The Chicago Group at Morgan Stanley 3 rd Quarter 2015 Update

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1 at Morgan Stanley 3 rd Quarter 2015 Update Index Returns Index 2 nd Quarter 2015 July 2015 YTD S&P % 3.36% Dow Jones Industrial Avg % 0.56% EAFE 3 MSCI Emerging Markets % 0.70% 7.72% -4.18% BC Agg Bonds -1.68% 0.59% Treasury Yields as of 8/10/ Year 2.21% 90 Day 0.07% Big Picture: Our 3 rd Quarter update was about to be sent out when the market dropped over 10% within 3 trading days. We have joked in the past that markets react to many things and sometimes to nothing. This is a time where many known concerns in the marketplace all seemed to come to a head at once. When will the FED raise rates? Is China suffering a hard landing and will it spill into the rest of the global economy? How low will oil go? Etc We continue to believe economic fundamentals support valuations, but remain committed to making sure all of our clients are on the correct risk model so that they can weather the inevitable storms in the market. A history of the inevitable storms: 1

2 Our previously written newsletter: Through the middle of August the US stock markets are supplying a good example of the terms trading sideways and range bound. The positive news is that as earnings continue to grow and stock prices remain generally flat the PE ratio of the market looks better and better. We started the year believing that US markets were at or near fair value and continue to believe this to be true. Internationally, we have seen the outperformance we expected from developed countries. We think this general trend could continue to play out over the next several years. That said, we will continue to have short term surprises from currency moves and other external factors (Greece will continue to annoy). After starting the year up 10%, Emerging Markets have had a difficult several months. We have always maintained that this will be a very volatile asset class, but even we were surprised by the huge growth and subsequent collapse of the Chinese equity markets. The slowdown in China has also caused significant downward pressure to commodity prices globally. The US and Global economies continue with slow growth, with China s growth slowing a bit more than anticipated. Rates in the developed world including the US remain low on both the short and long ends of the yield curve. Congress will once again face the debt ceiling (most likely in October). It is unclear at this point if this will be a business as usual issue, or a self-inflicted volatility spike. Either way, you can be sure it will be settled in time for congressmen to go home to their families for Thanksgiving! 2

3 We remain optimistic about the economy and equity prices over the next 3-5 years, but are clearly in a period of consolidation waiting for the next leg of the recovery. It would not be unusual for a sideways market like this to end in a minor correction prior to making new highs. Economic: In our last two reports we discussed how we thought economic and job growth numbers would slow towards the end of 1 st quarter and then pick up towards the end of the 2 nd quarter due to the impact of oil and currency moves. We were unfortunately correct at the end of the 1 st, and fortunately correct at the end of the 2 nd! For example, payroll numbers were averaging around 250,000 new jobs per month at the beginning of the year, dipped down to 119,000 in March and are now back to averaging well over 200,000 per month. 5 In fact, Jobless Claims have plunged to a 42-year low. 6 We remain optimistic that the drop in energy prices will be a boon for the majority of the economy. We have spent a large amount of space discussing the price of oil, but we think these two charts (one on demand and one on supply) go a long way towards explaining the prolonged drop in prices. We start by thinking about when the US will cross peak oil demand. Most people think the answer lays somewhere between the distant future and never. The truth is it looks like this is a trick question and we already passed that point a decade ago! Most people have drastically underestimated the impact of the improvements in fuel economy in the American fleet. A 2016 Ford F150 (the best selling car in the US) gets 31% more miles to the gallon than the 2000 version of the same vehicle. To put it another way, it gets the same milage as a 2000 Honda Accord! 7 The next chart shows that while US rig count is down siginificantly (hurting economies and employment in oil focused parts of the country), the supply has not yet dropped. 3

4 A quick table on how this affects the world geopolitically: We noted in the last newsletter that, unlike prior periods of falling gas prices, this time there has been a muted acceleration of spending in other parts of the economy. We remain optimistic that over time this savings at the pump will work its way into the economy, but have some charts that shed light on why the trend has slowed. The following chart shows the mean (average) inflation adjusted net worth in our country over time: 4

5 8 This seems to back up the gut feeling that the average American s wealth has stablized, but has not yet achieved the topfrom the days of the housing bubble. In short, a slow recovery is underway, but we have not, on average, recovered. There is a bleaker way to look at this however. Instead of looking at the average, look at the median (the middle person), and you will see that their net worth is barely at 1992 levels: 8 The below chart is even gloomier; look at what has happened over the years to the median net worth of those For this group getting ahead seems to be getting out of reach: 5

6 8 6

7 A big part of the reason getting ahead is getting harder can be shown here, and remember that much of this education has been paid for by borrowing over $1 trillion: In light of these numbers, it makes more sense that savings on gas are going towards paying down debt or increased bank balances, rather than further consumption. 7

8 Ending on an optimistic chart, the following shows how real (meaning after inflation) hourly income is starting to accelerate: In summary, while we believe that the US and Global enomomies will continue with steady growth, this mixed bag of economic data leads us to be less optimistic that a significant acceleration is right around the corner. Preserve: The market believes there is a significant possibility, though not probability, that the Federal Reserve will raise the Fed Funds rate at the September meeting. We think it is very likely that the Fed will act over the next 3 quarters. More importantly, we don t think it matters when they start raising rates unless you are trading interest rate futures. It will likely be more important what they say, giving direction to how quickly they will continue to raise. It may just be semantics, but we think it is clearer to think of it as the Fed normalizing rather than raising rates. However you want to look at it, we think it is priced into most markets, and will only be felt right away in your savings account and other short term debts. Earn: Everyone will be watching the US fixed income markets as the Fed begins to raise rates. As we mentioned above, the first moves are probably priced into the longer bond markets, but depending on how aggressive they continue to raise rates could impart the longer end of the yield curve. The chart below shows the price impact of a 1% rate move across the yield curve. 8

