Monthly Market Snapshot

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1 Monthly Market Snapshot Global Review December 2015 Christopher D. Piros, Ph.D., CFA Managing Director of Inv estment Strategy Amanda E. Agati, CFA Investment Strategist Key Observations United States: The End of an Era: Federal Reserve Hikes Key Interest Rate On December 16, the Federal Reserve (Fed) unanimously decided to raise the federal funds rate by 0.25%, the first rate increase since June The pace of interest rate hikes will have a significant impact on the magnitude of yield curve movements since the market is still pricing in a flatter trajectory than is implied by the Fed. See below for more on this topic. Although using the word gradual to describe the likely trajectory of rate increases, Fed forecasts (the so-called dot chart ) still call for four hikes in We view this as too aggressive. Even a second hike requires inflation measures and wage growth to intensify. We will look to slowly extend duration as rates begin to drift higher. We think that rates across the curve will increase, with a bias toward curve flattening. The Fed s decision to increase rates may reflect an effort to maintain credibility more than a reaction to marked improvement in economic fundamentals. Data have largely remained solid, but still somewhat mixed, in our view: Nonfarm payrolls increased 211,000 in November following an upwardly revised 298,000 increase in October. The U.S. service sector expanded in November, but at a slower pace than forecast. The reading of 55.9 remains firmly in expansion territory. Preliminary data for December slowed further to Manufacturing continues to struggle. The Institute for Supply Management (ISM) Manufacturing Index fell to contraction levels at Industrial production contracted more than forecast in November. We believe the U.S. economy will continue slow and steady growth in We expect the Fed to hike at most three times next year. As the jobs market tightens, we think wage pressure should build, ultimately contracting corporate profit margins. With sluggish revenue growth since the 2008 financial crisis, earnings growth has been largely dependent on profit margin expansion. We do not expect additional margin expansion in Equity returns are likely to be below average next year, in the low single digits, possibly even negative. 1

2 Europe: European Central Bank Disappoints Markets; Economy Still Stable The European Central Bank (ECB) fell short of market expectations when announcing additional stimulus at its December meeting. Stocks in both the United States and Europe fell sharply on the news, and the euro made significant gains versus the dollar. Policy change: The ECB cut its key interest rate by 10 basis points to -0.3% and extended its bond-buying program from September 2016 to March The market hoped for a larger rate cut and increase in the monthly purchase amount. Overall, we believe the market s reaction may be overdone. ECB President Mario Draghi made it clear that additional stimulus was in the pipeline, if necessary. Inflation remains far below the ECB s 2.0% target (Consumer Price Index was up just 0.1% year over year in November), and inflation forecasts continue to decline. Mr. Draghi has said he will increase policy support if this pattern persists. The Eurozone may now be in a bad news is good news paradigm, where bad economic data imply more stimulus, pushing asset prices higher. However, we think the market may be underappreciating evidence that a recovery is underway. The PMI survey continues to indicate expansion. We continue to favor Eurozone (and Japanese) stocks as we move into This view hinges on relatively attractive valuations, divergent policy conditions, and greater scope for a cyclical expansion in earnings growth and profit margins, which we are already seeing. China: Yuan Resumes Depreciation; Economy Still Facing Headwinds Another wave of depreciation has taken the yuan to 6.45 per dollar, its weakest level since the People s Bank of China (PBOC) let market forces play a bigger role in determining the currency s value. Speculation abounds regarding depreciation of the yuan. Some believe the PBOC is testing how far the currency can move without broader market disruptions, while others think the central bank is allowing for a more managed depreciation as U.S. interest rates begin to climb. The recent depreciation has not yet disrupted markets, but many investors worry that further weakness could reduce Chinese demand for foreign products, sending another deflationary pulse through global markets. Since China is a major energy importer, further depreciation of the yuan against the dollar is likely to become a meaningful headwind for energy prices in Despite some signs the economy is stabilizing, the PBOC is widely expected to keep monetary policy accommodative, if not expand it, in We believe stimulus efforts will help underpin economic stability in the coming quarters; however, China is likely growing slower than the 6.8% PBOC forecast for A hard landing (which is not our base-case forecast) would be extremely disruptive to global growth, and is a risk we continue to monitor closely. 2

3 Japan: Bank of Japan Adds Stimulus Japanese GDP growth was revised higher to 1.0% from the previously reported 0.8% decline. This revision outpaced consensus expectations for a 0.1% expansion and likely means that Japan avoided a technical recession. Capital expenditures were the primary bright spot, growing 2.3% versus the original report of a 5.0% contraction. Although by no means stellar, such data have given the Bank of Japan (BOJ) some confidence that the economy may be gradually gathering momentum. As such, the BOJ seemed less eager to increase policy accommodation; however, the central bank surprised markets at its December meeting when announcing supplemental monetary support in the form of an extension of the maturities of bond purchases and an additional 300 billion exchange-traded fund purchase program. After some brief enthusiasm, markets were ultimately underwhelmed. We believe these efforts will weaken the yen and be supportive of risky assets, as the market further digests this policy change. Energy: The Wild Ride Continues: Renewed Price Pressure Roils Markets Macro conditions continue to be challenging for energy prices: OPEC s decision to do away with any formal output ceiling, the removal of Iranian sanctions, waning storage capacity, and slower Chinese growth are all likely to be persistent headwinds. Although we believe significant downside from current levels is unlikely, we think energy prices will remain under pressure throughout It is likely that prices recover, but only modestly, as we move through next year. We believe $45-50 per barrel for West Texas Intermediate crude oil is a reasonable base-case forecast. Most recently, oil inventory data showed a build, while consensus was calling for a drawdown. 3

