2016 Market Outlook. Key Highlights. by Lee Partridge, Chief Investment Officer January 5, 2016

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1 Key Highlights 2016 Market Outlook by Lee Partridge, Chief Investment Officer January 5, 2016 As we approach the eighth year of this current market expansion, we would like to provide you with our thoughts on market positioning, which include an underweight to risk assets, including stocks and credit sensitive bonds, in favor of safe haven assets like developed sovereign debt as well as more market neutral strategies. Geographic: o Overweight United States, Germany, South Korean and China. o Underweight India, Russia and Brazil (as well as most South American countries). Sector: o Overweight information technology and health care sectors. o Underweight energy and utility sectors. o Favor midstream MLPs versus upstream energy and utility companies. Style: o Remain neutral on growth versus value stocks. We continue to monitor value stocks for an attractive entry point that will be characterized by positive return momentum relative to their growth counterparts. Remain neutral on small cap stocks. o Remain neutral with respect to duration on US Treasuries. We think that a rising dollar and more hawkish Federal Reserve will keep a ceiling on longer term interest rates while preserving the safe-haven elements of these instruments. Underweight high yield bonds. At an 8.7% yield, we do not believe many investors are adequately compensated for the risk of rising defaults and associated losses. 1 We believe investors will be well served to hold out for 10% or greater yields. Overweight emerging market corporate debt. We believe that many of these issues are attractively priced versus both emerging sovereign issuers and US high yield issuers. 1 Source: Barclay s High Yield Bond Index, December Salient. All rights reserved. The House View 1

2 Review The S&P 500 generated a 1.37% return in marking the worst performance year since The gain was driven entirely by dividends paid to investors, which offset a modest price decline of -0.7%. Consumer discretionary stocks led the market closing up10.11% for the year while consumer staple stocks increased 6.6%. Energy stocks were the biggest detractor (-21.12%) followed by materials stocks (-8.38%). Small cap stocks, as represented by the Russell 2000 index, posted a -4.41% loss for the year. 50% S&P 500 Index Total Return by Year 40% 37.1% Annual Return 30% 20% 10% 0% -10% -3.2% 29.9% 9.9% 7.4% 1.3% 22.6% 33.1% 28.3% 20.9% -9.0% -11.9% 28.3% 15.6% 10.7% 4.8% 5.6% 32.0% 25.9% 14.8% 15.9% 13.5% 2.1% 1.4% -20% -22.0% -30% -40% -36.6% -50% Year Source: Standard & Poor s, Bloomberg, as of 12/31/15. Past performance does not guarantee future results. Index performance does not reflect the deduction of fees, expenses or taxes. The indices are unmanaged and are not available for direct investment. The dollar advanced 9.26% versus a trade-weighted basket of foreign currencies as the euro lost % versus the greenback. Japanese equities, as measured by the Tokyo Stock Price Index, gained 12.06% while German stocks, as measured by the German Stock Index, advanced 9.56% over the course of the year (in their respective currencies). Emerging market stocks continued to fare poorly as the MSCI Emerging Markets Index tumbled % during the year. High yield bonds finished the year down -4.47%, as measured by the Barclays U.S. Corporate High Yield Bond Index, while core fixed income returns were up 0.55%, as measured by Barclays U.S. Aggregate Bond Index. We note that during the third round of the Federal 2016 Salient. All rights reserved. The House View 2

