We ask, isten and sove. Market Economic and Financia Market Outook January 2015 United States Is Driving Goba Economic Growth MARKET SUMMARY Overa, the U.S. economy appears to have reached a eve of sef-sustaining growth, and ooks particuary good compared to the rest of the word. The timing and size of the Fed rate hikes are expected to be the key drivers of the bond market. The positive dynamics that have sent U.S. stocks higher remain intact for 2015, but any sharp rise in short-term interest rates by the Fed coud sti trigger a puback. As ong as the U.S. doar continues to gain against other currencies, internationa stocks wi underperform domestic issues. Voatiity has returned to the investment markets and aternative funds may pay a greater roe managing market fuctuations. INTRODUCTION Over the past few years, investors have deat with the ongoing financia crises in Europe, a sowdown in China, subpar U.S. growth, and Midde East turmoi. These conditions have occurred aong side surprisingy ow goba interest rates. In fact, this ow-rate environment has been a key factor in the powerfu U.S. equity ray since the financia crisis. The Fed has recenty exited their asset purchasing program (Quantitative Easing) and is at east considering a tighter monetary poicy, whie at the same time, much of the rest of the word s centra banks are easing their poicies. Accordingy, investors wi need to stay focused going forward to gauge whether the goba economies may continue to diverge or begin to converge next year. This wi be an important factor in determining optima portfoio aocations. ECONOMIC OUTLOOK Among the deveoped nations, the U.S. economy remains the strongest anchor of the goba recovery. In fact, U.S. growth rates have recenty appeared to decoupe from the other major word economies. The reasons for the divergence in the various goba economies are the differences in the stages of their respective investment, credit and empoyment cyces. For exampe, China s economy has been deceerating, Europe s is treading water, and the United States is powing ahead. However, the suggish growth picture in Japan and the Eurozone is ikey to ook a itte better next year. Easing financia conditions, ower oi prices and some reaxation in ending conditions shoud contribute to better economic growth. As such, the goba deveoped markets picture shoud improve in 2015. Athough China s growth is ikey to sow further in underying terms, other parts of the Emerging Markets shoud see better I nside: Introduction 1 Economic Outook 1 Fixed Income Update 3 Equity Update 5 Aternative Investments 5
We ask, isten and sove. CHART 1 REAL GROSS DOMESTIC PRODUCT Wide quarter-to-quarter movements for GDP growth, but gaining upward momentum. n Year over Year Change n Year over Year (Estimate)* 10-Year Trend --- Sustainabe Growth Trend CHART 2 INFLATION Gradua rise in infation in 2015 is expected due to ess economic sack. CPI (YOY) 2.49% Avg. Core CPI (YOY) 2.33% Avg. CHART 3 EMPLOYMENT Payro numbers are up significanty in 2014 compared to ast year. n Monthy Increase (Left Axis) 3-Month Change (Right Axis) 9.0% 8.0% 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% -1.0% -2.0% -3.0% * Commerce Estimate: 2.5% for fourth quarter 2014, 3.0% for 2015-4.0% -5.0% 1973 1976 1980 1984 1988 1991 1995 1999 2003 2006 2010 2014 Monthy Increase (Thousand Jobs) 6.0% INFLATION CPI AND CORE CPI 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% -1.0% -2.0% -3.0% 1991 1994 1997 1999 2002 2005 2008 2011 2014 600 400 200 0-200 -400-600 -800-1000 growth as the Deveoped Markets recovery graduay fows through to the Emerging Market countries. In tota, goba growth is expected to approach 3.5%, up from 3.3% in 2014. So far in 2014, we have seen U.S. GDP fa 2.1% in the first quarter (bamed on the harsh weather), then a jump to a strong 4.6% in the second quarter, foowed by a soid 3.9% in the third quarter. These wide quarterto-quarter movements have become REAL GROSS DOMESTIC PRODUCT EMPLOYMENT 1999 2002 2005 2008 2011 2014 4% 3% 2% 1% 0% -1% -2% -3% -4% -5% -6% -7% the norm over the past few years. GDP growth ranged from a decine of 1.5% to an increase of 4.6% in 2011, from 0.1% to 2.5% in 2012, and from 1.8% to 4.5% in 2013. The swings revea the inconsistent nature of this extended recovery. Even so, the U.S. economy has grown by 3.5% or more in four out of the ast five quarters, and most indicators show that growth has been gathering momentum that shoud Source: Bureau of Economic Anaysis Source: Boomberg 3 Month Change Source: Bureau of Labor Statistics carry through we into 2015. Recent deveopments, incuding a further sharp decine in oi prices, ower ong-term yieds (both in the United States and abroad), and strong gains in equities, are expected to hep nearterm momentum. Overa, U.S. GDP growth in 2015 is projected to track near 