Key Points
• The Brexit vote will have some negative long-term economic and market effects, but the U.S. economy should remain relatively solid.
• Corporate earnings are the key for equities, and we expect modest improvements over the second half of 2016.
• Returns are likely to stay low, but equities should outperform bonds.
Brexit Worries Will Remain in Focus
A couple of weeks after the U.K.’s Brexit vote, financial markets have calmed but investors are still faced with a great deal of uncertainty. The good news is that the economies in the U.S. and much of Europe were mildly accelerating before the referendum. We expect the U.S. will continue on a slow-growth path. Consumer spending in the U.S. should benefit from still-strong employment, rising wages, a firming housing market and pent-up demand in the form of savings.
European equities, not surprisingly, are likely to be the most adversely affected by Brexit, but growth-oriented markets such as emerging markets and Japan will also suffer comparatively, as global growth expectations weaken and deflation fears continue to increase.
The political implications of Brexit are arguably more important than the economic effects. Brexit raises questions about the EU model of economic unity. The political influence of populist leaders has been rising throughout the world in recent years, and we believe the possibility of a broader move toward nationalist, isolationist and protectionist policies would be a negative for global economic growth and risk assets, including equities. This trend bears watching.
Economic Growth Signals Are Mixed
U.S. Treasury yields plummeted following the Brexit vote and have since moved into new record low territory. Normally, low yields are a sign that the economy is weakening (if not heading into recession) and/or that the country is facing deflation concerns. But the underlying economic fundamentals do not appear to match what yield levels are telling us.
The Federal Reserve Bank of Atlanta is estimating second quarter real gross domestic product growth will be 2.4% and the Federal Reserve Bank of New York’s Recession Model is forecasting only an 8% chance of a U.S. recession over the next year. These forecasts appear wildly inconsistent with a 10-year Treasury yielding less than 1.4%. So which signal is correct? In our view, low Treasury yields should not be mistaken for a signal that the U.S. economy is in serious trouble.
At present, global forces are the main driver of U.S. rates, and risks are rising for a clash between international forces pushing yields lower and domestic signs of inflation pushing yields higher. Core inflation rose to an annual rate of 2.2% in May, the seventh consecutive month at a level of 2% or more.1
The U.S. economy is likely to be held back by weaker overseas growth (primarily through declining trade), but the U.S. economy should remain relatively solid. We expect GDP growth to average around 2% in the second half of the year, which would be consistent with the slow pace since the end of the Great Recession.