The U.S. Economy
The nonfarm payroll report released at the beginning of June showed that the economy created only a paltry 38,000 jobs in May, well below the 178,000 average for the first four months of the year. The unemployment rate fell to 4.7% from 5.0%, but only due to a significant drop in the size of the labor force. The labor participation rate declined to a five-month low of 62.6%. The growth of average hourly earnings increased 2.5% year-over-year in May, the same rate as in April.
Digging deeper into employment data reveals some positive signs for job growth, however. The chart below shows that the United States has reached the point where the number of individuals who perceive jobs as being plentiful is equal to the number who believes jobs are hard to come by. We regard this as evidence that the labor market should continue to strengthen. Also, the chart illustrates that the percentage of total job separations that are voluntary ("Quits" as highlighted below) has been steadily increasing. This indicates that workers are feeling confident enough about their prospects in the labor market to quit their jobs.
The trend of upward revisions to U.S. gross domestic product (GDP) continued in June, as the third estimate of first quarter real GDP came in at a seasonally-adjusted annual rate of 1.1% (the second estimate was 0.8% and the first was 0.5%). Nevertheless, this was still the weakest pace of growth in a year. More exports than previously estimated and higher spending on software and research and development were the main factors behind the upward revision. In thinking about growth for the second quarter, it is worth noting that the economy has gotten off to a slow start the past few years and then rebounded in the second and third quarters.
The U.S. Federal Reserve took no action on interest rates at its June meeting. In testimony before Congress during the month, Chair Janet Yellen cited concerns about weaker economic data - such as employment growth - having prompted the Fed to adopt a more cautious stance in terms of monetary policy. Yellen also mentioned that a vote by the United Kingdom (U.K.) to leave the European Union (EU) could negatively affect the U.S. economic outlook.
These statements align with other signals from the Fed that point to a more gradual hiking of interest rates than previously anticipated. With the Fed having revised down its growth outlook, market expectations of rate hikes have declined. Independent of activity by the Fed, monetary conditions already have tightened over the last three years via the end of the Fed's quantitative easing program in 2013 and a stronger dollar.
On June 23, U.K. citizens voted to leave the EU. Now the country must decide when to begin negotiating a withdrawal accord and the terms of the U.K.'s relationship with the political-economic bloc. That process will not begin immediately, as Prime Minister David Cameron announced his resignation following the vote and left to his successor the decision about when to invoke Article 50 of the Lisbon Treaty, which would formally inform the EU of the U.K.'s intention to withdraw.
There will not be a new prime minister until at least September, so the next few months should be characterized by political uncertainty that likely will contribute to uncertainty in financial markets. Despite the result of the referendum, the ultimate decision to exit the EU resides with the members of parliament, so there is still a possibility that nothing changes in the end and Britain remains part of the EU. There also is a chance of a new election this year given turmoil in both the Conservative (the current government) and Labour parties.
From an investment perspective, there are various implications to consider. Looking at the longer term, we do not believe it is a foregone conclusion that the U.K. would be any worse off by leaving the EU. The country could actually benefit from less regulation and the ability to negotiate its own, potentially more favorable, trade deals. In the short term, we expect U.K. equity markets and the British pound to experience bouts of volatility, as the decision to leave the EU opens up significant uncertainty regarding the U.K.'s future political environment and trade policies. This means that the currency could see a selloff that continues for a while. Although a cheaper pound would benefit the U.K.'s international companies, the situation could lead to a de-facto tightening of the U.K. economy if the country's borrowing costs do in fact climb.
To counter any impact of financial conditions tightening, the Bank of England has already made £250 billion of liquidity available to the financial system, and could provide more monetary easing if conditions warrant. Nevertheless, business confidence, foreign and domestic investment, and ultimately economic growth in the U.K. could be adversely affected in the near term.
Britain's exiting the EU also could lead to spillover effects into the euro currency and euro-denominated assets, as investors might begin to price in more uncertainty in regard to European political unity. The vote to leave might increase the attention euro-skeptic political parties receive from their populations and from market participants.
It is worth noting that while U.K. and European equity markets fell sharply in the few days following the Brexit vote, they quickly bounced back to close out the month. Reasonably, there was a lot of attention given to this selloff and recovery, but not much notice was paid to the solid run-up in these markets in the days preceding the referendum. Select U.K. and European market indices actually finished the month higher than their mid-month lows.
Global equity markets generated negative absolute returns during June on both a local currency and U.S. dollar basis, while U.S. equity markets were essentially flat. Valuations in the broad U.S. stock market remain somewhat elevated, but we continue to see little evidence of excesses in the market or economy that would need to be unwound. In this environment, discernment and flexibility are critical.
Given the slow global growth environment, in portfolios geared toward investors that need capital growth, we are targeting investments in fundamentally strong businesses that are not heavily reliant upon macroeconomic growth to drive sales and earnings. More specifically, we see value in businesses that we believe have control of their destiny and are taking share in large established markets or are creating new markets on their own. The goal is to identify companies trading at attractive valuations relative to their growth potential.
For fixed income investors and investors with a shorter time horizon or current income needs, we still see value in the corporate bond sector, but remain mindful that we are further along in the economic cycle and valuations are not as compelling as they were previously. Regarding government debt, our portfolios have a sizeable allocation to Treasury Inflation-Protected Securities (TIPS).
We also recently increased intermediate-term nominal Treasury exposure in some portfolios to diversify sector allocation and yield curve positioning, but our short duration positioning has not materially changed. We believe a shorter duration remains in clients' best interests because investors are still not being paid to take on significantly higher levels of interest rate risk. In our view, short term and income-oriented investors should also explore equities that display stable fundamentals and are trading at attractive valuations. We believe companies that generate strong, stable cash flows and pay an attractive dividend could be compelling options for these types of investors in the current environment.
Source: FactSet. Analysis: Manning & Napier Advisors, LLC (Manning & Napier).