3%. (CHART 1) A coser ook at the recent U.S. data reveas that economic reeases have been mixed, but generay consistent with moderate growth in the near-term. Notaby, manufacturing, incuding the capita goods sectors, appears to be trending higher. The ISM Manufacturing Index indicates soid growth at 58.7 (readings above 50 signa expansion). In fact, an underying production gauge was the strongest in a decade. Simiary the three-month average of the ISM new orders index aso reached a cycica high. Nondefense capita goods and shipments have both experienced soid gains over the ast haf year or so. Resiient saes of motor vehices and gains in corporate investment are keeping assemby ines humming. Aso, the housing market is growing at a sow but steady pace on the back of the continued economic recovery in the United States, and is expected to improve further in 2015. Whie many Americans compain about the high cost of housing, the United States remains one of the most affordabe nations in the word for housing prices reative to median income. In other words, Americans spend ess on housing reative to income than the citizens of the majority of nations in the word. These conditions provide support for this important economic segment, especiay if mortgage rates remain reativey ow. On the infation front, the 12-month change in the core CPI remained at 1.7% in October. The recent rise in the doar appears to have heped restrain 2
infation, aong with sagging infation in other deveoped economies. Both have aayed fears hed by some that infation was in the process of moving up faster than was previousy expected. On the other hand, whie defation has been mentioned frequenty when discussing Europe, we do not beieve that the trend in infation in the United States is ebbing. Rather, we think the trend is graduay rising. It is true that eevated utiization sack (high unempoyment) and a strong doar have contributed to softer import prices and have combined to restrain infation. However, going forward, with diminishing economic sack and infation expectations projected to remain anchored at 2%, we expect the CPI price index to rise graduay toward 2% ater in 2015. (CHART 2) Non-farm payros rose a soid 312,000 in November, the strongest gain since January 2012. For the fourth quarter-to-date, the average monthy job gain is 282,000. In the third quarter, payros increased 239,000 a month, and the six-month moving average through November was 258,000. Of note, these job numbers are up significanty compared to the same period ast year. Whie the monthy figures are subject to much greater voatiity, civiian empoyment (drawn from the househod survey) has aso shown soid growth on average, as the unempoyment rate decined further to 5.8% in November, the owest reading since Juy 2008. Job and wage gains provide an important underpinning to the economy. (CHART 3) The continued recovery in empoyment refects soid increases in hours worked, as growth in output has been met with more suggish growth in productivity over the past three quarters. Near-trend GDP growth of 3% supports soid growth in empoyment and shoud resut in continued downward pressure on the unempoyment rate through 2015. With GDP growth having shifted up over the second haf of this year, we expect continued gains in nonfarm payros, averaging 225,000 per month in 2015. This remains consistent with a decining trend in the unempoyment rate. The unempoyment rate is projected to fa from 5.8% in the fourth quarter to 5.4% by the end of 2015. Overa, the U.S. economy is in decent shape on an absoute basis, and particuary good compared to the rest of the word. The U.S. economy has been expanding at about a 3% rate for the past six months, even as the Fed has pued back on its stimuus programs. The Fed s two previous Quantitative Easing programs ended abrupty, with growth and equities seing off. This time around, the Fed pued back much more graduay, aowing the private sector to gain some traction, at east so far. So, whie we see this uptrend continuing into 2015 for the United States, we expect goba growth to remain very diverse, with goba economic decouping sti an important theme. FIXED INCOME OUTLOOK At the start of 2014 the consensus expectation was that bond yieds woud rise, sending bond prices down. This beief was fueed by the Federa Reserve s announcement at the end of 2013 that the centra bank woud wind down its Quantitative Easing program in 2014. Contrary to expectations, Treasury yieds decined as a resut of pressure on rates from a number of sources. Geopoitica concerns kept the fight to quaity in pay (i.e., Russia-Ukraine, Midde East). Foreign purchases of U.S. Treasuries remained high as yieds in Japan and many European countries were ow. Aso, infation was subdued as energy and other commodity prices decined during the year. The Treasury yied