Quarterly Reflections & Outlook Prepared: July 2013

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1 SITUATION ANALYSIS Quarterly Reflections & Outlook Prepared: y Second quarter recap: U.S. economic growth and manufacturing activity slowed, but signs of recovery remained as employment, consumer confidence and housing improved and inflation pressures eased. Signs of recovery in Japan increased, but economic growth in China slowed and the eurozone remained mired in recession with rising unemployment. U.S. equities posted the best first half of the year performance since Long-term Treasury yields increased sharply in response to the prospect of the Federal Reserve beginning to taper the quantitative easing programs. The housing recovery appears to be broad based, despite a recent rise in mortgage rates. Select commodity prices fell during the quarter in reaction to slower global growth. Outlook summary: We believe the U.S. economy will continue to see signs of improvement, primarily led by strong trends in housing, employment and consumer confidence. Rates of global growth are likely to follow diverse trends as individual countries face their own complex issues, but global rates of inflation seem to remain muted. In our view, despite continued volatility, equities will continue to trend higher toward year end and into We expect Treasury yields to remain volatile but near current levels in the coming months as the Fed moves closer to reducing stimulus programs. The housing recovery is expected to continue and will support overall U.S. economic growth. Improving global growth over the second half of will likely provide support to commodity prices. Second quarter review U.S. economy The U.S. economy saw weaker data across the second quarter, in contrast to the Federal Reserve (Fed) talking about tapering the quantitative easing (QE) program, which implies they see a healthier economy where private economic activity may be reaching self-sustaining levels. Economic growth likely slowed in the second quarter as government spending cuts from sequestration dragged on the economy and appeared to reduce corporate confidence. Companies seemed to choose to defer capital spending in the face of uncertainty regarding the impact of spending cuts. Consumer spending has remained a stalwart for the economy and improving labor markets and rising home prices helped to maintain that condition. Inflation also eased over the quarter, especially aided by falling commodity prices as well as the slack in labor markets. As we move into the second half of the year another debt ceiling debate looms, however, improving labor and housing markets seem likely to be joined by a return of capital expenditures, which companies have deferred, to provide for improving economic activity. First quarter GDP growth in the United States improved to 1.8 percent from 0.4 percent in the fourth quarter of, but second quarter data seem to indicate growth will slow. As we entered the second quarter, automatic spending cuts were implemented as part of the prior debt ceiling and fiscal cliff compromises. The decline in government spending, especially defense spending cuts, created uncertainty for many businesses and also seemed to lead to declines Important disclosures provided on page 8.

2 in capital expenditure. Manufacturing activity slowed precipitously in the quarter as indicated by the ISM PMI for manufacturing which fell from an average of almost 53 in the first quarter to an average level of just over 50 in the second quarter. Consumer activity has remained consistently positive post-recession, and this quarter seems to be no exception. Labor markets improved as nonfarm payrolls increased by almost 590,000 jobs and weekly initial unemployment claims averaged less than 350,000 per week for the entire quarter. The unemployment rate remained unchanged at 7.6 percent, due primarily to the uptick in the labor force participation rate, which seems to indicate rising confidence by previously discouraged job seekers. This seems to ring true as consumer confidence measures reached their highest levels post-recession during the quarter and seem to be reaching levels previously consistent with a period of recovery. Housing was also a strong positive in the second quarter with prices rising 12 percent over the past year through il according to the S&P/Case-Shiller Index. Housing market activity, including sales of new and existing homes as well as new building activity, continued their path of improvement. Slowing inflation was also a positive in the quarter, especially for consumers, as year-over-year Consumer Price Index (CPI) results slowed to just 1.4 percent through May. The nearly 6 percent decline in commodity prices over the quarter, as measured by the S&P GSCI, helped ease prices. Price pressure from wage growth and housing prices also remained modest. Index Level Dec 2010 Source: FactSet