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PERSPECTIVES | NOVEMBER 2015

KEEP THE LINE MOVING

The Mutual Fund Store was founded in a Kansas City-area suburb back in 1996, and since that time we’ve seen an impressive run of losing seasons by the Kansas City Royals. Yet we now celebrate the city’s first World Series championship since 1985. As the team put together one late-inning comeback after another during the playoffs, they adopted the mantra “keep the line moving.” It refers to their commitment to simply put the ball in play with hit after hit rather than relying on one home-run hitter to carry the day. Similarly, the U.S. economy may not be hitting many home runs right now, but we think it will continue to string together some base hits to keep the line moving through this lengthy recovery.

The World Series is often followed by the realization that the year is drawing to a close. The first three quarters of 2015 saw their fair share of volatility yet overall, the U.S. economy is in fine shape. Gross domestic product (GDP) increased in the third quarter at an

inflation-adjusted annual rate of +1.5%, following a second-quarter increase of +3.9%. Personal consumption expenditures (PCE), the primary measure of consumer spending on goods and services in our economy, continue to play a large part in the growth. Also, personal income and consumer spending increased at a healthy rate during the first two months of the third quarter.

Of course, not all of the news has been good. Weak global demand and a strong U.S. dollar have put pressure on U.S. manufacturers who produce goods for global markets and as a result, U.S. exports decreased while imports increased in August. Manufacturing activity fell to its lowest level in more than two years in October1, but as manufacturing is a relatively small portion of the U.S. economy, the hits generated by the stronger consumption and services segments lead us to the conclusion that economically, we too should be able to keep the line moving.

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PUTTING IT ALLTOGETHER P. 11

PERSPECTIVESIN A FLASH P. 2

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PERSPECTIVES IN A FLASH

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MARKET PERSPECTIVESA Quick Correction: Not surprisingly, despite the S&P 500 suffering a -10% correction during the third quarter, a strong October put the index back into positive territory and near its all-time high. Eye on the Fed: An increase in the federal funds rate may finally be in the cards, although with compelling arguments both for and against, a December rate hike remains a coin flip.

ECONOMIC PERSPECTIVESSlowdown in China: Growth is decelerating following China’s summertime financial collapse, industrial downturn and currency devaluation. Now their export-driven economy is shifting toward a more consumption-driven economy focused on domestic goods and services.

U.S. Economics: The combination of a weakening Chinese economy, falling commodities and a strengthening dollar is a mixed blessing for the United States. Although U.S. exporters may start to feel the pinch, imports are cheaper, gas prices keep declining and inflation is firmly in check.

Updating the Recession Scorecard: All data points tracked by our scorecard indicate a positive outlook except for manufacturing, which sits in the neutral range.

POLITICAL PERSPECTIVESThe View from D.C.: House Speaker Paul Ryan was gifted with a two-year budget, a debt-ceiling deal and a clean slate, yet a few less-contentious issues remain to be resolved. Looking ahead to the 2016 presidential race, we still have a long way to go.

PUTTING IT ALL TOGETHERKeeping the Line Moving: We expect the U.S. economy to lead us into 2016; meanwhile, we’re paying close attention to the upcoming Fed rate-hike decision, the effect of events in the Eurozone and Japan on developed international markets, and opportunities in emerging-market equities.

Interested in what’s happening, but prefer not to get into the nitty-gritty details? Here’s what you need to know about the most recent quarter and where the markets and economy stand now.

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MARKET PERSPECTIVES

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A QUICK CORRECTION For the first time since 2011, the S&P 500 suffered a -10% correction during the third quarter – although unlike many corrections, this decline didn’t have much staying power. Peak-to-trough, the sell-off lasted just eight days from Aug. 17 to Aug. 25 with the S&P 500 at one point -12.4% off its May all-time high. Such a spike in market volatility after a long period of relative calm stirred up some bad memories, and the first thing that popped into many investors’ heads was, “Is this a repeat of 2008?” Our answer to that question was a resounding “no.” Bear markets, which indicate an extended period of falling prices and market decline, typically coincide with an economic recession, spike in commodity prices, aggressive Federal Reserve (Fed) rate hikes or extreme market valuations. At this point, we still don’t see any of those red flags, which is why we think the possibility of a bear market remains low. Most non-recessionary corrections – as we strongly believe last quarter’s was – tend to have a U-shaped recovery, meaning a gradual decline in economic measures is followed by a period of bumping along the bottom before a gradual rise back to previous levels (when plotted on a standard

