In This Issue: Economic And Market Update Equity Market Update Fixed Income Market Update MARKET POINT An Economic & Market commentary from Trust Point Fourth Quarter 2015 Issue no.12 Trust Point La Crosse 230 Front Street North, PO Box 489 La Crosse, WI 54602-0489 Phone: 608.782.1148 800.658.9474 Trust Point Minneapolis 43 Main Street, S.E. Suite 214 Minneapolis, MN 55414 Phone: 612.339.2343 800.658.9474 Visit us at trustpointinc.com
An Economic and Market Update from Trust Point 2015 has finally come to an end, and what a meat grinder it has been. It was the year of no return and high volatility. From start to finish, major equity and bond indices fluctuated wildly with most ending the year close to where they started. From a macroeconomic standpoint, 2015 didn t surprise us. Low growth, low inflation, and low interest rates were the three key global themes, although regional differences in currency, monetary, and fiscal policies created some diverging trends spreading confusion and anxiety among investors. Recap of 2015 Economic Activity As of Actual 3 Mths Ago 1 Year Ago Dollar Index Level Dec 98.6 96.4 90.3 US Economic Activity ISM Manufacturing (>50=Expansion) Dec 48.2 50.2 55.1 ISM Non-Manufacturing (>50=Expansion) Dec 55.3 56.9 56.5 Non-Farm Payrolls Dec 292k 145k 329k Unemployment Rate Dec 5.0% 5.1% 5.6% CPI Ex-Food & Energy (yoy) Nov 2.0% 1.8% 1.7% Global Economic Activity JP Morgan Global Manufacturing Index (>50=Expansion) Dec 50.9 50.7 51.5 JP Morgan Global Non-Manufacturing Index (>50=Expansion) Dec 53.1 53.3 52.5 Slow and desynchronized were the common threads for U.S. and global economic activity in 2015 (Chart 1). After a slow start (U.S. Q1 GDP: +0.6%), primarily due to temporary factors, U.S. growth reaccelerated in the last three quarters. Helped by lower energy prices, steady job gains, and a healthier housing market, consumer spending which makes up about 70% of the U.S. economy carried most of the load. On the global front, Europe performed satisfactorily. Throughout the year, Eurozone manufacturing and services activities accelerated, leading to a noticeable downturn in the unemployment rate, which, at more than 10%, still needs improvement. In Japan, Abenomics, a 2012 program of fiscal, monetary, and structural reforms, was supposed to bring the country to growth and prosperity. While Japan seems to be slowly turning the corner, the real benefits to spending, wages, and inflation are still not that visible. In emerging markets, macroeconomic conditions continued to deteriorate; although still growing at a faster pace than developed markets, their growth rate has slowed considerably in recent years. The era of positive inflows, low cost of capital, appreciating currencies, strong export demand, and good pricing power is over. And while China has shown signs of stabilization in Q4, its transformation to a servicebased economy will continue to worry investors for some time. Source: Bloomberg Chart 1 : Economic Growth Rate Among the Major Economies Source : International Monetary Fund United States Japan Euro area Emerging market and developing economies 2004 2006 2008 2010 2012 2014 2015 +5% 0% -5%
Equities Still Have an Edge Over Bonds Trends in economic activity are just one input into the decision-making process leading to tactical moves in portfolios. rates, slow but relatively stable economic growth, a positive yield curve, and attractive relative valuations. However, From an asset-allocation standpoint some clouds have started to appear on (considering whether to over- or the horizon. Weakening earnings, fuller under-allocate to equities and fixed income), several other variables must be considered. After maintaining a positive and constructive stance on equities for many years following the credit crisis of 2008-09, we have recently (and slowly) begun to reduce our equity allocation on short-term rallies. Compared with absolute valuations, waning momentum, and negative signals from the credit markets are leading us to become a bit more cautious. As we enter 2016, we believe that clear trends in stocks and bonds will be increasingly difficult to discern. Periodic corrections and rallies will remain the norm as we transition bonds, equities should continue to into a higher-volatility regime in the benefit from accommodative policies by years to come (Chart 2). central banks, low inflation, low interest Chart 2 : Global Equity Performance (MCSI World Index) High volatility expected to remain in 2016 > > 180 168.6 160 140 120 100 2010 2011 2012 2013 2014 2015 2016 Unexciting Markets Don t Equate to Unexciting Portfolios Higher volatility creates opportunities, but fuller valuations across a wide range of asset