quarterly market commentary — spring 2016 matters of …...source: trust company, factset. q4 2015...

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MATTERS OF TRUST

Quarterly Market Commentary — Spring 2016

PASSIONS, EXAGGERATIONS & FUNDAMENTALSAll passions exaggerate; and they are passions only because they do exaggerate.” - Nicolas Chamfort

Global equities – MSCI All Country World Index, Domestic Equities – S&P 500, International Developed – MSCI EAFE, Emerging Markets – MSCI EM, Global Bonds – Barclays Global Agg, U.S. Aggregate – Barclays U.S. Aggregate, International Developed - JPM Non-US GBI Unhedged, Emerging Market Debt - JPM GBI EM (Unhedged).

From the Desk of the CIO

J. Reed Murphy

Q1 YTD 1Y 3Y 5Y 10Y

Equities

Policy - Global Equities 0.3% 0.3% -4.4% 5.6% 5.2% 4.3%

Domestic Large Cap 1.4% 1.4% 1.8% 11.8% 11.6% 7.0%

International Developed -3.0% -3.0% -8.3% 2.2% 2.3% 1.8%

Emerging Markets 5.7% 5.7% -12.0% -4.5% -4.1% 3.0%

Real Estate - Global 4.3% 4.3% -0.1% 5.5% 7.3% 2.8%

MLP -4.2% -4.2% -31.8% -10.3% -0.6% 7.7%

Fixed Income

Policy - Global Bonds (USD) 3.3% 3.3% 2.4% 3.7% 4.6% 4.8%

Domestic U.S. Aggregate 3.0% 3.0% 2.0% 2.5% 3.8% 4.9%

International Developed (Unhedged) 9.1% 9.1% 8.2% 0.1% 0.3% 4.2%

Emerging Market Debt (USD) 5.2% 5.2% 4.4% 2.4% 6.0% 7.1%

Tax Exempt (Munis) 1.1% 1.1% 2.6% 2.1% 3.2% 4.0%

50/50 Blend Global Equities/Bonds 1.8% 1.8% -1.0% 4.6% 4.9% 4.5%

EXHIBIT 1 – PRIMARY MARKET RETURNSAS OF MARCH 31, 2016

The talented and troubled French writer from the 1700s known for his witty epigrams and aphorisms once penned this quotation. These same passions led to exaggerations and hyperbole in both the investment markets and U.S. presidential process this past quarter. While we will hold comment on the political scene for another day, passions did feed exaggerations on the investment front as economic news drove market sentiment out of line with true underlying fundamentals during the quarter. The byproduct of such extremes was a nose dive of over 11.5% for global equities from the beginning of the year through February 11th.

Global stocks eked out a positive 0.3% return for the quarter. Surprisingly, these returns were led by what

many consider a short-term bounce in emerging market stocks with a

positive 5.7% return. The U.S. stock market (i.e., S&P 500) was up 1.4%, while perhaps the most attractive group of international developed stocks were down 3%. On the sector front, global real estate returns of 4.3% were balanced out by MLPs (-4.2%).

On the heels of economic concerns and more central bank stimulus, global bonds were up 3.3% led by international and emerging markets. Overall, a 50/50 blend of global stocks and bonds was up 1.8% in the quarter. Disciplined investors were rewarded for their patience.

The 4Cs, Central Banks, China, Currencies and Commodities, set

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EXHIBIT 3 – S&P 500 BULL MARKETS

Source: Strategas Investment Research.

Source: Bloomberg. ACWI (All Country World Index)

EXHIBIT 2 – GLOBAL EQUITIES FIRST QUARTER PERFORMANCE

0%

50%

100%

150%

200%

250%

300%

350%

400%

450%

0 20 40 60 80 100 120

Bul

l Mar

ket A

dvan

ce (%

)

Bull Market Duration (Months)

S&P 500 Historical Bull Markets1928 to Present

1987 -901966 -68

1970 -731962 -66

1957-61 2002 -07

1942 -46

1974 -80

1982 -87

1949 -56

1932 -37

1990 -00

3/9/09 to Current, 85 Mos, 204%

Average57 Mos, 165%

“The underlying issue in all these exaggerated

concerns was that the global economy was headed

for a recession.”

the stage for a runaway of negative sentiment during the first half of the quarter. In December, the U.S. central bank (Federal Reserve) set the table for a bumpy ride by increasing short-term interest rates. China reported weaker than expected economic news. Oil accelerated its downward spiral based on global growth concerns. China promptly devalued its currency, causing more havoc. Trying to slow the negative tide, central banks in Japan (BofJ) and Europe (ECB) announced dramatic

stimulus plans. Markets responded favorably in the short-term, only to continue their downturn based on concerns that negative interest rates in those regions would damage their banking systems. Cooler heads started to prevail as better global economic news trickled out. Coming full circle, this merry-go-round of passions and exaggerations calmed down; as we predicted, the Federal Reserve has suggested that they will not raise interest rates four times in 2016. Was it really a surprise that

they were influenced more by the concern for faltering global growth and market stability over their core responsibilities for domestic inflation and employment, both of which suggest interest rate hikes are due?