curve fattened in 2014 as yieds decined for intermediate and ong maturities (5 to 30 years) and rose for short maturities (3 years and ess). The 10-year Treasury yied decined by 77 basis points (100 basis points equas 1%), ending the period at 2.26%. (CHART 4) The spread between the 2-year and 30-year Treasuries narrowed from 359 basis points at the start of the year to 245 basis points through November. Steep yieds hep bond performance by providing onger maturities with a degree of insuation from rising short-term rates. Whie the curve has fattened significanty over the past 12 months, there is sti ampe room for these spreads to narrow more. In 2006, the 2- to 30-year Treasury spread was essentiay zero. The overa U.S. bond market, as measured by the Barcays Aggregate Bond Index, beat expectations and returned 5.87% year-to-date through November. Average credit spreads, as measured by the Merri Lynch U.S. Corporate Master Index, moved from 118 basis points to 128 basis points. (CHART 5) This risk premium over Treasury yieds widened, but not enough to offset the positive impact of ower interest rates reaized by most maturities. A bond sectors are on pace to finish the year in positive territory, with Long Government eading the pack. Despite continued ow defaut rates, High Yied was one of the aggards for the period. (CHART 6) The Moody s specuative-grade defaut rate was 1.9% as of October, sti we beow its historic average of over 4.0%. Municipa bonds rebounded this year after being down -2.55% in 2013. The Barcays Municipa Bond Index was up 8.50% year-to-date through the end of November. Municipa bonds benefited from a combination of a benign interest-rate environment, ow 3
defauts, and steady investor demand. Overa creditworthiness among state and oca issuers of municipa debt remains strong, despite recenty weaker revenue growth. Municipa bonds are ikey to continue their good run into 2015, but ower returns are expected as state and oca municipaities wreste with heavy pension obigations. Defauts and bankruptcy may caim headines, but there s good reason to beieve they wi remain rare. High Yied is on pace to underperform (on annua basis) reative to investment grade corporate for the first time since 2011. Many investors moved to a risk-adverse mode as they moved out of ower quaity hodings. The historic spread on the Merri Lynch High Yied Index is 583 basis points. The index was as ow as 335 basis points at midyear and is 464 basis points at the end of November. After this recent adjustment, market conditions for High Yied ook favorabe. Future performance is dependent on continued economic growth, ow defaut rates and interest rates staying ow. Emerging Market bonds faced numerous chaenges in 2014, ranging from ower commodity prices to the U.S. Federa Reserve s monetary poicy. With many Emerging Markets dependent on exporting commodities, concern grew that ower commodity prices woud ead to weak economic growth. Some ingering effects of the Fed phasing out Quantitative Easing added some downward price pressure on Emerging Markets. Despite these hurdes, investors thirst for yied heped move Emerging Market returns into positive territory. Next year s returns are expected to come from opportunities in seect countries rather than from the market in genera. Emerging Market fundamentas are generay improving, but not universay. In 2014 the fixed income market saw yieds decine for most parts of the Treasury curve and credit spreads widen by a margina amount. In 2015, the opposite may occur, with spreads tightening modesty and interest rates rising graduay. Positive returns are possibe, but ikey in the ow singe digits. The economy needs to continue to show some growth with improvements in jobs and housing for this scenario to occur. Risks incude a Yied SPREAD (Basis Points) 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% 3 2000 1800 1600 1400 1200 1000 800 600 400 200 16% 14% 12% 10% 0.85% 0.77% HISTORICAL TREASURY YIELD CURVE 3.03% 2.17% bigger jump in infation than expected and unforeseen geopoitica events. Voatiity is rising for the bond market, party due to shrinking iquidity. The new capita rues are discouraging banks who act as deaers. Trading desks are in ess of a mood to take bonds on their baance sheet given the constraints they now face. The resut is greater fuctuations in price when negative headines hit the market. Investors desire for yied is expected 3.97% 2.89% 5 10 30 Years to Maturity 0 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 8% 6% 4% 2% 5.87% 0% Aggregate 3.45% Intermed. Gov/Cred 2.85% CORPORATE CREDIT SPREADS FIXED INCOME SECTOR RETURNS YTD Intermed Treasury 4.58% Intermed Credit 8.50% Municipa Index 2.47% Intermed TIPS 5.92% Mortgages 3.96% Corporate High Yied 13.24% Municipa High Yied 14.37% Preferred 7.47% Emerging Mkt (USD) Source: Boomberg Source: Barcays Capita Indices 467 bps 180 bps 103 bps Source: Merri Lynch/Bank of America CHART 4 HISTORICAL TREASURY YIELD CURVE (12/31/2013 11/30/2014) Yied curve fattened as yieds decined for intermediate and ong maturities, and rose for short maturities. 12/31/2013 11/30/2014 CHART 5 CORPORATE CREDIT SPREADS (1/31/91 11/30/2014) Corporate spreads widened modesty year-to-date. High Yied Avg. 510 bps BBB Rated Corporate Credits Avg. 185 bps A Rated Corporate Credits Avg. 126 bps CHART 6 FIXED INCOME SECTOR RETURNS (As of 11/30/2014) A Fixed Income sectors are generating a positive return year-to-date. 4