4 Sticking to the Headlines: The Federal Reserve and High Yield The Federal Reserve The Fed finally lifted interest rates as widely expected, in what we think may be the most telegraphed policy move in history. Consequently, the rate hike itself is not quite as interesting as some of the more nuanced commentary from Fed Chair Janet Yellen during her press conference. Of particular interest is the Fed s rate hike forecast, or dot chart. Before the meeting, the market widely expected the Federal Open Market Committee (FOMC) members to reduce the median rate forecast for They did not, and the median forecast still projects four interest rate increases next year. As stated earlier, we believe the Fed s projected path is likely more aggressive than what will actually occur. Key considerations include 1 : A number of FOMC members brought down their forecasts, indicating to us that the general trend within the committee is a shift toward a slower pace of tightening, even though the median dot would suggest no change. Listening carefully to Ms. Yellen s comments, she stated that additional rate increases are going to depend on realized and projected increases in inflation. Even with the base effect of low oil prices providing a potential boost to headline prices, our view is that core inflation likely remains under pressure. This supports a slower tightening trajectory. The bottom line for asset prices is that investors more shallow rate hike forecast is likely correct, meaning the market should not be forced to dramatically adjust to the realized pace of rate increases. Additionally, in addressing the possible shape of the curve, the Fed stated that it expects to keep its balance sheet constant until the path to normalization is well underway. In our view, this means that the Fed will not begin to reduce the size of its balance sheet until This is an important factor when considering that the curve should flatten, with long rates not moving up in dramatic fashion. One final point: In the July issue of the Monthly Market Snapshot, we raised the issue of the Fed s ability to actually increase short-term rates when the banking system is flush with reserves. We suggested that reverse repurchases would be a key tool allowing the Fed to induce reserves out of the system. In its December statement, the Fed specifically addressed this issue, stating that its reverse repurchase program will only be limited by the value of the Treasury securities it holds $2.5 trillion. As such, we are reasonably confident that the Fed has the necessary tools to move short-term rates higher. However, we still believe that the more heavily the Fed is forced to rely on this unconventional method, the more volatility that could be experienced in the shorter end of the curve. High Yield Weakness in the high yield market continues to be a theme. Spreads have widened significantly within the sector, and liquidity fears were exacerbated with the well-covered 1 Roberto Perli and Adam Laperriere, Don t Hold Your Breath for the Next Rate Hike, Cornerstone Macro, December 16,

5 collapse of high-yield mutual fund Third Avenue Management. We believe continued caution is warranted. While the prices and spreads of credit-intensive instruments have already moved significantly, we do not think the deterioration has fully run its course. Considerations include persistently weak revenue growth, declining profit margins without a commensurate increase in productivity, and lower-for-longer energy prices. There is no denying that the Energy sector has been the major driver of this initial high-yield weakness. However, there is some evidence that weakness is spreading into other sectors. In fact, Standard & Poor s said the percentage of junk bonds trading at distressed levels (spread of 10%+) is the highest in five years. Of the 361 distressed issues, 113 are in the oil and gas sector while 248 are from other sectors. Further, even more stable high-yield credits may experience collateral damage if the situation in energy continues to deteriorate. For example, high-yield portfolios that need to raise cash may find that liquidity for energy bonds is limited, perhaps forcing investors to sell high-yield bonds from other sectors that are more easily traded. We will continue to closely monitor the situation in high yield, both for opportunities and for broader market signals. 5

