THE SUMMER LETTER
God dug the bloody Channel for us, why do we keep trying to fill it in?”
– an old Royal Marines veteran to Neal Ascherson
Brexit
And thus the Little Englanders won the Brexit vote to Leave the EU. Though “What is the EU?” was the most Googled question in Britain the morning after. In retrospect, how could British Prime Minister David Cameron have been so stupid as to put the post-World War II European project at risk via a referendum? All major British parties failed to appreciate the magnitude of the potential protest vote behind a Leave plebiscite. False promises and demagoguery marked the Leave campaign. And Remain advocates failed to articulate a positive reason to stay.
The Brexit vote compounded the problems behind a lack of growth in S & P 500 corporate earnings over the past two years. The vote result spooked investors globally. With the British pound plunging and the US dollar rising, previous forecasts of a rebound in US corporate earnings have been called into question.
A stronger dollar is negatively impacting the earnings results of U S based multinationals. The slowing of China’s economic growth pace will dampen commodities’ prices for all global customers and assist our economy. While observed price increases abound in the supermarket, true price inflation requires wage rates to rise. At last, wage rates rose 2.5% in the past twelve months. Employer job listings continue to post multi-year highs. The job market is opening up. And while many discouraged workers remain, the unemployment rate fell below 5%. Though the labor force participation rate for middle aged workers remains stubbornly high.
Just as Europe was poised to escape the sovereign debt crisis, the prospect of a Brexit emerged. Brexit is one of a series of event shocks roiling the stock market this year.
Market Thoughts
Recent comments by Federal Reserve Chair Janet Yellen reconfirmed its data dependence in determining the future course of interest rates. This may present challenges for the stock market in the second half of the year. Stock price valuation continues extended but not excessive. So far every stock market dip elicits buying. Though market volatility, especially in response to British turbulence, has ratcheted upward.
Corporate profitability remains high thanks, amongst other things to the low cost of borrowing and wage growth restraint. There has been a massive increase in corporate profit margins through 2014. Strong profit margins provide substantive support for stocks. However, the quality of earnings in the banking sector, through the reversal of loan loss reserves, leaves a great deal to be desired. And now the banks are paying substantial fines for past misdeeds.
Historically, the energy, financial and health care sectors have outperformed during Presidential election years. In an effort to navigate the difficult market waters we have re-emphasized more defensive sectors: consumer products (Church & Dwight, Nestle); pharmaceuticals and medical equipment firms (Pfizer, Johnson & Johnson, Bristol-Myers Squibb); media and entertainment (Disney, Liberty Media); financial services (Allied World Assurance, and White Mountains) and as inflation hedges, energy (Royal Dutch Shell, Matador Resources and ONEOK Inc.) and timber (Weyerhaeuser). Some technology stocks (nVidia and Google) appear attractive.
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Stephen K. Bache, CFA
Sources: Bloomberg Business Week, The Economist, New York Times, The Wall Street Journal, Charles Duhigg, Smarter, Faster, Better, (New York, 2016)
