lsa 2016 market outlook

2016 LSA Market Outlook 1

These views represent the opinion of the Asset Allocation Committee and are informed by subjective assessment of the relative attractiveness of asset classes and subclasses over a 6- to 18-month time horizon. The approach is largely qualitative and valuation based, with attention to a broad scope of potential risks and potential return scenarios.

• Fixed Income: tightening cycle arrives– Long-awaited Fed tightening likely t put steady upward pressure on short-term yields.– Longer-term yields remain below equilibrium, and real yields should rise, but subdued inflation and central bank buying

provide some offset.– Credit spreads look wide relative to favorable U.S. economic circumstances. Exposures to High Yield have to potential to

capture potential spread narrowing.

• U.S. Equity: still in mid-cycle– Consumer spending has led to a recent pick up in U.S. growth.– The economy remains n the middle of its current expansion, with limited recession risk.– With the oil price fall mostly behind us, earning growth should improve.

• International Equity: European rebound continues, EM challenges remain– Euro area equities have held up against political risk and should benefit from improvements in corporate earnings.– Uncertainty surrounds the Japanese economic outlook, but improved corporate governance should boost stocks.– EM economies are facing challenges on a number of fronts, including Fed tightening, commodity price weakness and a

slowdown n China.

What you’ll find


2016 Probability Outlook

• We Remain Cautiously Bullish (since 2010)– Probability of a deep double dip recession (5%)– Probability of a pullback around 10-15% (50%)– Probability of Sideways moving market “Range Bound” (40%)– Probability of continued Bull Run above 19,000 (5%)

• We believe that the return of volatility will keep the markets guessing in 2016 creating more of a sideways market. Historically sideways markets have proven well for active management creating some favoritism to actively managed investments. The decline in oil prices is a concern for a possibility of defaults, and the continued restructuring of China will continue to cause unease in the markets in 2016.

• Domestic Equity – target return for 2016 mid single digit returns. (4% - 8%)• Fixed Income – targeted 10-yr 2.75% – 3.00%• International Equity – mid to high single digit returns (6% - 9%)


A Broad Outlook at 2016

• Fixed Income:

• Domestic Equities:

• International Equities:

Bearish Neutral Bullish



A bearish reading indicates the potential for an asset to underperform its class or subclass on a risk-adjusted basis. A bullish reading indicates the potential for an asset to outperform its class or subclass on a risk-adjusted basis. A neutral reading indicates the potential for performance in line with the asset’s historical averages. The arrow represents our 12-18 month view .


Fixed Income: tightening cycle arrives

Themes:• Low yields among high-quality investments –

average yield across developed market 10-year government bonds is 1.4%

• Competing forces are creating a tug of war on rates – competing pressures will likely result in a flatter yield curve

• High yield remain attractive in the context of an improving economy – with the U.S. economy improving and the Fed preparing to begin tightening, high yield is one of the most attractive options.

• Emerging Market fundamentals are weakening – percentage of EM investment-grade sovereign debt has fallen to 57% form 68% in 2014







Fixed Income

U.S. Government

U.S. Investment Grade

Non-U.S. Developed

Emerging Market debt (USD)

U.S. High Yield



Bank Loans

U.S. TIPS

Today’s environment of low yields and tight corporate spreads offers little opportunity beyond clipping coupons. Active management and mobility will help investors find value in 2016


Low yields among high-quality investments 1.4%Average yield across developed-market 10-year government bonds.


The Fed has anchored the short end and rates may stay lower longer

Our team continues to believe that we will see the 10-year continue to normalize over the next 2-5 years pushing the 10-year rate around 4.2 – 4.5%


High yield remains attractive in the context of an improving economy


High yield remains attractive in the context of an improving economy

Credit markets are experiencing reduced liquidity, in part due to outflows from mutual funds and ETFs. Extended declines in raw material prices, including oil, has created considerable stress in those particular sectors.

We view this as an opportunity for long-term investors. Liquidity is draining and high yield prices are off. This is our view, one of the better opportunities since 2008 to buy into well researched high yield positions. Barclays HY Yield to Worst is back to 8.71% with spreads over treasury's at 600 basis points. The index yield is at its highest level since the fall of 2011 and is well above long term averages. Furthermore, the High Yield risk premium (accounting for projected default losses) still looks attractive to us for this stage of the credit cycle.

