Quarterly Economic & Market Update 3rd Quarter 2016

Transcription

1 Quarterly Economic & Market Update 3rd Quarter 2016 Prateek Mehrotra, MBA, CFA, CAIA Chief Investment Officer Our sole mission is to provide wealth sustainability for individuals, families, endowments, foundations, and retirement plans through the implementation of our 3-D Endowment Investment Philosophy. 1

2 Important Information The views and opinions expressed are those of the speaker and are subject to change based on factors such as market and economic conditions. These views and opinions are not an offer to buy a particular security and should not be relied upon as investment advice. Past performance cannot guarantee comparable future results. 2

3 Important Information Performance quoted is past performance and cannot guarantee comparable future results; current performance may be higher or lower. Results shown assume the reinvestment of dividends. An investment cannot be made directly in an index. Investments with higher return potential carry greater risk for loss. Investing in small companies involves greater risks not associated with investing in more established companies, such as business risk, significant stock price fluctuations and illiquidity. Foreign securities have additional risks, including exchange rate changes, political and economic upheaval, the relative lack of information about these companies, relatively low market liquidity and the potential lack of strict financial and accounting controls and standards. Investing in emerging markets involves greater risk than investing in more established markets such as risks relating to the relatively smaller size and lesser liquidity of these markets, high inflation rates, adverse political developments and lack of timely information. Fluctuations in the price of gold and precious metals often dramatically affect the profitability of the companies in the gold and precious metals sector. Changes in political or economic climate for the two largest gold producers, South Africa and the former Soviet Union, may have a direct effect on the price of gold worldwide. 3

4 Point of View October 2016 Fed policy twin mandate points to continued dovish policy the Fed manages the yield curve the Fed has created every recession since the 1950s the Fed is constrained by ECB policy first rate hikes have signaled stock market strength 4

5 Federal Reserve policy Fed funds rate projected normalization Fed participants' median projected fed funds rate September, % Our ability to predict how the federal funds rate will evolve over time is quite limited because monetary policy will need to respond to whatever disturbances might buffet the economy. Percent % Chair Janet Yellen Jackson Hole August 26, Source: Federal Reserve, September 21, 2016.

6 Federal Reserve policy Fed funds rate Fed Funds Rate (%) The Fed s median fed funds rate forecast of 1.9% at year-end 2018 (previous chart) is very low by historic comparison. That s because the Fed believes the natural rate of interest is probably just 0.4%, down from 2.3% in 2007 and 3.5% in The fed funds rate should equal the natural rate plus inflation, or 0.4% + 1.5% = 1.9%. 2 0 Shaded bands represent recessions Source: Federal Reserve. Data through September % in 2018, median projection previous chart 6

7 Federal Reserve policy Fed s key policy lever is the yield curve March 31, This is an inverted (negative) yield curve resulting from the Fed s raising the Fed Funds target rate (1 mo. maturity) to 5.23%. 3.5 Yield (%) November 30, 2015 Today s is a positive yield curve resulting from the Fed s pushing the Fed Funds target rate down to 0.4%. 1.0 October 6, mo 3 mo 6 mo 1 yr 2 yr 3 yr 5 yr 7 yr 10 yr 20 yr 30 yr Maturity Yield Curve, n. A measure of interest rates on bonds at various maturities; predicting where the yield curve is headed is about as easy as forecasting exactly where a fistful of feathers will land in a hurricane. 1 Source: U.S. Department of the Treasury. 1 Jason Zweig, The Devil s Financial Dictionary (New York, NY: PublicAffairs, 2015),

8 Federal Reserve policy Fed s key policy lever is the yield curve 3.5 Shaded bands represent recession. Yield Curve 1 Steep yield curves high bond yields compared to Fed Funds rates are consistent with strong GDP growth. 10-year Treasury Yield - Fed Funds (%) Jul-83 Aug-84 Sep-85 Oct-86 Nov-87 Dec-88 Jan-90 Feb-91 Mar-92 Apr-93 May-94 Jun-95 Jul-96 Aug-97 Sep-98 Oct-99 Nov-00 Dec-01 Jan-03 Feb-04 Mar-05 Apr-06 May-07 Jun-08 Jul-09 Aug-10 Sep-11 Oct-12 Nov-13 Dec-14 Jan-16 Flat or negative yield curves have preceded recessions. Today the yield curve is positive but less than half as steep as immediately postrecession. The Fed has been saying that rate hikes are likely to be very gradual from here. Sources: NBER, Federal Reserve. Data through September The differential between the interest rate on Fed Funds (short term) and the 10-year Treasury bond (long term).

9 Unemployment rate (%) Price Index for Personal Consumption Expenditures 12-month percent change (%) Federal Reserve policy Dual mandate, dovish Fed Jan-04 Jun-04 Nov-04 Apr-05 Sep-05 Feb-06 Jul-06 Dec-06 Shaded band represents recession. May-07 Oct-07 Mar-08 Aug-08 Jan-09 Jun-09 Nov-09 Apr-10 Sep-10 PCED Core PCED Feb-11 Jul-11 Dec-11 May-12 U-3 U-6 Oct-12 Mar-13 Aug-13 Jan-14 Jun-14 Nov-14 Apr-15 Sep-15 Feb-16 Jul % Dec % 5.0% May-17 Oct-17 Fed s dual mandate: full employment 2% inflation With inflation still well below 2% the Fed might stay very dovish for awhile yet. It may take until well into 2017 to regain full employment. Fed s September 2016 central tendency forecast Mar-18 Aug-18 See footnotes in the notes to the slide. Jan-19 Jun-19 Nov-19

10 Economic data - jobs Employed and unemployed as a % of population 16 and older Percent Percent The red line, number of employed as a percent of employable age, is the key to Fed policy. Not the black line, the percent of unemployed. There is a lot more room for cyclical recovery Jan-96 Sep-96 May-97 Jan-98 Sep-98 May-99 Jan-00 Sep-00 May-01 Jan-02 Sep-02 May-03 Jan-04 Sep-04 May-05 Jan-06 Sep-06 May-07 Jan-08 Sep-08 May-09 Jan-10 Sep-10 May-11 Jan-12 Sep-12 May-13 Jan-14 Sep-14 May-15 Jan-16 Sep-16 Recession Employed % of population > 16 years Unemployed % of population > 16 years Source: Bureau of Labor Statistics. Data through September million). 10

