Economic Backdrop

The second quarter’s most prominent event ― a surprise vote by U.K. citizens in favour of leaving the European Union (EU) ― took place with roughly a week left in June. Market volatility had increased markedly ahead of the referendum, but not by enough to compensate for the unexpected outcome, as polls and bookmakers, while split, generally projected a victory for the “Remain” campaign. A sharp spike in global stock-market volatility ensued, yields were driven downward (yields move inversely to prices) to record levels on perceived safe-haven investments like developed-market government bonds, and the currencies at the centre of the developments ― sterling and the euro ― weakened substantially relative to the U.S. dollar and Japanese yen. Much of the stock-market losses were recovered within a week’s time, however, suggesting the impending multi-year uncertainty may not be as detrimental to global health as initial reactions implied.

What about the preceding 12 weeks of the quarter? We stand by our characterisation of April as “2016’s least-eventful month.” Major central-bank policies were essentially on hold, a theme that carried over in large part to May. The European Central Bank commenced two stimulus measures in early June that been announced in March: corporate-bond purchases and targeted long-term repo operations (bank loans). Oil prices advanced for much of the quarter, then levelled off in June as the Organization of the Petroleum Exporting Countries failed again to agree on a production freeze, and the yen strengthened relatively steadily against most other major currencies.

U.K. construction activity contracted with some intensity during June, its first decline since early 2013. Services sector activity decelerated to its slowest level in more than three years, albeit still in growth territory. Manufacturing growth actually picked up to its strongest level in five months, continuing a trend that began during the first quarter and demonstrated marked improvement in April, representing a potential bright spot in contributing to overall second-quarter economic growth. Retail sales volume growth tapered in June, but not by as much as retailers had projected, after an exceptional retail sales report in April and follow-on strength in May. The unemployment rate was relatively steady, with claimant count joblessness increasing to 2.2% in April and remaining there in May, while the unemployment rate for the February-April period edged downward to 5.0%. A final reading of economic growth registered 0.4% for the first quarter and 2.0% year over year.

Eurozone services sector growth softened modestly in June, while an increase in manufacturing growth compensated, keeping the composite level mostly steady going back to February. Consumer confidence slid in June after a significant improvement in May, while industrial sentiment continued to improve. Retail sales gained 0.4% in May, extending a recovery from March’s decline and matching their highest level of 2016. Consumer prices crept higher by 0.1% in the year through June, an increase from May’s still-negative year-over-year figure. Producer prices jumped 0.6% in May, more than offsetting April’s decline, but still deeply negative year over year. Eurozone unemployment remained high in May, declining by 0.1% to 10.1%; however, a 1% drop from a year earlier demonstrates slow and steady improvement in the labour market. First quarter economic growth for the EU was revised upward, to 0.6% and 1.7% year over year.

U.S. manufacturing growth accelerated to healthier levels in June, with new orders a key source of strength. Consumer confidence advanced in June to its highest level since October 2015, as personal spending and incomes rose in May, by 0.4% and 0.2%, respectively. The latest Job Openings and Labor Turnover Survey showed that hiring did not keep pace with increasing job openings in May, while layoffs and quit rates also moved lower. Despite a positive revision, the U.S. economy grew at its weakest rate in a year during the first quarter. Labour productivity (the amount of goods and services employees produce per hour worked) dropped by 0.6% in the first quarter — yet year-over-year productivity advanced by 0.7% as output gained by more than hours worked, suggesting seasonality might have contributed to weakness.

Market Impact [1]

Fixed-income markets had a strong second quarter, with most market segments realising a considerable portion of their gains in June as investors sought out less risky investments immediately following the Brexit vote. U.S. high-yield bonds were the top performers during the quarter, followed by foreign-currency-denominated (external) emerging-market debt. Global sovereign securities delivered impressive performance, with June’s gains accounting for its entire second-quarter advance. Investment-grade U.S. corporate bonds also performed well during the quarter, followed by local-currency-denominated emerging-market debt, which was the best-performing segment in June. U.S. dollar-hedged (which seeks to reduce U.S. dollar-related volatility) global sovereign securities trailed their unhedged counterparts during the quarter, but still delivered strong returns, as did dollar-hedged global non-government debt. U.S. Treasurys performed well, owing their entire second-quarter advance to gains during June. Unhedged global non-government debt, U.S. Treasury Inflation-Protected Securities, and U.S. mortgage- and asset-backed securities performed in line with each other at the low end of quarterly returns, albeit with firmly positive performance.