and sub-asset classes have made low-hanging fruit much more difficult to identify. In other words, finding compelling long-term opportunities has become a bigger challenge. Over the next five years, we do not expect the same returns as the ones achieved in the past five. The period from 2009-2014 (the crisis recovery period ) was characterized by massive and synchronized monetary stimulus, which led to falling risk premium (high returns), falling volatility (Chart 3), and low dispersion of returns. The next five years (the great normalization period ) may well bring increasing risk premium, rising volatility, and higher dispersion of returns. Such an environment will require increased use of unconventional strategies, a more nimble approach to tactical asset-allocation decisions, and an increased focus on costs in the vehicles used to build investment portfolios. We are working hard on all three components and have begun to implement exciting changes to portfolios to better align with this new reality. Chart 3 : Falling Volatility in Equity Markets 90 80 70 60 50 40 30 20 10 0 08 09 10 11 12 13 14 15 Source : JP Morgan Asset Management VIX Level 08 Peak 80.9 Average 21.8 Latest 16.1
An Equity Market Update from Trust Point One could say that the bull market is over, after a year of flat to slightly negative returns. Our expectations for returns going forward are more modest, and we expect 2016 to be another volatile year for equity investors. However, we think this is more of a pause in a continuing long-term upside in equities. Opportunities outside the U.S. may exist where investment returns have lagged U.S. markets. Difficult Year for Equity Investors Most equity investors are welcoming the beginning of a new year, as they hope to put 2015 behind them. Last year turned out to be a pause in the now six-year bull market. Global equities returned an unimpressive -1.8% while the S&P 500 produced +1.4% (Chart 4). To make matters worse, according to a recent Goldman Sachs report, only 27% of large-cap core mutual funds outpaced the S&P 500 in 2015. Investors have been climbing the Wall of Worry for most of the past six years, and that wall got a lot steeper in 2015, causing minor setbacks throughout the year. Many investors are pointing to the continued decline in oil prices and the strengthening U.S. dollar as the main catalysts for equity weakness. Fears of a global slowdown came to fruition as emerging economies failed to reach the growth rates they once achieved. The fears were centered on China, where some investors believe the supposed 7% growth target is really more like 3% or 4%. Declining commodity prices have been devastating to material producers and exporters like Brazil and Russia. The global slowdown also has hit manufacturing sectors particularly hard. On top of it all, in December, the Federal Reserve announced the first Fed Funds rate hike in more than 9.5 years. All of these headwinds kept markets in check in 2015. Major US Equity Index Level Quarter-End 3 Mths Ago 1 Year Ago 3 Years Ago 5 Years Ago S&P 500 2,044 1,920 2,059 1,426 1,258 Dow Jones Industrial Average 17,425 16,285 17,823 13,104 11,578 Nasdaq 5,007 4,620 4,736 3,020 2,653 Equity Returns (%) 3 Month YTD 1 Year 3 Year (Ann) 5 Year (Ann) US Large Cap Growth 7.3% 5.7% 5.7% 16.8% 13.5% US Large Cap Value 5.6% -3.8% -3.8% 13.1% 11.3% US Mid Cap Growth 4.1% -0.2% -0.2% 14.9% 11.5% US Mid Cap Value 3.1% -4.8% -4.8% 13.4% 11.3% US Small Cap Growth 4.3% -1.4% -1.4% 14.3% 10.7% US Small Cap Value 2.9% -7.5% -7.5% 9.1% 7.7% International Developed 4.7% -0.8% -0.8% 5.0% 3.6% (US Dollar) International Small/Mid Cap Developed 6.8% 9.6% 9.6% 10.4% 6.3% (US Dollar) Emerging Market (US Dollar) 0.7% -14.9% -14.9% -6.8% -4.8% Source: Bloomberg, Morningstar Chart 4 : U.S. Equities Slightly Outpace Non-U.S. Equities in U.S. Dollar Terms U.S. Equities Total Return Global Equities Total Return Non-U.S. Equities Total Return Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Note: S&P 500 Index, MSCI ACWI and MSCI ACWI ex. U.S. represent U.S. Equities, Global Equities and Non-U.S. Equities, respectively 10 5 1.374 0-1.804-5.179-10
