Q WestEnd Advisors. Macroeconomic Highlights. (888)

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1 Q WestEnd Advisors Macroeconomic Highlights (888)

2 1 U.S. Economic Picture Prior to the November Election 3-Month Moving Average Chicago Fed National Activity Index (MA) The U.S. economy continued to grow in the first three quarters of 2016, albeit at a subdued pace. Year-over-year GDP growth was 1.7% as of Q3 2016, even as quarter-over-quarter GDP growth improved to 3.5% in the third quarter. The Chicago Fed National Activity Index (CFNAI) estimates the current level of activity across the U.S. economy. The CFNAI is constructed to have an average value of zero. A positive index reading corresponds to above-trend growth, and a negative index reading corresponds to below trend growth. After-Tax Corp Profits with Inventory Adjustment (Billions) $1,800 $1,600 $1,400 $1,200 $1,000 Source: Federal Reserve Bank of Chicago, WestEnd Advisors $800 $600 $400 $200 $0 After-Tax Corporate Profits Using a three-month moving average to lessen volatility, the CFNAI was below zero for the last 22 months as of November Slow economic growth has also contributed to headwinds for corporate profit growth. The government s measure of corporate profits, which incorporates the earnings of both large and small businesses, indicates that profit growth has stalled in recent years. This deterioration in profits, which has been led by energy businesses, hurt business investment and weighed on the pace of hiring in Source: Bureau of Economic Analysis, WestEnd Advisors

3 2 Early Read on the Economic Impact of the U.S. Election U.S. Real GDP Year-over-Year Growth 4% 3% 2% 1% 0% Real GDP Year-over-Year Growth Source: Bureau of Economic Analysis, WestEnd Advisors GDP Growth Estimates (%) Change Post Election Change Post Election JP Morgan Merrill Morgan Stanley Citi Consensus Source: JP Morgan, Merrill Lynch, Morgan Stanley, Citi, Bloomberg, WestEnd Advisors The trend in GDP growth has softened compared to prior years, and it looks like real GDP growth for the year will be approximately 1.6%. Pro-growth policies from Republicans are likely to result in a more extended period of moderate economic growth. While many investors seem optimistic about a reacceleration of economic growth, our analysis of the potential impact of new progrowth policies indicates that the boost to growth is likely to peak at about half of one percentofgdpandthatwon't be achieved until Most economists generally agree with our more restrained assessment of the Trumpled policy shift, as illustrated by the bottom table. This potential policy-driven, incremental growth excludes any potential negative impact of higher interest rates, a stronger dollar and/or potential trade restrictions.

4 3 Cyclical Growth Drivers Have Already Made Significant Progress Auto Sales SA Annualized Rates 3 Month MA Annualized Construction (millions, SAAR) Monthly Auto Sales Source Bloomberg, WestEnd Advisors Cyclical Non-Res. Construction Spending $300,000 Lodging Office $250,000 Commercial Manufacturing $200,000 $150,000 $100,000 $50,000 In the wake of the surprising U.S. election results, investors focused on the potential positive impacts of anticipated tax cuts, reduced regulatory burden, and other fiscal stimulus under the new administration. However, investors have all but ignored the timing of implementation of these policies and the potential negatives from anti-trade and anti-immigration policies. Additionally, key cyclical engines that could power a resurgence of growth have limited upside at this point following years of relatively steady, economic gains. Examples of the economic fuel that has already been burned to a large extent include U.S. auto sales, which are above prior cyclical peaks, with record annual sales of 17.5 million units for 2016, and nonresidential construction, which is in line with its pre-financial crisis peak, led by strong 27.5% and 28.4% annual growth in the office and lodging subcategories, respectively. $0 Source U.S. Commerce Department, WestEnd Advisors

