National Economic Outlook MSBO Financial Strategies Conference January 17, 2018 Presented by: Kyle Jones, Director of Portfolio Strategies PFM Asset Management LLC One Keystone Plaza, Suite 300 N. Front & Market Streets Harrisburg, PA 17101 717.232.2723 www.pfm.com PFM 1
REVIEW Agenda Where are we today and how have capital markets reacted? OUTLOOK What is the Federal Reserve telling us? KEY TRENDS What are we watching? All data from Bloomberg as of December 31, 2017, unless otherwise noted. PFM 2
Where are we today and how have capital markets reacted? PFM 3
Economic Growth Remains Strong U.S. Real GDP QoQ, SAAR 6% 4% 3.1% 3.2% Bloomberg Survey of Economists 2% 2.7% 2.7% 2.0% 1.9% 0% -2% Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 2013 2014 2015 2016 2017 2018 Source: Bloomberg, as of Q3 2017. SAAR is seasonally adjusted annualized rate. Orange denotes rolling four-quarter averages. PFM 4
Synchronized Global Growth Across All World Regions GDP Growth (est.) Emerging and developing Asia ASEAN-5 Emerging market and developing economies Emerging and developing Europe World Sub-Saharan Africa European Union United States Middle East and North Africa Advanced economies Euro area Commonwealth of Independent States Major advanced economies (G7) Latin America and the Caribbean 2018 2017 0% 1% 2% 3% 4% 5% 6% 7% Source: IMF World Economic Outlook, as of October 2017 PFM 5
Global Macroeconomic Scorecard Gross Domestic Product (GDP) Growth Emerging Markets 5.4% Japan Eurozone United States 2.1% 2.6% 2.3% 10-Year Median Latest 10-Year Range -10% -5% 0% 5% 10% 14% 12% 10% 8% 6% 4% 2% 0% Unemployment Rate 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% -0.5% -1.0% Inflation (Core CPI, YoY) Dec '12 Dec '13 Dec '14 Dec '15 Dec '16 Dec '17 Dec '12 Dec '13 Dec '14 Dec '15 Dec '16 PFM 6
2017 Asset Class Returns Equities U.S. Developed ex U.S. Emerging Markets 21.9% 25.7% 37.5% Domestic Fixed Income Cash Short Bonds Core Bonds High Yield Corporates 0.8% 0.7% 3.6% 7.5% Alternatives Commodities Real Estate Hedge Funds 1.7% 9.3% 8.5% 2017 Returns Prior 5-Year Returns -10% -5% 0% 5% 10% 15% 20% 25% 30% 35% 40% Prior 5-Year Returns are based on time period from December 31, 2011 to December 31, PFM 2016, and are annualized. 7
Treasury Yields Range-Bound Amid Low Volatility U.S. 2-Year Treasury Yield U.S. 10-Year Treasury Yield 4% 4% 3% 3% 2% 2% 1% 1% 0% 0% Dec '08 Dec '09 Dec '10 Dec '11 Dec '12 Dec '13 Dec '14 Dec '15 Dec '16 Dec '17 Dec '08 Dec '09 Dec '10 Dec '11 Dec '12 Dec '13 Dec '14 Dec '15 Dec '16 Dec '17 Calendar-Year Range Year End PFM 8
Cash Yields Signal End of Financial Repression Fed Funds (Mid-point) S&P Govt. LGIP 2-Year T-Note 2.50% 2.25% Index Dec. 2014 Dec. 2015 Dec. 2016 Dec. 2017 Dec. 2018 (est.) Forecast 2.00% 1.75% Fed Funds 0.13% 0.38% 0.63% 1.38% 1.88% Govt. LGIP 0.11% 0.28% 0.53% 1.16% 2.06% 2-Year T-Note 0.66% 1.05% 1.19% 1.88% 2.21% 1.50% 1.25% 1.00%.75%.50%.25%.00% Dec '13 Dec '14 Dec '15 Dec '16 Dec '17 Dec '18 Fed Funds rate shown is the mid point of the target range. Fed Funds rate forecast is based on the Fed Funds futures. 3-month T-Bill and 2-Year T-Note forecast is based forward rates. Government PFM LGIP forecast is based on historical 1-Year moving average spread over 3-month T-Bill forward rate. 9
