U.S. Equities Update: Off to a Rough Start in 2016

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1 U.S. Equities Update: Off to a Rough Start in 2016 Executive summary U.S. equities are entering 2016 and approaching the seven-year bull market anniversary amidst market crosscurrents, however, we believe macro and fundamental backdrops remain favorable for equities. Inflation, earnings, valuation, interest rates and sentiment are all generally supportive of equity prices. Conversely, the continued drop in oil prices, slow pace of global growth, diverging monetary policies between the United States and central banks around the world, geopolitical instability and negative implications that rising interest rates and firming wages may have on profit margins are among items indicating that the risk profile for equities is elevated. In aggregate, we anticipate increased volatility and muted returns to be hallmarks of 2016 performance. Our price target for the S&P 500 in 2016 is 2,225, approximately 9 percent above 2015 levels. Our grind higher thesis is anchored on the belief that the pace of inflation and wage gains will be moderate and future Federal Reserve (Fed) rate hikes deliberate, effectively paving the way for cyclical sectors and companies that are growing revenue, gaining market share and that have thematic appeal to be among the best performers in the new year. Investors are beginning 2016 at the crossroads of concern and optimism, with a near-term bias toward caution. We believe risks are elevated, but maintain a moderately constructive outlook for equities. Performance Equity performance in 2015, on average, was varied, volatile, lackluster, yet remarkably resilient. To a degree, equities were a split personality asset class last year, with investor sentiment and market performance often swayed by the economic statistic du jour. Investment products and services are: NOT A DEPOSIT NOT FDIC INSURED MAY LOSE VALUE NOT BANK GUARANTEED NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY [ 1 ] Important disclosures provided on page 9.

2 Index Market and sector performance Price 12/31/ S&P 500 2, % -0.7% Dow Jones Industrials 17, % -2.2% Russell , % -5.7% MSCI EAFE 1, % -3.3% MSCI Emerging Markets % -17.0% Sectors of the S&P 500 Weight Information Technology 20.8% 18.2% 4.3% Financials 16.5% 13.1% -3.5% Healthcare 15.2% 23.3% 5.2% Consumer Discretionary 12.9% 8.0% 8.4% Energy 6.4% -10.0% -23.6% Consumer Staples 10.1% 12.9% 3.8% Industrials 10.1% 7.5% -4.7% Materials 2.8% 4.7% -10.4% Utilities 3.0% 24.3% -8.4% Telecommunication Services 2.4% -1.9% -1.7% Source: FactSet Research Systems. Data: 12/31/15; excludes dividends. Broad market performance. Overall equity performance was significantly below historical norms, with the Dow Jones Industrial Average, S&P 500 and Russell 2000 posting returns ranging from negative 0.7 percent to negative 5.7 percent. U.S. stocks outpaced international markets. On average, U.S. stocks outpaced both international domestic and emerging markets, evidenced by the 0.7 percent decline of the S&P 500 versus the 3.3 and 17.0 percent respective losses for the MSCI EAFE and Emerging Markets indices. The unexpected slowing in China s gross domestic product (GDP) growth led to a general reassessment of the outlook for emerging markets, particularly commodity producers and those with close trade links to China. Large versus small caps. Large caps outpaced small companies, with the large cap-oriented S&P 500 and Dow Jones Industrial Average declining 0.7 and 2.2 percent, respectively, versus the 5.7 percent loss of the small cap-oriented Russell This is a potentially troublesome trend for 2016 since small caps typically outperform during periods of economic expansion. Sector trends. Overall sector performance was underwhelming, negatively impacted by the decline in energy prices and slow pace of global growth. Only four of 10 S&P 500 sectors posted positive returns in 2015 (Consumer Discretionary, Consumer Staples, Healthcare and Information Technology). The Energy sector led performance to the downside, retreating 23.6 percent for the year. Oil. The continued collapse of oil prices was among the biggest stories impacting equity prices in The oil market is apt to impact stock prices in 2016 as well, with any broad-based equity rally likely to be suspect without an associated follow-through in the price of oil. Consumer Discretionary. Although the Consumer Discretionary sector was the best performing sector in 2015, the performance of a handful of large and mega cap names such as Netflix and Amazon, which both advanced over 100 percent, significantly influenced the performance of the sector. S&P 500 winners and losers. On average, performance varied greatly by and within sectors. The accompanying table reflects the S&P best and worst performers (by percentage change). In general, companies with above average revenuegrowth profiles outperformed while firms that are positioned in and around the energy patch lagged. [ 2 ] Important disclosures provided on page 9.