5 Lack of Credit Has Not Choked Off U.S. Economic Growth $2,800 $2,300 $1,800 $1,300 $800 U.S. Business and Household Credit Growth (Billions) Nonfinancial Business Borrowing (SAAR) Household Borrowing (SAAR) Households and businesses alike delevered in the wake of the global financial crisis. However, consumers and businesses have both increased borrowing during the recovery. $300 -$200 -$700 -$1,200 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 Source: Federal Reserve, WestEnd Advisors $30,000 $25,000 $20,000 $15,000 $10,000 $5,000 U.S. Business and Household Debt Levels (Billions) Nonfinancial business debt outstanding has risen ~5% per annum over the last six years. Household debt outstanding has grown at a slower pace, but was 9.5% above the Q trough as of Q As of the most recent report, household debt and nonfinancial business debt together are up 18.9% from the trough in Q The availability of credit may very well go up under a new regulatory regime, but it has not been a lack of credit or an absence of borrowing in recent years that has held back overall all economic growth. $0 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 Debt Outstanding - Nonfinancial Business Debt Outstanding - Households Source: Federal Reserve, WestEnd Advisors 4

6 5 Real Interest Rates Turned Positive, But Are Still Well Below Normal 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% 10% Source: Bloomberg, WestEnd Advisors 10-Year Yield and Core CPI 10-Year Treasury Yield Core CPI Real Interest Rate Real interest rates are nominal interest rates less inflation. Real interest rates, which compensate lenders for risks over and above inflation, have recently moved back into positive territory, but still have significant upside by historical standards. The bottom chart illustrates the current real interest rate is 0.4% compared to a long term average of 2.5%. We anticipate U.S. interest rates will continue to rise in With unemployment down to 4.7%, hourly wage growth reached 2.9% year-over-year in December of 2016, which indicates increased inflationary pressures. 10-Year Tsy Yield Less Core CPI 8% 6% 4% 2% 0% -2% -4% -6% Average Level 1972 to 2016: 2.53% Average Level 1997 to 2007: 2.74% (2% Inflation Period) Higher inflation is likely to put upward pressure on intermediate and long-term interest rates, while the Federal Reserve is likely to continue pursuing short-term interest rate hikes in Lower personal and corporate income taxes combined with increasing fiscal stimulus could widen the U.S. budget deficit, putting additional upward pressure on U.S. Treasury rates. Source: Bloomberg, WestEnd Advisors

7 Higher Interest Rates and Currency Strength Present Potential Headwinds to Growth and Profits Bond Yield % Historical Government Bond Yields (Nominal) Anticipated pro-growth initiatives from the new President and Republican-controlled Congress have increased longer-term inflation expectations. Longer-dated U.S. government debt yields have risen as the interest rates of longerdated fixed income securities are, in part, dictated by inflation expectations. Index Level -0.5 Japan 10 Yr Yield Germany 10 Yr Yield UK 10 Yr Yield US 10 Yr Yield Dec-10 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Jun-14 Dec-14 Jun-15 Dec-15 Jun-16 Dec-16 Source: Bloomberg, WestEnd Advisors Historical USD FX Rate U.S. Trade Weighted Dollar ( Major Currencies) Index Higher interest rates in the U.S. can slow business and consumer credit growth. The nominal 10-Year U.S. Treasury yield is materially higher than the yields on other major foreign economies government debt. Foreign investor demand for U.S. assets has likely contributed to a renewed strengthening of the U.S. dollar. A stronger dollar can hurt corporate profits and export-oriented businesses. Source: Federal Reserve, WestEnd Advisors 6

7 Varied Valuation and Earnings Picture within the Stock Market Over the past quarter century, the Heath Care Sector has traded at a premium to the S&P 500 more than 70% of the time.

8 7 Varied Valuation and Earnings Picture within the Stock Market Over the past quarter century, the Heath Care Sector has traded at a premium to the S&P 500 more than 70% of the time. Today, amid ongoing political rhetoric over drug pricing, the Health Care sector trades at a 15% discount to the S&P based on 2017 EPS estimates. With favorable earnings growth potential in a moderate economic growth environment, Health Care should outperform as political uncertainty eases in Energy Sector Index Value Source: Bloomberg, WestEnd Advisors S&P 500 Energy Index Earnings and Index Level 800 S&P 500 Energy Index Value 700 Energy Sector EPS $60 $50 $40 $30 $20 $10 $0 Energy Sector EPS (LTM) The Energy Sector s 2016 rally and high valuation seem predicated on an unlikely sharp rebound in oil prices. OPEC s agreement to cut production, which only goes through May 2017, could support oil prices in the $50 to $60 dollar range for a time. We doubt OPEC members will maintain production discipline for long, and higher oil prices could bring additional supply from U.S. fracking back on line. Potential over-supply issues coupled with continued tepid global demand will weigh on oil prices, even as current Energy valuations look like they are discounting another 50% or more increase in the price of oil in the near-term. Source: Bloomberg, WestEnd Advisors

