Brexit: What Does It Mean for U.S. Corporate Credit?

By

Collin Martin

- June 28, 2016

Key Points

• The Brexit decision is likely to affect most types of investments, including U.S. corporate credit.
• High-yield bonds and preferred securities may be particularly vulnerable to price declines.
• Investment-grade corporate bonds should continue to make up a fixed income investor’s core portfolio holdings, in our view.

British voters’ decision to leave the European Union—commonly known as the “Brexit”—is likely to affect most types of investments, including U.S. corporate credit. In the hours after the Brexit vote, global investors focused on what they perceived to be the safest investments, and money flowed into U.S. Treasury securities. Performance was mixed for other investments, such as investment-grade corporate bonds, high-yield corporate bonds and preferred securities. Going forward, we think the Brexit decision will lead to more volatility in the fixed income markets, especially for those securities with higher credit risk.

Higher-rated investments performed relatively well on the day after the Brexit vote

Source: Bloomberg and Barclays. Barclays U.S. Treasury Index, Barclays U.S. Corporate Bond Index, Barclays U.S. Corporate High-Yield Bond Index, BofA Merrill Lynch Fixed Rate Preferred Securities Index, and S&P 500 Index. Total returns from market close on 6/23/16 through market close on 6/24/16. Returns assume reinvestment of dividends, interest, and capital gains. Indexes are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Past performance is no indication of future results.

High-yield corporate bonds may be particularly volatile

During periods of heightened market volatility, investors often seek safe-haven investments such as U.S. Treasuries, while high-yield corporate bond prices have tended to suffer.¹ High-yield corporate bonds have a higher risk of default than investment-grade corporate bonds—that is, a higher probability that the issuer won’t be able to make scheduled debt payments, and in a worst-case scenario might not even return investors’ principal. Given that higher risk, they tend to perform poorly when economic conditions deteriorate.

The high-yield bond market also tends to have relatively low liquidity, a measure of the ease and price efficiency with which securities can be bought and sold. When investors seek safe havens in times of market stress and try to sell higher-risk investments, low liquidity could lead to large price fluctuations. Historically, the performance of high-yield corporate bonds has tended to be more correlated with U.S. equities than with U.S. Treasuries.² In other words, when stock markets fall, high-yield bond prices also tend to move down.

Another key risk for high-yield bonds is the market’s exposure to the price of oil. In the past few years, the percentage of bonds in the high-yield market issued by speculative-grade energy and natural resource companies has surged, to the point that energy sector issuers now make up nearly 14% of the Barclays U.S. Corporate High-Yield Bond Index. Lower prices mean less revenue and cash flow to pay creditors, heightening the risk that some companies could default on their debt. At the end of May, the trailing 12-month speculative-grade default rate had risen to 4.1%, compared with just 1.4% two years earlier.³

What does Brexit have to do with oil prices? It could affect two pressure points: the value of the U.S. dollar and the pace of global economic growth. In the two trading days after the June 23 Brexit vote the U.S. dollar rose by more than 3% compared with a broad basket of currencies, while the price of West Texas Intermediate crude oil dropped more than 7%. Most globally traded commodities, including oil, are priced in U.S. dollars. A stronger dollar makes these commodities more expensive for buyers who must convert their currency, even if the actual price of the commodity hasn’t changed, and commodity prices often move lower to offset that rise. Oil prices also tend to be sensitive to the ups and downs of the global economy, so if Brexit results in slower growth, oil prices could decline. While the price of oil had risen from lows reached this past January, stabilizing in the $40-$50 per barrel range during the previous two months, a further rise in the U.S. dollar could push the price lower.

High-yield bond prices have trended with the price of oil

Source: Federal Reserve Bank of St. Louis and Barclays. Crude Oil Prices: West Texas Intermediate – Cushing, Oklahoma and the Barclays U.S. Corporate High-Yield Bond Index. Daily data as of 6/27/16. Past performance is no guarantee of future results.

A credit spread is the difference between the yield on a corporate bond and the yield on a Treasury with a comparable maturity—it can be considered a premium for taking on the additional risk of a corporate bond. Although high-yield credit spreads are near their long-term average, we see risks ahead, including last week’s decision in the U.K. The Brexit decision will likely lead to more volatility and potential price declines, so we think it’s best for investors to stick with their long-term allocations to high-yield bonds, and not reach for yield if it’s not suitable for your risk tolerance.

Investment-grade corporate bonds: check your sectors

Investment-grade corporate bonds performed better than high-yield bonds immediately after the Brexit decision was announced, posting a positive return on June 24. Unlike high-yield bonds, investment-grade corporate bonds are more correlated with Treasuries than with stocks, so stock market volatility and declines doesn’t necessarily have the same effect on higher-rated bonds as on lower-rated ones.