Steady employment growth may lead to improving economic activity ISM Index Total Nonfarm payroll ISM Non-manufacturing Index 2,600 2,400 2,200 2,000 1,800 1,600 1,400 1,200 1, The second quarter was likely one of transition for the U.S. economy as slowing from government spending contraction gave way to renewed economic activity in the private sector. Healthy consumer data from the quarter, including improving labor markets, rising net worth from Figures in thousands housing and stocks and normalizing consumer confidence are likely to continue to be positives for the remainder of the year. The rising housing market seems likely to continue as household formation returns to its long-term trend rate, despite the recent rise in mortgage rates. These positive trends may be joined by rising capital expenditures as new orders for durable goods have recently improved. Second quarter review global economy Eurozone growth continued to wane as measures of growth, such as GDP and PMI, continued to contract and unemployment reached more than 12 percent. These figures gave policymakers little to work with to help placate populations that appear to be weary of austerity. Pressure to deflate balance sheets remained on the financial system and except for the steely glare of the European Central Bank (ECB) there remained little demand for eurozone debt. Markets seem poised to wait for German elections to be held in September to determine the next phase in this crisis. One positive was delivered at the end of the quarter as PMI data for the eurozone seemed to moderate their pace of decline, perhaps indicating the nadir of the recession may be at hand. Growth data from Japan improved, perhaps through the will of Prime Minister Abe, or perhaps from the significant monetary stimulus. The Markit Manufacturing PMI reached a two and a half year high in June of 52.3, leading economic indicators improved in both il and May and industrial production grew by nearly 3 percent for the first two months of the quarter after being virtually unchanged in the first quarter. Deflation eased in the quarter as prices fell just 0.3 percent in the year ended May and the economy seemed to be on the precipice of stronger nominal economic growth in the second quarter. PMI level Global manufacturing Jun U.S. Japan Germany Global Economies China Source: Strategas Research Partners; data begins May 2006 Important disclosures provided on page 8. Page 2

3 Growth has been slowing in China (the world s second largest economy) as the new central government has enacted programs to reduce corruption and begin to shift toward consumption from exports and investments. In June, these policies led to a spike in overnight interest rates in China (via the Shanghai Interbank Offered Rate or SHIBOR) to more than 13 percent at one point from an average level in the first quarter of around 2 to 3 percent. The slowing in demand for commodities from China helped prices ease and depressed activity in commoditylinked emerging market nations such as Russia and Brazil. As we closed the quarter, the liquidity crisis in China had eased as overnight lending rates slipped back below 3 percent. However, manufacturing PMI for China has continued to indicate some minor contraction. The slowdown seems to be modest and the transition toward more consumption in the economic mix appears to be quite positive for stabilization of long-term growth in China. Second quarter review capital markets Equities: U.S. equities ended the second quarter and the mid-year by posting the best first half of the year performances since The year-to-date performance ending June 30 for all the major indices was superb the S&P 500 (12.6 percent), Dow Jones Industrial Average (13.8 percent), NASDAQ Composite (12.7 percent) and Russell 2000 (15.1 percent). By many measures, the broad indices exceeded expectations, advancing in the first six months to levels that many pundits had forecasted to be reached at year end or in early This performance seems particularly noteworthy as stock prices managed to forge higher despite the year-end fiscal cliff, implementation of sequestration and associated tax increases and spending cuts, political wrangling over deficit and debt levels and preliminary discussions surrounding tapering and eventual ending of QE programs. Year-to-date small-cap outperformance and emerging markets underperformance seem worthy of note. Smallcap companies often outperform during the initial phase of an improving economy, typically indicative of an equity market that is poised to trend higher. This seems to have occurred during the first half of. Additionally, the U.S. small-cap outperformance may partially be the result of fund flows that otherwise would be directed to emerging markets a hometown bias so to speak. Emerging market performance has lagged year to date, largely due to the slowing in the rate of economic growth in China. While the