Stocks decline on Brexit, global growth fears

In Wall Street, the only thing that’s hard to explain is next week. – Louis Rukeyser

Fears that the United Kingdom will vote on June 23^rd to leave the European Union caused stocks to tumble last week as all of the major stock averages finished more than 1% lower. Investors sought refuge in U.S. government securities and other fixed income investments as bonds rallied. The yield on the 10-year Treasury fell to 1.62%. Whether or not these anxieties are justified is open to debate, but it is clear that investors are worried about recent polls that show increasing momentum for exiting rather than staying. If these concerns weren’t enough, the Federal Reserve Open Market Committee (FOMC) decided to leave interest rates unchanged after reaching the conclusion that the economy has softened and job gains have diminished. In a unanimous decision, the FOMC maintained the fed funds rate between 0.25% and 0.50% and lowered its projection for full-year gross domestic product (GDP) growth to just 2% from 2.2%. Although inflation estimates were raised, they still remain below the Fed’s target of 2%. They also acknowledged that business fixed investment remains soft, contributing to weaker economic growth. As many as six Fed officials now believe that there will be only one interest rate hike this year, up from only one official as recently as March. While the Fed wants desperately to normalize monetary policy and begin to raise interest rates, it remains hamstrung by a soft U.S. economy and even lower bond yields overseas. Negative interest rates in Europe and Japan make the Fed’s task even more difficult as the yield on the German 10-year bond fell below zero for the first time ever. The odds of a rate hike in July have now fallen considerably and with the election in November, it appears that the Fed will probably wait until December provided the incoming economic data warrants such a move. In the meantime, all eyes will be on Great Britain this week. The market may have already priced in a leave vote and could even rally should the vote be to stay. Stay tuned.

Last Week

Retail sales in May rose 0.5%, better than expected, and followed a 1.3% gain in April, providing evidence that the economy is picking up in the second quarter. U.S. import prices for May rose 1.4%, the biggest increase in four years, as oil prices rebounded from multi-year lows. The May producer price index (PPI) was higher than expected but for the last 12 months, it has fallen 0.1%. The May consumer price index (CPI) was also slightly higher but for the last 12 months ended in May, it has risen only 1%. Other economic data included May industrial production, which fell slightly, and weekly jobless claims, which rose slightly but whose underlying trend is still consistent with a healthy labor market.

St. Louis Fed President James Bullard said that slow growth and a low fed funds rate will likely remain in place through 2018, implying only one more rate hike until then.

For the week, the Dow Jones Industrial Average lost 1.1% to close at 17,675 while the S&P 500 Index fell 1.2% to close at 2,071. The Nasdaq Composite Index declined 1.2% to close at 4,800.

This Week

It will be a slow week for economic data with May leading economic indicators, new home sales and durable goods orders all expected to be softer than the previous month. Federal Reserve Chair Janet Yellen will be in the spotlight again as she gives her semi-annual monetary policy report before the Senate Banking Committee and provides testimony before the House Financial Services Committee.

Among the more prominent companies scheduled to report earnings this week include CarMax, Adobe Systems, Carnival, FedEx, Winnebago, Bed Bath & Beyond and Accenture.

Portfolio Strategy

The moment of truth for investors will arrive on Thursday when the British people decide whether to remain in the European Union or secede from the EU and go it alone. Anxiety among investors has been running high as polls last week showed an increase in momentum for the leave camp and a virtual tossup, although the odds still favor Britain remaining in the European Union but only by the slimmest of margins. If the voters decide to exit, stocks would likely sell off while gold and bonds would rally as investors seek safe havens that these investments usually provide. If, on the other hand, voters cast their ballots to stay, equities would likely rise while bonds would decline in value and yields would increase. In anticipation of a yes vote, stocks have been weak recently with the S&P 500 ending the week at 2,071 after hitting 2,119 less than two weeks ago. This weakness could mean that the markets are reaching a point where a “stay” victory could translate into a bigger upside move in stocks than a “leave” result would generate on the downside. The big fear if Britain leaves is that other Eurozone countries could choose to exit, threatening the future of the single euro economy. But it has been estimated that negotiating the exit could take more than two years and the United Kingdom is not a big trade partner with the U.S. Whatever the outcome of the vote this week, it should have only a minimal effect on the U.S. economy and not be a major factor for the global economy. For this reason, investors would be wise to stay the course and not make any significant changes to the asset allocation in their portfolios.