9 The 30 year Treasury illustrates very clearly why we are skittish about the long end of the bond market. We have stated before, and continue to believe, it will be very hard to beat inflation over the next 5 years in high quality bonds. This is why we continue to recommend our Flexible Income Portfolio for those who can tolerate the higher price volatility. The MLP piece of the Flexible Income Portfolio has had a difficult 2015 with the closest ETF (AMLP) down around 16% YTD prior to dividends. 9 In addition, the discounts on many of the closed end funds in the portfolio have widened. We feel the MLP market has overreacted to the price decline of oil, and look forward to the anticipated price recovery within this group. The primary function of the portfolio is to provide a high level of income (compared with mid-term bonds) and the portfolio continues to do so. 9

10 Grow: US stocks are slightly up YTD with Developed International doing well and Emerging Markets doing poorly. An amazing fact is that while the S&P 500 is up YTD, energy companies have experienced a cumulative drop of $1.3 Trillion in value over that time. 10 The steady growth we have been expecting and experiencing continues but for the collapse in the oil sector. This is a table of 9 different ways to analyze the value of the stock market: - These methods imply an 8-9% expected return over the next 10 years. Slightly below historical norms, but certainly acceptable and matching up with the planning we have done for many of our clients. We remain mid- and long-term positive on the stock markets, domestic and international. That said it has been more than 75 months since our last bear market (defined as a drop of 20% or more). This is longer than the median historic bull market (50 months), and is getting close to being one of the 5 longest bull markets ever! We believe it is only prudent to make sure our clients are within their risk tolerance and are prepared at all times for a month bear market. Chicago Team Changes We hope you will join us in welcoming Kylie Kaufman to our team. Kylie is originally from outside Cleveland, Ohio. While in high school she had the opportunity to attend and play soccer at IMG Academy in Bradenton, FL. She then moved to New York to attend Columbia University (Craig s alma mater) where she majored in Spanish. Recently she was working at Morgan Stanley in our Community Affairs department when she heard of the opening with our team. We are excited she has moved back to the mid-west and become part of the Chicago. Grou As always, please contact us if there is anything we can do for you. Best Regards, 10

11 Mike Del Campo Director Senior Institutional Consultant Financial Advisor Frank DeVincentis, CFP Senior Vice President Financial Advisor Bill Lenz Director Senior Institutional Consultant Financial Advisor Craig Eyler, CFP Senior Vice President Financial Advisor Jennifer Huns, CFP Tracy Weidman Kylie Kaufman Administrator Consulting Analyst Client Service Associate West Monroe Suite 3400 Chicago IL, PLEASE DO NOT DISTRIBUTE WITHOUT PERMISION International investing may not be suitable for every investor and is subject to additional risks, including currency fluctuations, political factors, withholding, lack of liquidity, the absence of adequate financial information, and exchange control restrictions impacting foreign issuers. These risks may be magnified in emerging markets. Interest in municipal bonds is generally exempt from federal income tax. However, some bonds may be subject to the alternative minimum tax (AMT). Typically, state tax-exemption applies if securities are issued within one s state of residence and, local tax-exemption typically applies if securities are issued within one s city of residence. The views expressed herein are those of the author and do not necessarily reflect the views of Morgan Stanley Smith Barney or its affiliates. All opinions are subject to change without notice. Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Past performance is no guarantee of future results. Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bond's maturity, the more sensitive it is to this risk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer. Bonds are subject to the credit risk of the issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment risk, which is the risk that principal and/or interest payments from a given investment may be reinvested at a lower interest rate. Morgan Stanley Smith Barney LLC, member SIPC Please contact your Financial Advisor for a complete listing of all transactions that occurred during the last twelve months. This material is intended only for clients and prospective clients of the Portfolio Management program. It has been prepared solely for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security or other financial instrument, or to participate in any trading strategy. Tax laws are complex and subject to change. Morgan Stanley Smith Barney LLC ( Morgan Stanley ), its affiliates and Morgan Stanley Financial Advisors and Private Wealth Advisors do not provide tax or legal advice and are not fiduciaries (under the Internal Revenue Code or otherwise) with respect to the services or activities described herein except as otherwise agreed to in writing by Morgan Stanley. This material was not intended or written to be used for the purpose of avoiding tax penalties that may be imposed on the taxpayer. Individuals are encouraged to consult their tax and legal advisors regarding any potential tax and related consequences of any investments made under such account. 1 S&P 500 Index is an unmanaged, market value-weighted index of 500 stocks generally representative of the broad stock market. An investment cannot be made directly in a market index. 2 Dow Jones Industrial Average is a price-weighted index of the 30 blue-chip stocks and serves as a measure of the U.S. market, covering such diverse industries as financial services, technology, retail, entertainment and consumer goods. An investment cannot be made directly in a market index. 3 The MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure developed market equity performance, excluding the US & Canada. As of May 2005 the MSCI EAFE Index consisted of the following 21 developed market country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Italy, Japan, 11

12 the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the United Kingdom. An investment cannot be made directly in a market index. 4 The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. As of May , the MSCI Emerging Markets Index consists of the following 21 emerging market country indices: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey. An investment cannot be made directly in a market index. 5 Bloomberg Economic Calendar, 8/7/15 6 Bespoke Invest July Federal Reserve, The Big Picture 9 Thompson 1 10 Bloomberg/fivethirtyeight Morgan Stanley Smith Barney LLC. member SIPC 12