July 2016

The Fed and Brexit

A Look Back at the Quarter and Year

The second quarter of 2016 actually had some positive movement in the S&P 500. The quarter began at 2064 and ended at 2099, an increase of 35 points or, more importantly, of 1.7%.  Since the beginning of the year, when the S&P 500 was at 2044, we have had an overall gain of 2.69%. This is the first real movement we have had in over 15 months. As I have stated in the past, the stock market does not move in predictable ways. Although the results are less than stunning, they are part of a very important trend that we see continuing into July. On July 5, 2016 the interest rate on the 10-year Treasury dropped below 1.4% for the first time in the U.S.’s 240-year history! Because this benchmark guides many other interest rates it is a very important one. This change has already had an impact on lowering 30-year mortgage rates, widening the spread banks can keep on the difference between lending and borrowing rates (making them more profitable) and making other types of loans more available.

The Fed

As we began the second quarter of 2016, the Fed’s response to the economy was of concern. While the economy seemed to be limping along, the Fed appeared to be staying with their long-term strategy to increase interest rates, and new employment numbers were not looking particularly attractive. Then the Fed met in June, a week before Britain’s Brexit vote, and decided to leave interest rates alone, believing it would help stabilize the economy. As it turned out their decision was very fortuitous. Britain did vote to exit the EU leaving worldwide markets in turmoil.

Brexit

Although the vote was expected to be close, worldwide markets had predicted that Britain would remain in the EU, and had given little thought to the possibility that Britain might exit. Once the vote was announced it roiled the complacency of both the stock and bond markets worldwide. As happens after unexpected events, the stock market took a substantial downturn.

As we closed out the month of June, the impact in the U.S., was a strengthening dollar, interest rates going to new lows and the market recovering in a significant way. The U.S. was seen as the strongest place in the world to invest money.

In Britain, the pound dropped to dramatic lows, real estate plummeted and bond trading was suspended. The unions were appalled that their members had voted in favor of leaving the EU, since union leaders had been quite clear that this would not be in the best interest of the workers. Prime Minister, David Cameron, tendered his resignation. International companies began to look at buying British companies on the cheap. The older population had voted overwhelmingly to return Britain to its former glory, but could not articulate what this really meant.

The EU now has to decide how to deal with Britain’s exit and how to form a new alliance. They are in a particularly difficult position since the rest of the EU countries are tied together by one currency that Britain had chosen not to use. Without going into much detail at this point, countries such as Greece, Italy, Spain, and Portugal are all severely distressed economically. France too is not in the best economic shape.

Going Forward

The U.S. economy is in an unusual position in the world. While growth seems to be slow, it is sustainable. Employers are still hiring new workers. Wages are beginning to trend upwards, and consumers are spending. Manufacturers are suffering, however, as they have not been producing sufficiently to meet demand. This could result in an increase in capital spending. Companies have been buying back their own stock, resulting in higher stock prices. Interest rates are low and rents are rising. This is usually the scenario that brings about the development of new housing. While not robust, the outlook appears good.

Our strange environment favors borrowers over savers. If the 10-year Treasury is at 1.4% and inflation is at 1.9%, you actually have a negative interest rate of 0.5%. While this has happened in the past, it has happened when inflation spiked up, not when inflation was so low. This will likely mean that investors will need to take more risk in order to obtain yields. But what if interest rates begin to rise? That’s not so good either. Historically, when interest rates rise, the returns, after inflation, of both stocks and bonds are considerably lower.

Investing

What does all of this mean for investors? Clearly, the U.S. is in better shape than the rest of the world. To this end, an overweighting of U.S. stocks would seem like a good idea. Bonds in the U.S. appear to be very safe, even at these historically low rates. Therefore, investing in bonds seems to makes sense. With markets having been hurt in Europe, owning large international stocks (buy low, sell high) would seem like a good idea. International bonds have also done well, so owning them makes sense, too. In other words, remain diversified with investments.

REIT’s

S&P Dow Jones Indices and MSCI have indicated that a change in the way publicly traded companies are categorized will result in the creation of a separate real estate sector, bringing the number of Global Industry Classification Standard sectors to eleven. The real estate sector is “increasingly being incorporated separately into the strategic asset allocation”, global head of equity research at MSCI, Remy Briand, said in a statement. The GICS changes will likely be implemented after market close on August 31, 2016. For a number of years Secure Planning has considered traded real estate investment trusts (REIT’s) as a separate asset class from stocks, and has used them, for this reason, in some of the portfolios we manage. We think this change will be good for investors and REITs.

Conclusion

There continues to be a great deal in the world, and as investors we are far happier when things are calm and more predictable. Like it or not, we must continue to invest while monitoring what is taking place. While events like Brexit may impact investments for a certain period of time, the past year and a half has proven that diversification is our most important ally against all that ails the markets.

Ed Mallon

Posted Monday, July 18, 2016 at 2:00 PM