• Business fundamentals drive results for both HY and Equities• HY Bonds typically provides much better downside protection than equities

– HY has a known terminal value you can count on– After accounting for maturities, tenders and callable bonds the HY market typically returns approximately 18-22% of its value

each year in cash.

• Peak to trough losses of over 5% (11 in the last 25 years):– Have been recovered in as little as 2 months, and on average about 6 months.

• After a market bottom, HY tends to reclaim prior highs in less than a year– Only once did it take more than a year:

• § An investment at the peak in June 2007 took 24 months to return to the prior peak (after the 5% loss from June to July).


Looking Forward – Fixed IncomeWe are looking to continue to overweigh credit in high yield and bank loans amid liquidity and default concerns that could come into play in 2016. The high yield sector continues to offer a yield advantage and lower duration profile that is less sensitive to rising interest rates. Continued strength in M&A activity could be supportive of select issuers.

Although the covenant terms in recent issuances have become less favorable to investors, high yield bonds remain attractive relative to other sectors in this low-yield environment, particularly given prospects for a slowly improving economy. Many high yield issuers have improved their liquidity profile by extending maturities and refinancing to lower-coupon debt. Default rates remain low, and the tendency for high yield debt to be less sensitive to changes in interest rates has appeal given that the general level of interest rates remains low from a historical perspective.

EM bonds are facing economic headwinds, most notably from China. This has caused several rating downgrades within EMD countries in 2015. Emerging-market fundamentals have disappointed for longer than expected and with the US beginning to raise rates many investors are wary.

The U.S. dollar is supported by prospects for improving growth and the potential for higher rates in the U.S. as the Federal Reserve’s tapering program concluded October 31 st and U.S. interest rate policy normalization begins. Further policy actions by the European Central Bank (ECB) and Bank of Japan (BOJ) to stimulate growth and inflation could provide catalyst for their currencies to decline relative to the dollar.

Cast a wider net for income while carefully balancing the trade-offs between yield and duration risk.

Use core bonds for diversification benefits and potential protection from unforeseen shocks to equity markets.

Consider a flexible strategy with the ability to actively manage duration.

Insight: With interest rates likely to continue to rise in the United States in 2016, fixed income investors continue to face significant challenges.


Looking Forward – Fixed Income

2016 Order of Attractiveness• High Yield• Bank Loans• World Bond• Multi-Sector Bond• Intermediate/Short Term Bonds• Municipal Bonds• Treasury Inflation Protected

Securities• MBS/CMBS/ABS• U.S. Treasuries• EM Debt


U.S. Equity: improving economy and high valuations have markets at a crossroad

Themes:• The U.S expansion continues to mature – 69 consecutive

months of positive leading indicators.• As rates rise, expect volatility and opportunities, but not

a recession – average annual return on stocks is 11% during the past four tightening cycles.

• Macro factors point to select opportunities – there is a negative correlation of consumer discretionary stocks to commodity prices over the past 10 years.

• Valuations still suggest more muted returns – since 1954, P/E ratios of 17x have led to 4% price returns on average over the subsequent decade.






U.S. Equity

U.S. Large Cap

U.S. Growth

U.S. Value

U.S. Small Cap

At this stage of the recovery, multiple expansion may have run its course, suggesting that companies must deliver earnings growth for the market to continue it’s advance. Earnings growth is attainable if economic activity continues to be strong over the next couple of years.


The U.S. expansion continues to mature


Equities: Is the recessionary writing on the wall? A historical look-back at recessionary indicators


Valuations still suggest sluggish returns


Looking Forward: Domestic Equities

Active management will play a bigger role in 2016. In 2015 only 10 stocks in the S&P 500 were in positive territory and many stocks experienced a bear market in the 3Q pullback.

Stay focused on more attractive valuation areas that could potentially dampen the impact of increased volatility.

Insight: Although markets should be more volatile in 2016, the United States remains the strongest economy in the developed world.

We continue to remain cautiously bullish on U.S. stocks. However sluggish earnings growth, elevated margins, and high P/E multiples leave little room for upside. We are forecasting continued elevated volatility based on the Fed continuing to tighten and limited upside.

An accelerating U.S. economy is a notable exception in a world where growth is expected to be below the long-term trend for most countries. We anticipate GDP growth in the area of 2.25% to 2.75% in 2016.