The impact may be more significant in some sectors than others, however. We think the financials sector is one area of the investment-grade corporate bond market that may see more volatility. If the Brexit vote leads to slowdown in global growth, bank profitability often takes a hit because borrowing, from both businesses and consumers, tends to slow down. And many large U.S. banks earn a portion of their revenues from Europe—another potential hit to their profitability.
The Brexit vote has also led lower market expectations for further U.S. interest rate hikes, which can be a hindrance for banks as well. With yields so low, it’s difficult for banks to make much money on their loans. An ongoing near-zero interest rate environment may continue to weigh on bank performance. Overall, U.S. banks are in pretty good shape, however. Regulations put it place since the 2008 financial crisis are meant to keep the balance sheets more stable. Also, the Federal Reserve released on June 23 the first set of results from its most recent bank stress tests—all U.S. banks that were tested passed.

Investment-grade corporate bonds should continue to make up part of a fixed income investor’s core portfolio holdings, along with high-quality investments like Treasuries, in our view. While investment-grade corporate bonds may be more volatile than Treasuries in the short-term, volatility should remain lower than that of high-yield corporate bonds. But check your sectors—bonds issued by financial institutions could be more prone to price declines than those issued by companies in other sectors, such as utilities or industrials.

Preferred securities’ exposure to financial issuers may increase their volatility

Preferred securities could be volatile in the coming months not only because they share characteristics of both stocks and bonds, but because the market is dominated by financial institutions. Financial-institution issuers make up more than 70% of the BofA Merrill Lynch Fixed Rate Preferred Securities Index.

In the two trading days ending on June 27, the S&P 500^® Financials Index dropped by more than 8%, compared with a 5.3% decline in the broad S&P 500 Index. The preferreds market tends to move in the same direction as financial stocks, especially during periods of market volatility.

Preferred securities may act more like stocks than bonds during periods of market volatility

Source: Bloomberg. Daily data as of 6/27/16. Past performance is no guarantee of future results.

The average price of the preferred securities index only dropped 0.7% in the two trading days ending on June 27, but earlier this year the index was pulled sharply lower by the drop in financial stocks. And considering the average price of the index is close to its highest level in more than three years, and not much lower than its all-time high, there might be more downside than upside here. The direction of financial stocks will almost certainly spill over into how preferred securities perform in the second half of the year, in our view.

Investors looking for higher income opportunities should still consider preferred securities, but we expect plenty of volatility ahead. For investors with longer time horizons who can stomach large price fluctuations in exchange for the higher yields, preferreds may make sense. But for investors with shorter investment horizons who can’t handle large price swings, we’d recommend a more conservative investment approach and a focus on core fixed income holdings.

What to do now

Don’t reach for yield if you can’t stomach increased volatility. We expect heightened volatility, and potential price declines, in high-yield corporate bonds and preferred securities, meaning there may be better times to invest in the months to come. Investment-grade corporate bonds should be less volatile, and still make sense for investors’ core fixed income holdings, in our view.

¹ High-yield corporate bonds, also known as sub-investment-grade corporate bonds, carry ratings of Ba1 and below by Moody’s and BB+ and below by Standard & Poor’s.

² Correlation is a statistical measure of how investments move in relation to one another.

³ Standard & Poor’s, “The U.S. Speculative-Grade Corporate Default Rate Increased To 4.1% In May,” 6/1/2016. 

Bear(s)-exit the Markets

Charles Schwab: On the Market

Posted: 6/23/2016 4:15 PM ET

Bear(s)-exit the Markets

U.S. stocks rallied and the European markets finished to the upside, despite the palpable uneasiness as to the outcome of the Brexit vote, with current expectations seemingly leaning toward the U.K. remaining in the EU. Domestic economic news was mixed, as jobless claims fell more than expected and new home sales dropped, while a preliminary read on manufacturing bested expectations. Treasuries were lower, crude oil prices were higher, while gold and the U.S. dollar dipped.

The Dow Jones Industrial Average (DJIA) jumped 230 points (1.3%) to 18,011, the S&P 500 Index rose 28 points (1.3%) to 2,113, and the Nasdaq Composite rallied 77 points (1.6%) to 4,910. In moderate volume, 837 million shares were traded on the NYSE and 1.7 billion shares changed hands on the Nasdaq. WTI crude oil gained $0.98 to $50.11 per barrel and wholesale gasoline was $0.02 higher at $1.61 per gallon, while the Bloomberg gold spot price moved $2.03 lower to $1,266.09 per ounce. Elsewhere, the Dollar Index—a comparison of the U.S. dollar to six major world currencies—was down 0.2% at 93.52.

Macy's Inc. (M $33) announced that Chief Executive Officer (CEO) Terry Lundgren will transition the position of CEO to Jeff Gennette in 1Q 2017. Lundgren will continue as Executive Chairman of the company and work side-by-side with Gennette as President and CEO. Shares were nicely higher.

Bed Bath & Beyond Inc. (BBBY $44) reported fiscal 1Q earnings-per-share (EPS) of $0.80, six cents below the FactSet estimate, as revenues were roughly flat year-over-year (y/y) at $2.7 billion, compared to the projected $2.8 billion. 1Q same-store sales declined 0.5% y/y, versus the estimated 0.6% gain. BBBY lowered its full-year same-store sales outlook. Shares finished higher.

Red Hat Inc. (RHT $78) posted 1Q EPS ex-items of $0.50, roughly in line with forecasts, as revenues rose 18.0% y/y to $568 million, compared to the projected $563 million. RHT issued 2Q and full-year guidance that missed the Street's expectations. Separately, the company announced a new $1.0 billion stock buyback plan and the acquisition of 3scale with terms not disclosed. RHT was lower. 

