Nola Kulig
Kulig Financial Advisors
Longmeadow, MA, 01116 USA
413-565-2839
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2016 Q2 Market Review: Brexit Creates Market Uncertainty

July 13th, 2016

This is our second quarterly review of the markets for 2016. As you know, we do not believe in making forecasts, but we comment on cross currents influencing the markets. As usual, our goal is to look at recent market results, put them in perspective, and see how that experience should set our expectations going forward.

We look at the following topics:

  • 2016 Q2 Markets Review
    • Summary of Returns
    • A European Political Earthquake that’s felt at Home
  • What Does all This Mean?
  • Conclusion

2016 Q2 and Year-do-Date Market Review

Summary of Returns

Volatility continued into the second quarter after a tumultuous start to the year. How quickly investor focus has changed from China’s slowdown to Brexit, the UK’s decision to withdraw from the European Union. Consensus thinking that the Fed would hike interest hikes also shifted to perceptions of “lower for longer” given uncertainties abroad. Commodities came roaring back, and along with them, the junk bond market, which had sunk in the first quarter, since many energy companies had borrowed high yield debt.

Barron’s put it well, when it said “A perusal of returns for the first half shows an investment world turned upside down. Investors have been turning to stocks for income, while bonds have been the biggest source of capital gains.”

Overall, investors made a flight to quality in uncertain times, which boosted high quality bonds, US stocks and gold as safe havens. Given perceptions of a more relaxed Federal Reserve policy, income securities of all types did very well. Some additional observations are from the table of returns, which follows:

  • Despite volatility surrounding Brexit, US stocks ground out gains for June, the second quarter and the year.
  • US midcap and small cap companies have had the advantage for the quarter and the year-to-date.
  • Non-US stocks have continued to trail US stocks given concerns with Brexit.
  • Emerging markets solidified gains last quarter, and they now have lead for the year-to-date. Part of this is due to the rebound in commodity prices.
  • Bonds of all types turned in strong results not only for the quarter, but for the year-to-date. Long-term Treasury securities, which are not shown in our table, were particularly strong, gaining 15.1% for the first six months, as measured by the Barclays Aggregate Government Treasury Long Index.
  • Real estate investment trusts (REITs) have turned in rather astounding returns this year, continuing on strength late last year.
  • Master limited partnerships have had a terrific rebound after a terrible year in 2015 and a tough start to 2016. They benefitted from both a rebound in energy prices and investors’ continuing hunt for income.
  • Commodities in general had another solid quarter, solidifying their gains for the year-to-date.
  • Gold had another terrific quarter, leading to a large gain for the year-to-date.
Market Returns
Market Index June Q2 2016 2016 YTD
Stocks        
Large Cap S&P 500 Index 0.3% 2.5% 3.8%
Midcap S&P Midcap 0.4 4.0 7.9
Small Cap S&P Small Cap 0.6 3.5 6.2
Non-US Developed Markets MSCI EAFE -3.4 -1.5 -4.4
Emerging Markets MSCI Emerging Mkts. 4.0 0.7 6.4
US Bonds Barclays US Aggregate 1.8 2.2 5.3
REITs S&P US REIT 7.0 6.6 13.3
MLPs Alerian MLP 5.1 19.7 14.7
Gold Dow Jones-UBS Gold Sub index Total Return 8.5 6.8 24.3
Commodities Dow Jones-UBS Commodity Index TR 4.0 13.5 14.2

Sources: AJO Partners, Factset, Dow Jones Indexes

A European Political Earthquake that’s felt at Home

On June 23, the UK voted in a nonbinding referendum to exit the 28-nation economic and political bloc called the European Union. Though “Brexit” was chosen by a narrow margin, the people had spoken.

Given that it is a nonbinding referendum, British lawmakers could ignore the results. While there has been some talk that a UK exit will never happen, at this juncture, it doesn’t seem likely the referendum will be ignored.

Nonetheless, a victory by the “Leave” camp wasn’t supposed to happen. While the vote was expected to be close, pollsters, analysts, and even the bookies who took bets all projected “Remain” would squeak through with a win. In advance of the vote, stocks rallied in anticipation “Leave” would go down to defeat. With hindsight, the markets were complacent.

Recall from our past posts that markets dislike uncertainty. More accurately, short-term traders dislike added uncertainty and are much quicker to hit the sell button than longer term investors, who are more tolerant of disappointments.

Why might this be viewed as heightened uncertainty? Well, we’re in uncharted waters. No nation has ever asked to leave the EU.

Could Brexit fuel other separatist movements and create additional economic uncertainty in Europe? Might we see the euro currency, which is shared by 19 nations, begin to unravel? How might this pressure an already fragile European banking system? And will the dollar begin to strengthen as global investors see the relative safety of the U.S. as a shelter from the stormy global environment?

While these are potential outcomes, we also see analysts asking what if Brexit doesn’t happen? Is it possible that the UK will not act on Article 50, which would be required to begin their exit process? As a result of the Brexit vote, will the EU become more willing to be less bureaucratic with its member countries, making it easier for the UK or other countries to stay?

As with many other macro events, there really is no way to predict how events may turn out.

What Does All This Mean?

Immediately following Brexit, we wrote that we did not recommend making changes to portfolios in reaction to the UK vote for many reasons; many analysts pointed out that the economic impact in the US could be relatively small, even if it was a much bigger deal for UK citizens.

Indeed, in the volatility following Brexit, clients of ours benefited from holding high quality bonds as a bulwark against stock volatility. You may also recall that we sent some capital market history showing that stocks tend to rebound following large jolts such as Brexit created. So far, that is how it has played out. We think this continues to validate having a well diversified portfolio and resisting the temptation to trade based on short term events.

In addition, many of the themes that have kept stocks near highs continued to play out over the quarter that just ended. On the plus side, U.S. economic growth appears to have accelerated in Q2 and interest rates remain low. While Brexit may muddy the picture, earnings are forecast to begin rising again in Q3 (Thomson Reuters).

Meanwhile, the increase in oil prices has not only reduced the strong headwinds in the troubled energy sector, but it has reversed the surge in yields among junk bonds. Still, a fill-up at the gas station remains quite reasonable, helping US consumers.

Conclusion

As we noted in previous quarterly market reviews, we expect volatility to continue as markets sort things out. Not only do we have shifting perceptions of Federal Reserve policy and the state of the EU to sort out, but we are also in a presidential election year. We would reiterate to make sure you are at your recommended risk level and asset allocation for your portfolio. If you are, then all is well, and you can focus your attention elsewhere. If not, please make adjustments so that you are. And last but not least, if you are not sure, please call and let’s see where you need to be.

I hope you’ve found this review to be educational and helpful. If you have any questions or would like to discuss any matters, please feel free to give me a call.

Thank you very much for your trust and confidence.

Investment advisor representative of an investment advisory services offered through Garrett Investment Advisors, LLC, a fee-only SEC registered investment advisor. Tel: (910) FEE-ONLY. Kulig Financial Advisors may offer investment advisory services in the state of Massachusetts and other jurisdictions where exempted.