Beyond Liftoff: The Outlook for the U.S. Economy and Rates

Beyond Liftoff: The Outlook for the U.S. Economy and Rates June 21 st, 2016 Jim DeMasi, CFA Managing Director and Chief Fixed Income Strategist This research report is intended for institutional investors only. Refer to the last page of this report for Stifel Fixed Income Capital Markets disclosures and analyst certifications. Stifel, Nicolaus & Company, Incorporated Member NYSE / SIPC. 0

Macro Outlook Summary: 2016-2019 Economy: Our base-case scenario envisions another three years of sluggish GDP growth near the recovery s 2.0% average. Recession odds gradually increase from 20% today to 50% in 2019. Fed Policy: We expect the Fed to tighten monetary policy much less aggressively than its forward guidance suggests. Our forecast calls for one 25 basis point rate hike this year and two similar rate increases per year in 2017-2019. Treasury Yields: The 10-year Treasury yield has generally fluctuated between 1.6% and 3.0% over the past 3.5 years. This trading range should remain intact through the forecast horizon, with yields gradually moving toward the upper end of the range. Bond Market Performance: Given current market levels, the short and intermediate-maturity yield curve segments offer more attractive relative value than the long-end. Duration should be set at 90% of the benchmark s value or policy target. Municipal bond issuance levels should remain favorable. 1

U. S. Economic Trends: GDP Growth and Employment Total GDP and non-farm payrolls have shown slow but steady progress since the end of the Great Recession in June 2009. During the current expansion, GDP growth has averaged 2.1%, well below the U. S. long-term growth rate of 3.5%. Likewise, the employment to population ratio has struggled to return to pre-recession levels. Structural hurdles, including slower productivity growth, an aging work force, and a mismatch between workers skills and job requirements, are suppressing the cyclical benefits of low interest rates. (YoY% ) 6.0 5.0 4.0 3.0 2.0 1.0 0.0 1.0 2.0 3.0 4.0 5.0 (%) 82 81 80 79 78 77 76 75 74 Real GDP vs. GDP YoY Growth Mar 90 Jul 91 Nov 92 Mar 94 Jul 95 Nov 96 Mar 98 Jul 99 Nov 00 Mar 02 Jul 03 Nov 04 Mar 06 Jul 07 Nov 08 Mar 10 Jul 11 Nov 12 Mar 14 Jul 15 GDP YoY (L Axis) Real GDP (R Axis) Labor Market Conditions Jan 90 May 91 Sep 92 Jan 94 May 95 Sep 96 Jan 98 May 99 Sep 00 Jan 02 May 03 Sep 04 Jan 06 May 07 Sep 08 Jan 10 May 11 Sep 12 Jan 14 May 15 Employment to Population (25 54 y/o) [L Axis] Total NFP (R Axis) *Source: Bloomberg L.P. as of 6/10/16 ($B) 17,000 16,000 15,000 14,000 13,000 12,000 11,000 10,000 9,000 8,000 (000s) 150,000 145,000 140,000 135,000 130,000 125,000 120,000 115,000 110,000 105,000 100,000 2

U. S. Economic Forecast U. S. Economic Projections GDP Core PCE Price Index Unemployment Rate 2016 2017 2016 2017 2016 2017 Stifel's Economics Group Forecast 1.9% 1.7% 1.2% 1.3% 4.8% 4.6% Bloomberg Economists' Survey 1.9% 2.3% 1.7% 1.8% 4.8% 4.6% Fed Forecast Central Tendency Mid Point 2.2% 2.1% 1.6% 1.8% 4.7% 4.6% Positive Forces: Solid household consumption Housing market recovery Stabilization in business investment and exports Rebound in government investment Source: Bloomberg, Stifel.Updated as of 6/13/2016 Persistent Challenges: Strong U. S. Dollar Slower growth abroad, particularly in China and the emerging markets Negative consequences of low commodity prices on energy industry Geopolitical risks 3