longer-term projected growth rates in emerging markets in general, and China in particular, are nearly twice that of developed countries, the near-term visibility is lacking, arguably prompting investors to look toward other asset classes for beta (increased risk/reward opportunities). We continue to like the longer-term prospects of emerging markets and, for U.S. equities, favor multinational companies with an emerging markets presence. Fixed Income: The fixed income markets posted their worst quarterly performance in years as concerns over the eventual unwinding of the Federal Reserve s extraordinary policy strategy of quantitative easing rocked the markets. The U.S. Treasury curve steepened significantly as the two-year Treasury rose a modest 12 basis points (to 0.24 percent) while the 30-year rose 43 basis points (to 3.50 percent). The largest movement was felt in the intermediate term portion of the curve as five- and 10-year Treasuries rose 65 and 66 basis points respectively (to 1.40 percent and 2.49 percent, respectively). Comments following the May 1 Federal Open Market Committee (FOMC) meeting hinted that a change is coming but is not imminent since the economy remained too weak at that time for the Fed to take their foot off of the stimulus gas pedal. Concerns over a possible change in Fed action by as early as the next meeting resulted in yields rising by 50 basis points during the month. By the June 19 meeting, the Fed had laid the groundwork for the eventual reduction of the QE purchasing program. The markets did not interpret the FOMC statements as Bernanke intended. The mere mention of a potential end to the purchase program resulted in a market focused on both the end of QE and the future fate of the Fed funds rate. The result was a 10-year Treasury yield hitting highs not seen since the summer of, ending the quarter at 2.49 percent. Concerns over the possibility of a Fed Funds rate hike as early as 2014 have since resulted in U.S. Treasury yields pushing past the June highs to a level of 2.63 percent. 1.0% 0.5% 0.0% -0.5% -1.0% Jun 30 Source: Bloomberg Inflation-adjusted yields have reached multi-year highs Sep 30 Dec 31 Mar 31 Jun year Treasury Inflation-Protected Security Sep 30 Dec 31 Mar 31 Jun 30 Important disclosures provided on page 8. Page 3

4 All sectors of the fixed income markets posted negative returns for the quarter. The potential reduction in Fed accommodation put downward pressure on the price of Treasury Inflation-Protected Securities (TIPS) and they were the worst performing sector for the quarter, posting a negative return of over 7 percent. In addition to reduced accommodation, a stronger dollar resulted in downward price pressure on emerging debt, which closed the quarter with a negative return of around 6 percent (depending upon currency). Investment grade corporates, municipals and foreign sovereign also posted negative returns of 3 to 3.5 percent for the quarter. High yield held up the best of any of the fixed income sectors of the market with a modest negative 1.35 percent return for the quarter. Real Estate: Housing transaction volumes and prices increased dramatically throughout the second quarter. In May, the National Association of Realtors reported the highest level of pending contracts on existing homes since 2006 and the il S&P/Case-Shiller Index showed that all 20 of the cities comprising the Index had year-over-year price increases. The housing recovery appears to be broad based as demonstrated in transactions numbers and by price increases throughout the first half of the year. Along with the yield advance of the 10-year Treasury in late May, mortgage rates began to increase. By late June, 30-year mortgage rates had moved with the Treasury increase and were in the 4.5 percent range. Where real estate investors were getting good spread yield between Real Estate Investment Trusts (REITs), average dividend yield and Treasury rates earlier in the year, the spread suddenly eroded with the May rate increases and continued throughout June. After an almost six-year high, the Bloomberg REIT Index dropped about 11 percent in May as the yield on 10-year Treasury notes moved upward amid speculation the Fed would reduce bond purchases, which had kept borrowing costs low. Commodities: Commodity prices slipped nearly 6 percent in the second quarter as measured by the S&P GSCI, with the majority of declines being experienced in il and May. Commodity markets have been adjusting prices toward expectations for much slower global growth, and in particular slowing manufacturing and investment in China. The decline impacted all broad commodity segments energy, agriculture, industrial and precious metals. Oil painted a slightly different picture for the quarter as June saw prices rally as regime change emerged in Egypt, driving a risk premium into oil prices. The U.S. benchmark West Texas Intermediate (WTI) crude oil closed