ask isten sove to hep keep a more aggressive investment stance in pace for the time being. Corporate bonds (both investment grade and High Yied) shoud eke out a sight excess return reative to Treasuries in the coming year. Municipa bonds have some upside potentia, but not as much as they did at the start of 2014. Emerging Market debt appears to be sighty expensive reative to fundamentas, and a better buying opportunity may deveop ater in the year once the market starts to get coser to the first Fed rate hike since 2006. The timing and size of the Fed rate hikes are expected to be the key drivers of the bond market. Moving up in quaity and maintaining target durations sighty beow their benchmark shoud assist performance in 2015. EQUITY OUTLOOK Chak up another doube-digit gain for the S&P 500 in 2014. The S&P 500 has now risen over 240% from the March ows in 2009, so the natura question is what wi derai this bu market? We beieve the positive dynamics that have sent stocks higher remain intact for 2015, but we do have some concerns as the year progresses. Our main concern that coud trigger a 10% correction is a sharp rise in shortterm interest rates. Historicay when short-term interest rates have a sharp increase, regardess of the interest rate eve, stock prices have experienced weakness. A rise of 0.5% in the 3-year Treasury (currenty around 1.00%) over a few months woud quaify as a sharp jump. The Fed has hinted that short rates coud start to increase in June, but that coud be put off unti Fa or onger given the reativey ow eves of foreign interest rates and benign infation in the United States. We woud not adjust equity aocations in anticipation of rising rates, but wait unti it happens. As we enter 2015, vauation eves no onger are inexpensive and moved to the upper range of norma vauation. With mediocre U.S. economic growth in 2014, the S&P 500 earnings are expected to increase 9% to 10%. The S&P 500 operating earnings ratio stands at 18 times, up from 17.5 times at the beginning of the year. Earnings growth in 2015 is expected to be in the 8% to 10% range, giving investors the possibiity of another year with a doube-digit return. There is aso some further room for Price/Earnings ratios to move higher in ight of the ow interest rates and infation. Whie we remain quite positive on arge- and mid-cap domestic stocks, sma-cap domestic stocks underperformed by 10% ast year after a strong performance in 2013. Smacap stock vauations sti are trading at the upper end of their historica vauation range, eading to potentiay another year of subpar performance. The surge in company buyouts we saw ast year was centered in the midcapitaization range of domestic stocks. With the ow interest rates around the word to finance these acquisitions, we see no sowdown in takeovers of midcap companies in 2015. Turning from domestic equities to internationa equities, the outook isn t neary as optimistic. Over the ast 23 months ending in November 2015, the MSCI EAFE Index (Europe, Austraia and the Far East) has underperformed the S&P 500 Index by neary 30% and Emerging Markets have fared worse, underperforming by 50%. Whie internationa market vauations ook quite appeaing, we beieve this period of underperformance can continue. With the economic sowdown in China and the anemic economy in Europe hurting earnings growth, the rea headwind for internationa stocks is the strength in the U.S. doar. As ong as the doar gains against other currencies, internationa stocks wi continue to underperform domestic issues. ALTERNATIVES OUTLOOK Muti-Strategy, or Fund of Fund, Hedge Fund strategies are positive on a year-to-date basis. The HFRI Fund Weighted Composite Index year-todate returned 3.73% and the HFRI Fund of Funds Conservative Index returned 2.40% through November 30. Individua strategy hedge fund returns varied with Reative Vaue and Macro deivering the highest returns, foowed by Equity Hedge and Event-Driven. We empoy hedge funds to manage the risk, or voatiity, in portfoios. In the ast few years the returns of conservative hedge funds have been disappointing versus bonds. However, the end of the 30- year bu market for bonds, aong with the expected unwinding of centra bank intervention, may