Economic Commentary | Second Quarter 2016

The markets were mixed during the quarter, with domestic indices gaining ground while global markets sold off on the news of the Brexit vote. For the three months ending June 30th, the large cap S&P 500 index was up 2.46%, the mid/small cap Russell 2000 index gained 3.80%, and the international MSCI EAFE index declined by 1.45%.

The US economy continued to see slow, steady growth with the final reading for 1Q16 GDP coming in with a gain of 1.1%. Corporate earnings expectations had been set so low that they were relatively easy to beat: 72% of the companies in the S&P 500 index surpassed analysts’ expectations, while only 21% disappointed.

Oil prices rose steadily as global inventories of crude declined on supply disruptions from the Canadian wildfires and unrest in Nigeria. By the end of June, oil had rallied over 26% since March 1st closing the quarter at $48.33/barrel. This is a “goldilocks” level at which energy companies are incentivized to produce, but consumers and businesses benefit from relatively cheap oil prices. Manufacturing companies have been the largest beneficiaries in recent months, and we saw the ISM reading for the sector move back into expansion territory after four months of contraction.

The labor market began the quarter with a bang, as the March report ~ released in early April ~ capped the best two-year period for hiring since the late 1990s. The succeeding two reports were much weaker, giving investors pause since the labor market has been such a pillar of strength in recent years. The softer labor reports have pushed the Fed to defer raising rates yet again, an outcome that is disappointing to those of us who are eagerly anticipating a return to more normal yields.

We believe that the weaker May and June reports were an aberration in the longer-term trend of labor strength, as evidenced by persistently low levels of initial unemployment claims, which are more forward looking than the monthly payroll report. In fact, the unemployment claims figure released on June 24th hit a 42-year low. Wages also advanced significantly, rising 2.5% year-over-year as shown in the June report. We see higher household incomes and growing consumer confidence pointing to an economy that will continue to gain strength.

We had good news from Europe this quarter: despite the significant worries over the refugee crisis in Europe, the eurozone grew at an annualized rate of 2.4% during the first quarter, which was stronger than expected and lifted the eurozone economy to its highest level ever, surpassing its prior peak from the first quarter of 2008. Strength came particularly from France, Spain, and Germany, as the region’s consumer spending rebounded and unemployment fell to its lowest level in 5 years.

On June 23rd, voters in the UK had a momentous decision to make: whether to remain in the European Union or whether to leave (aka Brexit). While early polling suggested that voters were split roughly equally, in the days leading up to the referendum, it appeared that voters would elect to remain in the EU. The rest, as they say, is history as 52% of voters cast their ballots to leave the EU, leaving us all to ponder the consequences of Brexit.

A few more words about the UK referendum near the end of June: I happened to be in Scotland in the days before and after the vote, which was an incredibly exciting time to be there. Because we were cycling in the highlands, I had ample opportunity to meet many people in the rural areas to get their perspective, even stopping by a polling station on the day of the vote. What we have all read in the media in the aftermath of the vote was borne out by my experience: the more educated people that I encountered all thought it was crazy to contemplate a break from the EU while some of the less educated Scots in the villages were more apt to want to leave. When I spent some time after the vote in Edinburgh, almost everyone I encountered felt strongly that Scotland be permitted to remain a part of the EU. I had an opportunity to be in the Parliament on the day that Scotland’s First Minister, Nicola Sturgeon, made her case for why Scotland should not be dragged out of the EU unwillingly. When Scotland voted to stay in the UK less than two years ago, part of the resulting agreement was that the UK could not do anything that would hurt Scotland’s relationship with the EU without Scotland’s express approval. I was able to hear the overwhelming consensus that most members of parliament wished to remain a part of the EU, though there was clear disagreement on how best to proceed. Being in the UK at such a pivotal point to see history in the making was quite an opportunity for which I am grateful.

Given the economic implications as well as the broader social objectives, it is hard to see why so many people in the UK wished to leave the EU, though there were certainly many UK citizens that were not well educated about the issue. This vote to leave will certainly damage the UK’s financial wellbeing in both the short and long run. The UK will now need to negotiate trade agreements independent of the EU. With 40% of UK’s GDP dependent upon trade, there is much at risk. The uncertainty surrounding how the UK’s departure from the EU will play out in the coming months and years will weigh on investors for quite some time. Right after the vote, we saw a two-day selloff; however, investors have calmed since then and the markets have rebounded nicely.

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