Capital Markets Review First Quarter 2015

Capital Markets Review First Quarter 2015 First-quarter 2015 saw a meaningful increase in volatility across asset classes, as numerous global forces continued to evolve. Everything from stocks and bonds to currencies and energy struggled to find direction amid a global economy that is still dealing with myriad uncertainties. In the United States, economic data were mixed, and the S&P 500 has not been able to sustain gains thus far in 2015. Employment data continued to show strength, although March fell short of forecasts, adding only 126,000 jobs versus consensus estimates of 248,000. January and February jobs numbers were also revised lower by a total of 69,000, but average growth for the quarter was still solid at around 200,000 (the six-month average employment gains in March were also strong at 261,000). Although still sluggish, wage growth continued to show signs of improvement: average hourly wages grew 0.3% in March versus 0.1% in February. Wages may be the bigger story, and we believe this slow improvement keeps a data-dependent Federal Reserve (Fed) on track for a 2015 federal funds rate hike. The broader U-6 unemployment rate, which measures marginally attached workers and people employed part-time for economic reasons, is still at an elevated 10.9%; however, this is the lowest level since August 2008. As a potential symptom of weak wage growth, retail sales have not experienced the boost many predicted from lower fuel costs, and inflation remains well below the Fed s 2% target. At its most recent meeting, the Fed surprised the market with what was interpreted by many investors as an unexpectedly dovish outlook. Although the Fed dropped the ever important patient phrase, it also downgraded the language regarding growth and inflation. The Fed said the equilibrium unemployment rate is likely 25 basis points (bps) lower than previously estimated, meaning slack in the labor market remains. The Fed s dot chart, which depicts Fed voting member rate forecasts, moved more in line with market expectations for liftoff. However, the market is still projecting a much flatter trajectory once the hike cycle begins. Treasuries and the dollar have been quite volatile as each market tries to discern the likely path of the Fed. The 10-year Treasury bond is again well below 2%, and dollar volatility has been significantly higher than average. Looking abroad, we saw a consistent theme of monetary easing as numerous central banks around the world tried to jump start their economies. Most notably, beginning in March, the European Central Bank (ECB) embarked on its previously announced quantitative easing (QE) program. The program targets purchases of 60 billion worth of bonds per month until at least September 2016, and longer-term ECB inflation forecasts suggest that the ECB could extend the program beyond this date. In our view, the fundamental economic impact of QE in the euro area is questionable. However, the effect on financial markets may be the real story, since we feel QE could be the main driver of investment returns in the euro area over the coming year, especially as the economy in the region begins to show some signs of stabilization. For example, euro area composite PMI data point to slightly stronger GDP growth in first-half 2015, and retail sales data provide some reason for optimism. Undeniably, economic headwinds remain, but QE, a lower euro, falling yields, lower energy costs, and a confident consumer are likely to help boost growth in the euro area for the remainder of 2015. Elsewhere, China introduced new stimulus measures to help support their economy. Chinese government officials announced a real GDP forecast of around 7% for 2015, which represents the lowest level in more than two decades. In March, the People s Bank of China initiated another surprise interest rate cut, further signaling the country s flagging growth. In Japan, the economy has yet to show signs of improvement, with fourth-quarter 2014 GDP revised down from 2.2% to 1.5%. The Bank of Japan is already buying about 90% of all net government debt issuance, as well as being an active buyer of Japanese stocks, yet the question remains if the central bank can do more. Finally, emerging markets (EM) continued to struggle. A strengthening dollar is weighing heavily on already high dollar-denominated debt burdens, while slow growth in China and persistently depressed oil prices are pressuring exports. Global energy prices remained under pressure in the first quarter, although they have stabilized somewhat. Oil prices moved back into the 50s and low 60s before again testing lows after stronger-than-expected supply

numbers. Supply continues to expand, and until this trend begins to meaningfully reverse, it is likely that price pressure and volatility continue into the second quarter. We believe market returns exhibited significant variability among geographies and currencies. In local currency terms, U.S. equity first-quarter total returns were 0.95%; Europe, 11.74%; and EM, 4.94%. However, the dollar continued to strengthen throughout the quarter, weighing on U.S.-dollar-denominated international returns. Europe returned 3.54% in dollars and EM returned 2.22% (Table 1). Table 1 Total Returns: Major Asset Classes Source: Standard & Poor s, Russell, MSCI, Barclays Capital, FTSE, Bloomberg L.P., PNC Current Outlook and Strategy We believe the risk/return profile of the euro area provides an attractive opportunity to increase equity allocations to the region. Although we believe the U.S. economy is more fundamentally stable, asset prices may struggle to outperform Europe. The normalization of U.S. monetary policy is likely to induce volatility in the equity market, and valuation levels indicate a U.S. market that is fully valued. Additional headwinds in the United States include historically extended profit margins and a worsening earnings-per-share outlook. We believe that, tactically, European stocks offer greater upside. In our view, the U.S. economy remains on solid footing, and lower energy prices and subdued inflation should be a boon to consumers. Although retail sales have been softer than anticipated this year, they are still in an upward trend. We feel employment data and a strong dollar (which keeps downward pressure on inflation) should be supportive of a strengthening U.S. consumer in the coming quarters. The decline in energy prices happened extremely quickly, and it seems to us that consumers are hesitant to spend the extra cash. As prices remain depressed, we believe energy savings should begin to feel more permanent and spending is likely to increase. This environment should be beneficial for small cap stocks, which have lagged until recently, since they tend to be more sensitive than large caps to the domestic economy. An increasing number of EM countries have PMIs below 50 (the expansion/contraction line), and many EM countries have a debt problem that does not seem to be going away. In fact, a dollar that continues to strengthen is only making these problems worse. In recent years, emerging markets have added significant amounts of dollardenominated debt, and as the dollar rises, already high debt service payments become more difficult to accommodate. Sliding commodity prices add pressure to the revenue side of the equation and traditional tools for boosting growth may not work, in our view. For example, cutting rates may encourage even more capital flight and an even stronger dollar, while currency devaluation has yet to boost EM exports (in no small part because EM countries are generally vulnerable to slowing Chinese demand). 2