What is the Federal Reserve telling us? PFM 10
Dual Mandate Dueling Mandates PFM 11
Labor Market Activity Slows as Expected Monthly Change in Nonfarm Payrolls Nonfarm Payrolls 12-Month Moving Average Unemployment Rate 400k 9% 8% 7.9% 300k 7% 6.7% 200k 6% 5.6% 5% 5.0% 4.7% 100k 4% 4.1% 0k Dec '12 Dec '13 Dec '14 Dec '15 Dec '16 Dec '17 3% Dec '12 Dec '13 Dec '14 Dec '15 Dec '16 Dec '17 Source: Bloomberg, as of December 2017. PFM 12
Unemployment by Education Levels 16% Unemployment by Education Levels Less Than High School Diploma High School Graduate & No College Some College or Associate Degree Bachelors Degree & Higher 12% 8% 7.7% 4% 4.7% 3.8% 2.1% 0% Dec '07 Dec '08 Dec '09 Dec '10 Dec '11 Dec '12 Dec '13 Dec '14 Dec '15 Dec '16 Dec '17 Source: Bloomberg, most recent data as of December, 2017. PFM 13
Services Sector Employment Trends 2,000 Cumulative Change in Employment (Thousands) 1,500 Other services 1,000 500 0-500 -1,000-1,500 Financial activities Information Utilities Transportation and warehousing Wholesale trade -2,000 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 Source: Bureau of Labor Statistics, most recent data available as of November 2017. PFM 14
Inflation Steadies, but Outlook Remains Weak Inflation Measures (YoY) Expectations for Average Inflation Rate over next 5 years 2.5% 2.5% 2.0% 2.0% 1.5% 1.5% 1.0% 0.5% Core CPI Core PCE Fed's Long Term Inflation Target 1.0% 0.0% Nov '12 Nov '13 Nov '14 Nov '15 Nov '16 Nov '17 0.5% Nov '12 Nov '13 Nov '14 Nov '15 Nov '16 Nov '17 Source: Bloomberg, latest data available as of December 2017. Inflation expectations based on yield difference between 5-year Treasury note and 5-year Treasury Inflation Protected Securities (TIPS). PFM 15
The Fed s Updated Economic Projections Are Optimistic Indicator 2017 2018 2019 2020 Longer run Sep. Dec. Sep. Dec. Sep. Dec. Sep. Dec. Sep. Dec. Real GDP (YoY) 2.4% 2.5% 2.1% 2.5% 2.0% 2.1% 1.8% 2.0% 1.8% 1.8% Unemployment Rate PCE Inflation (YoY) 4.3% 4.1% 4.1% 3.9% 4.1% 3.9% 4.2% 4.0% 4.6% 4.6% 1.6% 1.7% 1.9% 1.9% 2.0% 2.0% 2.0% 2.0% 2.0% 2.0% Core PCE (YoY) 1.5% 1.5% 1.9% 1.9% 2.0% 2.0% 2.0% 2.0% - - Federal Funds Rate (Median) 1.4% 1.4% 2.1% 2.1% 2.7% 2.7% 2.9% 3.1% 2.8% 2.8% Source: Federal Reserve, as of December 2017. Green denotes an improved projection in December compared to September, red for lower projection. PFM 16
FOMC Dot Plot December 2017 Fed Participants Assessments of Appropriate Monetary Policy 5% 4% Dec-17 FOMC Projections Dec-17 Median Fed Funds Futures 3% 2% 1% 0% History of Recent Fed Rate Hikes Dec 17 1.25-1.50% Jun 17: Jun 17 1.00-1.25% Mar 17: Mar 17 Dec 16: 0.75-1.00% Dec Dec 16 15: 0.50-0.75% Dec 15 08: 0.25-0.50% Fed expects 3 more rate hikes in 2018 2017 2018 2019 2020 Longer Term Source: Federal Reserve and Bloomberg. Individual dots represent each Fed members judgement of the midpoint of the appropriate target range for the federal funds rate at each year-end. Fed funds futures as of 12/13/17. PFM 17