3 Reserve s quantitative easing program in 2013, corporate high yield issuance reached current cycle highs. We would typically expect to see a distressed cycle occur three to five years following peak issuance, which would fall into calendar years As illustrated in the chart on the following page, represented the first negative return posted by high yield bonds since the 2008 financial crisis. 70.0% Barclays U.S. Corporate High-Yield Bond Index Total Return by Year 60.0% 58.2% 50.0% 46.2% 40.0% 30.0% 29.0% Annual Return 20.0% 10.0% 0.0% -10.0% -9.6% 15.8% 17.1% 19.2% 11.4% 12.8% 5.3% 1.9% 2.4% -1.0% -1.4% -5.9% 11.1% 11.8% 2.7% 1.9% 15.1% 15.8% 7.4% 5.0% 2.5% -4.5% -20.0% -30.0% -26.2% -40.0% Year Source: Barclay s, Bloomberg, as of 12/31/15. Past performance does not guarantee future results. Index performance does not reflect the deduction of fees, expenses or taxes. The indices are unmanaged and are not available for direct investment. The yield on the 10-year U.S. Treasury note rose a modest 0.1% over the course of the year despite the Federal Reserve s decision to raise short-term interest rates at its December Federal Open Market Committee meeting. We believe the low nominal yields on longer dated U.S. Treasury securities reflect market sentiment with respect to muted growth prospects and nascent inflation concerns for the U.S. specifically and for the global economy more generally Salient. All rights reserved. The House View 3

4 9.0% 10-Year U.S. Treasury Yield 8.0% 7.0% 6.0% 5.0% Yield 4.0% 3.0% 2.0% 1.0% 0.0% Year Source: Bloomberg as of 12/31/15. Global Economic Outlook Growth The IMF estimates that global growth will slow to 3.1% in from 3.4% in Slower economic growth heightens our concerns about the waning influence of central bankers on capital markets (Catch 22) and the mountain of debt that has financed global consumption over the past 25 years (What's good for China...). Inflation Price levels have been trending downward in most major developed economies despite seven consecutive years of central bank stimulus. We believe the combination of global indebtedness, structural deficits and aging societies will culminate in a backdrop of deflationary pressures that will characterize the global economy for the rest of the decade. As the Federal Reserve moves to normalize short-term interest rates, we believe that many of these deflationary forces will manifest themselves in the US economy Salient. All rights reserved. The House View 4

5 7% U.S. Consumer Price Index Year-Over-Year Change 6% 5% 4% Yield 3% 2% 1% 0% Year Source: Bloomberg as of 12/31/15. We enter 2016 with a number of challenges that will likely result in another year of low returns, including: 1. We believe the headwind of a rising dollar will likely diminish the competitiveness of the U.S. export sector, reduce profits from foreign operations and challenge emerging market companies that externally finance their operations in dollars with principal revenue sources denominated in their home currencies. The Federal Reserve s tightening of short-term interest rates will likely further strengthen the dollar. 2. In addition to the currency-related challenges noted above, the continued decline in natural resources and slowing demand from China represent meaningful challenges for a number of emerging market economies. Furthermore, nearly all emerging market economies have shifted from accumulating to dispersing foreign exchange reserves. 3. The decline in both nominal and real interest rates continues to paint a troubling picture of global deflationary pressure and low capital market returns. 4. The sharp decline in energy prices witnessed last year has created stress in both stock and bond markets. Following the peak debt issuance in 2013 and the first half of 2014, many energy companies may be forced to restructure balance sheets and consider strategic options as their asset bases have eroded. 5. Global debt remains at record highs and exceeds the 2007 levels that resulted in the financial crisis of The methods for dealing with overindebtedness increasing 2016 Salient. All rights reserved. The House View 5

