Quarterly Market Update - Robert W. Baird

July 15, 2016 | Private Wealth Management

Market Update: Q2 2016 Review and Outlook

Global Markets Don’t Take a Summer Vacation Q2 Recap U.S. markets closed the quarter up 2.5% as measured by the S&P 500 benchmark. Stocks shrugged off weak earnings growth reports early in the quarter as well as the shock of the Brexit vote to push towards new all-time highs. The rally has been broad based, but still led by higher dividend sectors as investors reach for income in this low rate environment. International markets were roiled by the surprise UK vote to exit the EU. The MSCI EAFE index ended the quarter down 1.5%. It remains to be seen how the departure will progress which leaves uncertainty and concerns about the economic progress in the UK and greater Europe. Emerging markets, particularly Latin America, fared better as a result of continued improvement in commodity prices. China also eked out a small gain as investors seem to somewhat accept a slower growth trajectory. Bonds markets rallied once again with the Barclays U.S. Aggregate Bond Index returning 2.2% in the quarter. After a disappointing mid-quarter U.S. jobs report and renewed concerns about global economies, the Fed maintained interests rates at current levels. This coupled with the prospect of negative rates in several large international markets pushed U.S. Treasury yields to all time lows. The 10-year Treasury hit 1.36% before pushing back up to 1.49% to finish the quarter. Current Fed Funds futures markets predict little probability of additional Fed rate hikes this year. Don’t anticipate Q3 to be dull either. Earnings reports from Q2 are kicking off in fast fashion with very early signs that growth may prove somewhat better than the start of the year. And as we head into the quarter we expect the rhetoric around the U.S. Presidential election to increase particularly leading up and into the party conventions both scheduled for late July. There are sure to be plenty of sound bites to digest.

The Markets at a Glance Asset Class

Representative Benchmark

Q2 Return

YTD Return

U.S. Large Cap U.S. Small Cap

S&P 500

2.5%

3.8%

Russell 2000®

3.8%

2.2%

International

MSCI EAFE

-1.5%

-4.4%

Commodities

Bloomberg Commodity

12.8%

13.3%

Municipal Bonds Barclays Municipal

2.6%

4.3%

Taxable Bonds

Barclays Aggregate

2.2%

5.3%

Cash

Citi 3-mo T-Bills

0.1%

0.1%

Performance returns are as of 6/30/16.

in this issue 2

3

4

5

Brexit: Breaking Up Is Never Easy UK Vote Roils Financial Markets Life After Brexit Global Economic Impact of Brexit U.S. Equity Climbing a Wall of Worry Investors Flock to Yield Sectors Yield Stocks Rich Relative to History Oil's Rebound Helps Steady Markets International Equity International Struggles After Brexit Brexit Weighs on European Stocks Emerging Markets Eke Small Gain China Concerns Linger Fixed Income Yields Fall as Fed Punts on Rate Rise -

Laura Thurow, CFA Director, PWM Research, Products & Services [email protected] 414.298.1820

Kathy Carey, CFA Director of Asset Manager Research [email protected] 414.298.2313

Bond Returns Strong Across the Board Municipal Rally Continues

Blake Karls, CFA Portfolio Analyst [email protected] 414.298.7653 Robert W. Baird & Co. | 1

Brexit: Breaking Up Is Never Easy Figure 1

Britain Votes to Leave the EU

51.9% Leave

48.1% Remain

UK Vote Roils Financial Markets

Life After Brexit

After years of infighting, an anti-EU movement gained strength among UK citizens based on a idea that EU’s regulatory regime and required contributions were stifling economic potential and its open immigration policies were causing the employment market to sink under the weight of its new citizens. On June 23rd British voters had the opportunity to make unprecedented change through a yes or no vote: Should the UK stay in the European Union?

Uncertainty will be the resounding theme that will dominate markets and politics going forward in a process that could take years to shakeout. A new government will be tasked with negotiating the terms of the UK’s exit, and also in negotiating new trade agreements with both the EU and the UK’s other partners around the world. Because the EU wants to limit the threat of more countries leaving the union, it is expected the EU will take a hard negotiating stance that will lead to a messy and tumultuous exit process. The leap into the unknown is likely to weigh on the UK economy in the short term as business spending is likely to freeze until more is known about the country’s future trading partners. As a result, it is expected the Bank of England will act to cut the official interest rates to offset the negative impact of Brexit.