The underlying issue in all these exaggerated concerns was that the global economy was headed for a recession. Is it? No, at least not yet.

BULL MARKETS, BEAR MARKETS & RECESSIONS To set the record straight, bull and bear markets are different than recessions. Bulls and bears refer to whether the market is up or down. Recessions refer to the economy. Regarding domestic equities, which is only one asset class in a well diversified balanced portfolio, we recently celebrated a seven-year run of positive equity returns. It hasn’t been pretty that whole time, but it does suggest the bull market for domestic equities may be getting long in the tooth. According to Strategas Investment Research, this is the third longest bull market since 1928. This duration has some investors nervous, as a fall from such a perch could lead to a bear stock market (often defined as a decline of 20%). In January and February many thought we were on our way to a bear market and a recession.

So, how are bull and bear markets and recessions linked? The stock market is a leading indicator of the


EXHIBIT 4 – S&P 500 BEAR MARKETS

Source: Strategas Investment Research.

Source: Trust Company, FactSet.

Q4 2015 2015 Q1 2016 E 2016 E 2017 E

Revenue Growth -4.0% -3.6% -0.8% 1.5% 6.2%

EPS Growth -3.5% -1.1% -8.4% 2.5% 13.3%

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

S&P 500 - Revenue & Earnings Growth

“Equity bear markets infrequently occur without

an actual economic recession occurring.”

Start End

Duration (Months)

Percent Change

Market Correction Date Price Date Price Recession?

Fed Tightening?*

1929 Market Crash 9/16/1929 31.9 6/1/1932 4.4 32 -86.2% X X “New Deal” Policy Errors 3/10/1937 18.7 4/28/1942 7.5 62 -60.0% X X Post WWII Crash 5/29/1946 19.3 6/13/1949 13.6 37 -29.6% X ** Recession 8/2/1956 49.7 10 /22/1957 39 15 -21.6% X X Kennedy vs. U.S. Steel 12/12/1961 72.6 6/26/1962 52.3 6 -28.0%

X

Hanoi Bombed, Taxes, Fed 2/9/1966 94.1 10/7/1966 73.2 8 -22.2%

X “Go -Go” Bull Ends 11/29/1968 108.4 5/26/1970 69.3 18 -36.1% X X Stagflation 1/11/1973 120.2 10 /3/1974 62.3 21 -48.2% X X Volcker Breaks Inflation 11/28/1980 140.5 8/12/1982 102.4 20 -27.1% X X 1987 Crash 8/25/1987 336.8 12/4/1987 223.9 3 -33.5%

X

Gulf War I 7/16/1990 369 10/11/1990 295.5 3 -19.9% X X Tech Bubble Bursts 3/24/2000 1527.5 10/9/2002 776.8 31 -49.1% X X Global Financial Crisis 10/9/2007 1565.2 3/9/2009 676.5 17 -56.8% X X

Average 21 -39.9% *Fed tightening around or before incidence of bear market

**Inflation started to rise in this period after war-time price controls. The Fed did start to decrease the size of its balance sheet but wasreluctant to increase rates until 1948.

.

S&P 500 Bear Markets

EXHIBIT 5 – EARNINGS RECESSION

economy. Investors vote on whether or not an economic expansion or recession is going to happen. Using history as precedent, equity bear markets infrequently occur without an actual economic recession occurring. According to a study by Strategas, the U.S. economy experienced a recession in 10 of the past 13 bear markets and the Fed was tightening (i.e., raising interest rates) during all of those cycles.

Moving from equity bear markets to economic recessions, it is important to note that the common elements of recessions are imbalances. Economies are generally overheating based on overconsumption and overinvestment. The result is aggressive tightening by central banks. Currently, we are not experiencing these overheating imbalances, and the Federal Reserve is just starting to raise interest rates, albeit reluctantly.

