EQM Capital LLC – Quarterly Market Commentary for 2Q 2016 – When Money and Politics Collide

Posted on Jul 7, 2016

Politics and money puzzle pieces representing the corruption of wealth in elections

Market Recap for 2Q 2016

Despite the dramatic sell-off that occurred after the unexpected vote by Britain to exit the European Union, U.S. markets staged an impressive rally at month-end, climbing back into positive territory for the quarter. Small caps stock led the way with the largest gains for second quarter as the Russell 2000 Index advanced 3.8%. Large cap stocks also gained during the quarter with the S&P 500 Index up 2.5%. Only the tech-heavy NASDAQ lost 0.2%. It still trails significantly for the year, down 2.7% YTD through June.

Although the market experienced a post-Brexit rally by month end, growing political risk, both abroad and at home still weighs heavily on the financial markets. Slowing expectation for economic growth, Fed action uncertainty, and the headwind of a strong U.S. dollar remains a concern. According to FactSet, analysts are expecting a 5.2% decline in corporate earnings in the second quarter.

Developed international markets fared far worse than U.S. markets in the second quarter. The MSCI EAFE Index declined 2.6%. Emerging Markets performed slightly better with the MSCI Emerging Markets Index declining only 0.3%.

Thanks to the prolonged global environment of low interest rates, the bond market and other income-producing assets continue to perform well. The Barclays Aggregate Bond Index rose 2.2% for the quarter. Dividend paying stocks like REITs and Utilities have also outperformed as investors continue to be willing to “pay-up” for income. Commodity assets such as precious metals have also risen as a hedge for many deflating currencies, ending their 5-year streak of declines.

Domestic Economy Plugs Along …

News about the domestic economy was mostly positive during the quarter, with strong housing and consumer data offsetting a worrying decline in job creation. First quarter gross domestic product (GDP) growth was also revised upward to 1.1%. Although the May jobs report disappointed, consumer confidence increased to its highest level since last October and personal spending continued to increase.

Housing was also a boost to the economy during the quarter. Existing home sales exceeded initial estimates and a 2.4% YOY increase in pending home sales also indicated continued growth in the housing sector, helped by low mortgage interest rates.

 … While the International Outlook Remains Murky

Negative global headlines remained an overhang in Q2, with the unexpected Brexit vote in particular disrupting equity markets at the end of quarter. Although the referendum result creates many future uncertainties for Europe, the long-term impact on the U.S. economy will likely be minimal. In Asia, China’s growth continues to disappoint. To counter the slowdown, China has been devaluing the yuan, leaving the currency at its lowest level relative to the U.S. dollar since December 2010. And in Japan, the efficacy of Abenomics has come under more and more scrutiny.

The Rise of Political Risk

The recent Brexit vote was not only a lesson in the power of the people, but also in the rise of political risk as an important factor impacting the financial markets. Whereas previously the central banks were “running the show”, politics and fiscal policy are gaining greater prominence. Some of the lessons learned from the Brexit vote are as follows:

  • Political outcomes are much more difficult for markets to predict. People can and will act counter to their economic self-interest if it supports their other agendas. This is one of the economic risks of direct democracy.
  • Globalization and localization are loggerheads. People are conflicted about the impact of globalization and its threat to their local and national identities.
  • Central banks are running out of ammunition. After resorting to negative interest rates to stimulate the weak economy, central banks are running out of tools. Fiscal policy and initiatives could fill this void, but that requires political action and leadership.
  • Slow growth has exacerbated the wealth gap and seeded discontent. The tepid economic recovery experienced post the Financial Crisis has failed to lift all boats. Many workers have been displaced and “left behind”, creating anger and dissatisfaction with the political establishment and status quo.
  • Investors who did not panic were rewarded. Calmer heads prevailed and investors who stayed their ground and did not panic in the face of Brexit uncertainty were handsomely rewarded.

Despite the fact that financial markets have rallied and shrugged off the Brexit vote, there are many uncertainties that remain that could impact markets and spur heightened volatility going forward. But we continue to believe that investors should remain focused on their long-term goals and not allow their investment plans to be disrupted or derailed by external forces.

So continue to “Stay calm, and carry on.”

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