the quarter by nearing a price of $100 per barrel. Precious metals, such as gold, declined throughout the quarter, losing nearly 24 percent. Speculators fled exchange-traded products as the Fed signaled that it may begin reducing debt purchases, also known as tapering quantitative easing, as we near year end and as economic data continued to improve. Investors hoped for some arresting of the decline by renewed demand for physical gold from key consumers, China and India. While there was a modest increase in physical demand, it was insufficient to overcome the exodus of speculators from exchange-traded products, and gold prices plunged nearly $400 per ounce, reaching their lowest prices in nearly three years. Industrial metals also struggled, with copper losing 10 percent over the quarter. Despite some problems at mines, which temporarily constrained supplies, the supply of metals exchange stocks remained ample. While this led prices to rise modestly in the middle of the quarter, a further slowdown in economic data from China forced prices lower to end the quarter. Outlook U.S. economy In our view, U.S. economic output should improve over the rest of this year as it benefits from improving trends in housing, employment and consumer confidence. Also, the economy will likely benefit from an improvement in capital spending as businesses seek to converge capital spending with recently rising employment of labor. Growth seems likely to average 2.5 percent for the second half of, while the unemployment rate will continue to fall but will likely struggle to reach 7.3 percent as we may see further modest improvement in labor force participation Manufacturing Oct Jan Index level Source: FactSet Rising confidence, business to follow? Consumer Confidence Oct Jan Housing Market Oct Jan Index level Important disclosures provided on page 8. Page 4

5 Despite the rising Federal Reserve balance sheet, inflation pressures seem well contained in the United States. Inflation is defined as a rise in the overall general level of prices. We are likely to continue to see rising prices in areas where we have significant demand or a lack of supply (such as medical care, education or in labor in North Dakota). In addition, we generally continue to suffer from modest demand from low economic growth and ample supplies of labor and goods. Inflation seems most likely to average less than the Fed s target of 2 percent over the next year or so as labor markets remain in surplus and demand for loans has remained relatively modest. Risks to our forecast for the rest of seem likely to reside in government policy, as well as global economic policies. In the third quarter, it is anticipated that the United States will again reach its debt ceiling limit and therefore, another debate is likely to ensue on the funding of the government. The debate may have implications for markets and consumer confidence, but the outcome may have implications for tax and spending policy. Risks from global economic policy remain as Europe continues to battle its own debt crisis, Japan attempts to stimulate its economy to exit decades of deflation and China attempts to transition to more consumption relative to manufacturing. Outlook global economy Rates of global growth continue to follow diverse trends as individual countries face their own complex issues. Growth in China seems likely to average around 7 percent, but the transition toward a consumer economy will likely be volatile. Commodity-exporting emerging market countries likely struggle as China s economic rebalancing drags on demand for raw material. Eurozone growth will likely struggle to exit the recession before year end, but they have likely seen the worst of the recession. Risks remain from the debt crisis as financial institutions continue to deleverage and structural reforms continue to be debated, rather than implemented. Growth in 2014 will likely not exceed the range of 1 to 2 percent. Growth in Japan is being supported by significant monetary easing, but the acceleration in growth likely struggles past the end of this year. Structural reforms will take some time to implement and the effects will likely take a couple of years to fully benefit the economy. Outlook capital markets Equities: U.S. equities continue to trend higher in the third quarter, impacted by the Fed and company earnings. Following heightened uncertainty around mid year, investors seem increasingly reassured that the Fed will remain flexible in the timing of its withdrawal of stimulus measures while keeping interest rates low for the foreseeable future. This presents a favorable backdrop for equities. In our view, earnings and revenue growth will need to accelerate as we move further into the second half of and 2014 to warrant meaningfully higher equity prices Number of S&P 500 stocks paying a dividend Source: Strategas Research Partners; data through 7/1/13 Despite strong