6 Table A1: Equity Market Snapshot (total returns in U.S. dollars; through December 17, 2015) Total Returns Month to Date Quarter to Date Year to Date S&P % 6.87% 1.22% Small Cap (Russell 2000) -5.16% 3.45% -4.55% S&P 500 Value -2.17% 5.52% -3.62% S&P 500 Growth -1.37% 8.03% 5.68% S&P 500/Industrials-SEC -2.91% 7.00% -3.43% S&P 500/Consumer Discretionary-SEC -2.31% 6.30% 10.64% S&P 500/Consumer Staples-SEC 2.35% 7.11% 6.07% S&P 500/Health Care-SEC 0.99% 8.37% 6.06% S&P 500/Financials-SEC -1.82% 6.29% -1.21% S&P 500/Information Technology-SEC -1.83% 9.68% 6.42% S&P 500 Telecommunications Serv-SEC 1.00% 6.81% 2.64% S&P 500/Utilities-SEC 1.53% 0.44% -5.44% S&P 500/Energy-SEC % -0.40% % S&P 500/Materials-SEC -5.46% 8.21% -9.62% MSCI EM (Emerging Markets) -1.86% 1.05% % MSCI FM Frontier Markets -1.49% -2.39% % MSCI Europe -3.10% 1.96% -2.89% MSCI China -1.14% 4.20% -7.47% MSCI Japan -0.49% 8.47% 8.99% Source: FactSet Research Systems Inc., PNC Table A2: Fixed Income Market Snapshot (total returns in U.S. dollars; through December 17, 2015) Total Returns Month to Date Quarter to Date Year to Date Barclays US Aggregate -0.20% -0.45% 0.67% Barclays Global US Treasury (1-3 Y) -0.13% -0.47% 0.52% Barclays US Aggregate Government-Treasury (1-5 Y) -0.16% -0.69% 0.90% Barclays US Aggregate Government-Treasury (5-10 Y) -0.19% -1.20% 1.94% Barclays US Aggregate Government-Treasury-Intermediate -0.17% -0.84% 1.20% Barclays US Aggregate Government-Treasury-Long 1.27% -0.11% 0.06% Barclays US Treasury Inflation Protected Notes (TIPS) -1.05% -0.89% -1.69% Barclays US Aggregate Credit-Corporate-Investment Grade -0.58% -0.39% -0.49% Barclays US High Yield-Corporate -2.84% -2.38% -4.78% Barclays US Floating Rate Notes Corporates -0.05% 0.13% 0.44% Barclays US High Yield Loans -1.27% -2.41% -1.01% S&P Municipal Bond Investment Grade 0.47% 1.29% 3.09% S&P Municipal Bond High Yield -0.39% 0.95% 1.97% GS Commodity Index % % % Alerian MLP % % % Source: FactSet Research Systems Inc., PNC Table A3: F/X Market Snapshot (through December 17, 2015) Major Currencies Current 1 Month Ago 3 Months Ago Euro/U.S. Dollar Australian Dollar/U.S. Dollar Pound/U.S. Dollar U.S. Dollar/Yen Source: FactSet Research Systems Inc., PNC 6

7 Global Review December 2015 The PNC Financial Services Group, Inc. ( PNC ) uses the marketing names PNC Institutional Asset Management SM for the various discretionary and non-discretionary institutional investment activities conducted by PNC Bank, National Association ( PNC Bank ), which is a Member FDIC, and investment management activities conducted by PNC Capital Advisors, LLC, a registered investment adviser ( PNC Capital Advisors ). PNC Bank uses the marketing names PNC Retirement Solutions SM and Vested Interest to provide non-discretionary defined contribution plan services and PNC Institutional Advisory Solutions SM to provide discretionary investment management, trustee, and other related services. Standalone custody, escrow, and directed trustee services; FDIC-insured banking products and services; and lending of funds are also provided through PNC Bank. These materials are furnished for the use of PNC and its clients and does not constitute the provision of investment advice to any person. It is not prepared with respect to the specific investment objectives, financial situation, or particular needs of any specific person. Use of these materials is dependent upon the judgment and analysis applied by duly authorized investment personnel who consider a client s individual account circumstances. Persons reading these materials should consult with their PNC account representative regarding the appropriateness of investing in any securities or adopting any investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. The information contained in these materials was obtained from sources deemed reliable. Such information is not guaranteed as to its accuracy, timeliness or completeness by PNC. The information contained in these materials and the opinions expressed herein are subject to change without notice. Past performance is no guarantee of future results. Neither the information in these materials nor any opinion expressed herein constitutes an offer to buy or sell, nor a recommendation to buy or sell, any security or financial instrument. Accounts managed by PNC and its affiliates may take positions from time to time in securities recommended and followed by PNC affiliates. PNC does not provide legal, tax, or accounting advice unless, with respect to tax advice, PNC Bank has entered into a written tax services agreement. PNC does not provide services in any jurisdiction in which it is not authorized to conduct business. PNC does not provide investment advice to PNC Retirement Solutions and Vested Interest plan sponsors or participants. PNC Bank is not registered as a municipal advisor under the Dodd-Frank Wall Street Reform and Consumer Protection Act ( Act ). Investment management and related products and services provided to a municipal entity or obligated person regarding proceeds of municipal securities (as such terms are defined in the Act) will be provided by PNC Capital Advisors. Securities are not bank deposits, nor are they backed or guaranteed by PNC or any of its affiliates, and are not issued by, insured by, guaranteed by, or obligations of the FDIC, the Federal Reserve Board, or any government agency. Securities involve investment risks, including possible loss of principal. Vested Interest is a registered trademark and PNC Institutional Asset Management, PNC Retirement Solutions, and PNC Institutional Advisory Solutions are service marks of The PNC Financial Services Group, Inc The PNC Financial Services Group, Inc. All rights reserved.