line chart, the data appears to roughly resemble the shape of the letter U). With this type of recovery there comes a re-test of previous correction lows – the bumping along the bottom – before again beginning to climb. This is almost exactly how the third-quarter scenario played out, hitting a 2015 low on Aug. 17, then clawing back more than +7% before coming close to the August lows a second time following the Fed’s September meeting. However, a strong October put the S&P index back into positive territory on the year and within a few percentage points of its all-time high.As the chart below illustrates, some level of decline followed by recovery each calendar year is absolutely normal for equities. While the August correction might have felt worse than it really was coming after more than three years without a -10% drop, in actuality it wasn’t as severe as the average intra-year decline seen over the last 35 years. Typically we’ll see -5% pullbacks a few times a year, a -10% correction once a year and an average intra-year peak-to-trough decline of -14.2%. Market pullbacks and volatility are more normal than recent years would reflect, and even with some negative period during any given year, 75% of the time the full-calendar-year return ends up being positive.

Source: The Research Center, Standard & Poor’s

Annual Returns vs. Intra-Year Declines for the S&P 500

Note: Returns shown above are price returns only and do not account for reinvested dividends.

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MARKET PERSPECTIVES

EYE ON THE FED

It’s been more than nine years since the Fed raised its benchmark interest rate, the federal funds rate, which for nearly seven years has been kept near zero. Now with unemployment reaching the Fed’s stated goal of 5.1%, it would seem that a rate increase may finally be in the cards. Such an expectation has been reinforced by numerous statements given by Fed officials, including remarks made by Chairwoman Janet Yellen in a recent speech at the University of Massachusetts.

However, the Federal Open Market Committee (FOMC) declined to raise rates at both its September and October meetings, stating instead that, “Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term.” Thus the window for a rate increase this year has narrowed to the remaining FOMC meeting in mid-December, and market participants are putting the probability of a rate hike at just under 50%. Clearly whether the FOMC will pull the trigger and begin to raise rates in 2015 or instead continue to keep its powder dry by remaining cautiously ready to take action is still an open question.

On the one hand, proponents of delaying a rate increase argue that:

• Anemic wage growth means there is still considerable slack in the labor market and the United States remains vulnerable to negative shocks from abroad.

• Inflation remains well below the Fed’s target rate of 2% with the year-over-year increases in consumer prices, excluding food and energy, now at around 1.3%.

• Thanks to past rounds of quantitative easing (QE) – the issuing of short-term securities to buy mortgage-backed securities and Treasury bonds – the Fed owns a large quantity of long-term securities. Assets on the Fed’s balance sheet now sit at $4.48 trillion with over 90% being securities held outright. Over time, the Fed would like to reduce how much of these securities it holds and wants to avoid any need to reverse course and engage in yet another round of QE. Therefore, they want to make sure the economy is very strong – stronger than they would usually require – before increasing rates.

On the other hand, those in support of tightening monetary policy (i.e., raising rates) sooner rather than later hold that:

• Economic growth is firm with little slack remaining in the labor market. Unemployment has remained steady the last two months at 5.1%, lower than the rates at which the FOMC has tightened in previous cycles. Further, the recent modest growth in employment is a sign that employers are having trouble finding adequately skilled workers to hire.

“Whether the FOMC will pull the trigger and begin to raise rates in 2015 or instead continue to

keep its powder dry by remaining cautiously ready to take action is

still an open question.”

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• One of the original objectives of monetary policy easing was to get investors to take more risk, meaning to lend to private firms rather than park their money in relatively safe government bonds. But this increased risk-taking can go too far as investors “reach for yield” without due regard for the added risk and potentially sow the seeds of the next financial crisis.

• By keeping rates low, the Fed is signaling pessimism to the market about the strength of the U.S. economy. This creates a self-fulfilling prophecy as firms limit hiring and expansion until they’re confident the economy has regained solid footing. In other words, why should the private sector be optimistic about the future if the Fed is not?

