Market Data for the quarter ended June 30, 2016:

• S&P 500 Stock Index:  2099, up 1.9%
• Ten-year Treasury Note Yield:  1.49%, down 0.30%
• Gold:  $1,325 per ounce, up 7.5%
• Oil:  $48 per barrel, up 26.3%

Stocks ended the second quarter of 2016 with a modest increase.  The stock market rallied over the course of the quarter as action by the US Federal Reserve to raise interest rates was once again pushed back farther into the future because of recent weak US employment data.  The market suffered a setback late in the quarter, however, when the British people voted to leave the European Union (EU) by a margin of 52% to 48% in a popular, though technically non-binding, referendum (aka “Brexit”).  In addition to destabilizing world markets, the United Kingdom was thrown into a state of political disarray, with Conservative Party Prime Minister David Cameron submitting his resignation.  The leadership of the opposition Labor party has likewise been thrown into question.  Scotland, whose people voted decisively to remain in the EU, is threatening to leave the UK itself.  Although moderate in size, the UK has traditionally been a pillar of the global economy and world political order, and the current instability has the potential for wider political and economic disruption.  After a violent two day selloff of 5%, stocks regained their footing as worst case scenarios failed to materialize and cooler heads prevailed.

Brexit threatens the world economy on two counts.  First, the global economy was already in a fragile state, and the possibility of market turmoil can only serve to weaken it further.  In terms of the American economy and financial markets, global financial and economic disruption drives up the value of the US dollar, (the value of the British pound plunged to a thirty-one year low), which is widely considered by investors as a safe haven from global instability and economic weakness.  This makes American goods less competitive, thus weakening American production, and reduces the value of earnings American firms earned overseas.  Roughly half the value of sales by firms in the S&P 500 is generated in international markets.

Secondly, on a longer-term basis, a British withdrawal from the EU could be a harbinger for the unraveling of global trade and geopolitical cooperation in the West.  Throughout Western democracies, to include the United States, predominantly right-wing populist movements are on the march, threatening trade wars, a curtailment of immigration, and isolationism.  If realized, these policies would make the world poorer and less capable of dealing with global threats to political and economic stability.  The impact on firms would likely be depressed earnings and heightened uncertainty, making their shares less valuable.  Such a development is far from preordained, but the possibility is very real.  In the US, more specifically, Donald Trump becoming the presumptive Republican nominee represents a serious threat to America and the world.  If he were to be elected President, given his extreme rhetoric, volatile personality, and nearly incoherent policy positions, the stock market would likely decline significantly.  Although it currently seems unlikely that a President Trump will be the outcome of the election, the probability is not trivial.

On a more positive note, the volatility in markets in the aftermath of the Brexit vote has driven down long-term US interest rates and made it less likely the US Federal Reserve will increase its target rate in the near future.  We have previously named higher overnight interest rates as a major risk to the US economy and stock market.  Given modest growth and subdued inflation in the US and world economies, higher overnight interest rates are not appropriate.  They would only serve to weaken economic activity, depress employment, and lower investors’ estimates for corporate profits.  That having been said, the partial recovery of global stock markets to close the quarter does increase the threat posed by the Federal Reserve going forward.

In addition to Brexit and an overly aggressive Federal reserve, we have in previous letters listed the Chinese economy as a major risk to US stock markets.  While its growth has slowed, indebtedness in the Chinese economy has skyrocketed.  Such a combination is toxic and could lead to sharply lower Chinese growth, if not outright recession.  As China has been a major driver of global economic activity throughout the 21st century, Chinese weakness would reverberate around the world.  As detailed above regarding the causes and effects of a stronger US dollar, distress in China would likely lead to global economic instability and drive the dollar higher, thus suppressing US production and lowering the value of earnings by American firms generated overseas.  This is a threat we are monitoring closely.

For the remainder of 2016, we see the US stock market trading in a range of 1950 to 2200. It closed June 30 at 2099. The risks facing the market are not insignificant, but by no means assured.  In this uncertain environment, we will continue to execute our long-term strategy of purchasing high quality securities at attractive prices.  Thank you for the continued confidence you have shown in our management.  If you have any questions or concerns about your portfolio, please do not hesitate to contact us.