6 taxes, decreasing expenditures, growing out of it, inflating out of it or restructuring it seem either unpalatable or undoable. Despite this laundry list of woes, we enter 2016 with the S&P 500 trading at times its trailing 12 month s earnings while the federal funds target rate hovers between 0.25% and 0.50%, high yield bond yields have crept up to 8.74%, 10-year U.S. Treasurys yield a modest 2.27% and the price of West Texas Intermediate crude oil closed the year out at $37.04 per barrel. Equities As we consider options for where to invest globally we focus on three factors: valuation, momentum and central bank accommodation. Our proxies for these measures are the relative price-to-trailing twelve month earnings for each respective country relative to its 25-year average, the trailing 12-, 4- and 2- month returns for each market and the yield differential between ten-year sovereign bonds and 3-month interbank deposit rates. Relatively low P/E levels, positive momentum and steep yield curves are all interpreted as bullish indicators. Using this approach, we created a composite score for four major developed markets the United States, Japan, Germany and the United Kingdom and six emerging markets China, India, South Korea, Russia, Brazil and Mexico. The findings were interesting and generally favored the US, Germany and South Korea, which generated positive scores across all three metrics. China also received a positive score but was hindered by the relative flatness of their term structure of interest rates, which we found surprising given the central bank s recent efforts to provide monetary stimulus and weaken the value of the renminbi. India and Russia generated significantly negative scores. India suffers from higher than average valuations and negative price momentum on the heels of last year s rupee rout. Russia has become somewhat of an island as a relatively high cost producer of fossil fuel and foreign policy initiatives that continue to isolate it from its NATO counterparts. Valuation (Z-Score) Momentum 10YR Gov - 3MO Deposit Composite China (0.19) 1.52 India (1.35) (1.00) 0.31 (2.04) South Korea Russia (0.36) 0.25 (1.29) (1.40) Brazil 0.17 (1.00) Mexico (2.34) United States Japan Germany United Kingdom (0.20) (0.50) Source: Bloomberg as of 12/31/15. Past performance does not guarantee future results Salient. All rights reserved. The House View 6

7 We think it s reasonable to stay overweight a barbell of US, German, South Korean and Chinese stocks versus underweights in India, Russia and Brazil (as well as most South American countries). Sectors We used the same valuation and momentum metrics cited above to analyze S&P 500 sectors. The most attractive sectors based on composite scores were telecom, consumer discretionary, information technology and health care. All but health care had positive valuation and momentum scores. We qualify our analysis of the telecom sector with the fact that the index only contains five constituents making the robustness of the analysis somewhat questionable. Valuation (Z-Score) Momentum Composite Consumer Discretionary Consumer Staples Energy (1.44) Financials (0.39) Healthcare Industrials Information Technology Materials Telecom Utilities (1.12) Source: Bloomberg as of 12/31/15. Past performance does not guarantee future results. The energy and utility sectors are plagued by negative valuation scores largely due to a decline in earnings that the market seems to be pricing as transitory and negative momentum. We prefer to maintain underweights in these sectors until negative price momentum subsides or valuations are further reduced. We also believe the midstream MLP sector is attractively priced versus upstream energy and utility companies. Styles As we consider style factors across US stocks, we focus on value versus growth stocks as well as large versus small capitalization stocks. From a valuation perspective, value stocks and growth stocks are roughly in line with their long term averages. Based on the Russell 1000 growth and value indices, value stocks are actually slightly more expensive than growth stocks relative to their long term averages Salient. All rights reserved. The House View 7

8 Russell 1000 Value versus Growth TTM P/E Multiples (1995-Present) Value Multiple (P/E-TTM) Growth Multiple (P/E-TTM) Source: Standard & Poor s, Barclay s, Bloomberg, as of 12/31/15. Past performance does not guarantee future results. Index performance does not reflect the deduction of fees, expenses or taxes. The indices are unmanaged and are not available for direct investment. Nonetheless, value stocks have underperformed their growth counterparts since the onset of the financial crisis. We observe that from 2000 to 2007 the end of the dot com era to the onset of the financial crisis value stocks outperformed their growth counterparts. We believe that this was primarily driven by the dominance of the financial sector during a wave of financial innovation and shadow banking that boosted profits to unprecedented highs. Since 2008, value stocks have performed relatively poorly as information technology, life science and health care companies assumed leadership positions. We prefer to remain neutral on the growth/value spectrum as we observe the impact of a rising dollar on the US manufacturing base, which constituents a significant portion of value-oriented companies, as we wait for the negative momentum associated with value stocks to subside. Over the past 15 years there hasn t been a meaningful differentiation between the performance of large and small cap stocks. We believe this is a consequence of the conflation of the growth multiples applied to many small cap companies making the distinction between size and value factors more obscure. Accordingly, we remain neutral with respect to our assessment of the prospects for large versus small cap companies Salient. All rights reserved. The House View 8

