Economic progress, in capitalist society, means turmoil Josef A. Schumpeter Summary Capital Market Outlook Q 207 We are not sure that the economist and long time Harvard professor envisaged the type of turmoil we are now experiencing as the country transitions from a progressive administration to a more conservative administration. However, he reminds us that economic progress is hopefully occurring. The highlights of our outlook are as follows: The U.S. economic performance in the 2nd Quarter is expected to be stronger than the st Quarter. The U.S. dollar has declined and may show further weakness. Total inflation remains well below Fed targets, both core and headline statistics. This provides flexibility to the Fed in their interest rate policy. U.S. equities are at the high end of valuations. Emerging market economic performance, perhaps other than China, is expected to continue to strengthen. Energy prices appear to have stabilized and activity remains high in economical oil and gas plays. Economy The final revision to U.S. st Quarter GDP was.4%, a 0.7% upward revision from the first estimate of 0.7%, and up 0.2% from the second revision (Chart ). The additional analysis showed higher levels of personal consumption expenditures ( PCE ), non residential fixed construction, and net exports than previously estimated. While still lackluster, it surpassed the st Quarter of 206. U.S. employment data continues to improve. The U.S. economy added 222,000 jobs in June (Chart 2). June was the 8st consecutive month of job gains. The unemployment rate rose slightly to 4.4%, but this was due to an increase in the labor force participation rate. Average wages continue to increase, up 2.% for the trailing year. Underemployment, as measured by U 6, ticked up to 8.6% during the month. Inflation has been lower than expected in 207. Core consumer inflation, that is CPI less food and energy, has actually declined for the last three months ending in May and stands at.7% annualized. The core PCE deflator, watched more closely by the Federal Reserve ( Fed ), was at.4% for the trailing year (Chart ). This is well below the Fed target of 2.0% and under.% for the first time since 20. While increasing inflation is expected for the longer term, it remains benign for the near term. The Federal Reserve implemented another 0.2% increase in June for their range for Fed funds, despite the subdued inflation data. Bond markets have experienced a recent selloff, as investors are concerned that low interest rates may be ending. Nevertheless, while the Fed anticipates up to two more hikes in 207, the futures market and the performance of the 0 year Treasury yield prior to the announcement imply the Fed might actually hit the pause button (Chart 4). The Federal Reserve has announced a planned reduction in its balance sheet, a further sign of tightening monetary policy, but the start, speed and size of the reductions remain to be seen. The U.S. economy outlook remains positive. Leading indicators, positive consumer sentiment, and a slow but steady unraveling of the regulations imposed under the previous administration are all positive for improved growth. The upward revision in consumer spending in the st Quarter raises optimism. The expectation of the timing and magnitude of tax cuts, first notionally delayed until 208, and now advanced to the fall, should help growth, although how much will depend on the magnitude of the cuts. Health care legislation is proceeding in fits and starts, but it remains unclear if some form will pass. The recent U.S. dollar weakening should help exports, but the impact is likely minimal at this point. Energy exports are accelerating and helping net exports. Overall, U.S. GDP at this point will struggle to exceed % for the year. Globally, in developed economies, growth and inflation indicators are positive. Europe continues to surprise on the upside and may outperform the U.S. this year. While the Euro has strengthened recently, it remains to be seen whether immigration problems and financial crises, particularly Greece and Italy, will cause unforeseen strain. The doomsday scenarios in the U.K. from Brexit have not come to pass, and negotiations are set to commence. Commodity based economies, such as Australia, are struggling, and Japan continues to plod along. Emerging market economies are generally positive. Chinese debt continues to rise, but in a year of resetting the five year plan and party elections, no major changes in policy are expected. Growth is slowing, but is still positive between % and 7%, depending on whose calculations you believe. Modi s recent election successes in India mean his modernization and deregulation policies should continue, but it remains to be seen what the impact on growth will be.