11 Point of View October 2016 Bond Yields lowest yields in history forecasts have grossly missed forecast for steady rise to 3.35% pressure on yields from declining federal deficit pressure on yields from ECB s QE capping euro bond yields value in munis 11

12 Bond yields All-time low bond yields : 14.59% Lowest long-term interest rates in U.S. history. Long-term interest rates (%) Panic of 1873 Gold standard re-established 1875 WWI Iranian revolution and second oil shock 1979 Great Depression Vietnam War Korean War WWII OPEC oil embargo and first oil shock Panic of Source: Online Data Robert Shiller. Data through October 5,

13 Bond yields Much lower than expected bond yields 10-year U.S. Treasury Bond Yield (%) /2/11: Bill Gross: with the end of QE2, bond yields are likely to go "higher, maybe even much higher." 1.43% 1.72% Forecasts have been consistently and horribly wrong. Where yields go from here depends on the inflation data and supply and demand for bonds. Inflation is low and apt to remain so. The rate of net new supply of U.S Treasury bonds will be close to flat. The ECB is in the driver s seat with its QE QE 1 QE 2 Oct-17 Jul-17 Apr-17 Jan-17 Oct-16 Jul-16 Apr-16 Jan-16 Oct-15 Jul-15 Apr-15 Jan-15 Oct-14 Jul-14 Apr-14 Jan-14 Oct-13 Jul-13 Apr-13 Jan-13 Oct-12 Jul-12 Apr-12 Jan-12 Oct-11 Jul-11 Apr-11 Jan-11 Oct-10 Jul-10 Apr-10 Jan-10 Oct-09 Jul-09 Apr-09 Jan-09 Oct-08 Jul-08 Apr-08 Jan-08 QE 3 Source: Federal Reserve. Data through October 5, Average of economists forecasts from The Wall Street Journal s monthly surveys taken November 2011, January 2014, September 2014, January 2015 and December 2015.

14 Bond yields why so low? U.S. Treasury bond yields nominal and TIPS Yield (%) U.S. Treasury Bond Yields 10-year Maturity Recession QE Nominal Yield TIPS Yield However, bond yields no longer make sense fundamentally. With the 10-year TIPS yield at almost 0% an investor is receiving zero term premium for making a 10-year loan to Uncle Sam. Quantitative easing (QE) has driven bond yields steadily lower. Although the Federal Reserve is no longer purchasing bonds (QE), the ECB is, having a like effect on U.S. bond yields. See next chart. 14 Source: Federal Reserve. Data through September 2016.

15 Bond yields why so low? U.S. Treasury bond yield vs. German bund yield Yields moving in lockstep. The ECB is in control of U.S. Treasury yields. The ECB plans to continue their QE program until further notice. Yield (%) Jan 2-Feb 2-Mar 2-Apr 2-May 2-Jun 2-Jul 2-Aug 2-Sep 2-Oct 2-Nov 2-Dec 2-Jan 2-Feb 2-Mar 2-Apr 2-May 2-Jun 2-Jul 2-Aug 2-Sep 2-Oct German 10-year bund yield Source: The Wall Street Journal. Data through October 6, U.S. Treasury 10-year bond yield 15

16 Point of View October 2016 Inflation PCED headline +1.0%, more in the core but still far from the Fed s +2% target employment costs steady and still tame productivity and declining unit labor costs how you experience inflation depends on what you consume 16

17 Inflation PCE headline and core Price Index 12-month percent change (%) Shaded bands represent recessions. PCE 2% target Headline inflation (PCE) has plunged and partially recovered with the plunge in gasoline, diesel and fuel oil prices. Inflation ex-food and energy (core PCE) is higher than core but still below the Fed s 2% target % core % headline 0.5 Core PCE 0.0 Jan-95 Oct-95 Jul-96 Apr-97 Jan-98 Oct-98 Jul-99 Apr-00 Jan-01 Oct-01 Jul-02 Apr-03 Jan-04 Oct-04 Jul-05 Apr-06 Jan-07 Oct-07 Jul-08 Apr-09 Jan-10 Oct-10 Jul-11 Apr-12 Jan-13 Oct-13 Jul-14 Apr-15 Jan-16 Source: NBER, Federal Reserve Bank of St. Louis. Data through August 2016.

18 Inflation Employment cost index and inflation 12-month percent change (%) Employment Costs ECI %% Because wages, salaries and benefits are companies biggest single cost, they are also the biggest single inflation factor for the economy as a whole. Inflation (PCE deflator) generally runs lower than measured ECI inflation because higher employment costs can be offset by productivity gains. See next two charts % 0.0 Jun-82 Aug-83 Oct-84 Dec-85 Feb-87 Shaded bands represent recessions. Apr-88 Jun-89 Aug-90 Oct-91 Dec-92 Feb-94 Apr-95 Jun-96 PCE Deflator Aug-97 Oct-98 Dec-99 Feb-01 Apr-02 Jun-03 Aug-04 Oct-05 Dec-06 Feb-08 Apr-09 Jun-10 Aug-11 Oct-12 Dec-13 Feb-15 Apr Source: Bureau of Labor Statistics. Quarterly ECI data through June 2016; monthly PCE data through August Employment Cost Index. The BLS s ECI is built with fixed weights for individual industries and occupations.

