A relatively subdued quarter ended on a volatile note following the UK’s late-June vote to exit the European Union (EU). The UK’s decision to leave the EU, referred to in the media as Brexit, dominated the quarter. A record $2 trillion of global stock losses piled up in its wake as UK-EU trade relations and the possible contagion effects sent equity markets reeling.

Although equity markets rallied in the final trading days of the month, broad-based international indices lost ground during the quarter, with Financials suffering the largest losses. U.S. equity markets, a relative safe haven to the uncertainty in Europe, regained nearly all of their post-Brexit losses and the S&P 500 Index advanced a respectable 2.5% in the second quarter. Emerging market equities produced a gain of 0.7%  as commodity prices continued to stabilize.

The Fed left rates unchanged during the quarter citing slowing job growth and economic uncertainty globally. On the fixed-income side, a flight to safety sent the yield on the 10-year Treasury Bond down to 1.49% from 1.78% to start the quarter while high-yield bonds rallied in response to continued signs of stability across the energy complex. The U.S. dollar moved higher during the quarter and the British pound fell to a 31 year low.

The market narrative took an abrupt turn in late June following the unexpected decision by British (UK) voters to exit the European Union. The S&P 500 Index, a broad measure of the U.S. equity market, advanced for the thirteenth time in fourteen quarters. Reported earnings for the 1st quarter exceeded analyst expectations for 72% of the companies in the S&P 500 Index.

Small cap stocks outperformed large companies as investors were encouraged by the undercurrent of a strong domestic consumer. Eight out of the ten underlying sectors within the S&P 500 Index posted gains for the quarter with value oriented segments besting their growth brethren. Dividend-payers were preferred once again amid the volatility, as the Utilities and Telecommunications sectors were among the top performers. Energy was the best performer, up 11.6% during the quarter, as oil prices continued to push higher.

Non-U.S. developed market equities, as measured by the MSCI EAFE Index, decreased 1.5% in the second quarter. Euro area markets led the decline with major indices in France and Germany falling 4.3% and 5.6%, respectively, during the quarter. Downward earnings pressure is expected in both the United Kingdom and Europe, driven by lower growth and investment associated with the uncertainty surrounding the Brexit referendum, which sidelined activity this spring.

The global divergence of monetary policies between U.S. and international markets continues to drive market volatility and currency movements. The U.S. is facing the prospect of the Federal Reserve raising rates relatively soon while central banks across the globe are leaning toward additional easing measures.

Emerging market returns, as measured by the MSCI Emerging Markets Index, advanced 0.7% during the quarter and 4.0% in June. Positive performance was driven largely by the rebound in commodity prices led by gains in the export-reliant markets of Russia and Brazil. Asia trailed the benchmark once again due to flat results in China, up 0.1%, as the country continues to transition away from an investment-based economy to one that is consumer-driven.

Citing global economic instability, the Fed held rates during the quarter. The Barclays U.S. Universal Bond Index, a broad measure of U.S. fixed income markets, advanced 2.5% as a flight to safety and a change to the trajectory of Fed rate hike expectations sent the yield on the 10 year Treasury down to 1.49% from 1.78% this year. High-yield bonds produced the highest returns with a 5.5% advance during the quarter.

Better economic data coupled with a rebound across the energy market pushed investors back into the high-yield bond segment. Concerns over future defaults among energy and materials companies remain, but investors are beginning to believe that current yields compensate them for this risk.

The global bond market, as measured by the Barclays Global Aggregate Index, advanced 2.9% for the quarter as interest rates moved decidedly lower across the world. The yield on Germany’s 10-year government bond, Europe’s benchmark security, fell below 0% for the first time on record during the period. Investors’ seemingly insatiable demand for safe-haven assets created another bond-market milestone.

The nation joined Japan and Switzerland in having negative 10-year bond yields. There is now $13 trillion of negative-yielding debt globally. More than 70% of the bonds in developed-market government bond indexes today have yields of 1% or lower. Falling yields are dragging down expected returns across the capital markets. The plunge in yields, which has been driven by European Central Bank’s policy of negative interest rates and asset purchases, has accelerated amid a weakening global economic outlook and the Brexit vote.

Over the last year, investors have faced declining U.S. corporate earnings, stagnant global economic growth, falling oil prices, a rising U.S. dollar, negative interest rates in several countries, slowing growth in China, and Britain’s vote to exit the European Union. Is it any
wonder that stock indices have made little if any upward progress during the last year?

The S&P 500 Index has had two declines of over 10% in the last twelve months but quickly recovered both times. Despite the negative headlines, global economic growth has remained positive and is expected to continue at a modest clip in the coming quarters.

U.S. equities are trading above their long-term average valuation, developed market equities are trading near their long-term average, and emerging market equities are trading at a notable discount to their long-term average. As has been the case for several quarters, low interest rates rather than strong global consumption have supported modest economic growth.

However, global growth expectations have been ratcheted down, and U.S. corporate earnings growth has been non-existent for the last year. Economic growth in the developed markets has failed to improve notably despite central banks’ stimulus efforts and record low borrowing costs. Stocks have languished for more than a year as global growth has failed to improve and boost corporate earnings. Investors’ appetite for riskier assets has waned and money has continued to move into safer bonds and defensive equity sectors.

However, with interest rates at historic lows and arguably stretched valuations in the defensive sectors, any improvement in the economic outlook could provide a boost to stocks as investors search for higher returns.

Central banks and governments around the globe are actively trying to jumpstart economic growth. The ramifications include negative interest rates in many countries and significant currency movements. Wild currency swings and central bank and government intervention could have a significant impact on regional stock performance in the coming quarters.

Emerging market equities are attractively priced, but offer higher volatility and tend to struggle more when fear increases. Aggressive easing in Japan and Europe could lead to increased borrowing and spending as the costs of leverage are insignificant.

There are many forces at work in the global market that could lead to an increase in economic growth, but at this time it’s difficult to tell when and if the measures will have a positive impact. A diversified global approach is warranted as every region has some form of stimulus in place and it’s unlikely they will all generate the desired result of faster economic growth.

Interest rates around the globe continue to move lower. At quarter-end, over 70% of sovereign bonds were offering yields of less than 1.0%. Bond yields in Europe, Japan, and the U.S. are at or near all-time lows as a combination of accommodative central banks and economic uncertainty has helped push yields lower.

Although yields could still fall, it’s unlikely they will move much lower unless inflation drops from already low levels. Bond prices reflect a slim chance that Federal Reserve will raise rates in 2016. Bond returns have been strong this year, but, with yields at historic lows, it’s unlikely returns will remain attractive in the coming quarters. The risk and return profile of bonds creates a difficult dilemma for investors looking for a combination of safety and income.

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