U.S. EARNINGS RECESSION While we are not experiencing an economic recession, we are experiencing a domestic earnings

recession. S&P 500 earnings growth declined 3.5% for the fourth quarter and 1.1% in 2015 (99% reporting). The primary culprits for these declining earnings are the strongly rising U.S. dollar and the devastating impact of declining oil prices on the energy sector. Energy sector earnings were down 72.6% in the fourth quarter and down 60.2% for 2015.

Going forward, first quarter earnings are expected to decline 8.4%. If this occurs, the S&P 500 will have experienced five consecutive

quarters of declining earnings – a clear earnings recession. However, we expect that the drag of a strengthening U.S. dollar and low energy prices will abate. This will create more attractive revenue and earnings comparisons in the latter half of 2016 and into 2017. Nonetheless, productivity and wage pressures are mounting. The result is corporate profitability measures are rolling over. This is often a precursor to a slowing economy or an economic recession.

THE ECONOMY Global GDP growth forecasts for 2016 and 2017 have been coming down in recent quarters. The base case for 2016 U.S. GDP growth is in the 2% to 2.5% range, which is in line with the post-recession expansion of 2.2%, but much lower than the long-term average of 3.1% since 1960.


Source: BLS, FactSet, J.P. Morgan Asset Management.

U.S. GDP Growth (Quarterly, annualized)

-10 -7.5

-5 -2.5

0 2.5

5 7.5 10

12.5 15

17.5

Q1

1960

Q

2 19

61

Q3

1962

Q

4 19

63

Q1

1965

Q

2 19

66

Q3

1967

Q

4 19

68

Q1

1970

Q

2 19

71

Q3

1972

Q

4 19

73

Q1

1975

Q

2 19

76

Q3

1977

Q

4 19

78

Q1

1980

Q

2 19

81

Q3

1982

Q

4 19

83

Q1

1985

Q

2 19

86

Q3

1987

Q

4 19

88

Q1

1990

Q

2 19

91

Q3

1992

Q

4 19

93

Q1

1995

Q

2 19

96

Q3

1997

Q

4 19

98

Q1

2000

Q

2 20

01

Q3

2002

Q

4 20

03

Q1

2005

Q

2 20

06

Q3

2007

Q

4 20

08

Q1

2010

Q

2 20

11

Q3

2012

Q

4 20

13

Q1

2015

GD

P G

row

th R

ate

EXHIBIT 6 – U.S. GDP GROWTH

“U.S. continues to diverge from the rest of world with small increases in

short-term interest rates.”

Civilian unemployment rate and year-over-year growth in wages of production and non-supervisory workers

Seasonally adjusted

50-yr. average: 4.3%Mar. 2016: 5.0%

Oct. 2009: 10.0%

Mar. 2016: 2.3%

50-yr. average: 6.2%

Wage growth

Unemployment

EXHIBIT 7 – UNEMPLOYMENT & WAGE GROWTH

Source: Trust Company, Bloomberg.

Important factors to watch for the U.S. economy are economic growth patterns overseas and the state of the U.S. consumer. Domestically, higher savings rates and slow wage growth have contributed to sub-par economic growth. However, consumers, which make up approximately 70% of GDP growth, are in strong shape fiscally as debt coverage ratios are historically low and total net worth has increased largely due to housing prices and investments. Exhibit 7 highlights both the positive trends in unemployment and the negative sluggish trend in wage growth.

While sovereign debt levels, domestically and abroad, are contributing to anemic growth, further downside risks include exogenous events, outright policy missteps and weaker than desired benefits from such economic policies.

2016 THEMES REVISITED The themes that we discussed at year-end were certainly in full force

during the quarter. We were rewarded by focusing on fundamentals instead of letting negative sentiment dictate selling into fear. While we refused to give way to negative sentiment, going forward we believe in a Goldilocks scenario – the economy isn’t too hot, nor is it too cold. As we look at current valuations and fundamentals, we believe that a keen eye towards risk management is ever more important. As such, we have taken several steps to provide some shock absorbers in portfolios. Here are

some updates on 2016 themes:

1) Divergence (Monetary Policy) - U.S. continues to diverge from the rest of world with small increases in short-term interest rates, while much of the rest of the world remains stimulative through rate cuts and other quantitative easing. Expect the U.S. Fed to increase short-term rates (i.e., tightening monetary policy), but not nearly as many times as most were expecting. Delays have already occurred due to suppressed oil prices, currency strains driven by an increasing U.S. dollar, concerns for slow global growth and market stability. The base case is that global central banks continue to stimulate and take new approaches to doing so, while the Fed increases short-term rates later in the year.