year-to-date performance, the fundamental backdrop seems favorable for U.S. equities to trend still higher, albeit at a more modest pace. We believe valuation is fair, with the S&P 500 trading at a price-earnings multiple of roughly 15 times our earnings estimate of $110, and our year-end S&P 500 price target is Sentiment appears to remain constructive, likely driven by the housing recovery and wealth effect associated with higher stock prices, and inflation is currently benign, presenting an attractive environment of potential priceearnings multiple expansion. Additionally, with investor appetite for yield remaining high and over 80 percent of S&P 500 companies offering dividends, select U.S. equities present compelling opportunities for both income and appreciation potential. Fixed Income: For multiple reasons, we do not believe rates will sell off aggressively from current levels. First, the Fed will continue to hold a substantial book of assets on their balance sheet, the increased regulatory demand for safe assets remains in place, net issuance of government securities will continue to decline, the backdrop of extremely low levels of inflation puts downward pressure on rates and, lastly, the Fed has explicitly stated that they will not be considering Fed Funds increases until Important disclosures provided on page 8. Page 5

6 employment breaches the 6.5 percent threshold. Thus, the scope for Treasury yields to rise significantly higher from here appears limited. We expect Treasury yields to remain volatile but near current levels in the coming months as the Fed moves closer to reducing its QE programs. In our view, the Fed is likely to taper its bond purchases at the September FOMC meeting as the recent improvement in the U.S. labor outlook has spurred policymakers to scale back monetary stimulus. materials. However, supply may not meet demand, and low inventory of new and existing homes on the market may continue some tightness in the market. Thus, house prices may rise as was the case in the first half of the year. Mortgage rates could have a dampening effect on an otherwise fairly robust housing market. The recent jump in mortgage rates has tracked the surge in bonds and while these increased rates are likely to remove some buyers from the immediate market, the improving economy and outlook will provide support for housing transactions. Basis points Dec 31 Expectations of reduced stimulus have driven volatility higher Jan 31 Merrill Lynch Treasury Option Volatility Index Feb 28 Mar May 31 Jun 30 Supporting the housing market is the creation of more jobs. As new jobs continue to be added, housing is expected to track accordingly. Also supporting housing and commercial real estate recovery is the wealth effect of consumer spending. Although their incomes may not be increasing at an appreciable rate, the wealth effect is a reason for the resiliency in consumer spending. We expect some bounce-back in REIT prices as the economy continues to grow and as yield rates adjust to Fed policy. Source: BofA Merrill Lynch; Bloomberg We have a cautious view of foreign-denominated international debt over the near term due to increased demand for the U.S. dollar relative to other currencies. While the Fed has recently shifted to a less accommodative stance, policymakers abroad have moved in the opposite direction. Central banks in Western Europe remain concerned regarding the pace of economic growth in the region and have all recently provided additional monetary easing, which will likely produce lower interest rates and currency depreciation in those countries. High yield is historically the least sensitive sector to interest rate rises, as the sector is typically correlated with riskier assets, such as equities. Additionally, the higher coupons offered by high yield often offset the capital losses sustained when interest rates move higher. We believe the environment of steady economic growth, continued low default rates and the perpetual hunt for more attractive yield levels should support credit strength in the third quarter, albeit with some increased volatility. Real Estate: The housing recovery is expected to continue its advance this year and will support overall U.S. economic growth. The anticipation of 900,000+ housing starts this year provides fuel for construction jobs and Yield 10% 8% 6% 4% 2% 0% -2% -4% -6% -8% Corporate Bonds Capitalization rates & yields U.S. Treasuries Sources: NCREIF, FactSet, ISI Group, Federal Reserve 2009 REITs 2010 NCREIF May Commodities: Improving global growth over the second half of likely provides support to commodity prices. The size of the gains may be modest as supply development has recently led to significant expansion of U.S. oil production as well as rising global mining output. Price trends will likely be volatile as the markets seek to balance rising supplies in certain regions with the diverse and distinct nature of economic growth across countries and regions. Important disclosures provided on page 8. Page 6

