"Brexit... What Brexit?"

16 August 2016

Brexit… what Brexit?” was the question markets were asking in a July that saw strong rises, despite the UK’s vote to leave the European Union, Japanese stimulus that failed to stimulate growth and the revealing of weak US second-quarter economic growth.

The Federal Open Market Committee (FOMC) at its July meeting kept open the possibility of a further increase in rates in 2016 as it emphasised the recovery in the US labour market, which had been highlighted by the better-than-expected June non-farm jobs report. However, data then showed that US gross domestic product (GDP) grew at an annual rate of 1.2 per cent in the second quarter, well below consensus expectations of  2.6 per cent, and again indicating that the US Federal Reserve is likely to delay lifting US interest rates.

US revises first-quarter GDP

The weak annual growth rate was sheeted home to a large decline in business investment. In addition, the serial revisers at the Commerce Department downgraded first-quarter growth from the 1.1 per cent annual rate first reported to 0.8 per cent.

Balancing that out was data that US private consumption surged by 4.2 per cent in the second quarter, data which, given the importance of the American consumer to the global economy, was highly welcome to put it mildly. Eurozone economic confidence also improved in July – unexpectedly, as economists had predicted a decline. 

Bank of Japan disappoints, investors look to fiscal support 

Markets were disappointed late in the month by the Bank of Japan’s relatively modest expansion of its monetary easing program, with the Bank citing the Brexit vote as the biggest uncertainty facing world markets. The UK referendum result sparked a yen rally that threatens to crimp further corporate Japan’s bottom line, and increase mounting concerns about the Government’s apparent inability to spark growth.

While markets expected a much more substantial set of actions from the Bank of Japan, it made no changes to interest rates or to its bond-buying program, only lifting its purchase target of exchange-traded funds (ETFs) to ¥6 trillion (US$57 billion) annually from ¥3.3 trillion previously. Japanese business confidence has slumped to levels last seen when Japan’s Prime Minister Abe was elected, in late 2012, as the Government’s efforts to galvanise the world’s number three economy, dubbed ‘Abenomics’, seemingly falters. Late in July, after winning Upper House elections, Abe announced an ¥28 trillion (US$266 billion) fiscal package (5.5 per cent of GDP), but markets were not enamoured, perhaps cynical as to the extent to which that figure represents an actual real increase in spending. 

Sovereign bonds continue to plumb record low yields, with the 30-year US Treasuries reaching an historic low of 2.14 per cent in July. The 10-year US Treasury yield traded as low as 1.36 per cent in July, marking an all-time low. Government bond yields are negative in six European countries, as well as in Japan: one-third of the JP Morgan Global Government Bond Index, covering US$8.9 trillion of bonds, is on negative yields. 

Global interest rates are likely to remain lower for longer. In that context, investors have reason to look at equities, and the emerging pick-up in global economic growth backs that strategy, as does the fact that Japanese and European share valuations are at near-record low valuations. 

In the US, price/earnings (P/E) multiples appear on the historically high side, but not when adjusted for the record-low interest rates, which translate into cheap borrowing costs for US companies. However, further equity market gains would appear to need a significant improvement in earnings. Second-quarter earnings have been reasonably positive, particularly from the technology sector.

Tech gains lift US market

The post-Brexit surge saw the S&P 500 Index rack up its fifth straight month of gains, adding 3.6 per cent for July to a fresh record high. The Dow Jones Industrial Average gained 2.8 per cent, while the technology-heavy Nasdaq Composite Index surged 6.6 per cent, as Alphabet (parent of Google) and Amazon in particular rose after announcing strong second-quarter results.

European markets rallied toward the end of the month, driven by bank stocks, ahead of results of stress tests for European banks, due out after month end, and aided by a positive start to the second-quarter earnings season. Over the month, the German DAX Index rose by 6.8 per cent, the CAC 40 in Paris added 4.8 per cent, and the Euro STOXX 600 Index gained 3.6 per cent; in London, the FT-SE 100 Index climbed 3.4 per cent.

On the data front, Eurozone GDP rose 0.3 per cent on the quarter, (compared to a 0.6 per cent expansion in 2016's first quarter), while unemployment remained unchanged at 10.1 per cent in June.

In Asia, the Nikkei in Tokyo surged 6.4 per cent, recovering from its June sell-off, while the Shanghai Composite Index was up 5.3 per cent for the month, as the world’s second-largest economy reported that GDP grew at an annual rate of 6.7 per cent in the second quarter –slightly ahead of expectations. The widely-watched Caixin manufacturing PMI (purchasing managers’ index) posted a June reading of 48.6, down from May’s 49.2 and below the 50 mark that indicates growth: however, this was offset by a more positive result in the services sector, which continued to show expansion.

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