Global equity markets, as reflected by the components of the MSCI AC World Index (Net), rose modestly during the second quarter, and were slightly negative in June. Global sectors were mostly positive, led with a sharp gain by energy, and followed at a distance by healthcare and utilities. Consumer staples, materials and telecommunications also had a good quarter, while industrials was modestly positive. Consumer discretionary had the deepest losses, while information technology and financials also declined. At the country level, Peru and Brazil led, continuing their red-hot performance from the first quarter. New Zealand and the Philippines followed with impressive performance, trailed by Indonesia, Russia and India. Unsurprisingly given the Brexit vote, Europe was heavily represented at the bottom; 16 of the 22 countries that registered a decline during the second quarter were European. Poland delivered the quarter’s worst performance, followed by Greece, Italy and Austria. Ireland, Turkey and Spain also performed poorly

Index Data (Second Quarter 2016)

• The MSCI AC World Index (Net), used to gauge global equity performance, rose by 0.99%.
• The Barclays Global Aggregate Index, which represents global bond markets, advanced by 2.89%.
• The Chicago Board Options Exchange Volatility Index, a measure of implied volatility in the S&P 500 Index that is also known as the “fear index”, increased in the quarter as a whole, moving from 13.95 to 15.63, peaking at 25.76 on 24 June (the day after the Brexit vote).
• WTI Cushing crude oil prices, a key indicator of movements in the oil market, moved from $38.34 a barrel at the end of March and briefly topped $50 for the first time this year before ending at $48.33 on the last day in June.
• The U.S. dollar strengthened sharply against sterling during the quarter, and moderately versus the euro, but weakened considerably relative to yen. The U.S. dollar ended June at $1.34 versus sterling, $1.11 against the euro, and at 102.6 yen.

SEI’s View

Angst is the one thing everyone seems to share in common across the world. The U.K.’s vote to leave the EU is a major political and economic event that will likely weigh on international financial markets, not just for weeks and months, but perhaps for years. The leap into the unknown will likely depress economic growth as business spending gets frozen until some clarity re-emerges on the country’s trading relationships. Sterling’s plunge immediately following the Leave vote, however, should provide a much-needed offset to the mostly negative impact of all the uncertainty, as U.K. exporters find themselves in a more competitive position.

Britain’s growth prospects were decent prior to Brexit; by contrast, continental Europe was already struggling to improve. Of the many economic imbalances that exist in the world, among the greatest is the huge trade surplus run by the eurozone. In the aftermath of the Leave vote, nationalist parties in various countries are lobbying for their own referendums on continued membership in the EU, which adds to the uncertainty facing investors.

The ability of the equity market to bounce back from the immediate shock is heartening, but it is hard to draw firm conclusions on how disruptive Brexit will be on future EU and eurozone economic activity. The fragility of the recovery going into this crisis is a matter of deep concern. The fact that bond yields did not bounce higher even as stock prices rallied post-Brexit is a divergence worth noting.

The U.S. remains, in our opinion, the cleanest shirt in the laundry bag, staying resilient despite numerous shocks over the past seven years. We would bet this resiliency will once again be on display following the U.K. vote. The May employment figure was the weakest since 2010, but it’s worth noting that other labour market data are not quite as downbeat. Job openings remain in a solid uptrend, rising well beyond the previous cycle’s peak reached in mid-2007. The first hints of wage pressure are coming through, with a moderate acceleration in wages and total labour compensation apparent on a year-over-year basis. As corporate margins get squeezed by the pick-up in labour costs, the pressure to raise prices will likely intensify.

This puts the Federal Reserve in something of a quandary, since the Brexit shock has seemingly upended any possibility of a near-term rise in the federal funds rate. Market-implied expectations for the next policy-rate move have been pushed out to late-2017; in fact, futures traders have priced in the mild possibility of a rate cut in the near term. Yet, we admit to a growing uneasiness that the central bank may be a falling behind the inflation curve.

We understand that the still-soggy global economy and the shock delivered by the U.K. vote argue for a very cautious process of interest-rate normalization. But if the upward trend in labour costs is sustained, a more aggressive response by the U.S. central bank eventually will be justified.

