“History has demonstrated time and again the inherent resilience and recuperative powers of the American economy.” — Ben Bernanke
Second Quarter Highlights
The U. S. equity market rose during the second quarter and managed to shrug off near term effects of Brexit, while most international indices struggled. The economy was a big support to stocks, which bounced back after another weak first quarter. Housing continued its recovery, and employment and consumer spending advanced, albeit in an irregular manner. China and oil prices continued to stabilize after a very weak start to the year.
Bond prices continued to rise, with negative interest rates pulling down yields in the U.S. and countries with relatively higher rates. Additionally, the Federal Reserve seemed to acknowledge the “new normal” in its June meeting, when it revised significantly lower forecasts of GDP growth, inflation and the Federal Funds rate for the next few years. The U. S. dollar has continued to trade within a range which has persisted since early last year, adding to further clarity on the part of investors.
Brexit so far
The longer term impact of Brexit is still unknown, though some details are becoming clearer. Fortunately, the transition of power in the U. K. was quick and relatively uneventful. The new Prime Minister, Theresa May, has stated that the will of the people must be respected and will proceed with an orderly withdrawal from the European Union (E. U.).
As far as the U.S. is concerned, initial earnings reports from money center banks indicate that the Brexit problem is manageable, though British and European companies will be impacted more. Of greater concern is whether Brexit causes other E. U. members to leave. Right wing populists, particularly in France and Austria, have seized the opportunity to say that their countries should also leave. Unfortunately, the latest terrorist tragedy in Nice will also inflame anti-immigration advocates.
As we stated in our special Brexit report last month, any further departures from the E. U. would be greatly complicated because the remaining countries all use the Euro as their currency, a fact that kept Greece from leaving. The current situation does, however, put Germany, the chief E. U. member, in a quandary. Can it afford major concessions to other E. U. members to induce them to stay, or will the cost of further diluted economic growth eventually outweigh the benefits?
Yen headaches and a proposed remedy
As the negative interest rate policy instituted earlier this year backfired, Japan has struggled with the rising yen putting pressure on Japanese exports. The most recent elections, however, has strengthened Prime Minister Abe’s hand and a vigorous policy response is likely. Earlier this week, former Fed Chairman Bernanke travelled to Tokyo to discuss policy options with Japanese government officials. One option (originally conceptualized by economist Milton Friedman) concerns “helicopter money”, either a direct or indirect form of currency printing. The end result is that money ends up in the hands of consumers, who could then freely spend it without having to repay it. With all other policies falling short, this controversial proposal could be the remedy to stoke Japanese inflation, weaken the yen, and thus boost the economy. In Japan’s case, it is important that the consumers see the advantage of the non-taxable money and thus be more willing to spend it. Overall, the concept of helicopter money is gaining traction and has been predicted by such financial luminaries as Ray Dalio of Bridgewater Associates, Jeff Gundlach of DoubleLine Capital and Bill Gross of Janus to be eventually implemented by governments to increase inflation and economic activity.
Looking ahead
The Rice Partnership’s investment outlook continues to focus on the American economy, which is likely to maintain its average growth pace between 2.0-2.2%.
- U. S. equities should do well, especially those with limited European exposure. In particular, small and midcap stocks should perform, as they have done since the February lows.
- Earnings headwinds such as oil and China are fading.
- Bonds may be overbought at this point. Much of the recent rally in yields was due to a convergence in global yields and not because of a significant slowdown in the U. S. economy. This global yield convergence has its limits, however, as volatility caused by exchange rates begins to outweigh the returns from this strategy. Also, negative interest rate policies may be frozen or abandoned if investors begin to hold cash instead of paying interest to borrowers.