9 600% Cumulative Returns for U.S. Large and Small Capitalization Stocks (1995-Present) 500% 400% Cumulative Return 300% 200% 100% Small Cap Large Cap 0% Year Source: Standard & Poor s, Barclay s, Bloomberg, as of 12/31/15. Past performance does not guarantee future results. Index performance does not reflect the deduction of fees, expenses or taxes. The indices are unmanaged and are not available for direct investment. High Yield As we turn our analysis to high yield markets we recognize that the spreads to treasuries may look attractive to yield-starved investors; however, we believe that the nominal yields do not compensate investors for the likely rise in default rates and loss severities that will be incurred over the next cycle. High yield spreads and accompanying yields have widened in sympathy with the poor stock performance of the energy sector, in particular. We believe that a return to more normative default rates and accompanying loss levels across sectors would demand higher yield levels and wider spreads. We advise investors to wait for a more attractive entry point at which the yield-to-worst on the Barclay s high yield index is above 10% Salient. All rights reserved. The House View 9

10 25% Barclay's High Yield Bond Index (Yield-to-Worst) 1990-Present 20% Yield-to-Worst 15% 10% 5% 0% Year Source: Standard & Poor s, Barclay s, Bloomberg, as of 12/31/15. Past performance does not guarantee future results. Index performance does not reflect the deduction of fees, expenses or taxes. The indices are unmanaged and are not available for direct investment. Emerging Market Debt The emerging market debt sector has evolved significantly since the 1998 emerging market debt crisis. There is greater differentiation between hard currency and local debt issuers as well as corporate versus sovereign issuers. Accordingly, we believe this segmentation lends itself to greater relative value opportunities within the emerging market debt sector and relative to other markets. Many emerging market sovereign and corporate issuers have moved from a position of foreign currency reserve accumulation to dissipation. During this transition, most issuers yield spreads have widened in sympathy. We believe the best opportunities to capitalize on this more generalized repricing may be found amongst hard currency, corporate issuers. Yield spreads in this sector have gapped out significantly as investors fear that they won t be able to generate sufficient profits to cover their foreign obligations. While we recognize that the combination of a strengthening US dollar and falling oil prices threaten a number of emerging market issuers, we believe that the financial resilience of these companies and their implied sovereign backing make them the most attractive segment of the emerging bond market and represent relative value versus many US high yield bond issuers Salient. All rights reserved. The House View 10

11 Emerging Market Debt Yields 7.0% Bloomberg USD Emerging Market Sovereign Bond Index Bloomberg USD Emerging Market Corporate Bond Index 6.5% Bloomberg Emerging Market Local Sovereign Index 6.0% Yield 5.5% 5.0% 4.5% 4.0% Aug 2014 Sep 2014 Oct 2014 Nov 2014 Dec 2014 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Month Source: Standard & Poor s, Barclay s, Bloomberg, as of 12/31/15. Past performance does not guarantee future results. Index performance does not reflect the deduction of fees, expenses or taxes. The indices are unmanaged and are not available for direct investment. Conclusion We enter 2016 with a tone of caution. We are troubled by shifts in central bank policy, the levels of global debt, relatively full valuations of equities and credit sensitive debt and the length of the current market expansion. The United States, Germany and certain East Asian countries look attractive to us while we generally prefer to avoid India, Russia and Brazil. Information technology and health care sectors look more attractive than energy and utility sectors. Midstream MLPs seem to offer a more attractive means of obtaining energy-related exposure compared to both upstream energy and utility sectors. Lastly, we favor emerging market corporate debt over both emerging market sovereign debt and US high yield bonds Salient. All rights reserved. The House View 11