2016 Order of Attractiveness• Large Caps

– Growth valuations are slightly more attractive than value

• Mid Caps– Growth valuations are slightly more

attractive than value

• Small Caps– Growth valuations are slightly more

attractive than value


The energy crisis is struggling to find a reliable bottom


Looking Forward Sectors

2016 Order of Attractiveness

• Technology• Financials• Global Real Estate• Healthcare• Consumer Discretionary• Energy• Industrials• Materials• Utilities• Consumer Staples• Telecommunications

• Themes:• We continue to like the technology , global real

estate, healthcare and financials sectors. With the U.S. economy rebounding and Fed policy normalization approaching, we prefer cyclical sectors that are still reasonably valued and are geared toward benefiting from a pick-up in global growth and lower energy prices.

• We continue to be concerned with the energy sector. While we still like global integrated oil companies for their attractive valuations and diversified business models, we are becoming more cautious toward exploration and production companies as well as oil servicing companies given that they are more sensitive to any further downward pressure on oil prices.

• We continue to be cautious on defensive and certain dividend-rich sectors, particularly consumer staples and U.S. utilities. These sectors all sport aggressive valuations and carry hidden duration risk, or interest rate sensitivity. If bond yields increase even moderately in 2016, these equity sectors are likely to underperform.


International Equity: the road to recovery has begun

Themes:• QE in Europe and Japan could boost stock returns – the

European Central Bank and Bank of Japan could inflate their balance sheets by more than $1T in coming years.

• EU sentiment, credit flows and GDP, moving in the right direction – economic sentiment has risen to a level not seen since 2010.

• Abenomics bodes well for Japanese equities – reforms are shifting to investor returns: profit margins are on the rise.

• Opposing forces in China suggest a neutral stance – slowing growth and unpredictable policy moves temper China’s appeal for many investors.






International Equity

Overall Developed-Market (ex-U.S.) equity

Japanese Equity

Emerging Market Equity

European Equity

Relative to the United States, select foreign markets continue to offer compelling valuations and earnings growth potential, through an accommodative monetary policy. Emerging-market fundamentals are stabilizing as more institutional investors are looking overseas for 2016 but we believe EM will continue to be volatile.


QE in Europe and Japan could boost stock returns – “Central bank policies in Europe and Japan have gone from meet to aggressive. The intent is to weaken currencies, spark inflation, and induce risk taking, which should support equities, in bot developed and emerging markets.”


International Rates


China continues to adjust the Yuan


Chinese equities present opportunities and risks “Supportive monetary policies are helping to offset slower economic growth and unexpected policy moves”


Looking Forward: International Equities

It may be time to consider getting back to a greater emerging market exposure but we should remain selective.

Use an active manager approach with strong selection expertise. Allow value managers time to allow value calls to be realized.

Insight: Europe has intriguing pockets of value, while Japan appears relatively undervalued in the world today

Our global growth expectations remain modest over the next several quarters. Gradual improvement in U.S. economic activity is supported by diminishing fiscal headwinds, increased state & local government spending, improving private sector demand and moderate job growth. Offsetting this growth, Japanese and European growth momentum has moderated recently with Europe remaining hindered by high debt loads, high unemployment, and deflation worries. Slowing growth in China, Brazil, and other emerging economies weighs on global trade as commodity prices continue to apply pressure across the globe.

2016 Order of Attractiveness• Global/World Stock• Developed Markets

– Foreign Large– Foreign Small/Mid

• Eurozone• Japan

• Emerging Markets– Region specific

• India


2016 Probability Outlook

• We Remain Cautiously Bullish (since 2010)– Probability of a deep double dip recession (5%)– Probability of a pullback around 10-15% (50%)– Probability of Sideways moving market “Range Bound” (40%)– Probability of continued Bull Run above 19,000 (5%)

• We believe that the return of volatility will keep the markets guessing in 2016 creating more of a sideways market. Historically sideways markets have proven well for active management creating some favoritism to actively managed investments. The decline in oil prices is a concern for a possibility of defaults, and the continued restructuring of China will continue to cause unease in the markets in 2016.

• Domestic Equity – target return for 2016 mid single digit returns. (4% - 8%)• Fixed Income – targeted 10-yr 2.75% – 3.00%• International Equity – mid to high single digit returns (6% - 9%)


2015 LSA Market Outlook

This report and more analysis can be found online.

www.LSABeta.com

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lsa 2016 market outlook

Economy & Finance