In the months immediately ahead, investors’ attention will be focused on the U.S. presidential election. Secretary of State Clinton starts out with a huge fundraising advantage and small poll leads in all the important swing-vote states. We want to make one simple point: markets hate the unknown. For good or ill, Secretary Clinton is the familiar, status quo candidate. Donald Trump, on the other hand, promises to shake things up. In a year where voter dissatisfaction is exceptionally strong in the U.S., we would not hazard a guess as to the outcome this early in the process. Investors need to be prepared for a bit of volatility in the months ahead, since the uncertainty level has been ratcheted upward, and will likely remain elevated between now and the elections. For now, we lean toward the optimistic side, mainly because U.S. economic and financial fundamentals appear relatively healthy.

One of the more surprising market responses to the U.K. Brexit vote is the sharp appreciation of the Japanese yen. This is the last thing that the country needs, since an ultra-strong currency exacerbates downward pressure on inflation. Corporate earnings have begun to roll over in response to the currency’s appreciation. As Japanese yields sink further into negative territory across the curve, we wonder what kind of rabbit the Bank of Japan can pull out of its hat, since the most recent interest rate moves have failed to weaken the currency or boost the economy.

Investor fears earlier this year of an imminent Chinese debt and currency meltdown have receded. China’s economy mostly appears to treading water, much like the rest of the world. The government continues to use the old and familiar economic playbook: encourage growth fuelled by additional debt, prop up state-owned enterprises and allow its currency to fall. Economic and financial reforms are proceeding, but at an erratic pace. Chinese equities have not shown much spark, however, despite the “risk-on” environment for emerging-market assets that began in late January.

Globally, the points of general consistency in our investment outlook and positioning are that the stability alpha source and momentum appear expensive within equities, and that our fixed-income managers generally favour credit at the expense of interest-rate duration.

Glossary of Financial Terms

• Alpha source: Alpha source is a term used by SEI as part of our internal classification system to categorise and evaluate investment managers in order to build diversified fund portfolios. An alpha source is the investment approach taken by an active investment manager in an effort to generate excess returns. Another way to define an alpha source is that it is the inefficiency that an active investment manager seeks to exploit in order to add value.
• Asset-backed securities: Asset-backed securities are a type of securitised debt that are backed by loans, leases or credit card debt, but not mortgages. Securitised debt consists of a portfolio of assets, such as mortgages or bank loans, which have been grouped together and repackaged as individual securities.
• Duration: Duration is a measure of risk in bond investing and indicates how price-sensitive a bond is to changes in interest rates. A long (overweight) duration stance indicates the portfolio duration is higher than that of the benchmark whereas a short (underweight) duration stance indicates a lower duration. Duration is measured in years and securities with longer durations are more sensitive to interest-rate changes.
• Federal funds rate: The Federal funds rate is the interest rate at which a depository institution lends immediately available funds (balances at the Federal Reserve) to another depository institution overnight in the U.S.
• Fundamentals: Fundamentals refers to data that can be used to assess a country or company's financial health such as amount of debt, level of profitability, cash-flow, inventory size etc.
• High-yield debt: High yield debt is rated below investment grade and is considered to be riskier.
• Mortgage-backed securities: Mortgage-backed securities are made up of multiple mortgages packaged together into single securities. These can be comprised of commercial or residential mortgages. Agency means that the debt is guaranteed by a government-sponsored entity, while non-agency means that it is not.
• Treasury Inflation-Protected Securities: Treasury Inflation-Protected Securities are U.S. Treasury securities issued at a fixed rate of interest but with principal adjusted every six months based on changes in the consumer price index.

Important Information:
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SEI sources data directly from Factset, Lipper, and BlackRock.

[1] 1 in USD, Global Bonds = Barclays Global Aggregate Bond Index, U.S. High Yield = BofA Merrill Lynch U.S. HY Master II Constrained, Global Sovereign Securities = Barclays Global Treasury Index, Global non-Government Debt = Barclays Global non-Treasury Index, Emerging Markets Debt (local currency) = JP Morgan GBI EM Global Diversified, Emerging Markets Debt (external currency) = J.P. Morgan EMBI Global Diversified, U.S. Mortgage-Backed Securities = Barclays U.S. Mortgage Backed Securities Index, Asset-Backed Securities = Barclays US Asset-Backed Security Index, U.S. TIPS = Barclays 1-10 Year U.S. TIPS Index, U.S. Investment-Grade Corporate = Barclays Investment Grade U.S. Corporate.