19 Inflation Inflation by expenditure category 160 Education 150 4% 140 Medical care Index (Jan = 100) % 2% CPI 1% Food Housing Airfare Transportation Apparel Recreation New and used vehicles How you experience inflation depends on what you consume % 60 Jan-16 Aug-15 Mar-15 Oct-14 May-14 Dec-13 Jul-13 Feb-13 Sep-12 Apr-12 Nov-11 Jun-11 Jan-11 Aug-10 Mar-10 Oct-09 May-09 Dec-08 Jul-08 Feb-08 Sep-07 Apr-07 Nov-06 Jun-06 Jan-06 Information technology Source: BLS. Data through April Dotted lines indicate compound annual growth rate trajectories at rates indicated.

20 Point of View October 2016 Stock Market record highs driven by earnings turnaround following the anniversary of $USD surge and energy prices bottoming stocks are fully-, but not over-valued margins are likely sustainable Fed is accommodative inflation is tame lack of irrational exuberance 20

21 Market data S&P /17/15 Fed defers on rate hike 10/22/15 ECB, China signal more stimulus 12/16/15 Fed rate hike 8/5/16 Strong July jobs report /4/16 Strong Feb jobs report, oil rally 9/9/16 Fed's Rosengren suggests September rate hike /29/15 Greek vote 7/8/16 Strong June jobs report S&P /29/14 Fed begins QE taper -6.1% April 2014 Ukraine -4.4% 7/30/14 Fed reaffirms taper will conclude QE by October % 12/17/14 Fed to be "patient" raising rates -5.1% October 2014 QE3 ends, Fed rate hike jitters, global slowdown worries -9.8% 8/24/15 flash crash; China devaluation, global slowdown worries -11.2% 12/11/15 Third Avenue suspends redemptions -4.3% 2/12/16 China, global slowdown worries, oil -12.0% 6/24/16 Brexit -5.3% Sep-16 Aug-16 Jul-16 Jun-16 May-16 Apr-16 Mar-16 Feb-16 Jan-16 Dec-15 Nov-15 Oct-15 Sep-15 Aug-15 Jul-15 Jun-15 May-15 Apr-15 Mar-15 Feb-15 Jan-15 Dec-14 Nov-14 Oct-14 Sep-14 Aug-14 Jul-14 Jun-14 May-14 Apr-14 Mar-14 Feb-14 Jan-14 Dec Source: Standard & Poor s. data through September 30, 2016.

22 Stock market arithmetic Total return = 7.0% earnings-driven price + 2.3% dividends reinvested S&P 500 Index (6/30/91 = 100) Big, fat, ugly bubble? This was a bubble. S&P 500 w/ dividends reinvested % 1 growth path The run higher put these two indices slightly above their long-term trajectories. Today they are in line. +9.3% per year S&P 500 total return over the last 25 years is right in line with the stock market s longterm returns going back to 1926, or back even further to % 1 growth path S&P Jul-91 Jul-92 Jul-93 Jul-94 Jul-95 Jul-96 Jul-97 Jul-98 Jul-99 Jul-00 Jul-01 Jul-02 Jul-03 Source: Standard and Poor s. Data through October 10, Compound annual growth rate. 2 S&P 500 total return index. 3 per Professor Jeremy Siegel s seminal Stocks for the Long Run, first published in Jul-04 Jul-05 Jul-06 Jul-07 Jul-08 Jul-09 Jul-10 Jul-11 Jul-12 Jul-13 Jul-14 Jul-15 Jul-16

23 Valuation S&P 500 vs. 17X actual and estimated earnings This is not a forecast or prediction. It s simply a calculation of 17X actual and estimated S&P 500 earnings S&P S&P 500 Index X S&P 500 actual and estimated earnings Q4 2016Q4 2015Q4 2014Q4 2013Q4 2012Q4 2011Q4 2010Q4 2009Q4 2008Q4 2007Q4 2006Q4 2005Q4 2004Q4 2003Q4 2002Q4 2001Q4 2000Q4 1999Q4 1998Q4 1997Q4 1996Q4 1995Q4 1994Q4 1993Q4 1992Q4 1991Q4 1990Q4 1989Q4 1988Q (actual), 2016 (estimated) and 2017 (estimated) bottom-up S&P 500 operating earnings per share as of October 6, 2016: for 2015, $117.46; for 2016(e), $117.23; for 2017(e), $ Sources: Yardeni Research, Inc. and Thomson Reuters I/B/E/S survey of consensus estimates. Standard and Poor s for index price data through September 30, 2016; and actual operating earnings data through

24 Earnings S&P 500 earnings recession and recovery S&P 500 quarterly operating earnings ($) $36.00 $34.00 $32.00 $30.00 $28.00 $26.00 $24.00 $22.00 S&P 500 earnings S&P 500 earnings ex-energy and materials +11% y/y trendline According to Standard & Poor s forecasts, earnings are on a +11% growth trajectory through the end of % might be too optimistic but just half of that would be fine. $20.00 Actual Forecast Dec-17 Oct-17 Aug-17 Jun-17 Apr-17 Feb-17 Dec-16 Oct-16 Aug-16 Jun-16 Apr-16 Feb-16 Dec-15 Oct-15 Aug-15 Jun-15 Apr-15 Feb-15 Dec-14 Oct-14 Aug-14 Jun-14 Apr-14 Feb-14 Dec-13 Source: Standard & Poor s. Earnings estimates are based on the Capital IQ consensus forecast. Actual earnings through Q Data as of September 30,

25 Point of View October 2016 Economy +1.4% Q2 GDP strength in C, weakness in I strong growth in: personal income, DPI, real DPI, real DPI per capita, retail sales strong household balance sheets, savings rate and record low household financial obligations ratio rising LEI, strong PMIs, strong hiring, record high job openings, declining unemployment rate, record low weekly unemployment claims, strong car sales, rising housing starts no inflation threat Can you say Goldilocks? 25