Equity Markets U.S. equity markets continued to rise in the 2 nd Quarter, with the S&P 00 up.% and the tech heavy NASDAQ composite advancing 4.2%. The ongoing strength of the equity markets resulted in a year over year return of 7.9% for the S&P 00. The NASDAQ composite delivered a 29.4% return over the trailing year. 2 nd Quarter S&P 00 earnings are estimated to be up 6.6% following an increase in the st Quarter of.9%. However, U.S. equities continue to trade at the high end of valuation ranges (Chart ). Market volatility remains low, suggesting in part that the recent leveling of U.S. equity market indices reflects more a pause than portending a coming correction. Although recent turmoil has occurred in the tech sector, overall market trends appear positive. However, we remain cautious in the near term on domestic equity markets. International developed market equities delivered a positive quarter with the MSCI EAFE returning 6.%. In Euroland, markets modestly declined in local currencies, but with the decline in the U.S. dollar relative to the Euro, significantly outperformed in U.S. dollar terms. European equities, measured by Euro STO 600, fell 0.% in Euro terms but advanced by 6.% in U.S. dollar terms (Chart 6). More importantly, Euroland equities ended the eight year downward trend post the 2008 financial crisis relative to U.S. equities. European equities are trading above their normal valuation ranges, but not by as much as U.S. equities. Inflation remains benign in Europe, although signs of increases are appearing, and the ECB remains expansionary albeit signaling a reduction in the level of accommodation. Emerging market equities have rebounded strongly, up 2.8% over the trailing year, but have not yet attained their normal valuation multiples, leaving room for growth. Nevertheless, investing in emerging market equities remains country specific, with China continuing to show significant vulnerabilities economically with the debt bubble and slowing growth, while others are more positive. Active management and country specific allocation remain the preferred method for investing in EM equities. Global equity markets remain vulnerable to geopolitical risks. North Korea, Syria, the Arab states dust up with the UAE, terrorism, and Russian and Chinese expansionist activities all pose event risk threats. Interest Rates The yield on the 0 year U.S. Treasury declined for most of the quarter, but rose after the Fed announcement of the June rate hike and reiterated intentions to reduce its balance sheet assets (Chart 7). There has been a recent selloff in the bond markets, but it is too soon to tell if this portends a structural rise in rates. Despite the Treasury yield increases, bond spreads have compacted. Analysts suggest current interest rate levels are too low given growth prospects. The high yield debt market continues to improve in credit quality and default reduction. Despite the recent drop in oil prices, the energy issues, a large part of U.S. high yield bonds, continue to show improved debt service coverage. The high yield index returned 2.% for the quarter, and signs remain positive. Emerging market debt appears positive, but again is country specific. With the decline of the U.S. dollar, improvements in local currency returns are enhanced for U.S. investors. Energy and Commodities Oil markets, after peaking above $/Bbl WTI early in the quarter, have declined back to $46/Bbl WTI, as traders, despite the production cuts by major producers other than the U.S., remain concerned about the high level of inventories relative to demand (Chart 8). Many shale oil plays are profitable, even at these low levels, and U.S. oil exports are increasing. The roll back of energy and environmental regulations has led to increased coal usage, despite the conversion of many power plants to natural gas. Natural gas over $/Mmcf makes western coal competitive, and that is the level at which domestic gas pricing has held. Energy Master Limited Partnerships (MLPs) The Alerian Index, an index of MLPs, was down 6.4% for the 2 nd Quarter, affected by the 9% decline in oil prices. However, active drilling requiring transportation and storage facilities, increasing construction of fractionation plants to capture liquids and flared gas, and increased LNG and oil exports including expansion plans, all have the MLP industry growing significantly. This improves potential future distribution levels, as well as distribution coverage. We continue to believe the asset class offers excellent riskadjusted and tax effective yields. JWM Strategy Our Current Allocation Strategy is attached. We continue to emphasize an overweight allocation to U.S. equities relative to international, short duration for fixed income coupled with a diversified mix of non traditional income assets as income assets substitutes. We continue to closely monitor core real estate assets, particularly in the multi family space, due to the high and continuing levels of new construction over the last few years and concerns about lease up in new projects. Thank you for your continued confidence in JWM.