2) Convergence (GDP Growth) – The base case is that U.S. GDP should continue to grow slowly,


particularly if the pace of the U.S. dollar strength slows, government fiscal stimulus takes hold and energy prices rebound. The base case is that central bank intervention, particularly in Europe and Japan, bears GDP fruits. We continue to see loan demand in Europe pick up. The downside concern is that these monetary actions are losing their luster.

3) Low Rates & Inflation - Expect low global interest rates and inflation on spotty and overall lower levels of global growth. Domestically, wage increases are improving and a rise in oil prices could provide upside pressures on inflation. However, the base case is still for low interest rates and inflation.

4) Currency – The base case is for the impact of the divergence in monetary policies between the U.S. and the

rest of the world to subside, providing a respite for U.S. dollar advances. As we previously discussed, the declining strength of the U.S. dollar has benefited oil prices, as they are priced in dollars and are consequently less expensive for various countries to

import. In turn, this could be a positive to many emerging market economies. However, emerging markets have leveraged up in recent years, which may dampen the upside in certain emerging market debt instruments.

5) Energy – The dramatic collapse in oil prices has been based on a

sentiment-based sell-off due to a supply/demand imbalance. Currently, the oil market has an oversupply of approximately 2 million barrels per day on a base of 95 million barrels per day in demand. The magnitude of this imbalance seems small relative to the drop in price from $112 (i.e., Brent Crude) in June of 2014 to a recent low in the high $20s. The concerns have been based on two fronts. The first is slowing demand based on global economic growth concerns. The second is based on an oversupply concern due in part to the dramatic run-up in U.S. stockpiles based on fracking and horizontal drilling. The base case is that the supply/demand imbalance will level out in the second half of 2016. We have already seen a significant run-up in oil to the $40 range. Emerging markets and MLP investments responded favorably

Divergence (Monetary Policy)

U.S. continues to diverge from the rest of world. However, our predicted delays in rate increases in the U.S. provided a rally in risk assets. Base case is that this will be short lived.

Currency

The divergence in monetary policies between the U.S. and the rest of the world may subside, providing a respite for U.S. dollar advances. Base case is that the momentum slows

Low Rates & Inflation

Expect low rates based on anemic global growth. Domestically, wage increases are improving and a rise in oil prices could provide upside pressures on inflation.

Convergence (GDP Growth)

U.S. GDP growth should continue, while many foreign developed countries have better year-over-year improvements off a lower base.

Energy

Stabilization in oil prices could result from a supply/demand rebalance and help risk based assets. Benefits to commodity driven economies may be dampened by other issues.

Increasing Volatility

Expect more market volatility this year based on continued geo-political strains and teetering economic news on many already expensive investment markets.

Equities

International developed countries, particularly Europe, could continue to provide better returns than the U.S. Emerging markets are cheap but have lingering issues.

Fixed Income

While interest rates may remain low and rise slowly , we are not content with historically low yields and the risk/return profile.

Complementary Strategies

Given the tenuous nature of equity markets and the unattractive fixed income outlook, we continue to look at other lower/non-correlated strategies and risk hedging strategies.

“Expect low global interest rates and inflation on spotty and overall lower levels of

global growth.”

ASSET CLASSES (PRIMARY)

THEMES


during the quarter.

6) Increasing Volatility - Expect more market volatility this year based on investor concerns for the length of equity bull markets, extrapolation of weak economic news, potential monetary and policy missteps and continued geo-political strains on many already expensive investment markets.

PORTFOLIO IMPLICATIONS

EQUITIES While domestic equity valuations are at or higher than historical norms, the base case for expected returns

should come from earnings growth. Alternatively, international developed countries, particularly in Europe, could post better returns than the U.S. going forward. While Eurozone GDP growth is still lower than the U.S., the region has experienced 33 consecutive quarters of growth, and loan growth is on the uptick. They possess lower valuation levels, their earnings still haven’t recovered to pre-recession levels and the ECB is committed to stimulus. Exhibit 8 illustrates valuations and historical earnings levels. While emerging markets are historically very cheap and rebounded handsomely in the first quarter, the base case is that

these returns may be fleeting.

Regarding MLP investments, we believe that the recent tight correlation between oil prices and MLP investments is not sustainable over a long period of time. This dislocation of fundamentals relative to stock prices has already provided a rebound in MLPs.