ead to ow or negative returns for bonds. Therefore, hedge funds may pay a needed roe in reducing portfoio voatiity. Rea Estate Investment Trusts (REITs) are one of the best performing assets casses in 2014. The MSCI US REIT Index is up 27.86% through November 30, foowing subdued performance in 2013. The U.S. rea estate market outook is for above average cash fow in 2015. Supporting REITs are ow interest rates, steady job growth, ow debt funding costs and a baanced ratio of suppy and demand. Rea estate performs best when GDP growth is above average and infation adjusted interest rates ( rea rates) are beow average. With our forecast of improving economic growth, and rea rates remaining beow average, it is reasonabe to expect rea estate produces resuts in ine with its ongterm average. Infrastructure MLP investing is gaining more acceptance as an asset cass. Investors seeking income aong 5
We ask, isten and sove. CHART 7 INCOME-ORIENTED INVESTMENT RETURNS YTD (As of 11/30/2014 vs. 2013 Performance) Aerian MLP Index is on pace for a doube digit return for the second consecutive year. n YTD 2014 Performance n 2013 Performance CTC INVESTMENT CONTACTS Christie Cody, CFA (816) 234-2415 Mike Cody, CFA (314) 746-8551 Scott Cobert, CFA (314) 746-8557 Doug Koester, CFA (314) 746-7337 Cynthia Rapponotti, CFA (314) 746-8794 Barbara Turey, CFA (314) 746-8726 Joe Wiiams, CFA (816) 234-2564 35% 30% 25% 20% 15% 10% 5% 0% -5% 11.01% 27.59% 3.45% Aerian MLP Index 27.91% 4.58% 2.50% with growth potentia aocated more to this sector over the ast severa years. The Aerian MLP Index is up 11.01% through November 30 foowing a return of 27.59% in 2013. (CHART 7) The major performance drivers for MLPs are growing U.S. energy production and, to a esser extent, wordwide energy demand. Higher U.S. production means more voume fowing through pipeines, transating into revenue growth and higher dividends for MLPs. The production outook continues to be bright and the United States currenty produces more natura gas than any other country in the word. Production is expected to continue to increase into 2020 according to the U.S. Energy Information Administration, particuary from offshore and shae driing. Wordwide YIELD-ORIENTED INVESTMENT RETURNS MSCI U.S. REIT Index 26.57% 12.69% Dow Jones Utiities Average 5.87% -2.02% Barcays U.S. Aggregate Bond Index energy consumption, on the other hand, is ess encouraging. European demand wi ikey continue to be a headwind due to the region s weak macro outook. After a strong start in eary 2014, the broad Commodity index has been in a decine since June with the Boomberg Commodity Index returning -10.18% through November 30. U.S. doar strength and an upturn in U.S. interest rates wi keep downward pressure on god prices into next year. CONCLUSION The United States is separating itsef from the strugging economies of the word, gaining steady and favorabe traction based on key economic indicators. Unempoyment continues to fa, infation remains in check and rea wage increases may eventuay Source: Boomberg take root. European countries are now foowing simiar accommodative fisca poicies to those of the United States to jump start their economies. Athough China s growth is ikey to sow further, tota goba growth is expected to approach 3.8%, up from 3.3% in 2014. Easing financia conditions, ower oi prices and some reaxation in ending conditions shoud aso contribute to most major deveoped markets in the new year, and maybe even pu some Emerging Markets aong. In the United States, the favorabe environment for equities remains in pace for now. Potentia Fed interest rate hikes wi be key drivers of bond market returns in 2015. INVESTMENT POLICY COMMITTEE DECEMBER 17, 2014 For more information on this or on other topics important to you as an investor, pease ca your oca Commerce Trust Company professiona. DISCLOSURES Past performance is no guarantee of future resuts and the opinions and other information in the Market Outook are as of December 17, 2014. The 2015 annua Market Outook is a specia report designed to provide investment information on economic markets for Commerce Trust Company cients. It is intended to provide genera information ony and is refective of the opinions of the senior investment management committee. This materia is not a recommendation of any particuar security, is not based on any particuar financia situation or needs, and is not intended to repace the advice of a quaified attorney, tax advisor, or investment professiona. Diversification does not guarantee a profit or protect against a risk. Commerce does not provide tax advice or ega advice to customers. Consut a tax speciaist regarding tax impications reated to any product and specific financia situations. commercetrustcompany.com Not FDIC Insured May Lose Vaue No Bank Guarantee CTC1214 PC1331A