3 S&P 500 winners and losers in 2015 S&P 500 Ticker % Change Top 10 Netflix Inc NFLX Amazon.com Inc AMZN Activision Blizzard ATVI 92.1 NVIDIA Corp NVDA 61.8 VeriSign Inc VRSN 52.1 Cablevision Systems Corp CVC 51.3 Hormel Foods Corp HRL 49.1 First Solar Inc FSLR 48.2 Starbucks Corp SBUX 46.8 Total System Services Inc TSS 46.2 Bottom 10 Chesapeake Energy Corp CHK CONSOL Energy Inc CNX Southwestern Energy Co SWN Freeport-McMoRan Inc FCX Fossil Group Inc FOSL Kinder Morgan Inc/DE KMI Micron Technology Inc MU NRG Energy Inc NRG Murphy Oil Corp MUR Marathon Oil Corp MRO Source: Bloomberg. Outlook for 2016 We are maintaining our moderately constructive outlook for equities, mindful that risks are elevated, believing that key drivers remain in place warranting a grind higher equity market in We also suspect volatility is apt to remain high, with overall performance lagging historical levels. Price target. Our price target for the S&P 500 in 2016 is 2,225, approximately 9 percent above the 2015 closing price of 2,043.94, based on earnings growth in the 5 percent to 6 percent range and modest expansion. Macro and fundamental backdrops. Macro and fundamental backdrops seem supportive of higher equity prices. Inflation remains restrained, supporting priceearnings multiples near current levels. Earnings are increasing, albeit at a moderating pace. Valuations, while at the high side of fair, are short of extremes. Interest rates are low, adding to the relative attractiveness of equities. Sentiment is generally positive, bolstered by firming wages, a stable housing market, low core inflation, low energy prices and rising consumer net worth. Additionally, select equities offer both income and appreciation potential, with 43 percent of S&P 500 companies beginning 2016 with dividends yielding above the 10-year Treasury yield of 2.3 percent. Key drivers of equity prices. Fed-driven liquidity, priceearnings multiple expansion and increasing earnings are among key drivers of advancing stock prices. In 2016, we expect earnings to be the primary driver. Earnings-driven market. With the Federal Reserve having begun the rate normalization process and current valuation levels already elevated, it seems most probable that equities will advance in 2016 commensurate with the pace of earnings growth. This places increased importance on an improving economy to drive earnings, and earnings to propel stock prices higher. According to S&P Cap IQ, as illustrated in the following chart, earnings are estimated to increase 7.4 percent in 2016 over 2015 levels, with earnings from the Energy sector projected to continue to hamper overall growth. Evercore ISI is forecasting a similar earnings growth trajectory in 2016 of 7.3 percent while consensus year-over-year earnings growth in 2016, according to Bloomberg as of year-end, is modestly higher at roughly 10 percent. [ 3 ] Important disclosures provided on page 9.

4 S&P earnings growth & S&P revenue growth Improving earnings have been a key support for equities Operating earnings-per-share (% change) S&P 500 Sector 2014 actual 2015 estimated 2016 estimated Consumer Discretionary Consumer Staples Energy Financials Healthcare Industrials Information Technology Materials Telecommunication Services Utilities S&P 500 Index Source: S&P Capital IQ. Data: 12/24/15, year-over-year percent change. 40% 30% 20% 10% 0% -10% -20% Annual earnings and revenue growth Revenue Earnings -30% estimated Source: Evercore ISI Quantitative Research. Buybacks. In recent years, share buybacks have contributed to earnings growth. According to FactSet Research Systems, companies have consistently bought back approximately 3 percent of outstanding shares in recent years, effectively offsetting new share issuance and contributing to earnings growth. Of mounting concern is that buyback-induced earnings growth is likely to wane if revenue growth stalls and profit margins become squeezed due to rising interest costs and firming wages. Fewer publically traded equities. Adding to market complexity is the declining number of publically traded equities. The number of companies listed on U.S. exchanges have fallen nearly 40 percent from 1998 levels. Fewer publically traded shares would seemingly result in an upward bias to equity prices due to supply/demand forces while perhaps contributing to the extended duration of the current bull market. 9,500 9,000 8,500 8,000 7,500 7,000 6,500 6,000 5,500 5,000 4,500 Number of companies listed on U.S. exchanges Source: World Federation of Exchanges. Data: Sum of AMEX, NASDAQ, NYSE. Seems premature to forecast a prolonged downturn. While the current bull market is advanced in age, in the absence of rising inflation and a looming recession, we continue to believe that it is premature to forecast a prolonged downturn. Historically, bear markets have occurred in and around recessions when inflation is heating up, the Fed is fully entrenched in a tightening mode, valuations are at extremes and investor sentiment is approaching euphoria rather than in the middle of an economic recovery, as appears to be the current environment. Additionally, as asserted by Gavekal Research, the gap between the real, marginal return on invested capital (the real return companies can [ 4 ] Important disclosures provided on page 9.

