Second Quarter 2016 Comments

Despite a significant dip following Britain’s vote to exit the European Union (“Brexit”), the second quarter of 2016 saw healthy gains in most major asset classes, with the S&P 500 up 2.5%, the MSCI Emerging Market Index up 0.8%, and the US Aggregate Bond index up 2.2%.  The only major index with a loss was the MSCI Developed Market Index, down 1.5%.


Though it got off to a slow start, the second quarter presented a ride nearly as turbulent as that of the first quarter.  Based on an excessive buildup in inventories and continued weakness in the energy industry, and exacerbated by a relatively strong dollar and weak foreign markets, production of goods continued to slow and producer prices fell.  In turn, so too fell inflation expectations and yields on bonds.

In fact, reflecting global expectations of slow growth and continued disinflation (if not outright deflation), bond yields around the globe fell to their lowest levels in over 500 years.  Over $13 Trillion around the world is reportedly now invested in government bonds trading at negative interest rates, which is to say that large investors are willing to accept mild losses in safe, liquid investments for lack of any better opportunity.  These low interest rates combined with strength in the housing market and increasing employment to sustain advances in stocks.

At the same time, simmering discontent with slow economies and diminished opportunities reached something closer to a boil at home and abroad.  In America, this discontent on one hand translated into support for the anti-“establishment” Democratic Socialist Bernie Sanders, who has conceded to a left-of-center Democrat Hillary Clinton more calming to establishment sensibilities, and on the other hand to the more populist and less-than-calming Donald Trump, who is attacking global trade and security agreements heretofore thought by both parties to be pillars of modern peace and prosperity.

Across the Atlantic malcontented British, to the surprise both of observers and apparently even of themselves, voted to leave the European Union.   This vote was so unexpected to sanguine markets that it created the largest global two-day dollar loss in history before recovering to finish the quarter back in positive territory.

For us asset managers and our clients, suffering historic market drops but enjoying full recoveries twice in 6 months, we are reminded of Winston Churchill’s famous dictum: “Nothing in life is so exhilarating as to be shot at without result.”


Both the U.S. stock and bond markets are enjoying a good year, as the U.S. economy has seemed to be on sounder footing than other parts of the world.  More importantly, as central banks elsewhere have reduced interest rates, as their currencies have weakened, and especially as a result of the uncertainties introduced by Brexit, investors from around the world have been attracted to U.S. investments for our higher interest rates in fixed income compared to those offered abroad and for our stable earnings in high quality stocks, all in a currency more likely to appreciate than depreciate in the near term.

On top of foreign investment in U.S. assets, U.S. corporations too have been supporting these prices through purchases of their shares, drawing from cash or issuing debt at low interest in order to buy back an amount over the last year higher even than they had earned, on track to produce the first annual reduction in S&P 500 shares outstanding since 2011.

Reasons for concern going forward are well known.  Consumer spending is up, but as a result of increased consumer debt and decreased household savings rates.  Though home sales are powering forward under conditions of low interest rates, auto purchases are leveling off and entering decline, having been fueled by a ramp-up of debt under looser standards.  Automobile manufacturers are now discounting.  So too are restaurants, which seem to be suffering their own recession.  In fact, subtracting the consumer, Deutsche Bank has observed that there has been no economic growth anywhere else in the economy.  Orders for long-lasting factory goods are off sharply, reflecting underutilization of existing capacity, high levels of existing inventory, and weaker foreign currencies weighing upon exports.  If the consumer turns over, the economy could enter contraction with little Federal Reserve ability to stop it.

Meanwhile, Blackstone’s Larry Fink states that between the U.S., Japan, and China alone, there is $55 Trillion in cash sitting in bank deposits, presumably in the hands of people and institutions without the desire, the need, or the incentive to spend it.

With consumer incomes still under stress, business investment still unnecessary, and immense amounts of cash sitting on the sidelines with nowhere to go, the call for increasing government spending has become ever more widespread, even the Wall Street Journal from the right joining the New York Times from the left to acknowledge a consensus among economists that “fiscal stimulus is a better tool than monetary stimulus to combat the low growth and tepid inflation that has bedeviled economies in recent years.”  Donald Trump has proposed “to prime the pump” with an increase in infrastructure spending that would add about 1% to the nation’s growth in GDP, nearly twice that proposed by Hillary Clinton, and funded by increased debt, compared to the taxes and infrastructure bank that Hillary Clinton proposes.

These calls from both major party candidates are consistent with the argument of former Treasury Secretary Larry Summers for $1-2 Trillion of additional infrastructure spending over the next ten years.  Harvard’s Kenneth Rogoff, who with Carmen Reinhart has enjoyed at least some respect from the right since they penned This Time is Different in the wake of the financial crisis, is endorsing the concept of increased spending, provided that it is directed towards infrastructure and worker training, and he endorses as economically superior the Clinton approach of funding spending with increased taxes on the rich instead of Trump’s approach of tax cuts and increased debt.  A third option of finance exists, Benjamin Bernanke’s famous “helicopter” option, by which the Federal Reserve could buy U.S. Government bonds with infinite maturity at a zero percent interest rate, never to be paid back, thus effectively creating “free” money.


Whether by Republican or Democrat, it seems more and more likely that increased government spending is headed in our direction, which enhances the prospect of a new source of demand for the goods and services businesses have to offer.  There remains uncertainty both as to how that government spending would be financed (with different ramifications for interest rates and earnings), and as to whether and to what degree that spending would be reinforced by similar policies abroad.  In any case, while all risk must be acknowledged, undue confidence in bonds or pessimism in stocks seems unwarranted given the potential economic upsides associated with looming fiscal expansion.


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