Six Key Reasons for the Fed to Proceed Cautiously in Normalizing Monetary Policy #1: There is more excess capacity in the labor market than implied by a 4.7% UR. #2: Realized inflation and inflation expectations remain below the 2% target. #3: The economy is still not firing on all cylinders. #4: Another surge in the value of the U. S. Dollar would be counterproductive. #5: Favorable financial conditions must be maintained to exit successfully. #6: Rate hikes should be calibrated with global growth to prevent curve flattening. 4

Reason #1: Persistent Labor Market Slack Labor Market Dashboard '03-'07 Most Recent Difference from Pre-Crisis Avg. Average Monthly Nonfarm Payrolls** 131k 170k + 29.64% Average Monthly Job Openings (Millions) 3.96 5.79 + 46.16% Unemployment Rate 5.2% 4.7% - 0.5 percentage points Annual Worker Wage Growth 2.9% 2.5% - 0.4 percentage points U6 Unemployment Rate 9.0% 9.7% + 0.7 percentage points Employment to Population Ratio (25-54 y/o) 78.6% 77.8% - 0.8 percentage points People Quitting Jobs, Monthly Avg. (Millions) 2.75 2.75-0.1% Long-Term Unemployed (Millions) 1.54 1.89 + 22.99% Part-Time Seeking Full-Time Jobs (Millions) 4.44 6.43 + 44.82% *Source: Federal Reserve Board; Bureau of Labor Statistics; Bloomberg L.P. as of 6/13/2016 **The Most Recent data point is a calculated figure based on the average of the prior six months. 5

Reason #2: Inflation Remains Below Target (%) 3.00 2.80 2.60 2.40 2.20 2.00 1.80 1.60 1.40 1.20 Jan 12 Mar 12 Jun 12 Source: Bloomberg L.P. as of 6/10/16 5yr / 5yr Forward Inflation Breakeven vs. CORE PCE Price Index Sep 12 Dec 12 Mar 13 Jun 13 Sep 13 Longer-term measures of market-based inflation expectations remain well below the Fed s 2.0% price stability target. The 5-year/5-year forward break-even inflation rate derived from TIPS has held under 2% since last July. The Core PCE Price Index has remained consistently below 2.0% since April 2012. Dec 13 The price stability side of the dual mandate must also be defended from downside risks to prevent deflation. Mar 14 5 yr Fwd Breakeven Infl CORE PCE Price Idx Fed Target Jun 14 Sep 14 Dec 14 Mar 15 Jun 15 Sep 15 Dec 15 Mar 16 Jun 16 6

Reason #3: Uneven Performance Across Sectors Consumer Spending Business Investment (BBs) 13,000 (BBs) (MMs) 1,900 450,000 12,500 12,000 11,500 11,000 10,500 10,000 Residential Construction International Trade 7 Jan 10 May 10 Sep 10 Jan 11 May 11 Sep 11 Jan 12 May 12 Sep 12 Jan 13 May 13 Sep 13 Jan 14 May 14 Sep 14 Jan 15 May 15 Sep 15 Jan 16 Personal Spending 1,800 1,700 1,600 1,500 1,400 1,300 430,000 410,000 390,000 370,000 350,000 330,000 310,000 Jan 10 Jun 10 Nov 10 Apr 11 Sep 11 Feb 12 Jul 12 Dec 12 May 13 Oct 13 Mar 14 Aug 14 Jan 15 Jun 15 Nov 15 Apr 16 Inventories [L Axis] Manufacturers Orders Ex Transport [R Axis] (000s) 1,400 1,300 1,200 1,100 1,000 900 800 700 600 500 Jan 10 May 10 Sep 10 Jan 11 May 11 Sep 11 Jan 12 May 12 Sep 12 Jan 13 May 13 Sep 13 Jan 14 May 14 Sep 14 Jan 15 May 15 Sep 15 Jan 16 Housing Starts Building Permits (MMs) 150,000 140,000 130,000 120,000 110,000 100,000 90,000 Jan 10 May 10 Sep 10 Jan 11 May 11 Sep 11 Jan 12 May 12 Sep 12 Jan 13 May 13 Sep 13 Jan 14 May 14 Sep 14 Jan 15 May 15 Sep 15 Jan 16 Exports *Source: Bureau of Economic Analysis, U.S. Census Bureau, Bloomberg L.P. as of 6/10/16