5 Estimated real, marginal ROIC (derived from long-term corporate yields) expect to make on new investments) and the cost of debt, while narrowing, remains wide. By this measure, the U.S. economy is nowhere near a recession. Rather, the positive spread reflected in the accompanying graph is favorable for equities. 9% 8% 7% 6% 5% 4% 3% 2% Return on invested capital (ROIC) vs. cost of capital ROIC (before tax) Real long-term corporate yield 1% Source: Gavekal Research. Data: 12/15. Corporate yield based on 20- to 30- year Baa bonds. Potential disruptions and looming headwinds While our outlook for equities remains constructive relative to other asset classes, the risk profile of equities is clearly elevated, giving investors reason for pause. To a degree, investors are beginning 2016 at the crossroads of concern and optimism, with a near-term bias toward concern. Fed policy shift. With the December 2015 rate hike, the Federal Reserve emoved an element of uncertainty while introducing another. Focus now is on the pace of subsequent hikes. While timing remains uncertain, the direction of travel is clear we expect a moderate and gradual glide path toward higher rates resulting in a modest headwind for equities. Adding to market uncertainty and volatility is the likelihood that the Fed becomes more divided in 2016 as policymakers assess the health of the U.S. economy and debate whether, when and how much further to raise short-term rates. A faster-than-expected rebound in inflation could be a swing factor causing the Fed to abandon its current pledge that policy tightening will be unusually gradual. It will be harder for the Fed to hold interest rates low should inflation become more pervasive. Slow pace of global growth. At present, the pace of global growth remains slow, which is problematic to earnings growth of multinational companies. Without sales growth, profits can only grow through cost cutting, share buybacks and margin expansion. This becomes increasingly difficult in an environment where both wages and interest rates are rising. Our base case is for continued acceleration in U.S. economic growth, recovery in the eurozone and Japan, and stabilization in China. Outside of the United States, we expect to see continued divergence in economic growth, with commodity-importing economies outpacing commodity producers in In Europe and Japan, the combination of low oil prices, competitive currency values, reasonable equity valuations and continued monetary policy stimulus should be supportive for foreign-developed equities. Both Europe and Japan have tailwinds from stimulus, with prospects for additional easing if growth falters. Policymakers in China are committed to supporting domestic demand as the country transitions from an investment- to consumption-led economy. That said, while we expect modest gains broadly across foreign equities in 2016, indications of rising credit stress in certain emerging economies suggest that developed markets may continue to outperform emerging market equities. Relatedly, if economic growth in Europe, Japan and China surprise to the upside, this would boost earnings of U.S. multinationals and be a driving force behind better-than-expected performance of equities in the new year. [ 5 ] Important disclosures provided on page 9.

6 Geopolitical instability. Rising geopolitical tensions around the globe, resurgence of terrorism, and the U.S. elections will undoubtedly contribute to ongoing uncertainty and market volatility in Presidential cycle theory. Political wrangling and brinksmanship are apt to intensify leading up to the November elections. Broad equity market performance has historically lagged during election years. In the United States, the presidential cycle theory suggests that presidents make tough decisions early in their terms in order to set up a favorable election-year economy. According to Bloomberg and Cornerstone Macro, when assessing S&P 500 performance during second presidential terms, years two and three are generally the best performing, and year four is the worst. While this theory did not hold true for performance in 2015, it points toward lackluster returns in % 15% 10% 5% 0% -5% Year 1 Change in S&P 500 during second Presidential terms Year 2 Year 3 Year 4 Average All Presidents Democrats Republicans Sources: Bloomberg and Cornerstone Macro. Data: (12/28/15). Elevated valuations. Valuations, while short of extremes, are at the high side of fair, implying a narrow margin of error. At year-end, the S&P 500 traded at 18 times consensus 2015 estimates and 16.5 times 2016 forecasts. Adding to angst is that S&P multiples typically decline during Fed rate hikes. According to Strategas Research Partners, it is not until inflation reaches the 4 percent level that meaningful priceearnings multiple contraction is seen. While there are signs of looming inflation (firming wages along costs), headline inflation is being held down by low energy prices. S&P 500 earnings per share $110 $115 $120 $125 $130 $145 Price-earnings multiple 14x 1,540 1,160 1,680 1,750 1,820 2,030 15x 1,650 1,725 1,800 1,875 1,950 2,175 16x 1,760 1,840 1,920 2,000 2,080 2,320 17x 1,870 1,955 2,040 2,125 2,210 2,465 18x 1,980 2,070 2,160 2,250 2,340 2,610 19x 2,090 2,185 2,280 2,375 2,470 2,755 20x 2,200 2,300 2,400 2,500 2,600 2,900 Source: Strategas Research Partners. [ 6 ] Important disclosures provided on page 9.