Chart The final revision to U.S. st Quarter GDP was.4%, a 0.7% upward revision from the first estimate of 0.7%, and up 0.2% from the second revision. The U.S. economic performance in the 2nd Quarter is expected to be stronger than the st Quarter. U.S. GDP Chart 2 The U.S. economy added 222,000 jobs in June. The unemployment rate rose slightly to 4.4%, but this was due to an increase in the labor force participation rate. Average wages continue to increase, up 2.% for the trailing year. U.S. Unemployment Source: The Wall Street Journal Real GDP growth is measured at seasonally adjusted annual rates. Chart Total inflation remains well below Fed targets, both core and headline statistics. The core PCE deflator, watched more closely by the Fed, was at.4% for the trailing year. This provides flexibility to the Fed in their interest rate policy. U.S. Inflation Source: The Wall Street Journal, U.S. Labor Department Seasonally Adjusted Chart 4 Global bond markets have experienced a recent sell off, as investors are concerned that low interest rates may be ending. The Fed anticipates up to two more hikes in 207, however the futures market implies the Fed might actually hit the pause button. Global Interest Rates Source: Source: The Wall Street Journal, The Commerce Department May 207 Source: J.P. Morgan Asset Management, Bloomberg ** Target Policy Rates for Japan are estimated
Source: FactSet. J.P. Morgan Asset Management Source: The Wall Street Journal Chart U.S. equities continue to trade at the high end of valuation ranges. International valuations remain attractive relative to domestic. 2 nd Quarter S&P 00 earnings are estimated to be up 6.6% following an increase in the st Quarter of.9%. International earnings are also accelerating. Global Equity Valuations & Earnings Chart 6 The U.S. dollar has declined and may show further weakness. Concerns about lack of progress in Washington and worries about the Fed s ability to raise rates with inflation declining have caused the pressure. The recent weakening should help exports, but the impact on corporate earnings is likely to be minimal. U.S. Dollar Index U.S. Interest Rates Source: FactSet, MSCI, Standard & Poor s, J.P. Morgan Asset Management Chart 7 The yield curve continues to flatten. The Fed has been raising interest rates and plans to begin shrinking its balance sheet. Longer term yields have been in retreat and as such, the yield curve has flattened meaningfully. U.S. Interest Rates Source: Federal Reserve Bank of St. Louis Chart 8 Oil markets, after peaking above $/Bbl WTI early in the quarter, have declined back to $46/Bbl WTI, as traders, despite the production cuts by major producers other than the U.S., remain concerned about the high level of inventories relative to demand. Oil Prices
JWM Current Allocation Strategy Q 207 Overall portfolio target allocations reflect customized client Investment Policy. The current JWM strategy within various assets classes is outlined below: Income Assets Significant Neutral Significant Underweight Underweight Weight Overweight Overweight Target Within Income Assets Traditional Fixed Income 0% Cash & Equivalents US Government Bonds Municipal Bonds US Corporate Bonds High Yield Bonds Convertible Bonds Floating Rate/Bank Loans Eurozone Bonds Developed Markets Other Emerging Market Bonds Non Traditional Income Assets 0% Master Limited Partnerships (MLP's)/Energy Preferred Stocks Conservative Allocation Funds Diversified Income Equities Target Within Equities US Equities 70% Large Cap Mid Cap Small Cap Hedged Equity International 0% Eurozone Developed Markets Other Currency Hedged International Emerging Markets Alternative Investments Core Alternatives Opportunistic Alternatives Target Within Alternative Varies by Client
Market Index Returns - June 207 Equity Returns Income Asset Returns Russell Style Index Returns Q2 US Fixed Income Maturity & Quality Returns Q2 Large Cap.. 4.7 Government/Corporate 0. 0.9 4.4 Mid Cap.4 2.7 4.2 Municipal Bonds 0.. 2.0 Small Cap 0.7 2. 4.4 High Yield.9 2..6 Value Blend Growth Short Intermediate Long Large Cap 4.7 9. 4.0 Government/Corporate 0.7.7 6.0 Mid Cap.2 8.0.4 Municipal Bonds.2.2.6 Small Cap 0..0 0.0 High Yield 4. 4.9 8.8 Value Blend Growth Short Intermediate Long - - Large Cap. 8.0 20.4 Government/Corporate 0.4 (0.2) (.) Mid Cap.9 6. 7. Municipal Bonds 0. 0.4 (0.) Small Cap 24.9 24.6 24.4 High Yield 2.0 2.8 7. Value Blend Growth Short Intermediate Long Domestic Equities Q2 - Traditional Fixed Income Q2 - Russell 000.0 8.9 8. BofAML US Convertible 2. 7.9 6.8 S&P 00. 9. 7.9 S&P/LSTA Leveraged Loan 0.8.9 7.4 Dow Jones Industrial Average 4.0 9.4 22. Barclays Global Aggregate Bond ex-usd.6 6. (.8) NASDAQ Composite 4.2 6.8 29.4 JPM EMBI Global Diversified (USD) 2.2 6.2 6.0 JPM GBI-EM Global Diversified (Local Currency).6 0.4 6.4 International Equities Non-Traditional Income Assets MSCI ACWI ex-us.8 4. 20. Alerian MLP Index (6.4) (2.7) 0.4 MSCI EAFE (Developed) 6..8 20. BofA ML Preferred Stock Fixed Rate.4 8.7.9 MSCI EAFE Hedged (Developed). 8. 2. DJ Mortgage REIT 4.8 6. 26.4 MSCI Emerging Markets 6. 8.4 2.8 Source: Morningstar; JWM believes the data is representative, but cannot guarantee its accuracy. All calculations represent total return and are annualized for periods exceeding year.