Jobless claims fall, new home sales retreat from 8-year high

Weekly initial jobless claims (chart) dropped by 18,000 to 259,000 last week, versus the Bloomberg estimate calling for claims to decrease to 270,000, as the prior week's figure was unrevised at 277,000. The four-week moving average declined by 2,250 to 267,000, while continuing claims decreased by 20,000 to 2,142,000, south of the estimated level of 2,150,000.

New home sales (chart) declined 6.0% month-over-month (m/m) in May to an annual rate of 551,000 after reaching the highest level since February 2008 last month, and compared to forecasts of 560,000. The median home price rose 1.0% y/y to $290,400. The supply of new home inventory increased 14.6% m/m to 4.7 months at the current sales pace as sales fell m/m in the Northeast and West, dipped in the South, and rose solidly in the Midwest. New home sales are based on contract signings instead of closings.

The Conference Board's Index of Leading Economic Indicators (LEI) (chart) declined 0.2% m/m in May, versus the projected 0.1% increase, and compared to April's unrevised 0.6% gain. Support came from the component pertaining to the yield curve, while jobless claims weighed on the index.

The preliminary Markit U.S. Manufacturing PMI Index for June improved to 51.4 from May's 50.7 level, and above the forecasted modest rise to 50.9, with a reading above 50 denoting expansion in activity.

The Kansas City Fed Manufacturing Activity Index for June improved to 2 from May's -5 level, where it was expected to remain, with a reading north of zero depicting expansion.

Treasuries were lower, as the yield on the 2-year note increased 2 basis points (bps) to 0.77%, while the yields on the 10-year note and the 30-year bond gained 5 bps to 1.73% and 2.55%, respectively. For our latest analysis on the bond markets see the video by Schwab's Managing Director of Trading and Derivatives, Randy Frederick, and Fixed Income Director Collin Martin, CFA, titled Is the ECB Driving European Bond Investors Into the US Bond Market?, at www.schwab.com/insights. Follow Randy and Schwab on Twitter: @randyafrederick and @schwabresearch.

Tomorrow's economic calendar will offer the preliminary durable goods orders report, with economists forecasting a 0.6% m/m decline for May, while ex-transportation, orders are expected to inch 0.1% higher. Rounding out the day will be the final University of Michigan Consumer Sentiment Index, anticipated to fall slightly to a level of 94.0.

Europe rallies on optimism, Asia mixed, as Brexit vote arrives

European equities traded nicely higher, with optimism that the U.K. will vote to remain in the EU fueling a fifth-consecutive session of gains. Financials were one of the best performers and the British pound rose versus the U.S. dollar as the U.K. is voting today on whether to remain or leave the EU—known as a Brexit—with results likely being announced early Friday morning. For our latest analysis on the Brexit issue read our article,  Will the UK Stay or Go? Markets Wait for Brexit Vote at www.schwab.com/insights, while Schwab's Chief Global Investment Strategist, Jeffrey Kleintop, CFA, discusses in his article, Brexit: 5 Things Investors Need to Know. Jeff adds that no matter the outcome, the issue of a Brexit may not be put to rest entirely as EU member parliaments must also agree to the changes being proposed. Nevertheless, the British understand the key role trade has always played in their economy. The British may resent bailed-out banks and bureaucrats in Brussels, but we believe economic considerations will favor the U.K. remaining within the EU. Read more at www.schwab.com/marketinsight, and be sure to follow Jeff on Twitter: @jeffreykleintop. In economic news, the preliminary Markit Eurozone Composite PMI Index—a gauge of business activity in the manufacturing and services sectors—declined to 52.8 in June, from 53.1 in May, and compared to expectations of a dip to 53.0. However, a reading above 50 denotes expansion. The euro gained solid ground on the U.S. dollar, while bond yields in the region were mixed.

Stocks in Asia finished mixed with volumes on the lighter side as the global markets awaited the results of today's U.K. Brexit vote. Japanese equities rose, with the yen holding steady during the session, while securities traded in Hong Kong posted a fifth-straight session of gains. Meanwhile basic materials stocks weakened to pressure mainland Chinese securities, as the sector was bogged down by reports that the U.S. may raise duties on some steel products. Finally, markets in Australia and India moved higher, but South Korean equities declined.

While all eyes will likely be on the results of the Brexit vote, other items on the international economic calendar for tomorrow include inflation figures from Japan, trade data from China, GDP from France, retail sales from Italy, and the Ifo Business Climate Index from Germany.

Fence-Sitting Ahead of Brexit Vote

Charles Schwab: On the Market

Posted: 6/22/2016 4:15 PM ET

Fence-Sitting Ahead of Brexit Vote

U.S. equities finished lower in cautious, choppy trading, with the shadow of tomorrow's U.K. Brexit vote hovering over the markets. Meanwhile, energy stocks suffered following a bearish Department of Energy report, while earnings reports from FedEx and Adobe, along with guidance from HP, were met with disappointment. Fed Chair Yellen concluded her two-day monetary policy report to Congress, while existing home sales rose to their highest level in more than nine years. Treasuries finished modestly higher, while gold and the U.S. dollar lost ground.