9 8 Japanese Consumers Continue to Struggle Japanese Real Consumption Expenditures Comsumption Tax Hike Much like the U.S., over 50% of Japan s GDP is derived from private domestic consumption. Index Level Real Consumption Expenditures (SA) A consumption tax hike that was implemented in April 2014 has impacted consumption expenditures. As illustrated in the top chart, real consumption expenditures have stepped down from the level seen prior to the consumption tax hike, and more recently, real consumption expenditures have continued to decline Source: Statistics Bureau of Japan Japan Population Age Distribution 23% < 25 YRS 25 < 33% < 50 YRS 50 YRS < 47% With no end to this weakness in sight, Japanese officials have postponed additional consumption tax hikes in an attempt to spur domestic consumption. Tens of Thousands At the same time, an aging population has shrunk Japan s workforce, which also has contributed to weak domestic consumption. An additional structural challenge is that older citizens have a higher propensity to save than their younger peers. Source: Statistics Bureau of Japan

10 9 Japan s QE has Outpaced Other Central Banks QE 90.0% Central Bank Balance Sheets as a Percentage of GDP 100.0% 80.0% 70.0% 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% United States Euro Area United Kingdom Japan 90.0% 80.0% 70.0% 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% 0.0% Source: Bloomberg, WestEnd Advisors The Bank of Japan s (BoJ) balance sheet expansion has surpassed the balance sheet growth of other central banks. The BoJ now holds assets equivalent to over 90% of Japanese GDP, which in percentage terms is essentially three times the assets of other major economies that have undertaken quantitative easing (QE). The BoJ continues to explore ways to stimulate growth. We expect additional QE by the BoJ would again have a limited impact on the pace of economic growth and may have less impact on equity markets, all while creating long-term risks for the Japanese economy and markets.

11 10 European Growth has Improved, But Challenges Remain Year-over-Year Real GDP Growth 6.0% 4.0% 2.0% 0.0% -2.0% -4.0% -6.0% Euro Area GDP Growth Euro Area year-over-year real GDP growth movedbackabove1.5%inthefirsthalfof Growth has been 1.7% each of the last three quarters and has remained between 1.7% and 2.0% from Q to Q The improved GDP growth in 2015 and 2016 reflects larger contributions from consumer spending. Consumer spending has, on average, accounted for 70% of GDP growth in the first three quarters of Year-Over-Year Growth (Seasonally and Working Day Adjusted) Source: Eurostat, WestEnd Advisors Euro Area Export Growth 30% 20% 10% 0% -10% -20% -30% Even with the additional contribution to growth from consumers, the absolute level of real GDP growth remains subdued. International trade has detracted from Euro Area GDP growth each of the last four quarters. European export growth has weakened as global demand continues to be soft, global competition remains significant, and the Euro has been supported by diminished prospects of additional European Central Bank easing. Source: Eurostat, WestEnd Advisors

12 This report should not be relied upon as investment advice or recommendations, and is not intended to predict the performance of any investment. These opinions may change at anytime without prior notice. All investments carry a certain degree of risk including the possible loss of principal, and an investment should be made with an understanding of the risks involved with owningaparticularsecurityorasset class. The information has been gathered from sources believed to be reliable, however data is not guaranteed. The Standard and Poor s 500 Stock Index includes 500 stocks and is a common measure of the performance of the overall U.S. stock market. An index is unmanaged and is not available for direct investment. 11

Economic and Financial Markets Monthly Review & Outlook Detailed Report. June 2014

Economic and Financial Markets Monthly Review & Outlook Detailed Report June 1 Overview of the Economy In the U.S., the Federal Reserve s Beige Book report on the economy through late May indicated that