Margin Pressure Putting Corporate Profit Growth at Risk When we look at the top equity performers in 2015, we find the leaders to be companies with resilient revenue and profit growth. Investors bid up the price of companies with high profit growth and dumped stocks that suffered earnings weakness. In aggregate, growth in profits from S&P 500 companies has been sluggish, with the hardest-hit sectors being those exposed to energy and materials. This decline in earnings growth has caused investors to re-rate the multiple they pay for those earnings (commonly known as the P/E ratio). Outside of the energy and materials sectors, the broader economy is also experiencing margin pressure. Recently, margins have peaked at near all-time highs (Chart 5). Lower margins are likely to come in the near future, as wages increase due to near full employment and interest expense begins to rise in line with a higher-yield environment. This doesn t mean an end to earnings growth, but it does give us a more cautious outlook on profits going forward. Will 2016 Be the Year the Eurozone Outperforms the U.S. Market? As we look forward to 2016 and what likely will be another volatile year for equities, we see more upside opportunities outside of the U.S. stock market. The strong and sustained economic recovery since 2009 in the U.S. has generated solid equity returns. Meanwhile, the more choppy growth elsewhere in the world has left non- U.S. equity markets lagging behind. We think this trend could start to reverse in 2016, and we like the Eurozone region in particular. The Euro currency has depreciated more than 20% relative to the U.S. dollar over the past two years. What is pain for the U.S. is gain for the Eurozone, as the stronger dollar has depressed U.S. earnings but has aided the profitability of European companies. Recently, we have seen earnings growth in Europe outpace growth in the U.S. for the first time in the past eight years. Additional catalysts include improved credit conditions and bank lending, diminishing fiscal drag, and the implementation of a QE program that will keep interest rates low for the foreseeable future. The improving fundamentals, in combination with cheaper valuations (Chart 6) and stronger growth, should help propel Eurozone equities higher in 2016. Trust Point is well positioned to take advantage of that. Chart 5 : Peaking Profit Margins A Cause For Concern 10.00 S&P 500 Trailing 12 Month Profit Margin 8.33 8.00 6.00 4.00 2.00 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 Chart 6 : Composite Valuation Measure for European Equities Remains Cheap -4 EXPENSIVE -3-2 -1 0 1 2 3 CHEAP 4 91 93 95 97 99 01 03 05 07 09 11 13 15, AMP Capital
A Fixed Income Market Update from Trust Point The Federal Reserve (Fed) had not raised rates for 9.5 years. This December, the Fed indicated that improvement in the labor market, along with signs of inflation rising over the medium term, justified a Federal Funds Rate hike. The Impact of Rate Hikes Last month, the Federal Open Market Committee decided to raise the target range of the Fed Funds Deposit Rate to 0.25%-0.50%. The Fed had telegraphed this interest-rate hike, and markets took the news in stride. The greatest impact was felt by short-term interest rates, which have risen throughout the fourth quarter, effectively pricing in the Fed rate hike prior to the announcement (Chart 7). Longer-term rates, however, barely budged. While the Fed is starting the gradual process of raising rates, the European Central Bank, the Bank of Japan, and People s Bank of China are pursuing easier policies and keeping rates low. Central Bank policies have been on track to diverge for a number of months, and the yield advantage in the U.S. relative to other developed nations is clearly apparent. This is likely to keep global demand strong for U.S. Treasuries. The normalization process of raising Fed Funds rates will put upward pressure on short-term yields, but it will be difficult for longer-term yields to move sharply higher, based on the current economic environment. Fixed-income portfolios are more influenced by intermediate to longterm interest rates, so this rate hike does not pose the same risks to fixed-income portfolios as past hiking cycles. US Yields (%) Quarter-End 3 Mths Ago 1 Year Ago 3 Years Ago 5 Years Ago 3 Month T-Bill 0.2% 0.0% 0.0% 0.0% 0.1% 2 Yr US Treasury 1.1% 0.6% 0.7% 0.2% 0.6% 10 Yr US Treasury 2.3% 2.0% 2.2% 1.8% 3.3% Fixed Income Returns (%) 3 Month YTD 1 Year 3 Year (Ann) 5 Year (Ann) US Intermediate Treasuries -1.3% 1.8% 1.8% 1.1% 3.9% US TIPS -0.6% -1.4% -1.4% -2.3% 2.5% US Mortgages -0.1% 1.5% 1.5% 2.0% 3.0% US Municipals 0.7% 2.3% 2.3% 2.1% 3.2% US Corporates -0.6% -0.7% -0.7% 1.7% 4.5% US Senior Bank Loans -2.1% -0.7% -0.7% 2.0% 3.4% US High Yield -2.2% -4.6% -4.6% 1.6% 4.8% US Convertibles 0.6% -3.2% -3.2% 9.8% 7.6% Global Bond (Hedged) 0.6% 1.7% 1.7% 4.3% 4.5% Global Bond (Unhedged) -0.9% -3.2% -3.2% -1.7% 0.9% Emerging Market Debt (US Dollar) 1.5% 1.2% 1.2% -0.1% 5.1% Source: Bloomberg, Morningstar Chart 7 : Short-Term Rates Have Risen in Anticipation of the Rate Hike 2 Year U.S. Treasury Yield 12/31/2012-12/31/2015 1.0477 1.0000 0.8000 0.6000 0.4000 0.2000 2013 2014 2015
