Capital Markets Review Fourth Quarter 2015

Fourth-quarter 2015 began with the S&P 500® still searching for direction after a volatile third quarter. After September jobs data came in much weaker than expected, the market began to take some comfort in the idea that the Federal Reserve (Fed) would delay the eventual increase in interest rates, and some of the concerns that initially sparked the third quarter sell-off (namely China) began to fade. As a result, stocks rebounded about 10% off their lows, settling back into the narrow trading channel we had seen for most of the year. October employment data far outpaced expectations, increasing the odds of a December rate hike. The 10-year Treasury yield initially jumped on the news from 2.00% to 2.25%; the dollar strengthened against most major currencies; and stocks began to slowly drift lower again, reflecting lingering Fed policy uncertainty. Further pressuring stocks heading into year-end 2015 was the well-publicized disruption in the high-yield bond market. Credit spreads widened significantly within the sector, and illiquidity fears were exacerbated with the collapse of a Third Avenue Management high-yield mutual fund. We believe continued caution in the asset class is warranted. Earnings reports throughout the quarter also did little to bolster equity prices beyond the initial bounce. Although earnings generally beat very weak expectations, corporate revenues continued to fall and company guidance for fourth-quarter 2015 performance was disappointing. Our view is that revenue growth will remain subpar, and compression of profit margins is likely to be an earnings headwind in early 2016. Throughout fourth-quarter 2015, the S&P 500 continued to be driven by a small percentage of the index’s largest constituents. For example, the 10 largest S&P 500 stocks were up about 17.0% in 2015; excluding those companies, the index would have been down 5.0%. 1 Perhaps most notably in our view, the Fed decided to increase the federal funds rate by 0.25% at its December meeting. The initial impact of this policy change was muted across most asset classes, with investors again shifting their focus to macro themes such as geopolitical tensions, oil prices, and the depreciation of China’s currency. Ultimately, we think the pace of interest rate hikes determines the true market impact, and we believe the likely path is slower than the Fed is currently forecasting and what the markets are pricing in. Internationally, a number of market-moving developments materialized throughout the fourth quarter. European and Japanese equities also searched for direction, and both central banks disappointed investors. The European Central Bank (ECB) fell short of market expectations when announcing additional stimulus at its December 2015 meeting. The ECB cut its key interest rate 10 basis points to -0.3% and extended its bond-buying program to March 2017 (from the original date of September 2016). The market hoped for a larger cut and an increase in the monthly purchase amount. Economic data in Europe remained stable, however, signaling a slow but improving economy. The Bank of Japan (BOJ) surprised markets at its December meeting by announcing supplemental monetary support in the form of an extension of the maturities of bond purchases and an additional ¥300 billion exchange-traded fund purchase program. However, the market’s initial enthusiasm fizzled. Data in Japan were also slightly better than expected: the latest GDP growth revisions showed the economy avoided a technical recession. In China, another wave of depreciation took the yuan to its weakest level since the People’s Bank of China (PBOC) let market forces play a bigger role in determining the currency’s value. During the last week of 2015, this depreciation began to disrupt global markets, as investors again focused on the fact that weakness in the yuan could further reduce Chinese demand, sending more deflationary shockwaves through the global economy. This fear has bled into 2016, serving as a primary catalyst for a meaningful selloff in global risk assets. Developments throughout fourth-quarter 2015 set the stage for a very uncertain start to 2016. The S&P 500 generated strong gains of 7.03% for the quarter; however, the last month of the quarter was much weaker than this figure suggests, declining 1.6%. Global equity markets exhibited similar total return profiles during the fourth quarter, with emerging and developed international markets returning 0.73% and 4.86%, respectively, for the quarter in dollar terms, but falling 2.17% and 1.3% during the final month. Bonds generally struggled, with higher rates eroding investors’ fixed income total returns (Table 1, page 2). .

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Source: Bloomberg, Strategas, PNC.

Table 1 Total Returns: Major Asset Classes As of December 31, 2015

*Annualized Source: Standard & Poor’s, Russell, MSCI, Barclays Capital, FTSE, Bloomberg L.P., PNC

Current Outlook and Strategy With the dollar already quite strong, U.S. growth is not, in our view, going to be strong enough to boost overall global growth. The days when the U.S. consumer could/would “float the global boat” are over, and the day when the Chinese consumer can/will float that boat has not yet arrived. Investment as a share of global GDP is waning, and governments are not in a position to spend aggressively. We believe the upshot is another year of tepid global growth.