After a very close vote, 51.9% of UK citizens elected to leave the European Union. The outcome of the vote took most market participants by surprise and the shock of the result sent volatility surging through global markets and currencies, leading to heavy selling across all asset classes. The most extreme occurred with the British pound falling to multi-decade lows against the dollar and the Euro declining more than 3%. Markets were further shaken after the surprise announcement that UK Prime Minister David Cameron would resign by October and allow a pro-leave successor to steer the UK’s exit from the EU. After stocks gave up ground in the days following the vote, markets recovered a bit with a strong rally into month-end. Figure 2

UK Contribution to EU Budget (£ Millions) £20,000

Global Economic Impact of Brexit The longer the period of uncertainty exists, the greater the chance that the leave vote will put a dent on global growth. The IMF has already cut this year’s growth forecasts for the UK economy to 1.9% from 2.2%. The UK is the second largest economy in the EU and comprises approximately onesixth of the EU economy. Any prolonged destabilization could have heightened effects on Europe’s fragile economic recovery. For the U.S., the ripple effects of Brexit should be less pronounced as economists forecast little change to U.S. GDP. The biggest impact would likely be the effect on monetary policy in the U.S. The Fed has mentioned they’re actively gauging the impact of Brexit on global financial markets and this will no doubt play into plans for future policy moves.

£15,000 £10,000 £5,000 £0 -£5,000 -£10,000 1990

1995

Gross Contribution

2000 Rebate

2005 Public Sector Receipts

2010

2015 Net Contribution

Source: HM Treasury European Finances 2015, Baird Analysis

Robert W. Baird & Co. | 2

U.S. Equity Climbing a Wall of Worry

Yield Stocks Rich Relative to History

U.S. equities capped the relatively quiet quarter with a wave of volatility in the wake of the UK’s surprise decision to exit the European Union. Despite increased uncertainty, markets were able to climb a wall of worry to hold onto the quarter’s gains and finished near alltime highs. The S&P 500 notched a 2.5% gain for the quarter to finish up 3.8% so far in 2016. Helping boost sentiment was a further recovery in commodities, gains in employment and wages, mild inflation and continued accommodation from the Federal Reserve.

The push into equities whose outlook are less tied to the broader business cycle has led to heightened valuations in areas that are normally considered safe-haven sectors. Valuations for low volatility, high dividend stocks, such as Utilities, Consumer Staples, and Telecom have reached extraordinary levels, despite less than stellar growth outlooks. Utilities, in particular, now trade at a premium relative to the broader market and possess valuations that are approaching all-time highs. If history is any guide, investors should temper expectations for future returns. Since 1990, Utilities at current valuation levels have historically generated negative future returns (Figure 3).

Investors Flock to Yield Sectors

Despite increased volatility, sector returns were largely positive through the Oil’s Rebound Helps Steady Markets first six months of the year. Aided by more than an 80% rally in crude from After an unprecedented two-year rout, February’s lows, Energy shares led all energy prices recovered to more sectors on the upside both during the normalized levels during the quarter quarter (+11.6%) and so far YTD after global production levels steadied (16.1%). Defensive sectors with high and the strong U.S. dollar took a dividend yields have continued to breather. Still, at $48 a barrel, crude oil benefit from a decline in government is far from its 2014 highs of $107 and is bond yields, leading investors to look for still not high enough to push some steady, bond-like equity opportunities. companies into the black. While such a Utilities and Telecom were among the sharp rise has dismayed investors in the best performing sectors in Q2 with gains past, the price increase was seen as a of 7.1% and 6.8%, respectively. The positive, both for the sector and the gains also mean both sectors have economy. returned more than 20% YTD. Figure 4 Among laggards for the quarter were Technology (-2.8%) and Consumer Discretionary (-0.9%) sectors. These sectors are typically considered economically sensitive and can be vulnerable to an uncertain economic environment. From a style and market cap perspective, small-cap stocks generally outperformed large- and mid-cap stocks during the quarter while value stocks continued their outperformance over their growth counterparts. However, on a YTD basis, mid-caps have been the clear winner given the larger concentration of dividend sectors like Utilities and REITs.

U.S. Equity Market Benchmarks Asset Class


Large Cap

S&P 500

2.5%

3.8%

Mid Cap

Russell Midcap®

3.2%

5.5%

Small Cap

Russell 2000®

3.8%

2.2%

Value Stocks

Russell 3000 Value

4.6%

6.3%

0.8%

1.1%

Q2 Return

Growth Stocks Russell 3000 Growth

YTD Return

Figure 3

S&P 500 Utilities Sector Annualized Forward Returns by P/E* 12%

1 Year 3 Year 5 Year

8%

4%

0%

-4%

-8%

-12% 17x

Source: Bloomberg, Baird Analysis; * P/E and forward returns since 1/1/90.