Reason #4: Monetary policy has already tightened considerably via a stronger USD 1,000 Dollar Index vs. U.S. Exports ($) (MMs) 150,000 1,050 140,000 1,100 130,000 1,150 1,200 120,000 1,250 110,000 1,300 100,000 Jun 14 Sep 14 Dec 14 Mar 15 Jul 15 Oct 15 Jan 16 May 16 Source: Bloomberg L.P. as of 6/10/16 BBDXY Dollar Index (L Axis) ** BBDXY Dollar Index shown on an inverted scale Exports The Bloomberg Dollar Index (BBDXY) has increased by 20% over the past two years. This surge in the value of the greenback has lowered import and commodity prices, reduced inflation expectations, and restrained exports. An overly hawkish Fed could reignite the rally in the U. S. Dollar, which would be counterproductive to achieving the Fed s dual mandate. 8

Reason #5: Favorable Financial Conditions are Essential for a Successful Exit Strategy 1.20 1.00 Bloomberg Financial Conditions Index December:Liftoff 0.80 0.60 0.40 0.20 0.00 0.20 Jul 15 Aug 15 Sep 15 Oct 15 Nov 15 Dec 15 Jan 16 Feb 16 Mar 16 Apr 16 May 16 Jun 16 Source: Bloomberg L.P. as of 6/10/16 Bloomberg Financial Conditions Index Plus Following the December 2015 rate hike, financial conditions deteriorated significantly over the next several weeks, as credit spreads widened, equity prices dropped, and market volatility soared. There is a positive correlation between financial conditions and real economic activity. While financial conditions have tentatively improved since mid-february, the Fed needs to adopt less hawkish forward guidance in conjunction with the next rate move to avoid a protracted and potentially severe market dislocation. 9

Reason #6: Need to Maintain a Positively Sloped Yield Curve US 10-Year vs. German 10-Year Treasury Yield Comparison 1.50 1.25 1.00 0.75 0.50 0.25 0.00 Jul 14 Sep 14 Nov 14 Jan 15 Mar 15 May 15 Jul 15 Sep 15 Nov 15 Jan 16 Mar 16 May 16 2.70 2.50 2.30 2.10 1.90 1.70 1.50 12/31/2015 6/10/2016 YTD 3 Month 0.17% 0.25% +8 bps 1 Year 0.60% 0.54% 6 bps 2 Year 1.05% 0.73% 32 bps 5 Year 1.76% 1.17% 59 bps 7 Year 2.09% 1.44% 65 bps 10 Year 2.27% 1.64% 63 bps 30 Year 3.02% 2.45% 56 bps Source: Bloomberg L.P. as of 6/10/16 German 10 year (Left Axis) US 10 Year (Right Axis) Contrary to conventional wisdom, Treasury rates have declined significantly at most points along the yield curve so far this year. Global macro forces are driving long-term sovereign bond yields in the U. S. and Europe, with the U. S. 10-year yield closely tracking the German 10-year yield. The spillover from the negative interest rate and QE policies of other major central banks is suppressing long-term interest rates across the globe. A flatter curve would reduce the incentive for banks to increase lending activity and send a negative signal regarding the U. S. economic outlook. 10