Equities Our general outlook for U.S. equities paints an underwhelming picture compared with average historical returns. Returns will likely remain subdued in 2016, mainly due to continued earnings growth pressures and full valuations. We think equity risks are skewed to the downside, and the higher prices move, the more compressed the risk premium becomes. We believe investors should remain selective, focusing on strategies that tend to perform well in volatile markets. Beta exposure alone is no longer sufficient, in our view. Broad market returns that resemble the historical average of roughly 10% 2 may be difficult to achieve in 2016 absent multiple expansion. The median stock on the New York Stock Exchange at the end of November 2015 was trading at 25.6 times its latest 12-month earnings, the highest price-to earnings (P/E) ratio in history barring when earnings collapsed in the last two recessions. The average annual return when the median stock P/E is at current levels is almost zero. 3 The year 2016 will anniversary the plunge in oil prices and the sharp upward move in the dollar, likely easing year-over-year comparisons for the Energy sector and multinational corporations. However, analysts project that fourth-quarter 2015 will mark yet another period of revenue contraction, led by Energy. With sluggish revenue growth since the end of the 2008 financial crisis, earnings growth has largely depended on margin expansion, a waning tailwind in 2016. We believe additional pressure on margins could come in the form of rising wages, strengthening commodity prices, and/or higher interest rates. These potential headwinds, along with the fact that much of the low-hanging fruit on the expense side of the ledger has already been picked, lead us to believe that margins have likely peaked for the cycle. Also, we think revenue growth may define the winners and losers in 2016. Focusing on active managers with a selective, bottom-up approach emphasizing companies with strong businesses, pricing power, and revenue growth is likely to be critical. Index tracking investments may 2 Ten percent represents the long-term average total return from 1928 through 2014. Going forward, we expect average returns to be closer to 8-9% over very long horizons. 3 Ned Davis Research, “Price/Earnings and Price/Sales Higher than 2000 and 2007” (December 9, 2015).

expose investors to unwanted risks, failing to distinguish companies that stand a better-than-average chance of increasing revenue and consequently growing their earnings base in the face of potentially contracting profit margins. We continue to favor the Eurozone and Japan over the United States moving into 2016. This view hinges on three primary factors: relative valuation, monetary policy, and earnings growth/margin expansion capacity. Also, we remain skeptical of short-term rallies in emerging market assets and maintain our underweight allocation heading into 2016.

Fixed Income At the risk of sounding like a broken record, we believe global central bank divergence will remain an important theme throughout 2016. Unemployment and inflation reached levels that allowed the Fed to finally lift interest rates in December 2015. Conversely, we expect the ECB, BOJ, PBOC, and other central banks to continue stimulative policy actions. As a consequence, we believe interest rates will diverge even further, although we expect the increase in U.S. rates to be slow. The PNC Economics team expects three rate increases in 2016, starting in March. Our own view is that there may only be two hikes, likely starting in June. If rates do move three times, we think the increases will be back-end-loaded. Historical analysis indicates that the yield curve tends to flatten after the Fed begins to hike interest rates. In fact, this has been the pattern in each of the last nine tightening cycles. We believe this will occur in 2016 as well. Of course, the pace of interest rate hikes will have a significant impact on the magnitude of yield curve moves because the market is currently pricing in a much flatter trajectory than is implied by the Fed. Also, as other central banks try to keep their own rates low, we think the relative attractiveness of U.S. interest rates could support the longer end of the curve. However, we believe upside surprises in either inflation or inflation expectations and/or above-consensus U.S. GDP growth could steepen the curve. Our base case for 2016 is for incremental interest rate increases across the curve, with the short end rising more quickly. Although the initial 25-basis-point increase would have little impact in isolation, it was a landmark policy shift and potentially the beginning of a new phase of rate dynamics. The market has already brought forward expectations for future increases. However, there is still a significant disconnect between market expectations and the path that the Fed is signaling (roughly a 160-basis-point differential in the implied year-end 2018 federal funds rate). The risk is that the market’s rate expectations continue to be pulled forward, causing even more significant interest rate fluctuations and volatility. Credit instruments continue to show strains amid concerns that global growth is slowing and U.S. profit margins are declining just as the Fed is drawing the curtains on its easy-money policies. Particularly within high yield, we believe that meaningfully wider spreads may be required to make this market attractive once again, especially for highly taxed investors. Our view on municipal credit is that the overall market is sound, and the credit events in Chicago and Puerto Rico are idiosyncratic developments that will have little, if any, broader market implications. From a value perspective, municipal bonds are currently trading at attractive historical levels relative to taxable bonds (Treasuries).

Commodities Ultimately, sharper declines in U.S. shale output coupled with growing global demand should help the oil market begin to rebalance as we move into second-half 2016. However, OPEC is unlikely to reduce production, meaning global oil inventories may still modestly increase. This leads us to believe that the market will begin to stabilize, but we are likely to see low price levels for all of 2016. We believe West Texas Intermediate (WTI) and Brent crude will trade at much tighter spreads throughout 2016, with $45–50 per barrel being a reasonable base case equilibrium over the medium term. Risks to this target are skewed to the downside, in our view. Being focused on long-term trends, we maintain our positive long-term outlook for the midstream master limited partnership industry and see the current weakness as an attractive entry point for long-term investors to dollar cost average into positions.

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Real Estate We view the environment for real estate as largely supportive going into 2016 with property demand supported by steady GDP growth and continued capital flows into real estate assets. Sector bifurcation is possible as the Fed begins to hike rates and supply/demand imbalances evolve. The retail sector is facing headwinds from record level store closures (more than 5,000 through third-quarter 2015). However, apartment demand is being supported by job gains, and an increase in interest rates may even be a boon for the sector as higher residential mortgage rates affect homeownership affordability.