We continue to believe that global real interest rates are likely to stay low for a considerable period. Generally speaking, global central banks continue to pursue monetary easing, and this should generate pressure on rates in the United States. As an example, the commencement of QE in Europe has pushed the 10-year German Bund below 20 bps, leading to renewed pressure on the 10-year U.S. Treasury yield. The prospect of a Fed rate hike cycle will likely cause more volatility in U.S. Treasuries, but low global rates will likely continue to make U.S. bonds attractive to conservative investors looking for higher yields. That said, the market is pricing in a slower rate hike trajectory than the Fed has indicated. Investors run the risk of rates moving up quickly if the market is forced to play catch-up in the event the Fed proceeds with more aggressive tightening. Our view is that U.S. economic data reflect an environment in which the Fed can afford to remain patient, but a delicate balance remains between reaching for additional yield and the capital loss that would occur with even a modest increase in rates from currently depressed levels. Generally, we believe that 2015 will see persistent volatility across asset classes, which tends to be a more supportive environment for active managers. Specifically, within fixed income we believe that actively managed absolute-return-oriented strategies can be an effective complement to an investor s fixed income allocation. From a credit perspective, spreads have tightened somewhat, making it more difficult to add significant return via longonly credit exposure. Consequently, absolute-return strategies that have the ability to take advantage of both long and short positioning, and identify value within specific credits, increase the probability of strong performance. Asset Class Performance Recap 1 Stocks The U.S. market, as measured by the S&P 500, generated a 0.95% return in first-quarter 2015. Foreign developed markets, as measured by the MSCI World ex USA index, outperformed the U.S. market in local currency terms, 10.22%, and in dollar terms, 4.00%. The MSCI EAFE index gained 10.97% for the quarter in local currency while rising 5.04% in dollar terms. Currencies broadly gave ground to the dollar, with the Trade Weighted U.S. Dollar index appreciating 8.14% over the course of the quarter. Notably, this comes on the heels of a 5.00% appreciation of the dollar in the fourth quarter. Emerging markets, as measured by the MSCI Emerging Markets Index, returned 4.94% in local currency terms and 2.22% in dollars. Currency movements subtracted from investments in terms of dollars nearly across the board. The largest negative impact was seen in Brazil, with a 17-percentage-point difference between returns in dollars versus real. Based on respective S&P indexes, for the quarter U.S. large cap gained 0.95%; mid cap, 5.31%; and small cap, 3.95%. In terms of equity styles, growth outperformed value across the board, outpacing value in large, mid, and Table 2 Total Returns: S&P 500 Sectors Source: Standard & Poor s, Bloomberg L.P., PNC 1 Return data are sourced from Bloomberg where available. Local currency returns, for example, are sourced from FactSet Research Systems, Inc. 3

small cap categories. Within the S&P 500, the Health Care sector, 6.53%, was the strongest, followed by Consumer Discretionary, 4.80%. Negative performing sectors for the quarter included Utilities, -5.17%; Energy, -2.85%; Financials, -2.05%; and Industrials, -0.86% (Table 2, page 3). Bonds The broad taxable U.S. investment-grade bond market, represented by the Barclays Capital Aggregate Bond Index, returned 1.61%. Within the aggregate index, Treasuries gained 1.64%; mortgaged-backed securities, 1.06%; and investment-grade corporate bonds, 2.32%. Treasury Inflation-Protected Securities returned 1.42%. The high-yield corporate bond market returned 2.52%, and leveraged loans returned 1.85%. Most developed country sovereign bond markets outperformed U.S. Treasuries in their own currencies but lagged in dollar terms. JP Morgan Global Bond index ex U.S. returned 2.36% in local currency terms and -4.08% in dollars. Commodities Commodities in general, as measured by the S&P GSCI, returned -8.22%. Commodity returns struggled across the board, with precious metals being the only positive category, 0.44%. Softs, -11.78%; agriculture, -9.68%; and grains, -8.99% were the worst performers. Energy was also down another 8.85%. Specialty Classes Real estate exposure, as proxied by the FTSE NAREIT All Equity REITs Index, returned 3.98%. The Alerian Index of master limited partnerships returned -5.23%. Hedge funds, as measured by the HFRX Aggregate Index, returned approximately 1.97%. 4

Appendix This section provides additional valuation and return data covering equities, fixed income, currencies, and alternatives. Table A1 Total Returns: Equity Indexes Source: Standard & Poor s, Russell, MSCI, Bloomberg L.P., PNC Table A2 Valuations: Equity Indexes Source: Bloomberg L.P. Estimates 5

Table A3 Total Returns: Fixed Income Indexes Source: Barclays Capital; FactSet Research Systems, Inc.; Bloomberg L.P.; PNC Table A4 Valuations: Fixed Income Indexes Source: Barclays Capital; FactSet Research Systems, Inc.; PNC 6

Table A5 Total Returns: Corporate Indexes Source: Barclays Capital; FactSet Research Systems, Inc.; PNC Table A6 Total Returns: Alternatives Source: GSCI, HFR, Bloomberg L.P., PNC 7

Table A7 Total Returns: Currencies *Data as of first-quarter 2015 Source: FactSet Research Systems, Inc., PNC 8

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