The Dow Jones Industrial Average (DJIA) fell 49 points (0.3%) to 17,781, the S&P 500 Index lost 3 points (0.2%) to 2,085, and the Nasdaq Composite finished 10 points (0.2%) lower at 4,833. In moderate volume, 812 million shares were traded on the NYSE and 1.7 billion shares changed hands on the Nasdaq. WTI crude oil declined $0.72 to $49.13 per barrel and wholesale gasoline was unchanged at $1.59 per gallon, while the Bloomberg gold spot price moved $2.03 lower to $1,266.09 per ounce. Elsewhere, the Dollar Index—a comparison of the U.S. dollar to six major world currencies—was down 0.3% at 93.74.

FedEx Corp. (FDX $157) reported fiscal 4Q earnings-per-share (EPS) ex-items of $3.30, above the $3.28 FactSet estimate, as revenues grew 7.4% year-over-year (y/y) to $13.0 billion, north of the projected $12.8 billion. FDX issued current year EPS guidance with a midpoint below analysts' expectations. Shares finished lower.

Adobe Systems Inc. (ADBE $94) posted fiscal 2Q profits of $0.71 per share, above the estimated $0.68, with revenues rising 20.0% y/y to $1.4 billion, roughly in line with forecasts. ADBE issued 3Q EPS guidance that came in mostly below the Street's expectations. Shares were solidly lower.

Shares of HP Inc. (HPQ $13) fell after the company reaffirmed its full-year profit outlook, lowered its cash flow target and announced a plan to change the company's printing supplies inventory management strategy. These overshadowed its raised 3Q EPS guidance.

KB Home (KBH $15) announced fiscal 2Q EPS of $0.17, three cents north of forecasts, as revenues grew 30.2% y/y to $811 million, compared to the expected $753 million. KBH traded nicely higher.

Tesla Motors Inc. (TSLA $197) came under solid pressure after the company yesterday offered about $2.8 billion in all stock to acquire SolarCity Corp. (SCTY $22), which closed higher. TSLA's Chief Executive Officer and Founder Elon Musk noted on a conference call that the board opinion is unanimous at both companies, which he is the largest shareholder and chairman of both.

Existing home sales rise roughly in line with forecasts

Existing-home sales in May rose 1.8% month-over-month (m/m) to a 5.53 million annual rate—the highest annual pace since February 2007—compared to the Bloomberg forecast of a 5.55 million pace. April's figure was revised downward to a 5.43 million annual rate. Compared to last year, sales were 4.5% higher and the median existing-home price was up 4.7% at $239,700—an all-time high. Housing supply came in at a 4.7-month pace at the current sales rate. Sales were higher in the Northeast, South and West, while the Midwest fell. Single-family and condominium and co-op sales both rose.

National Association of Realtors (NAR) Chief Economist Lawrence Yun said the primary driver of the increase in sales was homeowners realizing the equity they have accumulated in recent years and finally deciding to trade-up or downsize, though first-time buyers are still struggling. "Barring further deceleration in job growth that could ultimately temper demand from these repeat buyers, sales have the potential to mostly maintain their current pace through the summer," Yun added.

Schwab's Director of Market and Sector Analysis, Brad Sorensen, CFA, notes in his latest Schwab Sector Views: Summer Lovin', higher wages and a continued improving housing market would go a long way toward improving consumer confidence, and that's what we believe we're seeing. A robust consumer would likely aid the more cyclical sectors, such as technology and consumer discretionary, as well as helping the overall U.S. economy. Read more at www.schwab.com/marketinsight, and follow Schwab on Twitter: @schwabresearch.

The MBA Mortgage Application Index rose 2.9% last week, after declining 2.4% in the previous week. The increase came as a 6.5% jump for the Refinance Index more than offset a 2.4% decline for the Purchase Index. The average 30-year mortgage rate fell 3 basis points (bps) to 3.76%.

Federal Reserve Chairwoman Janet Yellen concluded her two-day semiannual monetary policy report to Congress, speaking to the House Financial Services Committee shortly after the opening bell. Her prepared remarks did not differ from yesterday's testimony to the Senate, where she noted that the economy has made further progress. "However, the pace of improvement in the labor market appears to have slowed more recently, suggesting that our cautious approach to adjusting monetary policy remains appropriate," she added. Yellen also stressed that the Central Bank believes the recent slowing in employment growth is "transitory" but it is watching the job market carefully. Moreover, she said a U.K. vote to exit the European Union (EU)—known as a Brexit—"could have significant economic repercussions." Yellen concluded by saying the path of the fed funds rate will depend on economic and financial developments. The global markets are paying close attention to the Q&A session that is underway.