Stifel s Interest Rate Projections The Fed s March 2016 forward guidance (green line) implies 275 bps of rate increases through 2019. The bond market (blue line) expects the Fed to move much less aggressively, with futures pricing in only one rate hike per year, on average. Our forecast (red line) lies between these two extremes but closer to market expectations. We anticipate one rate hike this year (September FOMC meeting) followed by two increases annually in 2017, 2018, and 2019. Amid low international sovereign bond yields and sustained global easing, Treasury rates should remain range-bound and finish 2016 little changed on a year-over-year basis. Due to the unstable geopolitical environment, the risks to our interest rate forecasts are skewed to the downside. 3.50 3.00 2.50 2.00 1.50 1.00 0.50 0.00 Jun 16 Sep 16 Dec 16 Mar 17 Fed Funds Futures Jun 17 Sep 17 Fed Dot Plot Median (Mar. '16) Fed Funds Projections (%) Dec 17 Mar 18 Jun 18 Treasury Yield Curve Projections Sep 18 Dec 18 Mar 19 Stifel Fed Funds Projections Source: Bloomberg L.P. as of 6/10/16 2Q16 3Q16 4Q16 1Q17 2Q17 Fed Funds - Upper Bound 0.50% 0.75% 0.75% 0.75% 1.00% 2-year 0.80% 0.90% 1.00% 1.10% 1.25% 5-year 1.35% 1.50% 1.65% 1.75% 1.80% 10-year 1.90% 2.05% 2.20% 2.35% 2.40% 30-year 2.75% 2.90% 3.00% 3.15% 3.20% 2s to 10s +110 bps +115 bps +120 bps +125 bps +115 bps * Updated April 4, 2016 Source: Jim DeMasi, Chief Fixed Income Strategist. All projections are as of the end of the respective quarters. Fed funds represents the upper bound of the FOMC's target range. 11

Bond Market Performance Table Description 2015 Annual Returns 2016 YTD Returns Total (%) Excess (%) Total (%) Excess (%) US Broad Market Index 0.60 0.39 4.56 0.28 US Treasury 0.83 0.03 4.56 0.05 US Agency 1.01 0.04 2.94 0.19 Foreign Govt/Supra 0.18 0.77 4.32 0.56 Taxable Munis 0.00 0.48 10.18 1.68 Corporates 0.63 1.56 6.65 1.53 Financials 1.70 0.68 4.08 0.03 Industrials 1.63 2.54 7.66 2.22 Utilities 1.06 1.68 7.95 1.37 Mortgages 1.46 0.14 2.65 0.57 ABS 1.17 0.56 1.73 0.32 CMBS 1.13 0.14 4.32 0.96 Covered Bonds 0.94 0.10 2.59 0.55 High Yield Index 4.64 5.92 9.13 5.73 Municipal Bond Index 3.55 2.69 3.56 0.09 Source: Bank of America Merrill Lynch as of 6/10/16 Bond market total return performance has improved notably across sectors in 2016 compared to last year. Most sectors have also generated positive year-to-date excess returns. Credit spreads now appear to be fully valued in most sectors. At current levels, the short-end of the yield curve holds the most attractive relative value opportunities. Municipal bonds should out-perform over the coming months due to a combination of favorable fundamental and technical forces. 12

Municipal Market Overview Municipal yield curve largely mirrors trends in Treasury rates Municipal yields moved lower across nearly all maturities in sync with the flight to quality Weaker municipal to treasury ratios as the 5-year, 10-year, and 30-year ratios are currently 84%, 93%, and 92%, the 5-year and 30-year ratios currently below their ten year averages Positive Fund Flows into Municipal Asset Class 35 th consecutive week of inflows totaling $39.2 billion (October 2015 present) $28.4 billion net inflows since the start of the year AAA MMD 1 Index Recent Range Municipal Mutual Fund Flows 4.0% 3.0% One Year Ago 6/10/2015 ($ in Billions) 4 2 0 $65 billion in outflows ( May 2013 - Jan. 2014) 2.0% 1.0% Current 6/9/2016-2 -4-6 -8 $60 billion in inflows (Oct. 2011 - Dec. 2012 ) $26 billion in inflows (Jan. 2014 - Dec. 2014 ) $28.4 billion in net inflows (Jan. 2016 - Present) 0.0% 1 4 7 10 13 16 19 22 25 28-10 May-12 Jul-12 Sep-12 Nov-12 Jan-13 Mar-13 May-13 Jul-13 Sep-13 Nov-13 Jan-14 Mar-14 May-14 Jul-14 Sep-14 Nov-14 Jan-15 Mar-15 May-15 Jul-15 Sep-15 Nov-15 Jan-16 Mar-16 May-16 1 MMD (Municipal Market Data) is an index of AAA rated general obligation bonds. Sources: Investment Company Institute, Thomson Financial. As of 6/9/16 13