7 Within the commodity sectors, we prefer cyclical commodities, especially oil, relative to precious metals, such as gold. Oil prices seem likely to modestly increase as global growth improves over the second half of the year. This should also lend support to industrial metals, such as copper, especially toward the fourth quarter. Precious metals, and especially gold, are likely to struggle in the face of the nearing conclusion to U.S. quantitative easing policies. Stronger growth and rising long-term interest rates may sap gold demand and recent speculative outflows are likely to continue. Grains may see modest negative pressure as well. Record plantings will provide supply pressure to prices barring weather relative problems. Demand and global risk driving oil prices 7,500 40% Barrels per day (in thousands) 7,000 6,500 6,000 5,500 5,000 U.S. crude oil production Crude oil, WTI 30% 20% 10% 0% -10% -20% Year-over-year performance 4,500 Oct Jan Oct Jan -30% Source: FactSet We recommend, when suitable, that investors maintain a position in commodities as a hedge against potential market volatility that could result from inflationary pressures and global strife. Price spikes due to such issues typically have the greatest impact on food and energy prices. Investors may potentially benefit from using actively managed strategies that have the ability to adapt to the dynamics of the marketplace. Important disclosures provided on page 8. Page 7

8 Contributed by: Edgar W. Cowling, Jr., CCIM Director of Specialty Assets Robert L. Haworth, CFA Senior Investment Strategist Terry D. Sandven Chief Equity Strategist Jennifer L. Vail Head of Fixed Income Research reserve.usbank.com Insurance products are: Not a Deposit Not FDIC Insured May Lose Value Not Bank Guaranteed Not Insured by Any Federal Government Agency This commentary was prepared on y 24, 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. U.S. Bank is not responsible for and does not guarantee the products, services or performance of third party providers. Any organizations mentioned in this commentary are not affiliates 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 NASDAQ Composite Index is a market capitalization price-only index that tracks the performance of domestic common stocks traded on the regular NASDAQ market as well as National Market System traded foreign common stocks and American Depository receipts. 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 Bloomberg REITS Index is a price-weighted index designed to measure the performance of real estate investment trusts. The S&P GSCI is a composite index of commodity sector returns that is broadly diversified cross the spectrum of commodities. Equity securities are subject to stock market fluctuations that occur in response to economic and business developments. 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. Investing in fixed income securities are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. Investment in debt securities typically decrease in value when interest rates rise. The risk is usually greater for longer term debt securities. Investments in lower rated and non rated securities present a greater risk of loss to principal and interest than higher rated securities. Investments in high yield bonds offer the potential for high current income and attractive total return, but involve certain risks. Changes in economic conditions or other circumstances may adversely affect a bond issuer s ability to make principal and interest payments. The municipal bond market is volatile and can be significantly affected by adverse tax, legislative or political changes and the financial condition of the issuers of municipal securities. Interest rate increases can cause the price of a bond to decrease. Income on municipal bonds is free from federal taxes, but may be subject to the federal alternative minimum tax (AMT), state and local taxes. Investments in mortgage-backed securities include additional risks that investors should be aware of such as credit risk, prepayment risk, possible illiquidity and default, as well as increased susceptibility to adverse economic developments. Treasury Inflation-Protected Securities (TIPS) offer a lower return compared to other similar investments and the principal value may increase or decrease with the rate of inflation. Gains in principal are taxable in that year, even though not paid out until maturity. There are special risks associated with an investment in commodities, including market price fluctuations, regulatory changes, interest rate changes, credit risk, economic changes, and the impact of adverse political or financial factors. Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates, and risks related to renting properties (such as rental defaults). U.S. Bancorp (7/13) Page 8