Second Quarter 2016 Review & Outlook

“Kites rise highest against the wind, not with it.” – Winston Churchill

Q2 Review

According to the Wall Street Journal, there were in excess of $11.7 trillion dollars of government bonds trading at negative yields as of June 29, 2016. This represents a financial distortion that challenges conventional analysis. It is noteworthy that so far all of these bonds were issued by countries in Europe and Asia. United States fixed-income markets have not yet produced any negative yields. There were few, if any, economists who saw this coming at the beginning of 2016.

An investor who purchases these negative yielding bonds and holds them to maturity would be better off stuffing their money in a mattress. The prevalence of negative yielding government debt was building up even before the United Kingdom voted to leave the European Union on June 23, 2016. However, the “Brexit” result contributed to the quarter-end record level as investors sought the safety of sovereign debt.

Negative yields are a clear sign of the difficulty central banks around the world are having in boosting their economies. Growth for many of these economies is minimal, if they have any growth at all. Inflation levels remain low and central banks continue to purchase large amounts of debt.

The benchmark US Ten Year Treasury note set an all-time closing low on July 5, 2016, below 1.4%. United States Treasury rates at all-time lows would normally signal an economic recession. This time it appears to be a result of the negative-yield phenomenon in Europe and Asia causing money to flow to the United States. Foreign investors are attracted to the safety of the US with modest yields, well above negative yields elsewhere. This flow of funds into the US has pressured interest rates down and effectively prevented the Federal Reserve from its stated course of normalizing interest rates.

Most forecasts at the beginning of the year were for the Federal Reserve to raise our Federal Funds Rate on four different occasions in 2016. This forecast decreased to two or three early in 2016 as a result of dramatically lower energy prices and the sharp decline in the stock market. Following the surprise Brexit vote, the expectations for any interest rate hikes this year have diminished. As we stated in our First Quarter 2016 Review & Outlook, “We maintain the opinion that it will be difficult for the Federal Reserve to move rates higher by any significant measure given the propensity of other central banks continuing and/or expanding stimulative monetary policy.” We still maintain this opinion.

Concern about the slowing growth of China’s economy in late 2015/early 2016 now seems like a somewhat distant memory. The economy of the United States has continued to muddle along. Gross Domestic Product (“GDP”) increased by a mere 0.8% annual rate in the first quarter. Still, most economists forecast that the US economy likely grew approximately 2% annualized during the second quarter. Forecasts for economic growth have been slightly reduced as a result of the fallout from Brexit. S&P Global now expects US real GDP to show an increase of 2.0% for 2016 and 2.4% in 2017.

Average monthly job growth for the year trended down through May. However, the slowing trend was countered by the strong June employment report with an increase of 287,000 jobs. Although June was the largest monthly increase this year, some of this improvement was likely attributable to the rehiring of the striking Verizon workers. A slowing rate of job growth would normally be expected at this stage of the economic cycle. On a more positive note, wages are now seeing their strongest growth rates since the recovery began in 2009.

As communicated in our email blast on June 25, 2016, our immediate reaction to the UK’s referendum in favor of leaving the EU was that it was largely a political event. We expected world markets would likely overreact to the news, but cooler heads would eventually prevail. Initially the market did sharply decline, but markets recovered much faster than we expected. In particular, the US stock market showed resilience with the S&P 500 and Dow Jones Industrial Average moving up to close at all-time highs by mid-July.


Our view is that lower interest rates will most likely persist for the foreseeable future. We recognize a meaningful pick-up in economic activity and/or inflation could result in an increase in interest rates, particularly on longer maturity fixed income investments. Therefore, we maintain a cautious approach by purchasing short and intermediate term fixed-income investments.

Given our current economic outlook, we remain cautiously optimistic with respect to equities. Market valuations are elevated from a historical standpoint, but some level of premium is warranted given the low interest rate landscape. For equity investors, we maintain our preference for solid dividend paying investments.


Marietta Wealth Management, LLC