Spreads Narrow Across Sectors 225 Yield Spreads (basis points) $150 Net Foreign Purchases of U.S. Corporate Debt (Billions) 200 $125 175 $100 150 $75 125 $50 100 $25 75 50 25 0 Dec '12 Dec '13 Dec '14 Dec '15 Dec '16 Dec '17 $0 -$25 -$50 -$75 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 IG Corp Agency MBS ABS Yield spreads represent option-adjusted spreads. Foreign purchases of U.S. corporate bonds only include the major foreign buyers, namely official institutions, and international and regional PFM organizations as classified by the U.S. Department of the Treasury. 18
Geopolitical Risks Around the Globe NAFTA trade tensions Brexit & EU fragmentation; German coalition uncertainty Russia-NATO conflict U.S.-China trade tensions U.S.-Mexico border tensions Israel-Palestine conflict Iran unrest South China Sea dispute North Korea nuclear threat Venezuela political crisis PFM 19
What are we watching? PFM 20
Impact of Tax Cuts Short Term Boost in corporate profits and consumer spending Next 10+ Years Increased uncertainty due to sunset provisions Long Term Potential economic impact from business investment Expected Average Effective Tax Rate for the U.S. Corporate Sector 21% 17% 19% New Corporate Tax Rate: 21% 16% 9% 2018 (No reform) 2018 2023 2027 2040 Tax Cuts and Jobs Act Source: Penn Wharton Budget Model, as of December 15, 2017. PFM http://budgetmodel.wharton.upenn.edu/issues/2017/12/15/effective-tax-rates-by-industry 21
Business Cycle Risk Duration of U.S. Expansion Periods 10-Year/2-Year Treasury Yield Spread 2009 2001 225 1991 125 1982 25 1980-75 1975-175 1970 0 50 100 150 Time (months) -275 1977 1981 1985 1989 1993 1997 2001 2005 2009 Difference in Basis Points 2013 2017 Recession Left source: The National Bureau of Economic Research, as of December 2017. PFM 22
Global Central Banks Less Accommodative in 2018 Central Bank Rates Outlook Central Bank Net Asset Purchases 2.5% 2.0% U.S. Federal Reserve European Central Bank Bank of Japan 2.2% Billions $0 -$50 -$100 -$150 -$200 U.S. Federal Reserve 1.5% 16 Q1 16 Q2 16 Q3 16 Q4 17 Q1 17 Q2 17 Q3 17 Q4 18 Q1 18 Q2 18 Q3 18 Q4 300 European Central Bank 1.0% Billions 200 100 0 0.5% 16 Q1 16 Q2 16 Q3 16 Q4 17 Q1 17 Q2 17 Q3 17 Q4 18 Q1 18 Q2 18 Q3 18 Q4 0.0% 0.0% Trillions 30 20 10 Bank of Japan -0.5% 2010 2011 2012 2013 2014 2015 2016 2017 2018 0 16 Q1 16 Q2 16 Q3 16 Q4 17 Q1 17 Q2 17 Q3 17 Q4 18 Q1 18 Q2 18 Q3 18 Q4 PFM 23
ECONOMY Above-trend growth across global economies Summary of Our 2018 Outlook INTEREST RATES Rising at a modest pace as inflation remains well behaved CENTRAL BANKS Tighter monetary policies globally EQUITIES Positive returns buoyed by economic growth, tax reform and relatively low rates FIXED INCOME Credit markets continue to outperform interest rate sensitive investments PFM 24
What are the Risks to our 2018 Outlook? LESS ACCOMMODATIVE CENTRAL BANKS Can the market stand on its own two feet? HIGHER INFLATION Central banks could tighten more aggressively Triggers economic slowdown and market sell-off DECREASED GLOBAL TRADE U.S. trade war with one or more trading partners GEOPOLITICAL RISKS Increase in political tension in Asia and/or Middle East PFM 25
Questions? PFM 26
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Thank You PFM 28