Treasuries finished slightly higher, as the yields on the 2-year and 10-year notes, along with the 30-year bond, lost 2 basis points (bps) to 0.75%, 1.68% and 2.49%, respectively. Schwab's Chief Fixed Income Strategist Kathy Jones provides analysis of the global bond markets in her latest article, Global Bonds: A World Without Yield, at www.schwab.com/marketinsight, and she teams up with Schwab's Managing Director of Trading and Derivatives, Randy Frederick, in the video titled Fed on Pause: Watching and Waiting to Raise Rates, for further analysis on the Fed and the bond markets at www.schwab.com/insights. Follow Kathy and Randy on Twitter: @kathyjones and @randyafrederick.

Tomorrow's economic calendar will be the busiest of the week, beginning with weekly initial jobless claims, forecasted to decline to 270,000 from the prior week's 277,000, as well as Markit's preliminary Manufacturing PMI, with economists anticipating activity to move higher into expansionary territory (a reading above 50) for June to a level of 50.9 from May's 50.7. After the opening bell, investors will get a look at new home sales, with forecasts calling for a 9.5% m/m decline for May to an annual rate of 560,000 units, as well as the Leading Index, expected to have gained 0.1% m/m during May, following the 0.6% increase posted in April. Finally, the Kansas City Fed Manufacturing Activity Index will round out the day.

Europe higher, Asia mixed as Brexit vote draws closer

European equities traded mostly higher, as optimism appeared to be holding that the U.K. will vote to remain in the EU, despite recent polls suggesting it remains too close to call. Financials led the markets higher and oil & gas issues contributed modestly to the advance, with crude oil prices flirting with the $50 per barrel mark before some bearish U.S. inventory data. Tomorrow the U.K. will vote on whether to remain or leave the U.K., with results likely being announced early Friday morning. For our latest analysis on the Brexit issue read our article, Will the UK Stay or Go? Markets Wait for Brexit Vote at www.schwab.com/insights, while Schwab's Chief Global Investment Strategist, Jeffrey Kleintop, CFA, discusses in his article, Brexit: 5 Things Investors Need to Know. Jeff adds that no matter the outcome, the issue of a Brexit may not be put to rest entirely as EU member parliaments must also agree to the changes being proposed. Nevertheless, the British understand the key role trade has always played in their economy. The British may resent bailed-out banks and bureaucrats in Brussels, but we believe economic considerations will favor the U.K. remaining within the EU. Read more at at www.schwab.com/marketinsight, and be sure to follow Jeff on Twitter: @jeffreykleintop. The euro and British pound gained ground on the U.S. dollar, while bond yields in the region finished mixed, with earnings and economic data on the light side.

Stocks in Asia finished mixed as the global markets grapple with uncertainty ahead of tomorrow's Brexit vote in the U.K., while digesting testimony from U.S. Fed Chair Yellen to Congress, where she offered little new clues about the timing of future rate hikes. Japanese equities declined, after rallying the past three sessions, with the uncertainty toward the U.K. likely fostering some afternoon strength in the yen. Meanwhile, stocks in Australia and India declined, however those traded in South Korea, mainland China and Hong Kong all gained ground.

A host of manufacturing and services PMI readings from across the globe will be released tomorrow, while Japan will also release its Leading Index, and industrial sales will come from Italy.

Gains Continue

Charles Schwab: On the Market

Posted: 6/21/2016 4:15 PM ET

Gains Continue

U.S. equities slightly added to yesterday's rally, with technology issues leading the way, while energy stocks were resilient amid a modest decline in crude oil prices. Brexit uncertainty continued to swirl around the market ahead of Friday's vote, and Fed Chair Yellen offered little new information in her first day of testimony before Congress. Treasuries were nearly unchanged and the U.S. dollar was higher, while gold lost ground.

The Dow Jones Industrial Average (DJIA) rose 24 points (0.1%) to 17,830, the S&P 500 Index added 6 points (0.3%) to 2,089, and the Nasdaq Composite finished 7 points (0.1%) higher at 4,844. In moderate volume, 836 million shares were traded on the NYSE and 1.7 billion shares changed hands on the Nasdaq. WTI crude oil lost $0.11 to $49.85 per barrel and wholesale gasoline added $0.01 to $1.59 per gallon, while the Bloomberg gold spot price tumbled $24.23 to $1,265.67 per ounce. Elsewhere, the Dollar Index—a comparison of the U.S. dollar to six major world currencies—was up 0.5% at 94.05.

Lennar Corp. (LEN $46) reported fiscal 2Q earnings-per-share (EPS) of $0.95, above the $0.87 FactSet estimate, as revenues rose 14.8% year-over-year (y/y) to $2.7 billion, exceeding the projected $2.6 billion. The company said the homebuilding market continued its slow and steady recovery sustained by low interest rates, modest wage growth, positive consumer confidence and low unemployment levels combined with tight inventory levels. LEN gave up an early gain and finished lower.

Werner Enterprises Inc. (WERN $22) issued softer-than-expected 2Q EPS guidance, noting sluggish freight market conditions, the cost of driver pay increases, and a soft used truck market. WERN added that to address the challenging market conditions, it continues to focus on various cost management initiatives. Shares of WERN fell.

CarMax Inc. (KMX $48) posted 1Q profits of $0.90 per share, two cents shy of estimates, with revenues increasing 2.8% y/y to $4.1 billion, below the forecasted $4.2 billion. Shares were solidly lower. 