Asset Class Performance Recap 4 Stocks The U.S. market, as measured by the S&P 500, rose 7.03% in fourth-quarter 2015. Foreign developed markets, as measured by the MSCI World ex USA Index, underperformed the U.S. market in local currency terms, 5.73%, as well as in dollars, 3.97%. The dollar strengthened modestly in the fourth quarter, following its sharp rebound in the third quarter, as foreign currency performance was mixed. Emerging markets, as measured by the MSCI Emerging Markets Index, were up 1.56% in local currency terms but essentially flat in dollars, returning just 0.73%. Currency effects were broadly negative across Europe in fourth-quarter 2015, down 2-4%, with the only outlier being Sweden, down only 0.53%. On average, the dollar gained about 1% in the quarter versus emerging market currencies. The largest negative impact on returns was in South Africa, -10.80%, while the largest positive effect was in Indonesia, 7.14%. Based on respective S&P 500 indexes, for the fourth quarter U.S. large cap rose 7.04%; mid cap, 2.60%; and small cap, 3.72%. In terms of equity styles, growth again outperformed value across large, mid, and small cap categories. Within the S&P 500, Materials was the best performing sector, up 9.69% for the quarter. Health Care was the second best performer, up 9.22%, followed in descending order by Information Technology, 9.17%; Industrials, 8.0%; Consumer Staples, 7.64%; Telecommunication Services, 7.61%; Financials, 5.96%; and Consumer Discretionary, 5.79%. Utilities were up about 1%, while Energy was basically flat at 0.20% (Table 2).

Bonds The broad taxable U.S. investment-grade bond market, represented by the Barclays Capital Aggregate Bond Index, fell 0.57% on the quarter. Within the aggregate index, Treasuries fell 0.94%; commercial mortgage-backed securities declined 1.24%; mortgage-backed securities declined 0.10%; and investment-grade corporate bonds fell Table 2 Total Returns: S&P 500 Sectors As of December 31, 2015

*Annualized Source: Standard & Poor’s, Bloomberg L.P., PNC 4

Return data are sourced from Bloomberg where available. Local currency returns, for example, are sourced from FactSet Research Systems Inc.

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0.58%. Treasury Inflation-Protected Securities were down 0.64%. The high-yield bond market declined 2.07% and leveraged loans fell 2.25%. Investment-grade municipal bonds outperformed their taxable counterparts, returning 1.50%; high-yield municipal bonds also outperformed high-yield taxable bonds, returning 1.82%. Most developed country sovereign bond markets outperformed U.S. Treasuries in their own currencies but underperformed in dollar terms. South Africa was the biggest exception, declining 6.24% in local currency and down 16.33% in dollar terms, while returns in Sweden and the United Kingdom were marginally below Treasuries in local currency terms. The JPMorgan Global ex-U.S. Government Bond Index returned 0.48% in local currency terms and -1.30% in dollars.

Commodities Commodities in general, as measured by the S&P GSCI® index, fell 16.63% in the quarter. Specific commodity returns varied widely but were all negative for fourth-quarter 2015, with the exception of the “softs” component of the index, which includes coffee, sugar, cocoa, and cotton, and actually returned a rather robust 9.17%. Energy was again the weakest by far, -24.90%, followed by nonprecious metals, -17.12%.

Specialty Classes Real estate exposure, as proxied by the FTSE NAREIT® All Equity REITs Index, returned 7.68%. The Alerian MLP Index fell 2.76%. In hedge funds, the HFRX Equity Hedge was the best performing category, returning 0.82%, while the HFRX Relative Value Arbitrage was the worst, -2.30%.

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Appendix This section provides additional valuation and return data covering equities, fixed income, currencies, and alternatives. Table A1 Total Returns: Equity Indexes As of December 31, 2015

*Annualized Source: Standard & Poor’s, Russell, MSCI, Bloomberg L.P., PNC

Table A2 Valuations: Equity Indexes As of December 31, 2015

Source: Bloomberg L.P. Estimates

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Table A3 Total Returns: Fixed Income Indexes As of December 31, 2015

*Annualized Source: Barclays Capital, FactSet Research Systems Inc., Bloomberg L.P., PNC

Table A4 Valuations: Fixed Income Indexes As of December 31, 2015

Source: Barclays Capital, FactSet Research Systems Inc., PNC

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Table A5 Total Returns: Corporate Indexes As of December 31 2015

*Annualized Source: Barclays Capital, FactSet Research Systems Inc., PNC

Table A6 Total Returns: Alternatives As of December 31, 2015

*Annualized Source: GSCI, HFR, Bloomberg L.P., PNC

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Table A7 Total Returns: Currencies

*Data as of fourth-quarter 2015 Source: FactSet Research Systems Inc., PNC

Christopher D. Piros, PhD, CFA® Managing Director of Investment Strategy [email protected] Amanda E. Agati, CFA® Investment Strategist and Portfolio Advisor [email protected]

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