7 20x 18x 16x 14x 12x 16.8x Price-earnings multiples vs. inflation 17.9x 17.2x 14.7x 10.9x 10x 9.5x 8.5x 8.3x 8x -2-0% 0-2% 2-4% 4-6% 6-8% 8-10% 10-12% 12-14% Source: Strategas Research Partners. Data period: /28/15. Margin pressure. Higher wages and increased borrowing costs due to rising interest rates suggest future margin pressure. In fact, operating margins have begun to modestly fade from peak levels, which is not to say that margins are on a fast track toward deterioration. For instance, falling energy and input commodity costs as well as technology-driven enhancements are providing a boost to profitability. However, from the November employment report, average hourly earnings rose 2.3 percent year-overyear, implying that inflation may be creeping into the marketplace and eroding profitability. Global monetary divergence. The United States is raising rates just as other central banks around the world are easing, effectively putting upward pressure on the U.S. dollar. Additionally, the current benign inflation backdrop in the United States raises concerns about the impact of higher short-term rates. According to Evercore ISI, from 1966 to 2004, the Fed has never raised rates when core inflation was 2 percent or lower. This implies that the glide path for subsequent rate hikes is apt to be gradual, or perhaps that the Fed was premature in beginning the rate normalization policy in December. Nonetheless, according to Strategas Research Partners, on average, the S&P 500 has advanced three, six, and 12 months following initial rate hikes dating back to S&P 500 performance before and after first Fed tightening Date of first raise -6 mos -3 mos +3 mos +6 mos +12 mos Mar % 8.8% 9.9% 8.6% 4.1% Jan % 7.9% 19.1% 21.2% 2.6% Mar % 4.1% 6.0% 5.4% 13.3% Feb % 2.7% -3.9% -2.4% 1.9% Jun % 6.7% -6.6% 7.0% 6.0% Jun % 1.3% -2.3% 6.2% 4.4% Average 4.4% 5.2% 3.7% 7.7% 5.4% 11% 10% 9% 8% 7% 6% 5% S&P 500 operating margin Source: Strategas Research Partners. Data as of December Past performance is no guarantee of future results. 4% Source: Strategas Research Partners. Data as of 12/07/15, projected over next 12 months. [ 7 ] Important disclosures provided on page 9.

