On the Road to Brexit

We’re on the road to Brexit.

The United Kingdom (U.K.) government notified the European Union (EU) in writing this week that the U.K. is ready to begin negotiating its exit from the EU.

Most people don’t realize this, but the U.K. economy has been doing well since the Brexit vote to leave the European Union. Remember that the initial reaction to the vote was that it would be a disaster for Britain, and asset prices declined. But they quickly reversed course.

The economy has also held up. In fact, the United Kingdom has one of the strongest economies in the world. The Bank of England reacted quickly to the vote and increased liquidity enough to offset the negative effects of the vote.

Unemployment is close to the levels in the United States, which means near historic lows. Growth is above the economy’s potential, and inflation is rising and near the Bank of England’s goals.

Yet, markets still are pricing in disaster. Real long-term interest rates haven’t changed much, while they have increased in the United States. That means markets believe inflation will remain low and perhaps decline along with economic growth. U.K. stock prices indicate that investors believe future earnings growth will be negative.

None of us knows what the final terms of the Brexit deal will be or how it will affect the U.K. economy. I suspect it has to have some negative effect. But so far, investors have been far more pessimistic than economic conditions warrant, and I think that’s still the case. That’s one reason why I’ve been recommending we hold more international stocks than U.S. stocks. Assets outside of the United States are underpriced and don’t reflect the potential good things that can happen.

The Data

The past week’s data continue a divergence that’s been in place since November. Sentiment surveys of both households and businesses indicate strong optimism. But that optimism still hasn’t translated into economic activity. The hard data continue the same modest growth of the last year or two.

Consumer Confidence, as measured by The Conference Board, was the big headline in the last week. The index surged to 125.6 from 116.1 (revised higher from an original 114.8). That’s the highest reading since December 2000. Most components of the survey were very positive, though consumers indicated they didn’t expect prices to increase much in the next 12 months.

Manufacturing appears to be continuing its recovery.

The Kansas City Fed Manufacturing Index was the weakest of the regional bank reports because of that region’s reliance on commodities, especially oil and gas fracking. But the index has been strong the last few months. In the latest month, it jumped to 20 from 14. That’s its best level since March 2011.

The Dallas Fed Manufacturing Survey, which was the second-weakest of the regional Fed surveys, also shows new growth. The general activity index was 16.9. That’s down from last month’s surge to 24.5, but it still is an indicator of strong growth. Most components of the survey were strong.

The Richmond Fed Manufacturing Index increased for the fifth consecutive month, rising to 22 from 17. That’s its best reading since April 2010. The index was strong in almost all components.

Durable Goods Orders also show a recovery continuing in manufacturing if you look beyond the headlines. New orders were up 1.7% for the month, but when transportation is excluded they increased only 0.4%. More importantly, core capital gains investment by businesses declined 0.1%.

But last month’s core capital goods was revised higher to 0.1% from a negative 0.4%. Over 12 months they now are up 2.7% after being flat to negative for a couple of years. Also, the shipments component of the report is increasing. As the economy continues to grow and employment remains high, businesses are likely to increase capital investment.

New home sales continue to justify the optimism expressed in the home builder reports. In February, new home sales increased by 6.1%. The median price declined 3.9% and the 12-month price change is a negative 4.9%. But the average home price increased 9.9% in the last month and 11.7% over 12 months. The jump in average home prices indicates that prices are rising for higher-priced homes.

Pending Home Sales increased 5.5% for the month after a 2.8% decline last month. The index has been up and down in recent months. This might indicate a strong spring season for home sales.

Home prices continue to surge, according to the CoreLogic S&P Case-Shiller Home Price Index. It showed a 0.9% price increase for the month. That’s the third straight gain of that amount, which is the best streak in four years. The 12-month price increase is 5.7%, which is the highest rate for two and one half years. The Case-Shiller index has been out of sync with the FHFA House Price Index in recent months, but both are converging at 12-month price gains of around 6%.

The third and final estimate of fourth-quarter gross domestic product (GDP) increased growth slightly to 2.1% from 1.9%. The increase reflected a higher estimate in consumer spending.

New unemployment claims increased by 15,000 last week and declined 3,000 this week. They still are near historic lows and indicate no change in the labor market.

The Markets

The S&P 500 rose 0.56% for the week ended with Wednesday’s close. The Dow Jones Industrial Average fell 0.01%. The Russell 2000 gained 2.00%. The All-Country World Index returned 0.81%. Emerging market equities gained 0.56%.

Long-term treasuries rose 0.41%. Investment-grade bonds added 0.29%. Treasury Inflation-Protected Securities (TIPS) appreciated 0.27%. High-yield bonds rose 0.94%.

The dollar gained 0.37%.

Energy-based commodities soared 1.52%. Broader-based commodities rose 1.0%. Gold returned 0.17%.

Bob’s News & Updates

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