U.S. Economy SLUGish; Brexit Shock Lingers: Schwab’s Sonders

“Recent shocks in the United States, Japan and Europe suggest the negative market impact could linger for months and may heighten the potential for a recession in Europe,” according to Schwab’s outlook.

Jeffrey Kleintop, chief global investment strategist at Schwab, writes that consumer spending and business investment may slow further in the U.K. and Europe in the second half of the year due to the heightened uncertainty.

“However, the fallout may be limited if the Bank of England and European Central Bank can stabilize financial conditions and the U.K. and eurozone economies capitalize on the weakness in their currencies,” he writes.

While it remains to be seen how long it will take for the markets to recover from the Brexit shock, Kleintop points to several other recent market shocks that were short-term in nature.

“These included … the devastating earthquake and related nuclear accident in Japan, the congressional standoff over the U.S. debt ceiling and credit rating downgrade of the United States, and the European debt crisis,” Kleintop writes. “While the stock market losses were sharp and a recession resulted in two of the three shocks, the time stocks took to recover was three to four months.”

Kleintop suggests that short-term focused traders should be prepared for further stock market declines over the next three to six months, similar to past shocks.

Meanwhile, longer-term investors may want to maintain their globally diversified asset allocations intended to weather volatility on the way to longer-term goals, according to Kleintop.

Fixed Income

Returns in every major fixed income asset class are positive for the year so far, but this unusual pattern of performance is unlikely to continue, according to Kathy A. Jones, chief fixed income strategist at Schwab Center for Financial Research.

In the first half of the year, longer-duration bonds have outperformed shorter-duration bonds, and riskier high-yield bonds have outperformed “core” bonds, which include Treasuries, investment-grade corporate bonds and securitized bonds.

“The message from the fixed income markets is mixed,” Jones writes. “Typically, these various types of bonds don’t all perform well at the same time. Long-duration Treasury bonds tend to do well when economic growth is slowing and inflation is declining, while riskier high-yield and emerging market bonds along with [Treasury inflation-protected securities] tend to do well when the economy is in an upswing.”

This behavior is unlikely to continue for the second half of the year though, Jones predicts.

And Britain’s vote to leave the European Union may be a catalyst for a change.

Bond yields have dropped further in major developed countries considered safe havens such as Germany and Japan. Yields in the noncore developed countries such as Spain and Portugal, however, have risen since the vote, according to Jones.

Meanwhile, in the U.S., the likelihood of further rate increases by the Federal Reserve has diminished since the Brexit vote.

If there are no more rate increases this year, Jones anticipates that the yield curve will “flatten as a result of short-term rates holding steady or edging higher while long-term rates remain low.“

“Weak economic growth and deflationary pressures abroad coupled with relatively high rates domestically should mean that U.S. bonds remain in demand by global investors,” Jones writes.

—Related on ThinkAdvisor:

• Treasury Yields Hit Record Lows; Strategists Warn Against Chasing Yield
• US Growth Weakest Since ’09: Markit