Quarterly Market Review
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Second Quarter 2016
Brexit Rocked the Global Markets’ Status Quo
For most of the quarter, the status quo reigned. Global economic growth remained sluggish, corporate earnings growth was generally disappointing, oil prices continued to recover, and inflation was still muted. Central banks in Europe, Japan, and China continued their accommodative policies, while the Federal Reserve (the Fed) kept investors guessing as to the timing of its next move. Then came the surprising Brexit vote of June 23, which revealed United Kingdom (U.K.) voters’ desire to exit the European Union (EU). Stock prices and bond yields plunged on fears a U.K. departure would trigger a global recession and threaten the future of the EU. After a two-day sell-off that erased more than $3 trillion of global stock market value, cooler heads ultimately prevailed. Investors adopted a longer-term view of Brexit and its effect on global growth and financial markets, concluding that there’s a long exit road ahead, and the impact may not be as dire as originally thought. Meanwhile, Brexit uncertainty led to expectations for continued slow growth and central bank accommodations—a favorable backdrop for U.S. and global bonds.
Global growth concerns and Brexit-inspired uncertainty weighed on U.S. and non-U.S. equities. Bolstered by robust gains in May and a late-quarter rally, U.S. stocks advanced for the quarter. But developed markets elsewhere generally declined during the quarter (when priced in the U.S. dollar, which generally advanced versus developed-market currencies, with the notable exception of the yen). Meanwhile, emerging markets finished the quarter in positive territory.
As familiar themes of weak global growth, low inflation, and continued central bank accommodation continued, fixed-income returns climbed higher. U.S. Treasury yields declined but remained relatively more attractive than government bond yields elsewhere.
U.S. Stocks: Market Overcame Several Stumbling Blocks
U.S. stocks continued to face a range of headwinds—from weak economic growth in export markets, to disappointing corporate earnings, to the surprising decision by U.K. voters to leave the EU. Despite periodic weakness triggered by these obstacles, including a dramatic two-day sell-off following the Brexit vote, the U.S. stock market (S&P 500® Index) forged ahead, ending June with its third-consecutive quarterly gain.
The period began on a relatively subdued note. The broad U.S. stock market posted its second-consecutive monthly gain in April, but the advance was modest as investors responded to mixed economic news, including a fourth-consecutive quarterly decline in corporate earnings. Economic growth remained slow, but that dark cloud had a silver lining—the Fed held short-term rates steady and hinted that interest rates would stay lower for longer. This helped shore up corporate earnings outlooks, push oil prices higher, and keep stocks in the black.
The headwinds prevailed into May, but stocks continued to advance, posting their strongest monthly gain for the quarter (+1.80%). Global growth remained bleak, the April payrolls report fell short of estimates, and the minutes from the Fed’s April policy meeting indicated the central bank was considering a summer rate hike. Yet, housing and other data released in May suggested the U.S. economy was recovering from its first-quarter slump. Additionally, oil prices continued to rebound, which boosted energy stocks and helped promote a more optimistic tone.
Sentiment changed in June as uncertainty mounted. The May jobs report (released in early June) indicated another decline in job creation. The S&P 500 Index retreated from a seven-month high, and volatility increased ahead of the Brexit referendum. The surprising decision to exit the EU temporarily shook investors’ confidence, and stocks plunged swiftly and sharply. But optimism quickly returned, and U.S. stocks rallied in the quarter’s final days, recovering all of their Brexit-triggered losses and advancing 0.26% for the month.
Despite the quarter’s strong volatility, sector performance was mostly positive, led by the energy sector, which rallied on stronger oil prices. Eight of the S&P 500 Index’s 10 sectors advanced, and six of the positive-performing sectors outpaced the index average. Outperforming sectors included energy, up +11.62%; telecommunication services, up +7.06%; utilities, which gained +6.79%; health care, up +6.27%; consumer staples, which advanced +4.63%; and materials, which advanced +3.71%. The information technology sector was the quarter’s main laggard (-2.84%), weighed down by sluggishness in the smartphone industry.
In terms of capitalization and style, small-cap stocks generally outperformed large- and mid-cap stocks, while value stocks maintained an edge over growth stocks across the capitalization spectrum. Mid-cap value stocks (Russell Midcap Value Index) were top performers for the quarter, up +4.77%, while large-cap growth stocks (Russell 2000 Growth Index) were the weakest, gaining +0.61%.
Non-U.S. Stocks: Emerging Markets Stocks Weathered Brexit Storm the Best
The second quarter began with a continuation of the March rally. Ongoing central bank accommodation in Europe, Japan, and China—along with improving manufacturing and retail sales data in China and rising oil prices—helped maintain a generally positive tone despite ongoing concerns about weak global growth. But June proved to be the defining month of the quarter as global stock markets fell into a two-day tailspin after the Brexit decision. But just as quickly as stocks sold off, they rallied again. A three-day buying binge closed out the quarter and helped non-U.S. stock markets recover some of the previous days’ losses.