26 Economic data Contributions to GDP growth: C + I + G + Net Exports Personal consumption expenditures booming Q Gross private domestic investment 4-quarter inventory correction % change at annual rate I 2005-IV 2006-III 2007-II 2008-I 2008-IV 2009-III 2010-II 2011-I 2011-IV 2012-III 2013-II Government consumption and gross investment 2014-I 2014-IV 2015-III 2016-II Q2 contraction I 2005-III 2006-I 2006-III 2007-I 2007-III 2008-I 2008-III 2009-I 2009-III 2010-I 2010-III 2011-I 2011-III 2012-I 2012-III 2013-I 2013-III 2014-I 2014-III 2015-I 2015-III 2016-I Net exports of goods and services Q2 GDP Consumption +2.9% Investment -1.3% Government -0.3% Net Exports +0.2% Total +1.4% good news here I 2005-IV 2006-III 2007-II 2008-I 2008-IV 2009-III 2010-II 2011-I 2011-IV 2012-III 2013-II 2014-I 2014-IV 2015-III 2016-II I 2005-III 2006-I 2006-III 2007-I 2007-III 2008-I 2008-III 2009-I 2009-III 2010-I 2010-III 2011-I 2011-III 2012-I 2012-III 2013-I 2013-III 2014-I 2014-III 2015-I 2015-III 2016-I Source: Bureau of Economic Analysis, data through June Don t be surprised if we get a +3.0% quarter this year.

27 Economic data GDP breakdown 80% 70% 60% 69.3% Government Consumption (17% of total GDP) Consumer spending drives the U.S. economy. % of total real GDP (GDP in chained 2009 dollars) 50% 40% 30% 20% 17.5% 16.7% 10% -3.4% 0% -10% Personal consumption expenditures Government consumption expenditures and gross investment Gross private domestic investment Net exports of goods and services 27 Source: BEA. Data through June 2016.

28 15,000 13,000 Economic data consumer spending Consumer income, spending and saving Shaded bands represent recession. DPI 8/15-8/ % CAGR 1 3,000 2,500 Nominal DPI drives spending, spending drives GDP and corporate earnings. 11,000 DPI 7/02-7/ % CAGR 1 2,000 $ billions SAAR 9,000 7,000 5,000 3,000 1,000 Disposable Personal Income (left scale) Personal Outlays (70% of GDP) (left scale) Personal Saving (right scale) 1,500 1, The savings rate (5.7%) has recently run higher and has remained substantially higher than it was precrisis Jul 2016-Jan 2015-Jul 2015-Jan 2014-Jul 2014-Jan 2013-Jul 2013-Jan 2012-Jul 2012-Jan 2011-Jul 2011-Jan 2010-Jul 2010-Jan 2009-Jul 2009-Jan 2008-Jul 2008-Jan 2007-Jul 2007-Jan 2006-Jul 2006-Jan 2005-Jul 2005-Jan 2004-Jul 2004-Jan 2003-Jul 2003-Jan 2002-Jul 2002-Jan 2001-Jul 2001-Jan 2000-Jul 2000-Jan 1999-Jul 1999-Jan 1998-Jul 1998-Jan 1997-Jul 1997-Jan 1996-Jul 1996-Jan 1995-Jul 1995-Jan 28 Source: Bureau of Economic Analysis, monthly data through August Compound annual growth rate.

29 Economic data Retail sales 460,000 Strong retail sales growth. Retail sales ($millions) 440, , , , , ,000 10/06-10/ % Total retail sales 9/15-9/16 Government Consumption +3.3% (18% of total GDP) Services (44% of total GDP) Investment (17% of total GDP) Retail sales exgasoline Despite soft comp-store sales at Macy s, Nordstrom, Kohl s, Gap and more. 320, , ,000 Jan-2005 May-2005 Sep-2005 Jan-2006 May-2006 Sep-2006 Jan-2007 May-2007 Shaded band represents recession. Sep-2007 Jan-2008 May-2008 Sep-2008 Jan-2009 May-2009 Sep-2009 Jan-2010 May-2010 Source: U.S. Census Bureau. Data through September Sep-2010 Jan-2011 May-2011 Sep-2011 Jan-2012 May-2012 Sep-2012 Jan-2013 May-2013 Sep-2013 Jan-2014 May-2014 Sep-2014 Jan-2015 May-2015 Sep-2015 Jan-16 May-16 Sep-16 29

30 Economic data Retail sales by category Department stores are a dying retail format. 95,000 85,000 75,000 Government Consumption (18% of total GDP) motor vehicles and parts Retail sales ($ millions) 65,000 55,000 45,000 Investment (17% of total GDP) non-store retailers (internet) +10.9% y/y Services (44% of total GDP) food services and drinking places +6.3% y/y 35,000 25,000 15,000 5,000 Shaded band represents recession. health and personal care stores +5.7% y/y building materials and garden equipment dealers +5.7% department stores -6.0% y/y Jul-16 Apr-16 Jan-16 Oct-2015 Jul-2015 Apr-2015 Jan-2015 Oct-2014 Jul-2014 Apr-2014 Jan-2014 Oct-2013 Jul-2013 Apr-2013 Jan-2013 Oct-2012 Jul-2012 Apr-2012 Jan-2012 Oct-2011 Jul-2011 Apr-2011 Jan-2011 Oct-2010 Jul-2010 Apr-2010 Jan-2010 Oct-2009 Jul-2009 Apr-2009 Jan-2009 Oct-2008 Jul-2008 Apr-2008 Jan-2008 Oct-2007 Jul-2007 Apr-2007 Jan-2007 Oct-2006 Jul-2006 Apr-2006 Jan-2006 Oct-2005 Jul-2005 Apr-2005 Jan-2005 Source: U.S. Census Bureau. Data through September. In order to simplify this chart, not all retail categories are included. 30

31 Consensus GDP forecast Pick-up in growth expected Actual and Forecast The 70 economists surveyed in early September see an average +2.5% rate of quarterly GDP growth ahead. Real GDP Q/Q % change(annualized) I(E) 2016-III(E) 2016-I 2015-III 2015-I 2014-III 2014-I 2013-III 2013-I 2012-III 2012-I 2011-III 2011-I 2010-III 2010-I 2009-III 2009-I 2008-III 2008-I 2007-III 2007-I 2006-III 2006-I 2005-III 2005-I 2004-III 2004-I 2003-III 2003-I 2002-III 2002-I 2001-III 2001-I 2000-III 2000-I 1999-III 1999-I 1998-III 1998-I 1997-III 1997-I Q Japan tsunami Q Hurricane Sandy Q East Coast winter 4-quarter average +2.4% Sources: Bureau of Economic Analysis, actual data through June 2016; The Wall Street Journal survey taken October 2016.