Energy Sector Has Influenced Credit Markets Credit markets have been volatile, up. In addition, the closure of a deeply especially during the second half of the year, as the high-yield category posted a negative annual return for the first time distressed high-yield debt fund (Third Avenue) enhanced concerns and caused investors to rethink their higher-yielding since the credit crisis of 2008. A number fixed-income investments. Although of factors this quarter contributed to the weakness. Oil prices, the biggest culprit, have fallen to their lowest levels of the the Third Avenue Credit Fund wasn t your typical high-yield fund (it held the most speculative high-yield bonds), the year. This has directly influenced the closure caused a ripple effect through high-yield market, as energy companies have issued debt to participate in the U.S. shale oil boom (Chart 8). As oil prices have fallen, the profitability of these companies has been called into question and expected default rates have picked the entire market, which was already being pressured downward. There are certainly trouble spots in the market, and defaults are going to rise in 2016, but the market as a whole has been pushed to the point of extreme investors pessimism. Treasuries Have Led the Way Over the past two years, longer-term U.S. government bonds have outpaced most other fixed-income investment and might hike rates anywhere from two to four times during 2016, based on inflation, financial conditions, and returns. This has defied analyst growth. The market will remain focused expectations and is not representative of past tightening cycles. Although on these factors, and a small increase in long-term rates and volatility during beginning-of-year estimates for the the year would not be surprising. It will 10-year UST at the ends of 2014 and 2015 were 3.4% and 3%, respectively, 10-year treasury yield fell hard in 2014 and remained relatively flat in 2015, ending the year at 2.26% (Chart 9). The current outlook is for the 10-year UST to be half-a-percent higher by the end of 2016, based on average estimates of 66 Bloomberg analysts. Achieving this target will depend largely on how the be difficult for longer-term treasuries to repeat as top performers for a third year in a row, but it also will be difficult for yields to rise substantially, given the Fed s dovish stance and strong global demand for U.S Treasuries. The fear of a quick and substantial rise in yields, similar to what we saw in the spring of 2013, has subsided. Bonds will continue to play an important role in generating Fed implements rate hikes throughout income, preserving capital, and the year. The Fed will remain flexible providing diversification from stocks. Chart 8 : Drop in Oil Has Hurt the High Yield Energy Sector WTI Oil Price 110 100 90 80 70 60 50 40 Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov 14 14 14 14 14 14 14 15 15 15 15 15 15 15 15 15 15 15 Source : JP Morgan Chart 9 : U.S. Treasury Yields Have Fallen Over the Last Two Years WTI BB-rated Energy B-rated Energy CCC-rated Energy 10 Year U.S. Treasury Yield 12/31/2013-12/31/2015 2014 2015 110 100 90 80 70 60 50 40 3.0000 2.8000 2.6000 2.4000 Average Par-Weighted $-Price Energy Bonds 2.2694 2.2000 2.0000 1.8000 1.6000
MARKET POINT Market Point is a quarterly market commentary designed to provide you with an overview of economic conditions, as well as equity and fixed income market summaries for the quarter. This commentary is offered by the Investment management team. The individuals contributing to Market Point are Randy Van Rooyen, CFA, Yan Arsenault, CFA, CAIA, Brandon Hellenbrand, CFA, Steve Brudos and Ryan Bergan. Please feel free to contact any team member with questions. Copyright Trust Point Inc., La Crosse, WI, All Rights Reserved. Pictured: Left to right: Randy Van Rooyen, Yan Arsenault, Brandon Hellenbrand, Steve Brudos and Ryan Bergan The opinions expressed here reflect our judgment at this date and are subject to change. Trust Point uses its best efforts to compile its data from reliable sources, however, it does not warrant the accuracy, completeness or timeliness of any of the information provided. This publication is prepared for general information only. This material does not constitute investment advice and is not intended as an endorsement of any specific investment. Investors should seek advice regarding the appropriateness of investing in any securities or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Investment involves risk, Market conditions and trends will fluctuate. Past performance is no guarantee of future returns. 230 Front Street North I PO Box 489 La Crosse, WI 54602-0489 Standard U.S. Postage PAID Mailed from Zip Code 54601 Permit No. 125