8 Sector insights Believing that inflation will remain constrained and a recession is not imminent, we continue to have a cyclical bias, favoring sectors and companies that tend to perform well in a slow growth, low inflationary environment. Select companies within Technology, Consumer Discretionary, Healthcare and, to a degree, Financials and Industrials, are among our favorites. Our bias is toward companies that have attractive sales growth profiles in an otherwise slowgrowing global environment. Additionally, we are attracted to companies with thematic appeal, companies that cater to a global consumer, ecommerce, cloud computing, anytime-anywhere connectivity, an aging population, selfdirected healthcare, and so on. As such, perhaps more so than in 2015, outperformance in 2016 may be more about stock versus sector selection. Sector insights and preferences S&P 500 sector Index weight Recommemded emphasis Consumer Discretionary 12.9% Overweight Consumer Staples 10.1% Market weight Energy 6.4% Market weight Financials 16.4% Market weight Healthcare 15.1% Overweight Industrials 10.1% Overweight Information Technology 20.8% Overweight Materials 2.8% Market weight Telecommunication Services 2.4% Underweight Utilities 3.0% Underweight Rationale Firming wages, low energy prices and rising consumer net worth are among reasons to expect rising levels of consumer spending in The eventual rise in oil prices and a high savings rate are among concerns. A defensive sector. Lackluster global growth dynamics favor staples as an attractive placeholder amidst global uncertainty. Stocks appear expensive, particularly given sluggish same-store-sales data. Remains a wildcard due to the global supply/demand imbalance and overall price volatilty. No clear consensus on near-term price direction. Favor undervalued subindustries such as pipelines and refiners. Regulatory pressures and technology are transforming the nature of the industry. Balance sheet improvement and expectations for improving loan growth and net interest margins are partially offset by a flattening yield curve. Favor companies at the forefront of innovation (neurology, oncology, immunology), leaders in emerging markets, and growing sales and profits by reducing overall healthcare inflation. Debate over drug pricing is a headwind. Falling crude oil prices and slow global growth weighed on performance in Manufacturing remains soft. The risk/reward is intriguing given improving U.S. economic data, strong cash flows, attractive dividends, reasonable valuations. A pro-growth sector with many sources of innovation. Beneficiary of increasing cap ex. Many companies within the sector are demonstrating strong free cash flow, mounting cash levels, with attractive dividend growth potential. An eclectic sector, with wide-ranging company platforms. Biased toward commodityusing vs. commodity-producing companies. The economic landscape in China and other emerging markets metals-consuming economies are wildcards. Easing of competitive pricing pressures and attractive yields are positives. Growth seems limited given market saturation and industry maturity. High payout ratios limit the ability to increase dividends, and bond-like characteristics suggest caution. Valuations appear elevated, partly the result of investors searching for yield and as a safehaven given global uncertainty and market volatility. Inherent bond-proxy characteristics suggest underperformance when interest rates rebound. Source: U.S. Bank Strategic Equity Group. [ 8 ] Important disclosures provided on page 9.

9 Conclusion We are maintaining our moderately constructive outlook for equities, mindful that risks are elevated, believing that key drivers remain in place, warranting a grind higher equity market in Our price target for the S&P 500 in 2016 is 2,225, approximately 9 percent above 2015 levels. Our grind higher thesis is anchored on the belief that the pace of inflation and wage gains will be moderate, and future Fed rate hikes will be deliberate, effectively paving the way for cyclical sectors and companies that are growing revenue, gaining market share, and with thematic appeal to be among the best performers in the new year. Select companies within Technology, Consumer Discretionary, Healthcare and, to a degree, Financials and Industrials, are among our favorites. The implications of the shift in Fed monetary policy, slow pace of global growth, geopolitical instability, elevated valuations, profit margin pressure as a result of rising interest rates and firming wages, and global monetary policy divergence, which could fuel an additional rise in the U.S. dollar, are among items contributing to a more balanced risk profile while likely capping equity performance upside in This commentary was prepared January 2016, and the views are subject to change at any time based on market or other conditions. This information represents the opinion of U.S. Bank and is not intended to be a forecast of future events or guarantee of future results. It is not intended to provide specific advice or to be construed as an offering of securities or recommendation to invest. Not for use as a primary basis of investment decisions. Not to be construed to meet the needs of any particular investor. Not a representation or solicitation or an offer to sell/buy any security. Investors should consult with their investment professional for advice concerning their particular situation. The factual information provided has been obtained from sources believed to be reliable, but is not guaranteed as to accuracy or completeness. Any organizations mentioned in this commentary are not affiliated or associated with U.S. Bank in any way. Past performance is no guarantee of future results. All performance data, while deemed obtained from reliable sources, are not guaranteed for accuracy. Indexes shown are unmanaged and are not available for investment. The S&P 500 Index is an unmanaged, capitalization-weighted index of 500 widely traded stocks that are considered to represent the performance of the stock market in general. The Dow Jones Industrial Average (DJIA) is the price-weighted average of 30 actively traded blue chip stocks. The Russell 2000 Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index, and is representative of the U.S. small capitalization securities market. The MSCI EAFE Index includes approximately 1,000 companies representing the stock markets of 21 counties in Europe, Australasia and the Far East. The MSCI Emerging Markets Index is designed to measure equity market performance in global emerging markets. Equity securities are subject to stock market fluctuations that occur in response to economic and business developments. The value of large-cap stocks will rise and fall in response to the activities of the company that issued them, general market conditions, and/or economic conditions. Stocks of small-capitalization companies involve substantial risk. These stocks historically have experienced greater price volatility than stocks of larger companies and may be expected to do so in the future. International investing involves special risks, including foreign taxation, currency risks, risks associated with possible difference in financial standards and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility U.S. Bank N.A. (1/16) [ 9 ] reserve.usbank.com