such action. The result will be an extended period of economic uncertainty for both Britain and Europe and reduced expectations for growth in the region. While Brexit is likely to have significant repercussions in Europe, the impact on the U.S. economy should be modest, since our direct trade with Britain is minimal.

Aside from these concerning headlines, the U.S. economy has proven resilient, continuing to exhibit slow but steady gains. The most recent estimate of first-quarter real gross domestic product (GDP) growth was adjusted upward from 0.8 percent to 1.1 percent. Second-quarter real growth is expected to be stronger—around 2.5 percent. This expectation is based on recent improvements in several economic measurements, including:

  • The Institute for Supply Management (ISM) Manufacturing Index rose to a 16-month high of 53.2 in June, indicating activity is expanding.
  • The ISM Services Sector Index remains solidly in expansion territory, indicating continued strength in this important area.
  • The unemployment rate stood at 4.9 percent in June, and payroll employment grew by a larger than expected 287,000 jobs, reversing the weak May reading.
  • May retail sales exceeded expectations, despite weak payroll growth during that month.
  • The University of Michigan Consumer Sentiment Index held at an elevated level of 94.3 in June, implying future strength in personal consumption.

Prior to the Brexit vote, consensus expectations were that the Federal Reserve (the Fed) would raise interest rates once or twice more this year. However, the Fed is now expected to be on hold indefinitely due to the uncertainty surrounding this decision and associated risks to the global economy. As a result, market interest rates have significantly declined, creating an appealing environment for borrowers. This represents a net benefit to the U.S. economy at the margin.

Stock Market

For most of the second quarter, U.S. and international stocks drifted upward. However, the market calm was broken on June 24, 2016, as Britain’s decision to exit the EU sent stocks into a downward spiral. On that day, foreign stocks declined more than 6 percent, while U.S. stocks were down 3 percent in reaction to the unexpected outcome.

Global markets followed through with additional selling on Monday, June 27, 2016, before stabilizing and staging an impressive rebound over the final three trading days of the month. When all was said and done, U.S. stocks posted gains for the quarter and international stocks finished just below even for the period. Here are the major equity index returns for the second quarter of 2016 and year-to-date (YTD):

second quarter index

While late June’s spike in volatility proved to be short-lived, more market turmoil may develop as the result of Britain’s decision. Leaving the EU is an unprecedented multiyear process. Uncertainty will exist for some time, and news flow surrounding this topic likely will cause stocks to be erratic for a while, particularly in Europe. Due to this heightened uncertainty, the international stock allocation in our portfolio models was recently reduced by 10 percent.

One of the reasons stocks rebounded within a week of the post-Brexit drawdown was the conclusion that this event would keep the Fed from raising rates for the remainder of 2016. This change toward more monetary accommodation was interpreted as a positive for stocks. This particularly benefited U.S. and emerging market shares.

A key factor in determining market performance for the second half of 2016 will be the trend in corporate earnings growth. After several quarters of declining earnings (related to the slump in the energy sector), and with stock valuations at or slightly above their long-run average, increased profitability will be important to future market gains.

Bond Market

The Brexit turmoil also affected global debt markets, with government bond yields falling into negative territory in several developed market countries. The 10-year U.S. Treasury note yield fell as well, declining from 1.79 percent at the start of the quarter to 1.48 percent by the end of June 2016. This is near the record-low yield level for this instrument.

Since prices rise as yields fall, bonds posted another quarter of better than expected returns. The Barclays Aggregate Taxable Bond Index gained 2.21 percent for the quarter, while the Barclays Municipal Bond Index was up 2.61 percent on a total return basis. For the year, taxable bonds have gained more than 5 percent, while tax-free bonds have produced total returns above 4 percent.

Satellite bond categories also benefited from the decline in yields. The J.P. Morgan Emerging Market Bond Index returned 6 percent for the quarter and is up more than 12 percent for the year. High-yield bonds had a strong quarter, gaining 5.88 percent to take year-to-date returns above 9 percent. These riskier segments of the bond market have performed the best among all asset classes so far this year—but caution is warranted as these investments can be nearly as volatile as stocks in certain market environments.

Investment Outlook

The quick rebound in global markets after the initial Brexit sell-off acknowledges Britain’s exit from the EU will be a lengthy process. There may not be much change in the short run, but the intermediate and longer-term implications are more difficult to discern. While Brexit is likely to create an extended period of political, economic and market uncertainty in Europe, it also could represent a near-term positive for the U.S. economy, as interest rates are likely to stay lower for longer.

Investors weathered a 12-percent market correction to start the year and, more recently, a monumental and surprising geopolitical event. Markets have struggled to move higher. The U.S. stock market last hit a new high in May 2015, making this one of the longest market “corrections” in history. Stock indexes first reached current price levels in January 2015, nearly 18 months ago.

While such a protracted period of low returns can be frustrating, some positive signs are appearing. First, portfolio diversification is working. While recent developments had the potential to spur large losses, most balanced investors have experienced modest gains in the first half of 2016. Bonds, U.S. stocks and alternative investments all moved higher despite the turmoil.

Second, the markets and economy have been resilient, supported by several constructive underpinnings, including:

  • The U.S. consumer is healthy, and sentiment is strong.
  • Interest rates low and are likely to remain lower for longer, creating an accommodative environment for corporate and consumer borrowing.
  • Election year uncertainty will end soon. Sixteen of the last 18 election years have produced positive market results.
  • The oil rout appears to be over, which should help improve overall corporate earnings in the second half of the year.

While bonds have provided a better-than-expected contribution to total portfolio returns recently, the impact is likely to be less going forward. From 1991 to 2015, the 10-year Treasury bond yield averaged 4.7 percent. Recently, the yield was just 1.48 percent. While this interest rate environment is attractive for borrowers, it creates a challenging return environment for bond investors since initial yield accounts for the majority of the total return from bonds over time.

This is why alternative investments continue to warrant a place in portfolio design, despite poor 2015 results. These investments not only provide a hedge against stock market risk, but also offer an expected return higher than bonds. Alternative investments have delivered a much-needed diversification benefit in the down-market periods experienced so far in 2016 and also have contributed to portfolio gains in both absolute and relative terms.

Volatility has been the most persistent theme so far in 2016, and it’s likely to continue in the short run. Capital preservation is the investment priority in periods like this, and portfolio diversification has proven effective in meeting this objective.

Jeffrey A. Layman, CFA®
Chief Investment Officer

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BKD Wealth Advisors, LLC is an SEC registered investment adviser offering wealth management services for affluent families and investment consulting services for institutional clients and is a wholly owned subsidiary of BKD, LLP. The views are as of the date of this publication and are subject to change. Different types of investments involve varying risks, and it should not be assumed that future performance of any investment or investment strategy or any noninvestment-related content will equal historical performance level(s), be suitable for your individual situation or prove successful. A copy of BKD Wealth Advisors' current written disclosure statement is available upon request.

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