32 Secular stagnation. Anemic. Limping along. Flirting with recession. Stall speed. Sub-par. Struggling. Stuck in first gear. GDP growth potential = productivity + labor force 10.0 Real GDP growth The U.S. economy is already running at its full calculated potential. Real GDP % change y/y (%) linear regression trendline BLS forecast Since the 1950s, U.S. GDP growth has been gradually slowing, principally due to slower population growth and declining labor force participation % labor force + 1.8% productivity Sources: BEA, BLS. Annual data through BLS forecast through 2024 dated December 8, The Bureau of Labor statistics forecasts an average of +2.2% annual GDP growth through 2024, compared to two-year actual GDP growth of +2.4%.

33 GDP growth potential = productivity + labor force Labor force y/y % change civilian labor force (%) labor force The labor force surged post-wwii, peaking in the late 1970s. Since then the U.S. has seen gradually slowing growth in the labor force partly due to the aging population and partly due to a declining participation rate. (See next slide.) The Bureau of Labor Statistics forecasts annual labor force growth of +0.5% through BLS forecast Source: BLS. Annual data through BLS forecast through 2024 dated December 8, 2015.

34 GDP growth potential = productivity + labor force Productivity Productivity (output per hour) % change from previous quarter at annual rate (%) fitted trendline productivity BLS forecast Labor force productivity gains are driven by the application of automation, technology and improved work methods. The Bureau of Labor Statistics forecasts continued annual productivity gains of +1.8% through Source: BLS. Annual data through BLS forecast through 2024 dated December 8, 2015.

35 Economic data rest-of-world World GDP growth forecasts improving growth expected 10 8 GDP Growth (% change y/y) Forecast Actual -4-6 Euro Area U.S. Japan China Brazil India Source: IMF, World Economic Outlook, October 2016.

36 Point of View October 2016 Jobs job formation has not been anemic new jobs will be limited at full-employment good news in full-time employed record job openings strong relative U.S. job formation forecast long-term strong real wage and income growth mean and median incomes bottomed myth: but we re not creating good jobs 36

37 Economic data - jobs Net new job formation and the unemployment rate Monthly change in total nonfarm payrolls (000) Jan-95 Sep-95 May-96 Jan-97 Sep-97 May-98 Jan-99 Sep-99 May-00 Jan-01 Sep-01 May-02 Jan-03 Sep-03 May-04 Jan-05 Sep-05 May-06 Jan-07 Sep-07 May-08 Jan-09 Sep-09 May-10 Jan-11 Sep-11 May-12 Jan-13 Sep-13 May-14 Jan-15 Sep-15 May , % 4 2 Unemployment rate (%) Job growth stronger for longer in this recovery due to the depth of the last recession. Job growth will decline as the unemployment rate sinks further Shaded bands represent recession. Source: Bureau of Labor Statistics. Data through September

38 Economic data - jobs Net new job formation Shaded band represents recession. Household survey Monthly Change in Payrolls (000) ,100 Establishment survey 354, ,000 These two surveys move approximately together, the household survey being much more volatile month-tomonth. -1,300 Jul-16 Apr-16 Jan-16 Oct-15 Jul-15 Apr-15 Jan-15 Oct-14 Jul-14 Apr-14 Jan-14 Oct-13 Jul-13 Apr-13 Jan-13 Oct-12 Jul-12 Apr-12 Jan-12 Oct-11 Jul-11 Apr-11 Jan-11 Oct-10 Jul-10 Apr-10 Jan-10 Oct-09 Jul-09 Apr-09 Jan-09 Oct-08 Jul-08 Apr-08 Jan-08 Source: Bureau of Labor Statistics. Data through July 2016.

39 Economic data - jobs Job openings record high 6,000 5,500 Shaded bands represent recession. Record high job openings. 5,000 Job Openings thousands 4,500 4,000 3,500 3,000 2,500 2, Dec-12 Dec-11 Dec-10 Dec-09 Dec-08 Dec-07 Dec-06 Dec-05 Dec-04 Dec-03 Dec-02 Dec-01 Dec-00 Source: U.S. Department of Labor, NBER. Data through August 2016, released October 12, Dec-13 Dec-14 Dec-15

40 Demographics GDP growth potential = productivity + labor force Labor force to grow +0.5% per year ,500 boomers peak birth years recession recession recession 4, Age 19 Live Births (000) 3,500 3,000 2,500 Baby Boom ( ) 117 million 1976 Age 40 Echo Boom ( ) 149 million 2, Sources: 1909 to 2008: U.S. Census Bureau, 2012 Statistical Abstract; : U.S. Department of Health and Human Services. 1 U.S. Bureau of Labor Statistics, Monthly Labor Review, December 2013, by Mitra Toossi. The U.S. labor force grew at an annual rate of +1.2% in the decade ; and by an annual rate of +0.7% in the decade

41 Long-term growth prospects Working age population forecasts Working age population, indexed (2015 = 1.00) U.S. boomers peak retirement years India SE Asia 1 U.S. Brazil Europe China The U.S. has favorable longterm demographic prospects compared to the world s major economies. The baby boom peaked in Which means that the boomers peak retirement years will be Thereafter, growth in the working age population picks up Source: United Nations Population Division, World Population Prospects, the 2015 Revision. 1 Includes Cambodia, Indonesia, Malaysia, Philippines, Singapore, Thailand, Viet Nam Japan

42 Long-term growth prospects Will our children be better or worse off the us? Warren Buffet: America s golden goose will continue to lay more and larger eggs. 42 Source: Barron s, March 7, 2016.