We ourselves expect that a December rate hike remains a coin flip. If December is a no-go, the turnover the FOMC will see next year – the very dovish Narayana Kocherlakota will retire and hawk Esther George of Kansas City will rotate back to a voting member – may make early 2016 the most likely time for liftoff.

Of course, when Fed officials do speak about raising rates, they always leave themselves

a way out. Such uncertainty is typically not welcomed by markets and is one of the reasons why we’ve increased our allocation to flexible-bond-fund managers. This affords us two luxuries:

• First, these funds invest across a number of different bond sectors that have varying sensitivities to rate movements.

• Second, these managers are very in-tune with the underlying currents in fixed-income trading and have the flexibility to change their sector allocation much more quickly than we do at the company-wide level.

This flexibility to reduce exposure to the more rate-sensitive sectors is one reason why we don’t use exchange-traded funds (ETFs) for fixed-income asset classes in our client portfolios, choosing instead to use them only for equity exposure. An ETF that is tied to a broad fixed-income benchmark is required to mimic the underlying index and can’t make active decisions to reduce its duration, which is the measure of a bond’s sensitivity to rising interest rates. In our view, such limitation is less than ideal in the current environment.

Two Sides of the Coin

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ECONOMIC PERSPECTIVES

We usually kick off this section of Perspectives with a focus on the United States. However, the global economic landscape – and how it impacts the U.S. economy – appears much more relevant at this point in time.

Since the U.S. consumer is doing well for the most part, many eyes are focused on economies overseas. And lately, this attention has centered on commodity prices. After rising dramatically from 2000 to 2011, commodity prices declined steadily before dropping precipitously this past summer. The 22-commodity Bloomberg Commodity index – a global benchmark that tracks energy, metals and agricultural commodities – has fallen -23.8% in the last year2. What is driving these price movements? In a word: China.

SLOWDOWN IN CHINA

As the world’s second-largest economy and the largest importer of metals, China’s demand for raw materials has an oversized influence on the prices of many commodities. China’s rapid growth in the 2000s helped fuel a boom in the prices of copper, iron ore, nickel and oil. In response, producers of these commodities, many of whom reside in emerging markets such as Brazil, Indonesia and Zambia, expanded production and borrowed to invest in new capacity. But as the expansion of the Chinese economy began to decelerate, so did its demand for a wide range of commodities – and the combination of increasing production capacity and softening global demand caused prices to plummet.

In many emerging nations, weakening commodity prices have triggered sharp drops in the value of their home currencies. While depreciation in local currency value may help to spur exports of other goods, this combination of falling commodity prices and dropping currency values have

caused financial markets to tighten in these emerging nations. Such countries typically borrow abroad in dollars but earn profits and income in their local currencies. At the same time that their export income from commodities is declining, the cost of repaying debt is rising as the value of their own currency falls relative to the dollar.

So what are the prospects for China’s economy? China is in the midst of a major rebalancing process—moving away from an export-driven economy toward a more consumption-driven one. Hence the economy is pivoting away from a focus on manufacturing toward a greater focus on domestic goods and services. Much of this is part of the natural maturation of the Chinese economy, but it’s not been without growing pains.

China’s growth is clearly decelerating. Officially, Chinese authorities have reduced their growth target from 7.5% in 2014 to 7.0% in 2015. In other words, China’s economy is still expanding, but at a slower rate than it has been for the last couple of decades. These numbers should be taken with a grain of salt, however. Many independent observers, using measures such as electrical production and railway freight volumes to measure output, estimate that China is now growing between 5% and 6% per year. Even a 5% growth rate is quite healthy, but it is far cry from the double-digit increases we saw just a few years ago.

Evidence of a slowdown has been abundant. Over the summer, China’s financial markets collapsed and in response, China’s central

“As the expansion of the Chinese economy began to

decelerate, so did its demand for a wide range of commodities.”

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bank cut interest rates. More notably, Chinese officials imposed a number of draconian measures. For example, they limited short-selling, suspended new public offerings and arrested financial journalists on charges of “rumor mongering.” The government also provided money to pension funds and brokerage firms to buy shares in order to prop up prices. These measures not only had little effect in stabilizing the Chinese stock market, but they illustrated Chinese government officials’ ignorance of how financial markets work.