Range of YTD Returns for First Half of 2016 Telecom. Utilities Energy Cons. Staples Materials Industrials Cons. Disc. Health Care Technology Financials -20%

-15%

-10% Low

-5%

0%

5%

10%

15%

20%

25%

30%

High

Source: Morningstar Direct, Baird Analysis;


International Equity

International Market Benchmarks Asset Class


Developed

MSCI EAFE

-1.5%

-4.4%

Europe

MSCI Europe

-2.7%

-5.1%

Japan

MSCI Japan

1.0%

-5.6%

Asia

MSCI Pacific ex Jap.

0.7%

2.5%

MSCI Emerging Mkts

0.7%

6.4%

Emerging

YTD Q2 Return Return

Figure 5

QTD Returns for Select Countries Switzerland

2.5

Japan

International Struggles After Brexit

Emerging Markets Eke Small Gain

Developed international stocks were unable to overcome the headwinds in the aftermath of the Brexit, leading to small declines for the quarter. The MSCI EAFE posted a small decline of 1.5% for a YTD loss of 4.4% after being dragged down by slumping European countries. International sector returns were largely mixed, having been led by a sharp gain in Energy and followed at a distance by Health Care and Consumer Staples. Economically sensitive sectors like Consumer Discretionary and Financial stocks faced steep declines.

Emerging markets edged higher in the second quarter as expectations for a more dovish monetary policy in the U.S and around the globe spurred demand for risky assets. The MSCI Emerging Markets Index continued its ascent from Q1 with a 0.7% gain in the quarter, to finish the first six months of the year up 6.4%. Despite being weighed down by slumping stocks in emerging Europe, Latin American economies help offset the weakness having benefitted from a strong rebound in commodity prices.

From a style and market cap perspective, Growth outpaced Value while large-caps, in general, outperformed small- and mid-cap peers.

1.0

Brexit Weighs on European Stocks Australia

0.5

U.K.

European equities fell sharply following the June referendum as questions of EU stability and long-term ramifications sent investors running for the exits. Selling was particularly acute for Financials which experienced double-digit declines amid worries of a broad recession in Europe and the potential loss of the U.K. as a key financial center. Overall the final scorecard showed the MSCI Europe down 2.7% for the quarter and down 5.1% for the year.

-0.7

MSCI EAFE

-1.5

France

-3.5

Sweden

-4.6

Netherlands

-4.8

Germany

-5.0

Spain

-7.4

Italy

Japanese Stocks Rise

-9.7 -15

Source: Morningstar Direct

-10

-5 Return (%)

0

5

A strong yen and better-than-expected economic data helped push Japanese equities up more than 1% for the quarter. Economic data showed the Japanese economy not only avoiding a recession but growing at 1.9%; its largest increase in a year. The BOJ decided to hold off on additional easing in June which pushed an already strong yen to new highs. The yen’s sharp appreciation has caused downward pressure on inflation and has been a headwind to Japanese exporters.

From a country standpoint, a 13.9% return in Brazil led all emerging markets on the upside. While Brazil continues to face desperate economic conditions, the suspension of President Dilma Rousseff led to a regime change that promises to bring about a series of policy changes that were well received by the market. Brazilian returns were helped by a 11.8% rally in the real. Not surprisingly, emerging European markets were among the weakest performers over the quarter as the Brexit vote shook investor confidence in the region. China Concerns Linger Chinese equities finished marginally higher during the quarter stabilizing from the dramatic losses from earlier in the year. But slowing economic growth and policy uncertainty continues to weigh on sentiment in the region. Concerns over the waning effect of government stimulus actions and Brexit-related anxiety resulted in the yuan sinking to the lowest levels versus the dollar in five years. At the same time, data suggests the Chinese economy is continuing its shift into a lower gear.


Fixed Income Concerns of a slowing global economy capped with the uncertainty surrounding the future of a UK-less Europe, meant the appetite for safe-haven assets continued at an unprecedented clip during the quarter. Around the globe, the yields on safe government debt fell to record lows after the Brexit votes were tallied. The flight to safety trade sent 10-Year government yields in Japan, Germany, France, Sweden, Denmark and Switzerland to levels not seen before. In the US, interest rates moved to levels not seen since July 2012 when the 10-year Treasury fell to 1.49%, compared with 2.27% at the start of the year. The move lower for interest rates was helped by yet another quarter where the Federal Reserve decided to not hike interest rates. Despite having telegraphed a June move for months, the data-dependent Fed cited concerns of a weakening U.S. economy after labor-market data showed new job creation in May at the lowest levels since 2010. With the Fed on hold, Fed Fund Futures – an instrument that prices investors expectations for future interest rates – are pricing in less than a 10% chance of at least one rate hike before year-end (Figure 6). That is down from more than 40% in early June and well below the Fed’s target of four quarter-point rate hikes in 2016. Bond Returns Strong Across Board Despite yields near zero, fixed income returns continue to exceed expectations by providing both a decent yield and meaningful price appreciation. The Barclays Aggregate Bond Index posted a quarterly return of 2.2%, for a YTD return of 5.3%. The clear winner among investment grade sectors was corporate credit - which has benefitted from strong investor demand against a backdrop of steady, though, subdued economic growth – with returns of 3.6% to finished up 7.7% YTD.