Market Index Returns - June 207 Broad Index Domestic Equity Traditional Fixed Income S&P 00 0.6. 9. 7.9 9.6 4.6 7.2 Barclays US Treasury Bills 0. 0.2 0. 0. 0. 0.2 0.7 MSCI USA Minimum Volatility (0.).0 9.0 7.6.2 2.9 - Barclays US Treasury - Intermediate (0.) 0.7.2 (.)... S&P High Yield Dividend Aristocrats 0.8..4 9.9 0.6.0 8. Barclays Municipal (0.4)..2 0.4 2.0 2. 4.0 DJ Industrial Average.7 4.0 9.4 22..0. 7.6 Barclays Gov't/Corp - Intermediate (0.2) 0.9.7 (0.2).9.8.9 NASDAQ 00 (2.4) 4.2 6.8 29.4.0 8.2 2. Barclays US Aggregate Bond (0.). 2. (0.) 2. 2.2 4. Russell 000 0.9.0 8.9 8. 9. 4.6 7. BofA ML US High Yield Master 0. 2. 4.9 2.8 4. 6.9 7. Russell 000 0.7. 9. 8.0 9. 4.7 7. BofAML US Convertible 0.6 2. 7.9 6.8 4.9. 6. Russell Mid Cap.0 2.7 8.0 6. 7.7 4.7 7.7 S&P/LSTA Leveraged Loan (0.0) 0.8.9 7.4.4 4.6 - Russell 2000. 2..0 24.6 7.4.7 6.9 Barclays Global Aggregate Bond ex-usd (0.).6 6. (.8) (2.4) (0.4). Style Index JPM EMBI Global Diversified (0.) 2.2 6.2 6.0.4.7 7.4 Russell 000 Growth (0.) 4.7 4.0 20.4.. 8.9 JPM GBI-EM Global Diversified 0..6 0.4 6.4 (2.8) (0.7) 4.0 Russell 000 Value.6. 4.7. 7.4.9.6 Non-Traditional Income Assets Russell Mid Cap Growth 0. 4.2.4 7. 7.8 4.2 7.9 Alerian MLP Index (0.7) (6.4) (2.7) 0.4 (.2).8.7 Russell Mid Cap Value..4.2.9 7.. 7.2 BofA ML Preferred Stock Fixed Rate.0.4 8.7.9 7.2 6.7.6 Russell 2000 Growth.4 4.4 0.0 24.4 7.6 4.0 7.8 DJ Mortgage REIT 2.6 4.8 6. 26.4 8.0 7.6.4 Russell 2000 Value. 0.7 0. 24.9 7.0.4.9 0 Income Assets 0 Broad Index International Equity MSCI ACWI Ex USA 0..8 4. 20. 0.8 7.2. MSCI US REIT 2.0. 2.0 (.) 6.8 8.0 4.6 MSCI EAFE (0.2) 6..8 20..2 8.7.0 CBOE S&P 00 Buywrite 0.4. 7.2 2. 6. 7.7 4.6 MSCI EAFE Hedged (0.7). 8. 2. 7.4 2.7 2.4 CBOE Market Volatility (VI) 7.4 (9.6) (20.4) (28.) (.) (8.) (.7) MSCI EAFE Minimum Volatility (0.).0 9.0 7.6.2 2.9 - Bloomberg Commodity (0.2) (.0) (.) (6.) (4.8) (9.) (6.) MSCI EM.0 6. 8.4 2.8. 4.0.9 S&P 00 Sectors 0 MSCI EM Minimum Volatility 0.8 4.6. 0.9 (0.2).2.0 Energy (0.2) (6.4) (2.6) (4.) (0.).6. MSCI Frontier Markets 0.6 6..6 9.2 (.4) 8.6 - Materials.9.2 9.2 8.6 4.7..4 Regional/Country Index Industrials.4 4.7 9. 22. 0.2 6. 7.7 MSCI Canada. 0.6.2.7 (.9).0. Consumer Discretionary (.2) 2.4.0 6.9 2.2 7.4 0. MSCI UK (.9) 4.7 0.0.4 (.0). 0. Consumer Staples (2.).6 8.0. 0.2 2.6 0. MSCI EMU (.) 8.0 7. 28.2 0.8 0.8 (0.) Health Care 4.6 7. 6. 2..0 7.9 0.6 MSCI Japan..2 9.9 9.2. 9.6.2 Financials 6.4 4. 6.9.4 2.4 8.0 0.4 MSCI EM EMEA (2.) 2. 4.9 2.9 (6.0) (.) (.6) Information Technology (2.7) 4. 7.2.9 6.0 7.2 0.7 MSCI EM Asia.8 8.6 2.2 27.9.0 7.8.8 Telecom Services (2.9) (7.) (0.7) (.7) 4.0.9.7 MSCI EM Latin America 0.7 (.7) 0..0 (6.6) (.8) (.2) Utilities (2.7) 2.2 8.8 2. 9.4.2 7.0 Index Miscellaneous 0