A Deep Breath
On Thursday, June 24th, 51.8% of British voters surprisingly chose to leave the European Union, setting off a wave of global equity selling as investors fled to the safe haven of high quality fixed income securities. As investors considered the future of both the UK/Europe relationship and the potential stability of the euro itself, uncertainty drove measures of equity investor sentiment to "overly bearish" levels.
The AAII index of bullish sentiment fell to 22.0% compared to 35.2% for bearish sentiment. Broader measures of sentiment such as the NDR Daily Sentiment index reached similar relative levels. Historically, extreme sentiment swings have been associated with timely buying opportunities as they often represent investor's overly reflexive response to economic uncertainty. Although the impact on UK trade, finance and Eurosceptic country loyalty is not fully known, my response is "let's take a deep breath."
Essentially, the British have determined that the estimated benefits of EU independence exceeds the estimated costs. Capitalism and democracy demonstrated in full force. After 240 years since America chose independence from them, Great Britain has determined that they should now negotiate a better economic future away from the bureaucratic slow-growth EU and more carefully control immigration.
While Brexit has an undetermined, yet direct impact on Great Britain, Europe and most importantly Germany - the EU's biggest beneficiary, the simultaneous decline in both U.S. stock prices and interest rates has accentuated the U.S. high dividend equity investing opportunity. Relative values are now extreme as the S&P 500 dividend yield of 2.21% is nearly 50% higher than the ten-year U.S. Treasury yield and the Barron's Stock-Bond Yield Gap has reached minus -0.65% or near the lowest level in our lifetime.
While I recognize that the S&P 500 trading range over the last 13 months since its record high on May 21 can be justified based on negative revenue and earnings over the past five quarters, I anticipate that revenues and earnings will regain their historic positive growth trajectory in the second half of 2016 and in 2017. Oil prices which provided a severely depressing contribution to S&P 500 composite earnings and revenues recently are now up significantly this year such that this sector is expected to begin to provide a more neutral contribution. Dollar strength has also modestly depressed growth. Taken together, we believe compelling relative value to interest rates and inflation and a resurgence in moderate earnings growth should support equity prices in the intermediate term.
The New Mediocre
My equity market bullishness aside, I have a more sanguine view of near-term economic growth. Recent U.S. economic indicators have been non-homogeneous. Through May, the three-month average of real personal consumption expenditures is up 2.9%, the best such growth rate since last September, which contrasts with durable goods which on a year-over-year basis are barely rising, up just 0.8% as core business equipment orders have declined for 18 straight months.
Other economic reports show first quarter real GDP revised up to 1.1% from the previous 0.8% estimate, industrial production falling 0.4% in May and declining 1.1% on a year-over-year basis with capacity utilization falling 0.4% to 74.9% or the second lowest level since October 2010. Taken together, the Atlanta Fed's GDPNow model is currently tracking 2.6% annual growth. Although this forecast exceeds the lackluster first quarter report, I can't help but classify future economic growth as "the new mediocre" - low enough to keep the Fed from tightening but not high enough to cause inflation.
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