In August, the People’s Bank of China devalued the Chinese currency by 2% to reduce the price of Chinese exports. This move angered many of China’s trading partners who viewed it as a potential first shot in a currency war. This anger would prove to be misplaced, as the chart below shows that the yuan (the Chinese unit of currency) has been relatively stable since the August move. Perhaps the most damaging takeaway from the

surprise devaluation was that it was largely interpreted by markets across the globe as a sign that China’s economy was in worse shape than previously thought. As the chart illustrates, the S&P 500 would begin its sell-off shortly after the yuan devaluation.

The recent industrial downturn has made China’s realignment from manufacturing to services all the more urgent and as a result, the Chinese government continues to introduce structural reforms. In September, the government released a plan to restructure the state-owned enterprises. While this plan may generate widespread layoffs of state employees and therefore carries considerable political risks to the Communist Party, it is a step in the right direction. China must also keep a keen eye on its overheated housing market. Of course, as was illustrated by its botched attempt to manage the ups and downs of its financial markets, there are limits to what even an authoritarian government can do to stabilize markets.

Source: The Research Center, Board of Governors of the Federal Reserve System, Standard & Poor’s

Yuan Devaluation Spooks Global Markets

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ECONOMIC PERSPECTIVES

For the past two-plus years, our client portfolios have had little direct exposure to China and the emerging-market economies it influences, as we recommended removing the emerging-market equity asset class from our allocations in July 2013. At that time, we moved what had previously been allocated to emerging international markets into developed international markets instead.

This move has played out well: Over the period from July 31, 2013, to Oct. 27, 2015, developed international markets have seen +3.5% annualized returns while emerging markets have seen annualized losses of -2.1%. Given this discrepancy, emerging markets now look attractive from a relative valuation standpoint and we’re closely monitoring conditions to determine when we should re-enter the asset class.

At a high level, we’re looking for signs of improvement in China’s economy and would prefer to avoid being in emerging markets when the Fed first raises rates, as that likely will have an adverse impact on emerging nations.

U.S. ECONOMICS

What implications does a slowdown in the Chinese economy have on our lives here? The combination of a weakening Chinese economy, falling commodity prices and a strengthening dollar is a mixed blessing for the United States. America’s exports to China account for less than 1% of GDP, so the impact of a Chinese slowdown on our economy should be small. However, if a slowing China continues to drag down emerging markets or turns into a full-blown financial crisis, U.S. exporters will start to feel the pinch as generally, a strong dollar hurts U.S. manufacturers who export goods abroad. That’s because U.S. goods become more expensive and thus less attractive in foreign markets as the value of the dollar rises.

However, a strong dollar is welcome news for Americans travelling overseas. Consumers here at home benefit too, since imports from abroad are cheaper. Also, along with falling commodity prices, a strengthening dollar puts downward pressure on broad indicators of inflation. In particular, U.S. consumers continue to enjoy a steady decline in gasoline prices. According to AAA, the average price of a gallon of gas has fallen from $3.39 a year ago to $2.19 at the end of October. Barring any major supply disruptions, many consumers are likely to see the price of gas fall below $2 per gallon within the next few months. Overall, the U.S. government projects that the average household will save $700 in fuel payments this year relative to 2014.

What are consumers doing with this windfall?

• They’re spending more elsewhere. The Department of Commerce reports that consumer spending on all goods increased a healthy +0.4% in both July and August.

• They’re moving away from passenger cars in favor of buying SUVs and light trucks. While car sales are down -2.1% for the first nine months of the year relative to 2014, sales of light trucks are up +11.7%. Overall, total light vehicle sales are up +5% from last year.

• They’re driving more. During recessions, Americans typically cut back on driving and, unlike in the past, the average number of miles driven per person continued to decline even after the most recent recession ended. But now with gas prices falling, Americans are finally returning to the road.

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UPDATING THE RECESSION SCORECARD

In the August issue of Perspectives we introduced the “recession scorecard” to provide a snapshot of the health of some key U.S. economic data points. We’ve seen some weaker-than-anticipated economic releases over the past few months, yet we see only one indicator sitting in the neutral range.