Municipal Market Supply 2016 volume has decreased by 3% year-over-year Volume dominated by refundings Overall market contraction expected for 2016 Refunded and maturing bonds to outpace issuance New issuances have seasonally increased Significant rebound in amount issued to amount maturing or called National net municipal issuance was $9.2 billion in April Municipal Market Annual Supply National Net Municipal Issuance ($ in Billions) 500 450 400 350 300 250 200 150 100 50 Annual Average Issuance (Past 8 years): $359 bn 2008 2009 2010 2011 2012 2013 2014 2015 2015 YTD 2016 Issuance (1/1-5/16): $184.9 bn (3% decline from 2015 same period) 2016 YTD Visible Supply Announced Calls Matured/Maturing $'s in Billions Issued Net Issuance $45 $35 $25 $15 $5 -$5 -$15 -$25 -$35 -$45 -$55 Jun'15 Aug'15 Oct'15 Dec'15 Feb'16 Apr'16 Jun'16 1 Long term issues only. Weekly averages of estimated 30-day visible supply. Sources: SDC, Bloomberg. As of 6/9/16 14

30-Year Muni/Treasury Ratio 30-Yr M/T Ratio Over Last Year 115% 220% 30-Yr M/T Ratio Since 2006 105% Average = 102% 95% 85% Jun-15 Aug-15 Oct-15 Dec-15 Feb-16 Apr-16 Jun-16 200% 180% Max = 210% Min = 83% Current = 92% 160% 140% 120% 100% Average = 102% 80% 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Source: Thomson Financial and Federal Reserve. As of 6/9/16 15

Municipal Credit Spreads Near Averages Municipal Credit Historical Spreads (1995 Present) 360 310 260 150 130 110 2014 Present Baa GO 10 yr Aaa GO 10 yr 210 90 70 160 Jan 14 Apr 14 Jul 14 Oct 14 Jan 15 Apr 15 Jul 15 Oct 15 Jan 16 Apr 16 110 60 10 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 A GO 10 yr Aaa GO 10 yr A GO 10 yr Aaa GO 10 yr (AVG) 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Baa GO 10 yr Aaa GO 10 yr Baa GO 10 yr Aaa GO 10 yr (AVG) 85 80 75 70 65 60 55 50 45 Jan 14 Apr 14 Jul 14 2014 Present A GO 10 yr Aaa GO 10 yr Oct 14 Jan 15 Apr 15 Jul 15 Oct 15 Jan 16 Apr 16 A Aaa GO Spread Baa Aaa GO Spread Current as of 6/10/16: 49 Current as of 6/10/16: 74 Average 2010 2016: 74 Average 2010 2016: 150 Average 1995 2016: 48 Average 1995 2016: 108 **Average 1995 2016: 44 **Average 1995 2016: 99 ** Excluding period 11/25/2008 12/9/2009 Source: Stifel, MMD; as of 6/10/16 16

Disclosures Disclosures and Disclaimers For distribution to institutional clients only This material is prepared by the Fixed Income Strategy Department of Stifel Nicolaus & Co ( Stifel ). This material is for informational purposes only and is not an offer or solicitation to purchase or sell any security or instrument or to participate in any trading strategy discussed herein. The information contained is taken from sources believed to be reliable, but is not guaranteed by Stifel as to accuracy or completeness. The opinions expressed are those of the Fixed Income Strategy Department and may differ from those of the Fixed Income Research Department or other departments that produce similar material and are current as of the date of this publication and are subject to change without notice. Past performance is not necessarily a guide to future performance. Stifel does not provide accounting; tax or legal advice and clients are advised to consult with their accounting, tax or legal advisors prior to making any investment decision. Additional Information Available Upon Request. Stifel Nicolaus & Co is a broker-dealer registered with the United States Securities and Exchange Commission and is a member FINRA, NYSE & SIPC. 2016. 17