43 Wages middle class wage stagnation? Average hourly earnings vs. inflation % y/y AHE growth has picked up. AHE growth has outstripped inflation. Average Hourly Earnings ($/hour) all private non-farm employees % CAGR 1 Average hourly earnings 1 2.1% CAGR 1 Real wages have grown at a better clip than prerecession because inflation has been declining. Wage stagnation is a fiction. Inflation Mar-06 Jul-06 Nov-06 Mar-07 Jul-07 Shaded band represents recession. Nov-07 Mar-08 Jul-08 Nov-08 Mar-09 Jul-09 Nov-09 Mar-10 Jul-10 Nov-10 Mar-11 Jul-11 Nov-11 Mar-12 Jul-12 Nov-12 Mar-13 Jul-13 Nov-13 Mar-14 Jul-14 Nov-14 Mar-15 Jul-15 Nov-15 Mar-16 Jul Source: BLS, BEA. AHE data through September Inflation data through August AHE includes 100% of non-farm private employees, and excludes benefits and employers share of payroll taxes. 1 Compound annual growth rate March 2006 through December 2008 = 3.4%; CAGR December 2008 through June 2016 = 2.1%. 2 March 2006 average hourly earnings of $20.04 inflated by the personal consumption expenditures deflator (PCED).

44 Economic data consumer spending Real per capita purchasing power Real Disposable Personal Income per Capita (indexed) Real DPI per Capita +1.8% CAGR (2) +1.6% y/y Real per capita after-tax income is growing slower than prerecession. But, income stagnation is a fiction Shaded bands represent recessions. 2016Q1 2015Q3 2015Q1 2014Q3 2014Q1 2013Q3 2013Q1 2012Q3 2012Q1 2011Q3 2011Q1 2010Q3 2010Q1 2009Q3 2009Q1 2008Q3 2008Q1 2007Q3 2007Q1 2006Q3 2006Q1 2005Q3 2005Q1 2004Q3 2004Q1 2003Q3 2003Q1 2002Q3 2002Q1 2001Q3 2001Q1 2000Q3 2000Q1 1999Q3 1999Q1 1998Q3 1998Q1 1997Q3 1997Q1 1996Q3 1996Q1 1995Q3 1995Q1 1994Q3 1994Q1 1993Q3 1993Q1 1992Q3 1992Q1 1991Q3 1991Q1 1990Q3 1990Q1 Source: Bureau of Economic Analysis, quarterly data through June Compound annual growth rate. 2 Surge in compensation paid prior to 2013 tax hike.

45 Jobs but the jobs we re creating aren t good jobs. All jobs by category (average hourly earnings in parentheses) Employment by category, stacked chart 100% 90% 80% 70% 60% 50% 40% 30% 20% Other services ($22.80) Financial Information activities ($36.06) ($31.05) Professional and business Construction services ($27.59) ($29.48) Leisure and Construction hospitality ($26.81) ($14.61) Education and health services ($24.90) Manufacturing ($24.87) Trade, transportation and utilities ($21.49) Education and health services ($25.55) Information ($34.35) In 1950, Financial activities ($32.19) Trade, transportation and utilities ($22.12) Professional and business services ($30.50) manufacturing jobs were 37% of total jobs. Today that figure is 10%. Some manufacturing jobs have been replaced by lower-paying jobs in leisure and hospitality; but many more have been replaced by equal- or higherpaying jobs in health services and professional and business services. 10% Manufacturing ($25.61) 0% Jan-50 Jan-52 Jan-54 Jan-56 Jan-58 Jan-60 Jan-62 Jan-64 Jan-66 Jan-68 Jan-70 Jan-72 Jan-74 Jan-76 Jan-78 Jan-80 Jan-82 Jan-84 Source: Bureau of Labor Statistics. Employment data through December 2015, AHE data through January Mining and logging ($31.77) is the small sliver, fourth from the top. Jan-86 Jan-88 Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12 Jan-14 45

46 Consumer spending Personal consumption expenditures by category Personal consumption expenditures by category, stacked chart 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% Information ($34.35) Other services ($22.80) Financial Information activities ($36.06) ($31.05) Financial activities ($32.19) Professional and business Construction services ($27.59) ($29.48) Leisure and Construction hospitality ($26.81) ($14.61) Services Education and health services ($24.90) Trade, transportation and utilities ($22.12) Manufacturing ($24.87) Professional and business services ($30.50) Trade, transportation and utilities ($21.49) Education and health services ($25.55) Manufacturing ($25.61) Nondurable goods Durable goods Services: 39% 68% Goods: 61% 32% 0% Source: BEA. Annual data through

47 Consumer spending Personal consumption expenditures by category % of total personal consumption expenditures, stacked chart 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% The basics: food, clothing, shelter, transportation Information ($34.35) Other services ($22.80) Financial Information activities ($36.06) ($31.05) Other services Financial activities ($32.19) Food services and accommodations Professional and business Construction services ($27.59) ($29.48) Transportation services Other nondurable goods Leisure and Construction hospitality ($26.81) ($14.61) Gasoline and other energy goods Other durable goods Education and health services ($24.90) Financial services and insurance Trade, transportation and utilities ($22.12) Recreational services Recreational goods Manufacturing ($24.87) Professional and business services ($30.50) Health care Trade, transportation and utilities ($21.49) Clothing and footwear Education and health services ($25.55) Food and beverages Furnishings and durable household equipment Motor vehicles and parts Manufacturing ($25.61) Housing and utilities 10% 32% 58% 36% 0% Source: BEA. Annual data through

48 Debt U.S. government debt Federal budget CBO s March 2016 forecast looks good for a few years but the entitlements problem hasn t gone away rising debt/gdp ratio low U.S. tax burden allows flexibility to solve long-term entitlements problem 48

49 Federal deficit and debt Federal revenues and outlays a rising spending problem Outlays Widening, gap between outlays and revenues through Percent of GDP (%) Average Outlays 1966 to 2015 (20.2%) Medicare and Medicaid Revenues Other Federal Noninterest Spending Average Revenues 1966 to 2015 (17.4%) The ATRA 1 tax hikes of 2013 help push tax revenue up to 18% of GDP Actual Forecast Source: Congressional Budget Office, Updated Budget Projections: 2016 to 2026, dated March American Taxpayer Relief Act.