More impressive, though, has been the rally experienced by riskier areas of the bond market, including high yield and emerging markets. Since starting the year falling more than 5% on the back of cratering commodity prices, junk bonds have recovered all losses and are up more than 9.3% YTD (Figure 7). Even emerging market debt, which was the worst performing area in 2015, has posted double-digit returns YTD. The other clear winner was longmaturity securities. With yields coming down across the maturity spectrum, it meant those securities with the most interest rate risk fared the best. Indeed, returns for the Treasuries with maturities of 10-years and more are up more than 14% YTD. Municipal Rally Continues Municipal bonds recorded solid gains during the quarter including the best June return in more than 15 years. Bond yields across the municipal yield curve declined due to strong demand for tax-exempt income amid an environment of subdued new supply. Similar to the taxable market, lower quality credit notably outperformed high quality as investors reached for yield in the current low rate environment. In all, the Barclays Municipal Index advanced 2.6% during the quarter for a 4.3% return YTD.

Fixed Income Benchmarks Asset Class


Taxable

Barclays Aggregate

2.2%

5.3%

Treasury

Barclays Treasury

2.1%

5.4%

Corporate

Barclays Corporate

3.6%

7.7%

High Yield

BofA/ML HY Master II

5.9%

9.3%

Barclays Municipal

2.6%

4.3%

2.9%

8.9%

Municipal

International Barclays Global Agg.

Q2 YTD Return Return

Figure 6

Probability of Further Rate Hikes in 2016 80%

70%

% Chance of Rate Hike in 2016

Yields Fall as Fed Punts on Rate Hike

60%

50%

40%

30%

20%

10%

0% Jan-16 Feb-16 Mar-16 Apr-16 May-16 Jun-16 Source: Bloomberg, Fed Fund Futures, Baird Analysis

Figure 7

Junk Bond Rally: Total Returns for US High Yield Bonds by Year 16% 12% 8%

2016 2015 2014 2013 2012

4% 0% -4% -8% January

April

July

October

Source: Bloomberg, Baird Analysis


Appendix:Definitions Definitionsand andDisclosures Disclosures Appendix: Benchmark and Asset Classes Definitions S&P 500 Index (Large Cap / U.S. Stocks): A representative sample of 500 leading companies in leading industries of the U.S. economy. These are equity securities of large capitalization (generally $7 billion plus market cap) companies having growth and value characteristics. Russell 3000® Growth Index (All Cap Growth / Growth Stocks): Measures the performance of the 3,000 largest U.S. companies based on total market capitalization with higher price-to-book ratios and higher forecasted growth values. Russell 3000® Value Index (All Cap Value / Value Stocks): Measures the performance of the 3,000 largest U.S. companies based on total market capitalization with lower price-to-book ratios and lower forecasted growth values. Russell 1000® Growth Index (Large Growth): Measures the performance of those Russell 1000® Index companies with higher price-to-book ratios and higher forecasted growth values. These are equity securities of large capitalization ($7 billion plus market cap) companies having growth stock characteristics (high price to earnings, high return on equity and low dividend yield. Russell 1000® Value Index (Large Value): Measures the performance of those Russell 1000® Index companies with lower price-to-book ratios and lower forecasted growth values. These are equity securities of large capitalization ($7 billion plus market cap) companies having value stock characteristics (low forecasted price-to-earnings ratio, low price-to-book ratio, high dividend yield). Russell Midcap® Index (Mid Cap / Mid Core): Measures the performance of the 800 smallest companies of the Russell 1000® Index, which represent approximately 31% of the total market capitalization of the Russell 1000® Index. These are equity securities of middle capitalization ($2-7 billion plus market cap) companies having growth and value characteristics. Russell 2000® Index (Small Cap / Small Core): Measures the performance of the 2,000 smallest companies in the Russell 3000® Index, which represent approximately 10% of the total market capitalization of the Russell 3000® Index. These are equity securities of small capitalization (