Prior to the Brexit vote taking center stage, the economic landscape remained in the spotlight. The news in Europe appeared to be improving, supported by ongoing aggressive stimulus from the European Central Bank (ECB). First-quarter gross domestic product (GDP) showed that eurozone growth accelerated, while corporate earnings generally trended positive on improving consumer spending. But in the U.K., growth slowed, and the Bank of England cut its economic forecast ahead of the referendum on EU membership. Against this backdrop, European stocks generally posted modest gains through the first two months of the quarter. The sharp sell-off triggered by the Brexit vote hit Europe and the U.K. the hardest and led to second-quarter losses (in U.S. dollars) for their broad stock markets. But the damage was not as severe as originally feared, thanks to the quarter-end market rally.
In Japan, first-quarter GDP growth exceeded expectations, and the nation reported better-than-expected factory output. But late in the second quarter, data showed that consumer prices and household spending declined. In addition, persistent strength in the yen continued to pressure exports and corporate earnings. Japan’s markets also felt the ripple effects of the U.K. referendum, but events within Japan helped limit the losses. For example, Japan’s prime minister said he would postpone a scheduled sales tax increase (from 8% to 10%) until 2019 and implement new stimulus packages to aid the nation’s struggling economy. Overall, stocks advanced modestly as the dollar’s sharp decline versus the yen boosted returns for U.S. investors.
Although emerging markets stocks were not completely immune to the post-Brexit-vote sell-off, they did fare relatively better than developed market stocks. They also performed better in the quarter-end rally largely due to the limited effect the Brexit decision likely will have on emerging market economies. Furthermore, the Brexit vote triggered additional delays in the Fed’s rate-normalization plans, which should allow emerging markets central banks to be more accommodative, lower interest rates, and promote lending. Emerging markets stocks advanced 4.00% in June, offsetting earlier losses and pushing the benchmark into positive territory for the quarter.
Global Bonds: Demand for Yield and Safety Characterized Unusual Quarter
Continuing a trend in place for several quarters, events outside the U.S. had a greater influence on the U.S. interest rates than domestic factors. Growth in the U.S. was moderate, but sluggish growth elsewhere was highly dependent on the aggressive stimulus programs of central banks, particularly in Europe and Japan, where ultra-low rates prevailed. In addition, questions about the actual state of China’s economy (versus the profile provided by China’s government), along with low inflation, weak commodity prices, a strong U.S. dollar, and geopolitical challenges, clouded the global backdrop. Furthermore, uncertainty leading up to the Brexit referendum—and, in particular, the surprising “leave” vote—triggered sharp volatility and added to the aura of uncertainty, which supported gains in the U.S. and global fixed-income markets.
In the U.S., the Fed continued to walk back its rate-hike intentions due to the global environment, Brexit uncertainty, and weak non-U.S. economic growth. Treasury yields declined, and the yield curve flattened. In an unusual twist, longer-maturity U.S. Treasuries and corporate bonds each benefited in this environment. Economic uncertainty, low inflation, and expected additional central bank easing in Europe, Japan, and China in the wake of Brexit drove down U.S. Treasury yields and increased demand for perceived “safe-haven” assets. In addition, government bond yields in Germany and Japan were negative, further boosting the attractiveness of the U.S. Treasury market, where yields remained significantly higher than in other markets. At the same time, investor demand for yield remained robust, pushing corporate credit spreads tighter and investment-grade and high-yield corporate bond returns higher. The continued rebound in oil prices also helped high-yield bonds outperform.
All major sectors of the taxable U.S. investment-grade bond market advanced during the quarter. Corporate bonds and long-maturity Treasuries outperformed the market, while short-maturity Treasuries, Treasury inflation-protected securities (TIPS), mortgage-backed securities (MBS), and agencies underperformed. Elsewhere, municipal bonds (munis) continued to advance, as the tax advantages, perceived safe-haven status of the asset class, and favorable supply/demand dynamics supported strong muni market gains.
Outside the U.S., European bond markets were among the best performers, led by the U.K., where the yield on 10-year government bonds touched a record low after the Brexit vote triggered expectations for additional monetary easing. On the Continent, core European markets outpaced peripheral markets. Australia was the leading performer in the Asia/Pacific region. The flight to quality helped government securities outperform non-government bonds in most regions of the world.
The U.S. dollar was mixed but generally stronger versus most major currencies, according to Bloomberg. For example, the dollar rallied by 9% versus the British pound and 3% versus both the euro and the Australian dollar. The notable exception was the Japanese yen, against which the dollar declined 9%.
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Source: Bloomberg Index Services Ltd