Despite the weaker-than-expected data that’s come in, the housing market continues to look healthier. For the better part of the current recovery, the pace at which Americans are setting up homes has been relatively subdued when compared to the levels seen prior to the Great Recession of the late 2000s. There are many reasons for the lower levels of household formation, ranging from more millennials living with family after finishing school to the overall employment situation. However, with the improvement we’ve seen in the jobs market over the last year, we’ve seen

the pace of household formations pick up as well. We’ve also seen new residential construction up +17.5% year-over-year in September, existing-home sales up +8.8% in the last year and – despite a disappointing month-over-month drop – new-home sales are still +2% above their September 2014 level.

Given that household formation is a key driver of overall demand for housing, the pickup seen over the last year should be a sign of better days ahead.

Source: The Research Center, Bloomberg Intelligence

Recession Scorecard

Long-term U.S. Treasury rates remain above short-term rates, indicating economic contraction in the short term remains relatively low.

Energy prices continue to keep headline inflation low, while core inflation remains below 2%.

ISM producers’ manufacturing index is trending down and hit its lowest level since December 2012, remaining just slightly in expansion territory.

At 34.5, average weekly hours remain in the same range that was seen prior to the Great Recession.

New residential construction continues to move steadily with 1.206M housing starts in September; homebuilder confidence remains strong.

Total capacity utilization – as reported in the monthly industrial production figures – has remained consistently north of 77% this year.

Yield Curve

Capacity Utilization

Inflation

Manufacturing

Positive

Average Weekly Hours

Housing Starts

Positive

Positive

Neutral

Positive

Positive

Household Formations See Strong Rise

POLITICAL PERSPECTIVES

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THE VIEW FROM D.C.

Below is a sampling of recent conversation on Washington D.C. policy; content provided by Potomac Research Group (PRG). PRG is an independent research firm that provides Washington policy analysis to institutional investors and private equity firms. PRG’s evaluation of federal legislative activities and regulatory and Federal Reserve policies helps clients determine Washington’s impact on industry and the economy.

Going into the third quarter, we knew it was going to be a touchy period having been preceded by continuous calls from the right-wing for a government shutdown as part of a strategy to defund Planned Parenthood. However, House Speaker John Boehner shocked Washington in late September when he announced his decision to resign from his post. Speaker Boehner had been facing increasing opposition from his own party, including a proposed legislative tactic to oust him in August.

Boehner’s resignation resulted in uncertainty in Washington. Following his announcement, we saw the current Majority Leader Kevin McCarthy (R-CA) pursue the Speakership and subsequently drop his bid when the Freedom Caucus/Tea Party rallied against him. Eventually, after much deliberation, Paul Ryan stepped to the plate in late October to take on one of the toughest jobs in Washington.

Despite all the uncertainty, Congress managed to avoid a government shutdown by passing a Continuing Resolution to fund the government through Dec. 11. Furthermore, reports in late September revealed that President Obama, Speaker Boehner and Majority Leader McConnell had agreed to enter into budget talks with the aim of agreeing on a framework to set discretionary caps for the next two years. As we later saw, these talks came to fruition in late October when Boehner left the newly

elected Speaker Ryan with a two-year budget, a debt-ceiling deal and a clean slate.

Although the most contentious issues are off his plate, Speaker Ryan will still have to wrangle several remaining items before the end of the legislative calendar. These include cyber-security legislation, the Ex-Im Bank, a long-term transportation deal and shepherding the package of appropriations bills that will allocate money authorized by the budget deal – that bill will actually determine how much money each domestic agency is to receive for the rest of the fiscal year. All in all, we give favorable odds to Ryan and Washington having a relatively orderly rest of the year.

By early August, we saw the GOP race turn a corner. For the first time, we got to hear from the 16 candidates in two primary debates. One of the bigger surprises of the primary season came when Scott Walker announced he would drop out of the running. And while Carson and Trump continue to gain traction and poll well, we still maintain they will be out of the running as voters contemplate the policy issues and consider who should have a finger on the nuclear button. Ultimately, we may not have a GOP candidate until June or July of next year. Everyone will enjoy a surge, but we continue to believe Rubio is the GOP candidate to watch.

