With weaker than expected jobs growth in May, the Federal Reserve’s (Fed) recent disappointing economic forecast, negative interest rates around the globe, and the Brexit, the list of worries for investors continues to pile up. The U.S. economic recovery will turn seven at the end of this month, but very few realize that or feel like it has helped them. In the face of all the bad news, the S&P 500 is still only 2.8% away from a new all-time high. So maybe things aren’t so bad?
This week we examine some of the biggest worries we have when it comes to the stock market and the economy, but we also list some reasons to be positive. The worries tend to dominate the headlines, and with the recent volatility, it is easy to get wrapped up into what could go wrong. The good news is that we see some reasons to think things could actually go right during the second half of this year.
Reasons to worry
#1 Brexit
Nearly every day for the past month, the countdown to the June 23, 2016, vote on whether the United Kingdom will remain in the European Union has been in focus. The vote is expected to be very close, with the polls showing odds of a “leave” vote increasing over the past few weeks. Although markets appear to be pricing in the U.K. staying in the EU, the weakness in the British pound and British equities could be saying this vote has the potential to surprise.
We discussed the implications of Brexit last week in the Weekly Market Commentary and are covering it again this week in our Weekly Economic Commentary, so we won’t dive much more into this subject here. Please see those commentaries for our immediate thoughts on Brexit (along with today’s blog); but the bottom line is, the implications of this vote will be felt globally, and potentially for many years.
#2 European Banks Continue to Sink
With the Brexit and negative rates taking hold, European banks are near multi-year lows, with many down 80% and some as much as 90% from their all-time highs [Figure 1]. In fact, one well-known German bank made new all-time lows last week. With German 10-year bund yields in negative territory, Japanese government bond yields negative through 15 years, and Swiss government bond yields negative through 30 years, European banks are bearing the brunt of lower rates.
The primary driver for this underperformance was their slow reaction to the 2008–09 financial crisis. Although some European banks were quick to recapitalize and shed unprofitable businesses, these banks were not. They are now suffering from a challenging market environment in which profit centers are under attack. Margins on commercial lending are being pinched by the negative interest rate policy. Proprietary trading is restricted. Capital requirements are limiting leverage and restraining profitability. Meanwhile, investment banking market share is shifting to the U.S. because EU regulators say these are high-risk areas and need further regulatory oversight. A race for a bigger share of the wealth management business is underway among European banks, but that shift likely makes margins dependent on market performance. Add in non-transparent financial statements, large derivative exposures, still significant leverage, and ongoing fines, and these banks have headwinds coming in from nearly every direction.
#3 Surging Yen