Canadian Pacific Railway Ltd. (CP $124) issued a 2Q revenue and profit warning, due to lower-than-anticipated volumes in bulk commodities, the wildfires in northern Alberta and a strengthening Canadian dollar. CP said given the transitory nature of these impacts, coupled with an anticipated improvement in commodity volumes, it remains confident toward meeting its full-year guidance. Shares were lower.

Fed Chair Yellen takes to the Hill

Federal Reserve Chairwoman Janet Yellen kicked off her two-day semiannual monetary policy report to Congress, speaking to the Senate Banking Committee. In her prepared remarks, she noted that the economy has made further progress. "However, the pace of improvement in the labor market appears to have slowed more recently, suggesting that our cautious approach to adjusting monetary policy remains appropriate," she added. Yellen also stressed that the Central Bank believes the recent slowing in employment growth is "transitory" but it is watching the job market carefully. Moreover, she said a U.K. vote to exit the European Union (EU)—known as a Brexit—"could have significant economic repercussions." Yellen concluded by saying the path of the fed funds rate will depend on economic and financial developments. Traders are paying close attention to the Q&A session following her remarks. Yellen will conclude her testimony tomorrow in front of the House Financial Services Committee.

May's severely disappointing labor report and continued Brexit uncertainty have applied pressure on global bond yields. Schwab's Chief Fixed Income Strategist Kathy Jones provides analysis in her latest article, Global Bonds: A World Without Yield, and she teams up with Schwab's Managing Director of Trading and Derivatives, Randy Frederick, in the video titled Fed on Pause: Watching and Waiting to Raise Rates, for further analysis in the Fed and the bond markets at www.schwab.com/insights.

Moreover, Schwab's Chief Investment Strategist, Liz Ann Sonders notes in her latest article, Beast of Burden (No More): Households Choosing Savings over Debt, regardless of the efforts of the Federal Reserve, it’s unlikely a major new expansion of private sector debt is coming. The debt supercycle, lasting over three decades, allowed demand growth to exceed underlying income growth. That era has seemingly died and continued sluggish growth for the U.S. economy will likely continue to be a byproduct of that potential death. Read both articles at www.schwab.com/marketinsight, and follow Kathy, Liz Ann and Randy on Twitter: @kathyjones, @lizannsonders and @randyafrederick.

Treasuries were little changed, while the U.S. economic calendar was dormant today. The yields on the 2-year and 10-year notes were flat at 0.76% and 1.69%, respectively, while the 30-year bond rate dipped by 1 basis point to 2.49%.

Tomorrow, the economic front will awaken with the release of existing home sales, projected to rise 1.8% month-over-month (m/m) to an annual rate of 5.55 million units in May. As noted in the Schwab Market Perspective: Summer of Discontent?, investors should remain patient as positive signs are emerging. For the frustration in the stock market to end, we believe businesses need to pick up their capital spending but for now a relatively healthy consumer and housing are keeping the U.S. economy afloat. Read more at www.schwab.com/marketinsight.

Europe modestly adds to recent rally, Asia mixed

European equities finished modestly higher, coming off a strong two-day rally, with financials continuing to move upward and oil & gas issues showing some resiliency in the face of a retreat in crude oil prices from their run the past two days. European stocks have rallied as of late, fueled by eased concerns about a U.K. Brexit after polls over the weekend suggested the June 23 vote could favor the nation remaining in the EU. For our latest analysis on the Brexit issue ahead of Thursday's key vote read our article, Will the UK Stay or Go? Markets Wait for Brexit Vote at www.schwab.com/insights. However, the newest Brexit polls fostered some uncertainty and the markets focused on today's monetary policy testimony on Capitol Hill from U.S. Fed Chair Yellen, where she warned of possible "significant economic repercussions." The euro and British pound lost ground versus the U.S. dollar, while bond yields in the region mostly ticked higher. A favorable read on German investor confidence may have helped sentiment, as the ZEW reported an unexpected jump in its expectations survey for June, which rose to the highest level since August 2015.

Stocks in Asia finished mixed as some caution ahead of today's testimony from U.S. Fed Chair Yellen met recently eased concerns about a U.K. Brexit, which fueled a global market rally yesterday. A weaker yen helped lift Japanese equities higher, mainland Chinese securities declined as volatility fell and data remained light, while stocks traded in Hong Kong advanced. Australia's markets gained ground, as traders digested the minutes from the June monetary policy meeting from the Reserve Bank of Australia (RBA), where it kept its policy stance unchanged. The RBA noted some positive signs of economic activity, notably in non-mining, while adding that inflation was expected to remain low for some time. Meanwhile, stocks in India traded lower on the heels of yesterday's announcement that Reserve Bank of India Governor Rajan will step down at the end of his term in September. Schwab's Director of International Research, Michelle Gibley, CFA, offers a look at the global political landscape in her article, Performing Reformers: How Political Change Can Affect Stocks, at www.schwab.com/oninternational, and be sure to follow Schwab on Twitter: @schwabresearch. Finally, South Korean equities ticked slightly higher.

Economic reports abroad will be very limited tomorrow, with the lone item of note being the Import Price Index from Germany.