50 Federal deficit and debt Federal deficits % of GDP Federal Deficits % of GDP CBO is projecting low growth in federal borrowing requirements through Percent of GDP (%) Average projected Source: Congressional Budget Office, Updated Budget Projections: 2016 to 2026, dated March 2016.

51 Federal deficit and debt Federal debt % of GDP 100 Federal Debt % of GDP 86% Debt % of GDP about flat through 2018, then rises % Percent of GDP (%) Medicare and Medicaid Social Security 20 Other Federal Noninterest Spending 0 Actual Forecast Source: Congressional Budget Office, Updated Budget Projections: 2016 to 2026, dated March 2016.

52 Federal deficit and debt Government debt-to-gdp ratios ( ) Debt / GDP (%) Medicare and Medicaid Social Security 40 Other Federal Noninterest Spending Greece Japan Portugal Italy Ireland France United Kingdom Source: IMF, World Economic Outlook Database, October 2014 and April Data for years (from left to right) Actual (black) and forecast (red). United States Spain Germany Canada Australia

53 Federal deficit and debt Projected federal spending 1 through Percent of GDP (%) Stacked Chart CBO s latest projections, previous slides. Interest Expense Medicaid, CHIP and Exchange Subsidies Medicare Social Security Medicare and Medicaid Social Security Entitlements are on autopilot and interest expense keeps growing as a share of total spending as the debt accumulates Other Federal Noninterest Spending Defense and Other Discretionary All other discretionary (+0.0%) 2037 Defense (+0.4%) Source: Congressional Budget Office (CBO), The 2016 Long-Term Budget Outlook, July CBO s 10-year and extended baselines generally reflect current law and are meant to serve as benchmarks for measuring the budgetary effects of proposed changes in federal revenues or spending. They are not meant to be predictions of future budgetary outcomes; rather, they represent CBO s best assessment of how the economy and other factors would affect revenues and spending if current law generally remained unchanged.

54 Federal deficit and debt Federal debt % of GDP through Extended baseline projection WWII 100 Percent of GDP (%) Revolutionary War Louisiana Purchase Civil War WWI Medicare and Medicaid Great Depression Rising Deficits 1980s Social Security 20 Other Federal Noninterest Spending Actual Projected Source: Congressional Budget Office (CBO), The 2016 Long-Term Budget Outlook, July CBO s 10-year and extended baselines generally reflect current law and are meant to serve as benchmarks for measuring the budgetary effects of proposed changes in federal revenues or spending. They are not meant to be predictions of future budgetary outcomes; rather, they represent CBO s best assessment of how the economy and other factors would affect revenues and spending if current law generally remained unchanged.

55 Taxes Taxes % of GDP comparison Total tax revenue as a percent of GDP (%) Chile Korea United States Switzerland Australia Turkey Ireland Japan Canada Slovak Republic Israel Poland New Zealand United Kingdom Estonia The U.S. s comparatively low Medicare and Medicaidtax burden allows flexibility in solving its long-term entitlement Social Securityspending problem. Other Federal Noninterest Spending Spain Czech Republic Portugal Greece Germany While the U.S. has the highest corporate tax rate, the U.S. has one of the lowest total tax burdens among developed economies. Source: OECD, Revenue Statistics, 2015 Edition data for all countries except 2013 data for Australia, Japan, Netherlands and Poland. Does not include non-oecd countries such as China, Brazil, India and Russia. Includes all forms of taxes: federal, state and local; income taxes, sales taxes, VAT taxes, estate taxes, property taxes, etc. Slovenia Netherlands Luxembourg Hungary Iceland Norway Sweden Austria Italy Finland Belgium France Denmark

56 Point of View October 2016 Distribution of: income spending taxes transfer payments (income redistribution) Gini index 5 6

57 Middle class income stagnation? Median and mean household income Real household income 1 ($) constant (2015) dollars Mean Median 85,000 80,000 75,000 70,000 65,000 Medicare and Medicaid 60,000 Social Security 55,000 Recovery in household mean and median money income. Were the two asset bubbles of the last two decades responsible for pushing income ahead at an unsustainable pace? Shaded bands represent recessions. 50,000 45,000 40,000 NOTE: These measures based on money income don t account for income redistribution inherent in the tax code, food stamps, Medicare, Medicaid, public housing, etc Source: U.S. Census Bureau. Income and Poverty in the United States: 2015, issued September Data through The Census Bureau s income estimates are based solely on money income before taxes and do not include the value of non-cash benefits such as food stamps, Medicare, Medicaid, public housing and employer-provided fringe benefits.

58 Rising income inequality? Poverty rate coming down Number of people in poverty (000) 50,000 45,000 40,000 35,000 30,000 25,000 Number in poverty (left axis) Poverty rate (right axis) Social Security Percent of total in poverty (%) Recessions bring increased poverty. The poverty rate dropped in ,000 Shaded bands represent recessions Source: U.S. Census Bureau. Income and Poverty in the United States: 2015, issued September The Census Bureau s income estimates are based solely on money income before taxes and do not include the value of non-cash benefits such as food stamps, Medicare, Medicaid, public housing and employer-provided fringe benefits.

59 Rising income inequality? Income distribution behind the Gini index Greater income inequality? Demise of the middle class? Over the last 40 years, the distribution of income has both flattened and shifted to the right. Which means there are fewer (percentage of total) households making $50K-$75K and below because there are many more making $100K-$150K and up. Percent Distribution (%) The lines in this chart represent what percentage of the total number of households falls into each of the income brackets indicated. As such, the chart compares the distribution of household income by income bracket at twenty year intervals beginning with 1975 and ending with Under $15,000 $15,000 to $24,999 $25,000 to $34,999 Medicare and Medicaid Social Security Other Federal Noninterest Spending $35,000 to $49,999 $50,000 to $74,999 $75,000 to $99,999 $100,000 to $149,999 $150,000 to $199, $200,000 and over Household Income 1 Bracket Constant (2015) Dollars 59 Source: U.S. Census Bureau. Income and Poverty in the United States: 2015, issued September The Census Bureau s income estimates are based solely on money income before taxes and do not include the value of non-cash benefits such as food stamps, Medicare, Medicaid, public housing and employer-provided fringe benefits.

