Stocks soar as investors rethink Brexit vote

More money has been lost trying to anticipate and protect from corrections than actually in them. – Peter Lynch

Investors had second thoughts about the effects of the Brexit vote on global stock markets last week and decided that there won’t be any immediate consequences. All of the major U.S. stock averages rallied at least 3% and foreign markets also rebounded in a stunning reversal. After falling almost 6% in just two days following the decision by the United Kingdom to leave the European Union on June 23^rd, the S&P 500 Index ended the week only slightly lower than where it started before the vote was tabulated. While there may be longer-term implications for global stock markets, investors chose to put those aside and instead focus on current fundamentals and economic conditions, which are fairly positive. To be sure, the brunt of the fallout from the Brexit vote will be on Great Britain as S&P has already lowered their sovereign debt rating from AAA to AA. The likelihood of a recession has also increased in the United Kingdom but the fallout on both the U.S. economy and other global economies should be minimal. The timetable for the UK’s exit is also unclear. Scotland and Northern Ireland, which voted to remain in the EU, could block Brexit and postpone any potential exit until the second half of 2019. Even without this hurdle, it may take two years for Britain to completely cut ties with the European Union. Investors also chose to look at the potential positives from the Brexit vote. Almost immediately, there was speculation that there would be further monetary easing by the Bank of England and additional stimulus measures taken by the European Central Bank. The decision to leave the EU also probably puts the Federal Reserve on hold indefinitely for an interest rate hike, an event that has caused much anxiety for investors. The primary focus now for markets will be on incoming economic data and second quarter corporate earnings reports, which begin in about a week. Expectations for these earnings are low but S&P earnings growth is forecast to rebound in the second half of the year. Only time will tell if there is any effect on these earnings from weakness in Europe and the outcome of the Brexit vote.

Last Week

The strong rally in stocks last week could also be partly attributed to positive economic data. First quarter gross domestic product (GDP) was revised higher to 1.1% from 0.8% and there are signs that the economy has regained momentum as the Atlanta Federal Reserve estimated 2^nd quarter GDP at 2.6%. The Chicago purchasing managers index (PMI) for June was well-above its reading in May and signaled strong expansion. The ISM manufacturing index in June was also better than expected and the final Markit manufacturing PMI was at its highest level in three months. U.S. automobile sales were also on track for the best June in more than a decade and the consumer confidence index reached its highest level since October. Consumer spending rose in May after posting a big increase in April and should increase at a pace that is 2 to 3 times faster in the spring than during the first quarter. The Federal Reserve’s preferred inflation index, the personal consumption expenditures (PCE) index, increased slightly in May and has risen less than 1% in the 12 months ended in May. This reading provides yet another reason for the Fed to remain on hold with regard to interest rates.

The Federal Reserve’s stress test results for banks were released and 31 of 33 banks had their capital plans approved, allowing them to increase their dividends and repurchase their own stock. The two banks whose plans were rejected were U.S. arms of Deutsche Bank and Banco Santander.

For the week, the Dow Jones Industrial Average jumped 3% to close at 17,949 while the S&P 500 Index also climbed 3% to close at 2,102. The Nasdaq Composite Index soared 3.3% to close at 4,862.

This Week

In this holiday-shortened week due to Independence Day, the most important piece of economic data will be the June employment report on Friday, especially after the weak May report that saw only 38,000 new jobs. Expectations are for 180,000 new jobs to be created and for the unemployment rate to increase slightly to 4.8%. May factory orders are expected to decline slightly after posting a strong increase in orders the previous month.

Minutes from the last Federal Open Market Committee (FOMC) meeting will be released and New York Fed President William Dudley will offer his views on monetary policy and the economy.

Pepsico and Walgreen will headline a very sparse calendar this week for quarterly corporate earnings reports.

Portfolio Strategy

One of the consequences of the decision by the United Kingdom to leave the European Union has been the tremendous move in the yield of the 10-year Treasury, which ended the week at 1.45%. At one point last week, the yield on the 10-year fell to 1.38% and the yield on the 30-year Treasury bond plunged to an all-time low of just 2.18%. These huge downward moves in Treasury yields (bond yields move inversely to prices) resulted from panicky buying by investors seeking a safe haven due to uncertainty and fear of the unknown after the Brexit vote. They also occurred since U.S. bond yields are closely tied to global interest rates and there are trillions of dollars in negative yielding debt around the world. With negative yields in Japan and Europe and yields in the United Kingdom reaching new lows as their central bank talks of further easing, U.S. government securities and corporate bonds look downright attractive by comparison. Much of the buying has come from Europe and Asia as investors are not only seeking a safe haven with a flight to quality but also a better return on their investment.