Financial Review

Basic Economics – Brexit

Sinclair Noe — June 20, 2016

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Time now for another edition of What You Need to Know About Basic Economics – In today’s edition we will tell you what you need to know about the Brexit.

Brexit is the smash-up term for British and exit. It refers to a referendum which will be held this Thursday, asking voters: “Should the United Kingdom remain a member of the European Union or leave the European Union?”

The European Union – often known as the EU – is an economic and political partnership involving 28 European countries. It began after World War Two to foster economic co-operation, with the idea that countries which trade together are more likely to avoid going to war with each other. It has since grown to become a “single market” allowing goods and people to move around, basically as if the member states were one country.

It has its own parliament and it now sets rules in a wide range of areas – including on the environment, transport, consumer rights and even things like mobile phone charges. It has its own currency, the euro, which is used by 19 of the member countries; the United Kingdom still uses its own currency, the pound sterling.

The single market is seen by its advocates as the EU’s biggest achievement and one of the main reasons it was set up in the first place. Britain was a member of a free trade area in Europe before it joined what was then known as the common market. In a free trade area, countries can trade with each other without paying tariffs – but it is not a single market because the member states do not have to merge their economies together.

The European Union single market, which was completed in 1992, allows the free movement of goods, services, money and people within the European Union, as if it was a single country. It is possible to set up a business or take a job anywhere within it. The idea was to boost trade, create jobs and lower prices. But it requires common law-making to ensure products are made to the same technical standards and imposes other rules to ensure a “level playing field”.

Supporters of the “Leave” campaign say they want to protect the country’s identity: its culture, independence and place in the world.  “Leave” supporters argue that Britain is being held back by the EU, which they say imposes too many rules on business and charges billions of pounds a year in membership fees for little in return. The UK is one of 10 member states who pay more into the EU budget than they get out, only France and Germany contribute more. In 2014/15, Poland was the largest beneficiary, followed by Hungary and Greece.

They also want Britain to take back full control of its borders and reduce the number of people coming into Britain to live and/or work. One of the main principles of EU membership is “free movement”, which means you don’t need to get a visa to go and live in another EU country. They also object to the idea of “ever closer union” and what they see as moves towards the creation of a “United States of Europe”. There is a sense that Britain has lost some of its sovereignty and ability to control its borders and economy. This argument is often expressed by opposition to immigration.

“Remain” supporters typically argue that staying in the union is better for the British economy and that concerns about migration and other issues are not important enough to outweigh the economic consequences of leaving. Those campaigning for Britain to stay in the EU say it gets a big boost from membership – it makes selling things to other EU countries easier and, they argue, the flow of immigrants, most of whom are young and eager to work, fuels economic growth and helps pay for public services.

They also believe Britain’s status in the world would be damaged by leaving and that they are more secure as part of the 28 nation club, rather than going it alone. Big business – with a few exceptions – tends to be in favor of Britain staying in the EU because it makes it easier for them to move money, people and products around the world.

The Leave camp counters that an EU exit would allow the UK to negotiate trade deals as one country “rather than being one of 28 nations”. Many small and medium-sized firms would welcome a cut in red tape and regulations. Although much of the Leave argument seems to center around a cultural nostalgia promoted by nationalist parties frustrated with the complexities of a changing world.

Europe is Britain’s most important export market and EU membership has allowed London to become a financial hub for the continent and a source of foreign direct investment. The Remain Camp argues that a Brexit could result in massive financial market volatility; a big drop in the pound, a huge sell-off in stocks, and a major hit to already sluggish economic growth.

Right now, the vote is too close to call. Last week the Leave Camp seemed to be pulling ahead, then a Member of Parliament, Jo Cox, a Remain supporter was shot and killed. The campaigns were suspended for a couple of days, and today the Remain Camp seems to have a slight advantage.

Both sides seem to admit that the EU and the European Central Bank have done a poor job in growing the economy. The EU made a mess handling the Greek debt and refugee crises; it is bureaucratic. The EU is dysfunctional, it has structural flaws, and shows few signs of reforming. Still, the EU has been a unifying force in the aftermath of one of the bloodiest wars ever waged.

The idea of a unified and peaceful Europe is still important. And Brexit is a threat to the unity of both the EU and the UK.  The question is whether a vote to leave would make anything better or worse. It would certainly be a shock to the system. We will know more by the end of the week.

Stocks Rally to Start Week

On the Market

Posted: 6/20/2016 4:15 PM ET

Stocks Rally to Start Week

U.S. stocks rallied on the heels of broad-based advances in Asia and Europe, with global risk aversion pulling back amid eased U.K. Brexit concerns following new polls over the weekend ahead of Thursday's vote. Financials and technology issues saw solid gains, while a jump in crude oil prices powered the energy sector. Treasuries, gold and the U.S. dollar were lower, while the domestic economic front was quiet today.

