2016 3rd Quarter Outlook

Review of 2nd Quarter In the 2nd Quarter, the U.S. stock market continued the modest growth of the 1st quarter, in spite of the fears caused by the Brexit impact over the last week. Overall, the S&P 500 increased by 2% for the quarter, and 4% for the year. International stocks were mixed, with developed market stocks declining by 1% for the quarter (again, mainly caused by Brexit) and 4% for the year, while emerging market stocks increased in value by 1% for the quarter and 6% for the year. Bonds performed well again, increasing in value by 2% for the quarter and 5% for the year.

U.S. Economy Below is a table showing key economic and market indicators (as of June 30)*:

* Sources: Bureau of Economic Analysis, Bureau of Labor Statistics, JP Morgan, Federal Reserve Board

The economic news is good in general. Unemployment is on a level that many economists (including the Fed) consider to be full employment, and while economic growth has been far from spectacular, it’s been steady over the past seven years. Inflation remains at a historically low level. And while interest rates are low, the fear that rates will rise dramatically seems to have subsided. And yet, stock market valuations, based on price-earnings levels, are near long-term historical averages.

Stock Market Outlook

Because of the current state of the economy and reasonable stock market valuations, we remain moderately favorable on the long-term prospects of equity investing. The volatility we saw in January seems to have subsided – outside of the irrational Brexit two-day panic (we provided a more in depth analysis of the Brexit overreaction on June 27), the U.S. market has been relatively steady. European stocks, understandably, have more uncertainty as a result of the Brexit vote, but even they are beginning to show more stability over the past week. A point that few analysts are making is, as of July 11, British stocks are up 3% from the day before the Brexit vote. Emerging markets stocks have done well thus far in 2016, and we expect continued recovery from the 2015 downturn.

A final word about Brexit. Over the long July 4 weekend, U.S. stocks fell by 1% (the only negative day over the past nine trading days). The reason, according to the majority of articles in the popular press, was the impact of Brexit. Yet, over that same time period, the British stock market fell by only 0.2% -- implying that the impact of Brexit was five times larger on U.S. stocks than U.K. stocks. Brexit effects have become a useful excuse to offer when reporters have no justification for market reactions. Be wary of journalists and analysts who overuse the “Brexplanation.”

One potential impact on the stock market we’ve not yet discussed is the presidential election – we’ve ignored it because past history suggests presidential politics have little impact on the market. We discussed this in detail four years ago, and, despite the hype, little has changed to cause us to change that belief. We’re in the process of preparing a specific commentary on the subject – look for it around July 26.

Bond Market

Longer-term interest rates have once again declined over the past three months, and most bond analysts we talk to have doubts about when and how much the Fed will increase interest rates. While this belief could cause investors to move to longer-term bonds, we still caution against such a move. For us, it’s a simple case of potential benefits versus potential costs. Going to longer terms can cause an increase in yield (ten-year bonds have a 0.4% higher yield than five-year bonds), but if interest rates rise, longer term bonds have far more downside risk.

Summary

This can be a frustrating time to be an investor. The occasional spikes in volatility can be unsettling, and returns of late have been relatively tepid. Our memory may be influenced by the exciting post-recession returns (18% per year between 2009 and 2013). But there is nothing wrong with a slow and steady market – the 4% return for the first six months of 2016 is in line with our long-term expectations, and if compounded for several years with little volatility, that return would significantly benefit all of our portfolios.

#QuarterlyOutlook