60 Rising income inequality? Income distribution behind the Gini index 12.9% 38.8% Medicare and Medicaid 23.9% Social Security 24.3% Other Federal Noninterest Spending 60 Source: The Wall Street Journal, June 22, 2016; Urban Institute, The Growing Size and Incomes of the Upper Middle Class, by Stephen J. Rose, June, 2016.

61 Investment Strategy Modern Portfolio Theory = Asset Allocation Modern portfolio theory was introduced by Harry Markowitz with his paper Portfolio Selection, which appeared in the 1952 Journal of Finance. Thirty-eight years later, he shared a Nobel Prize with Merton Miller and William Sharpe for what has become a broad theory for portfolio selection. Modern Portfolio Theory Diversify Optimize Rebalance Asset allocation and diversification do not guarantee a profit or eliminate the risk of loss. Source: Riskglossary.com 61

62 Investment Strategy Asset Allocation An Example Let s construct a global balanced portfolio using 7 asset classes Commodities (14%) Large U.S. Stocks Small U.S. Stocks Real Estate (14%) Cash (14%) Stocks (43%) Non-U.S. Stocks Bonds Cash Real Estate Commodities Bonds (14%) 62 Source: 2012 The 7Twelve Portfolio powerpoint presentation, by Craig Israelsen. Used with permission. Indexes used in this illustration: Large-cap US equity represented by the S&P 500 Index. Small-cap US equity represented by the Ibbotson Small Companies Index from , and the Russell 2000 Index starting in Non-US equity represented by the MSCI EAFE Index. Real estate represented by the NAREIT Index from and the Dow Jones US Select REIT Index starting in 1978.Commodities represented by the Goldman Sachs Commodities Index (GSCI). As of February 6, 2007, the GSCI became the S&P GSCI Commodity Index.U.S. Aggregate Bonds represented by the Ibbotson Intermediate Term Bond Index from and the Barclays Capital Aggregate Bond index starting in Cash represented by 3-month Treasury Bills.

63 Investment Strategy Asset Allocation An Example 5000 Large US Equity Small US Equity Non-US Equity Aggregate US Bonds Cash REITs CAGR 1 = +11.5% S&P 500 CAGR 1 = +10.3% Diversified Portfolio CAGR 1 = +9.8% Index (1/1/70=100) (logarithmic scale) 500 Real Estate Commodities Equally Weighted Diversified Portfolio Compound annual growth rate. Past performance is not a guarantee of future results. An investment cannot be made directly in the indexes used in this illustration. Source: 2016 The 7Twelve Portfolio powerpoint presentation, by Craig Israelsen. Used with permission. Indexes used in this illustration: Large-cap US equity represented by the S&P 500 Index. Small-cap US equity represented by the Ibbotson Small Companies Index from , and the Russell 2000 Index starting in Non-US equity represented by the MSCI EAFE Index. Real estate represented by the NAREIT Index from and the Dow Jones US Select REIT Index starting in 1978.Commodities represented by the Goldman Sachs Commodities Index (GSCI). As of February 6, 2007, the GSCI became the S&P GSCI Commodity Index.U.S. Aggregate Bonds represented by the Ibbotson Intermediate Term Bond Index from and the Barclays Capital Aggregate Bond index starting in Cash represented by 3-month Treasury Bills.

64 Investment Strategy Asset Allocation MPT has delivered 12 Risk vs. Return by Asset Class Real Estate Compound Annual Return (%) Aggregate US Bonds Equally Weighted Diversified Portfolio Large US Stocks Small US Stocks Non-US Stocks Commodities 5 Cash Standard Deviation of Annual Returns (%) 64

65 Investment Strategy Declining bond returns Bond Index Annual Return 1 Bonds shrinking contribution to portfolio returns. Fixed income returns can no longer boost portfolio total returns as they have over the last 40 years. Expect very modest fixed income returns going forward. Percent (%) year U.S. Treasury Yield year average annual return of just +1.5% Source: Federal Reserve and 2015 The 7Twelve Portfolio powerpoint presentation, by Craig Israelsen. Used with permission. 1 3-year average annual return of the U.S. Aggregate Bond index represented by the Ibbotson Intermediate Term Bond Index from and the Barclays Capital Aggregate Bond index starting in Annual data through 2015.

66 Pension funds are trimming their total return assumptions. Investment Strategy Managing client expectations average target of 7.68% Source: The Wall Street Journal, September 5-6, my back of the envelope figures: New portfolio arithmetic? 60/40 stocks/bonds stocks:.6 X 8% = 4.8% bonds:.4 X 1.5% = 0.6% 5.4% 66

67 Important Information All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This is not to be construed as an offer to buy or sell any financial instruments and should not be relied upon as the sole factor in an investment making decision. As with all investments there are associated inherent risks. Please obtain and review all financial material carefully before investing. The opinions expressed are those of the author, are based on current market conditions and are subject to change without notice. These materials may contain statements that are not purely historical in nature but are forward-looking statements. These include, among other things, projections, forecasts, estimates of income, yield or return or future performance targets. These forward-looking statements are based upon certain assumptions, some of which are described herein. Actual events are difficult to predict and may substantially differ from those assumed. All forward-looking statements included herein are based on information available on the date hereof and Fritz Meyer assumes no duty to update any forwardlooking statement. Accordingly, there can be no assurance that estimated returns or projections can be realized, that forward-looking statements will materialize or that actual returns or results will not be materially lower than those presented. Note: Not all products, materials or services available at all firms. Advisers, please contact your home office. 67