The Dow Jones Industrial Average (DJIA) rallied 130 points (0.7%) to 17,805, the S&P 500 Index jumped 12 points (0.6%) to 2,083, and the Nasdaq Composite finished 37 points (0.8%) higher at 4,837. In moderately-heavy volume, 892 million shares were traded on the NYSE and 1.8 billion shares changed hands on the Nasdaq. WTI crude oil increased $1.40 to $49.96 per barrel and wholesale gasoline added $0.07 to $1.58 per gallon, while the Bloomberg gold spot price decreased $8.98 to $1,289.67 per ounce. Elsewhere, the Dollar Index—a comparison of the U.S. dollar to six major world currencies—was 0.6% lower at 93.67. 

Dow member Wal-Mart Stores Inc. (WMT $71) announced a strategic alliance with JD.com (JD $22), China's largest e-commerce company by revenue. The companies said the agreement includes a wide range of business initiatives, covering both online and offline retail. Shares of both companies traded higher.

Cigna Corp. (CI $128) and Anthem Inc. (ANTM $133) are in focus following a report from the Wall Street Journal suggesting their $44 billion merger agreement is raising antitrust concerns among U.S. regulators, per people familiar with the matter. None of the entities has commented on the report, while the companies have more meetings this week with top Justice Department officials. CI closed lower, while ANTM gained modest ground. 

Economic calendar dormant today

Treasuries were lower, while the U.S. economic calendar was void of any major releases today. The yield on the 2-year note rose 4 basis points (bps) to 0.73%, while the yields on the 10-year note and the 30-year bond gained 6 bps to 1.67% and 2.48%, respectively. Bond yields rebounded somewhat from their recent fall as the Fed suggested that it is still in a "wait-and-see" mode, remaining data dependent in the wake of May's severely disappointing labor report, while growth concerns and uncertainty regarding a U.K. exit from the European Union (EU), known as a Brexit, have also applied pressure.

Recent pressure on global bond yields has amplified the uneasy sentiment, with rates in Germany, Japan and the U.K. hitting record lows, while the U.S. 10-year Treasury yield touched to a four-year low. Schwab's Chief Fixed Income Strategist Kathy Jones provides analysis of this backdrop in her latest article, Global Bonds: A World Without Yield, at www.schwab.com/marketinsight. Follow Kathy on Twitter: @kathyjones.

This week's economic front will start slow but pick up steam tomorrow as Federal Reserve Chairwoman Janet Yellen will begin her two-day semiannual monetary policy report to Congress. Yellen's testimony will be accompanied by some key reads later this week on housing in the form of existing and new home sales reports, as well as manufacturing, with preliminary releases of durable goods orders and Markit's Manufacturing PMI Index. Other notable domestic reports due out this week include: the Leading Index and the final June University of Michigan Consumer Sentiment Index.

For our latest on the Fed and bond markets see the video by Schwab's Kathy Jones and Managing Director of Trading and Derivatives, Randy Frederick, titled Fed on Pause: Watching and Waiting to Raise Rates, at www.schwab.com/insights. Follow Randy on Twitter: @randyafrederick.

However, the focus of the global markets will likely be the looming June 23 U.K. Brexit vote and Schwab's Chief Global Investment Strategist, Jeffrey Kleintop, CFA, discusses in his article, Brexit: 5 Things Investors Need to Know, no matter the outcome, the issue of a Brexit may not be put to rest entirely as EU member parliaments must also agree to the changes being proposed. Nevertheless, the British understand the key role trade has always played in their economy. The British may resent bailed-out banks and bureaucrats in Brussels, but we believe economic considerations will favor the U.K. remaining within the EU. Read more at www.schwab.com/marketinsight, and be sure to follow Jeff on Twitter: @jeffreykleintop.

Europe and Asia gain ground as Brexit fears recede

European equities moved broadly higher, with global sentiment being soothed by eased concerns about a U.K. Brexit on the heels of new polls over the weekend suggesting the "remain" camp gained ground ahead of Thursday's vote. Financials rallied to lead the advance and higher crude oil prices lifted the energy sector, while the British pound surged versus the U.S. dollar. For more analysis on the Brexit issue read our article, Brexit: How Might Stocks Respond? at www.schwab.com/insights. The euro rose versus the U.S. dollar and bond yields in the region were mixed. In economic news, eurozone construction output declined in April.

Stocks in Asia finished broadly higher with global risk aversion waning as recent polls are easing concerns about a U.K. Brexit ahead of Thursday's vote. The yen gave back some of its recent rally to boost Japanese equities, despite a report showing the nation's exports fell more than expected in May. Chinese stocks battled back from some early weakness to finish higher, aided by an upbeat read on the country's May property prices. Australian securities advanced, led by strong gains in the heavy weight oil & gas, basic materials and financial sectors, while South Korean listings also rose. Indian stocks moved higher, with the announcement that Reserve Bank of India's Governor Rajan will step down at the end of his term in September being overshadowed by the eased Brexit concerns and the announcement that India's government relaxed foreign direct investment rules. Schwab's Director of International Research, Michelle Gibley, CFA, offers a look at the global political landscape in her article, Performing Reformers: How Political Change Can Affect Stocks, at www.schwab.com/oninternational, and be sure to follow Schwab on Twitter: @schwabresearch.

Tomorrow, the international economic docket will be light, offering CPI from Hong Kong, the Zew Economic Sentiment Survey from Germany and public sector net borrowing from the U.K.