FIXED INCOME While interest rates may remain low, we are not content with historically low yields and the risk/return profile. Exhibit 9 illustrates the low historical yields for U.S. Treasuries on a nominal and post-inflation

'01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '165x

10x

15x

20x

25x

30x

Current: 16.6x

Average: 16.0x

S&P 500

Sources: Compustat, FactSet, MSCI, Standard & Poor’s, J.P. Morgan Asset Management.All charts span the period of 6/30/2000 to the latest available data. NTM – Next 12 months. Price to earnings ratio is the current price of the index divided by estimated next 12 months’ earnings. Price to book ratio is the current price of the index divided by the last book value per share. Past performance is not indicative of future returns.Guide to the Markets – U.S. Data are as of March 31, 2016.

Earnings and price indexNTM USD earnings estimates, quarterly, local price index, daily

ValuationsMonthly

MSCI EAFE

MSCI EM

Current: 14.5x

Average: 14.5x

Current: 1.3x

Average: 1.8x

S&P 500 Forward P/E

MSCI EAFE Forward P/E

MSCI EM P/B

Index level Earnings

Source: JP Morgan

EXHIBIT 8 – VALUATION LEVELS & EARNINGS GROWTH POTENTIAL


SPONSORSHIPSTHE NEW PHILHARMONIC CONCERTApril 16 & 17

FAMILY SHELTER SERVICE GALAApril 23

SPECTRIOS INSTITUTE FOR LOW VISION30th Anniversary GalaApril 30

NEW HIRESJOHN “JACK” BARRYInvestment AnalystMarch 2016

NOTEWORTHY

basis. While short-term rates may climb domestically, longer-term rates should be flatter as foreign demand for much higher rates in the U.S. will most likely keep a ceiling on longer-term rates. The Fed would prefer to keep consumer and government debt service levels down through lower long-term interest rates. We prefer to underweight international developed and emerging market bonds. We are also utilizing opportunistic fixed income managers that can take advantage of various fixed income investments that can provide good risk management and potential positive returns in rising interest rate environments.

COMPLEMENTARY STRATEGIES The easier years of investing are behind us. Given the tenuous nature of equity markets and the unattractive

fixed income outlook, finding good returns is harder and risk management is ever more important. Hence, we

continue to evaluate and implement other less traditional and lower/non-correlated strategies.

EXHIBIT 9 – U.S. TREASURY HISTORICAL RATES

-5%

0%

5%

10%

15%

20%

'58 '63 '68 '73 '78 '83 '88 '93 '98 '03 '08 '13

Source: BLS, Federal Reserve, J.P. Morgan Asset Management.Real 10-year Treasury yields are calculated as the daily Treasury yield less year-over-year core CPI inflation for that month except for March 2016, where real yields are calculated by subtracting out February 2016 year-over-year core inflation. Guide to the Markets – U.S. Data are as of March 31, 2016.

Nominal and real 10-year Treasury yields

Mar. 31, 2016: -0.56%

Sep. 30, 1981: 15.84%

Mar. 31, 2016: 1.78%

Nominal 10-year Treasury yield

Real 10-year Treasury yield

Average(1958-YTD 2016) 3/31/2016

Nominal yields 6.21% 1.78%

Real yields 2.45% -0.56%

Inflation 3.76% 2.34%

Source: JP Morgan

ECONOMIC REALITIES & INVESTMENT OPPORTUNITIESPLUS, FAMILY CONVERSATIONS ABOUT RAISING FINANCIALLY ENGAGED CHILDREN

TRUST COMPANY ANNUAL SPRING CONFERENCE

MAY 24, 2016

Join us at our spring conference for a late afternoon presentation by Trust Company’s Chief Investment Officer J. Reed Murphy who will discuss the major themes driving market volatility and the opportunities they afford investors.

We also will feature Andrew Keyt, Executive Director of Loyola University Chicago’s Family Business Center, and author of the critically acclaimed book Myths & Mortals, who will speak on what it takes to raise normal kids in a privileged world.

TIME: 2:45 pm Doors Open 3:30 pm Program 5:00 pm Cocktail Reception

LOCATION: Northern Illinois University – Naperville Campus 1120 East Diehl Road, Naperville, IL 60563

RSVP by Wednesday, May 18th to Paula at 630-545-2200 or email at [email protected]. Guests Welcome!

SAVE THE DATE!

quarterly market commentary — spring 2016 matters of …...source: trust company, factset. q4 2015...

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