As we look ahead to the 2016 presidential race, keep in mind that what happens after the big state primaries will make all the difference for the GOP bench. We wouldn’t rule out Carson winning Iowa or Bernie Sanders narrowly taking New Hampshire – but this will mean little. Rick Santorum, after all, won Iowa in 2012. The big state races will be dominated by a saturation of negative ads – and that’s where Trump and Sanders are the most vulnerable. Bottom line: We still have a long way to go.

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Our Market & Economic Outlook Influences Our Decision Making

KEEPING THE LINE MOVING

In the August issue of Perspectives, we focused on a trio of risks and their implications for the United States. Looking back at those three risks, we are reminded of how quickly the focus changes when it comes to global markets, as the Greek debt crisis and Puerto Rico’s municipal issues have hardly garnered any attention during the third quarter – although China does remain a concern due to the sheer size of its economy and how intertwined the nation is with other emerging markets and developed commodity-focused nations. At the moment, however, none of the global issues we’ve talked about in this issue seem poised to derail the progress made by the U.S. economy over the last six years.

Looking ahead to the remainder of 2015 and the start of a new year, here are some of the key areas of concern we’re paying close attention to:

• Whether or not the Fed moves rates in December remains a coin flip, and if they don’t take action, then we wonder what sort of role politics and the election cycle will play in keeping them on the sidelines.

• We expect the European Central Bank to add to its stimulus for the Eurozone, likely sometime in December. Whether this means extending the current time frame for asset purchases, ramping up the amounts purchased, or both remains unknown. With the Bank of Japan likely to remain accommodative in an effort to support economic growth, we will likely maintain our current allocation to developed international markets.

• Removing emerging-market equities from client portfolios in 2013 made sense from a risk-return perspective, but now we think there may be an opportunity ahead to re-enter the asset class. Given China’s stature within the emerging-market world, we hope to see some “green shoots” there and would like to see how markets in developing nations react if the Fed raises rates later this year or early next.

All in all, we expect the U.S. economy to keep the line moving and lead us into 2016.

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1According to the Institute for Supply Management 2For the trailing 12 months ending Oct. 20, 2015.

Published quarterly by The Research Center, the research arm of The Mutual Fund Store®. The “Research Center,” as referenced throughout this publication, is The Mutual Fund Research Center, LLC.

The Research Center is an SEC-registered investment adviser and provides mutual fund research and analysis to The Mutual Fund Store franchise and affiliated entities and to TMFS Advisory Services, LLC. The research and analysis provided is non-discretionary and is primarily mutual fund recommendations, asset allocation models, and market and economic research and data. All franchise and affiliated Mutual Fund Stores receive the same information. Each Mutual Fund Store separately implements the recommendations and information provided on a discretionary basis for each of its clients, taking into consideration each client’s circumstances and investment objectives. Information provided to TMFS Advisory Services is specific to the Retirement Paycheck® service.

This issue shows data on select financial market indexes. Index returns are provided as a benchmark and are not illustrative of any particular investment. An investment cannot be made in an index. Index returns are calculated as a total return with dividends and capital gains reinvested unless otherwise noted. No index reflects the transaction or management fees investors would incur if investing in those stocks or a security that replicates the index’s holdings. Asset allocation models recommended by The Research Center may include allocations to mutual funds that invest in various asset classes, including asset classes other than the ones discussed in this issue. Your local Store advisor considers several factors when providing your account with advisory services, such as your personal investment objectives, your tolerance for risk and any instructions you have given the advisor. Those factors may influence how the asset allocation recommendations are utilized for your account. Thus, the asset classes discussed in this issue of Perspectives may or may not be the same asset classes utilized in your portfolio.

This report is published solely to provide information and perspective and should not be considered to be investment advice or a recommendation to buy or sell any specific mutual funds or securities. Opinions and estimates constitute our best judgment as of the date this material was prepared, are subject to change without notice due to changing market and economic conditions, and may differ from opinions expressed by other individuals or business areas or offices within The Mutual Fund Store or The Research Center. We believe information obtained from third-party sources is reliable, but neither The Research Center, nor The Mutual Fund Store franchise and affiliated entities, can guarantee its accuracy. Past performance does not guarantee future results.

Publication date of this issue – Nov. 17, 2015