12 DISCLOSURES Investing involves risk, including possible loss of principal. The value of any financial instruments or markets mentioned herein can fall as well as rise. Past performance does not guarantee future results. This material is distributed for informational purposes only and should not be considered as investment advice, a recommendation of any particular security, strategy or investment product, or as an offer or solicitation with respect to the purchase or sale of any investment. Statistics, prices, estimates, forward-looking statements, and other information contained herein have been obtained from sources believed to be reliable, but no guarantee is given as to their accuracy or completeness. All expressions of opinion are subject to change without notice. Neither diversification nor asset allocation assures profit or protects against risk. Limitations of Hypothetical Performance. The hypothetical backtested performance presented is supplemental to the GIPS-compliant presentation included as part of this presentation. The returns presented reflect hypothetical performance an investor would have obtained had it invested in the manner shown and does not represents returns that any investor actually attained. The information presented is based upon the following hypothetical assumptions: [1)The historical transactions costs are reflected by our estimates based on the modern costs of trading the instruments in the strategy. 2) No market events not accounted for in the model would have disrupted the rebalancing of assets throughout the backtest. 3) The computational resources required to conduct the strategy would have been available throughout the history. Certain of the assumptions have been made for modeling purposes and are unlikely to be realized. No representation or warranty is made as to the reasonableness of the assumptions made or that all assumptions used in achieving the returns have been stated or fully considered. Changes in the assumptions may have a material impact on the hypothetical returns presented. Hypothetical backtested returns have many inherent limitations. Unlike actual performance, it does not represent actual trading. Since trades have not been actually been executed, results may have under- or over-compensated for the impact, if any, of certain market factors, such as lack of liquidity, and may not reflect the impact that certain economic or market factors may have had on the decision-making process. Hypothetical backtested performance also is developed with the benefit of hindsight. Other periods selected may have different results, including losses. There can be no assurance that the Adviser will achieve profits or avoid incurring substantial losses. Lee Partridge has earned the right to use the Chartered Financial Analyst designation. CFA Institute marks are trademarks owned by the CFA Institute. DEFINITIONS Alerian MLP Index (AMZ) is a composite of the 50 most prominent energy MLPs that provides investors with a comprehensive benchmark for this emerging asset class. Barclays Global High Yield Index is a multi-currency flagship measure of the global high yield debt market. Barclays Intermediate Government/Credit Bond Index tracks the performance of intermediate term U.S. government and corporate bonds. Bloomberg Commodity Index is a broadly diversified index composed of exchange-traded futures contracts on physical commodities. Commodity trading advisor (CTA) is US financial regulatory term for an individual or organization who is retained by a fund or individual client to provide advice and services related to trading in futures contracts, commodity options and/or certain swaps. They are responsible for the trading within managed futures accounts. The definition of CTA may also apply to investment advisors for hedge funds and private funds including mutual funds and exchangetraded funds in certain cases.[3] CTAs are generally regulated by the United States federal government through registration with the Commodity Futures Trading Commission (CFTC) and membership of the National Futures Association (NFA). German Stock Index (DAX) is a blue chip stock market index consisting of the 30 manjor German companies trading on the Frankfurt Stock Exchange. Global Industry Classification Standard (GICS) is a standardized classification system for equities developed jointly by Morgan Stanley Capital International (MSCI) and Standard & Poor's. The GICS methodology is used by the MSCI indexes, which include domestic and international stocks, as well as by a large portion of the professional investment management community Salient. All rights reserved. The House View 12

13 MSCI Emerging Markets (EM) Index is an index created by Morgan Stanley Capital International (MSCI) that is designed to measure equity market performance in global emerging markets. Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership. The Russell 2000 is constructed to provide a comprehensive and unbiased small-cap barometer and is completely reconstituted annually to ensure larger stocks do not distort the performance and characteristics of the true small-cap opportunity set. S&P 500 Index is an unmanaged, capitalization weighted index comprising publicly traded common stocks issued by companies in various industries. The S&P 500 Index is widely recognized as the leading broad-based measurement of changes in conditions of the U.S. equities market. S&P GSCI Commodity Index is a composite index of commodity sector returns representing an unleveraged, longonly investment in commodity futures that is broadly diversified across the spectrum of commodities and serves as a measure of commodity performance over time. Tokyo Stock Price Index is an index that measures stock prices on the Tokyo Stock Exchange (TSE). One cannot invest directly in an index Salient. All rights reserved. The House View 13