Economic and Market Review

Economic and Market Review Fourth Quarter 2014 Economic Review During the fourth quarter of 2014, three major themes impacted the capital markets and...
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Economic and Market Review Fourth Quarter 2014

Economic Review During the fourth quarter of 2014, three major themes impacted the capital markets and set the stage for calendar year 2015: • Diverging monetary policies among major developed nations • Strengthening of the U.S. dollar vs. other nations • Sharp declines in oil prices With the U.S. unemployment rate below 6%, and monthly payroll additions averaging over 240,000 throughout 2014, the Federal Open Market Committee (FOMC) felt comfortable enough with improvements in the labor markets to conclude the Federal Reserve’s asset purchase program. At each FOMC meeting throughout 2014, the original $85 billion in U.S. Treasury and agency mortgage backed security (MBS) purchases was reduced or “tapered” by $10 billion. The final stages of QE added $1.7 trillion to the Fed’s balance sheet assets between September 2012 and October 2014, where assets peaked at $4.4 trillion. The size of the balance sheet should remain at current levels as the Fed continues to reinvest principal payments from agency debt and MBS into agency MBS, as well as roll-over maturity Treasury securities.

12%

Unconventional Monetary Policy

$5.0

Fed. B/S Assets 4.46

10%

8%

$3.5

6%

$3.0 Unemployment 5.80 $2.5 Exp. Infl. 2.00 Rel. Infl. 1.70 Fed Funds 0.25

2%

0%

'07 '08 '09 '10 Source: S&P, BEA, FRB

'11

'12

'13

12/2008: +$600 B - Agency MBS

B) Quantitative Easing 2 (QE2) November 2010 – June 2011

10/2010: +$600 B - U.S. Longer-dated Treasuries

C) Operation Twist September 2011

9/2011: Swap $400 B – Sell Shorter-Dated (Less Than 3 Year Maturity ), Buy Longer Dated (6 to 30 Year Maturity)

D) Twist Extension June 2012

6/2012: Swap $267 B – Sell Shorter-Dated (Less Than 3 Year Maturity ), Buy Longer Dated (6 to 30 Year Maturity)

E) Quantitative Easing 3 (QE3) September 2012 – December 2013

9/2012: Open-ended +$40 B/month – Agency MBS

$4.5 $4.0

4%

A) Quantitative Easing 1 ( QE1) December 2008 – March 2010

$2.0 $1.5

12/2012: Open-ended +$45 B/month – Longer-dated U.S. Treasuries.

$1.0

$0.5 '14 ©FactSet Research Systems

3/2009: +$750 B - Agency MBS +$300 B - U.S. Treasuries

F) QE Tapering December 2013 – October 2014

12/2013: Reduction in the pace of openended purchases. Pace was $10 B per FOMC meeting. Ended at October FOMC meeting.

The next steps for the Fed will be removing the zero interest rate policy (ZIRP) that has been in place for six years, and begin to normalize interest rates. The current “lift-off” date is expected to occur during the second half 2015. However, relatively benign realized inflation readings and recent declines in inflation expectations gives the Fed cover should they decide to delay the policy change in an attempt to allow the domestic expansion to gain further momentum. The indicators the Fed will be keeping an eye on are: a) the ongoing improvements in the labor markets, b) different measures of inflations both realized and expected, and c) the global economic outlook. Outside the U.S., the global economic outlook downshifted during the fourth quarter. Global growth expectations for CY 2015 during the first half of 2014 started above 3.0%, but have steadily declined during the second half of the year. Inflation expectations have also plunged as a result of a lower energy prices and lower growth expectations. Central banks outside the U.S. continued to have substantial cover for further monetary policy accommodation. ECB President Mario Draghi stated there were “significant and increasing differences in the monetary policy cycle between major advanced economies.” In Europe, lower inflation, accompanied by weaker real GDP growth have opened the door for additional monetary policy accommodation. Expectations are the ECB will re-expand their balance sheet over the next two years.

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Economic and Market Review Fourth Quarter 2014

3.25

2015 Growth & Inflation Expectations World

World GDP Growth International Monetary Fund Forecast

8.0

2012A

7.0

2013A

2014F

2015F

2016F

6.0 5.0

3.00

4.0 3.0 2.0

2.75

1.0 -

Middle East & North Africa

Latin America

Emerging Europe

Emerging Asia

Emerging & Developing

Other Advanced

World

2.25

Advanced Economies

(2.0)

2015 World CPI Expectations (LS)

G7

2015 World GDP Expectations (LS)

2.50

Euro-Area

(1.0)

Source: International Monetary Fund, World Economic Outlook Database October 2014

Source: Bloomberg

In Japan, the expansion of the balance sheet has been unsuccessful at generating real growth and has led to significant devaluation of the Japanese yen. Since the end of 2012 the yen was valued at ¥87 JPN/USD and has since depreciated to ¥118. Balance sheet assets at the Bank of Japan have doubled during that time period from 30% to over 60% of GDP. With deflation risks still entrenched, Japan will continue to increase the size of its balance sheet and it is highly likely the yen will continue to depreciate against the U.S. dollar.

70% 60%

Year-to-Date Price Changes Major Currencies (Based in USD)

Central Banking Balance Sheet Assets Bank of England (% of U.K. GDP) Federal Reserve (% of U.S. GDP) Bank of Japan (% of Japanes e GDP) European Central Bank (% of Eurozone (17) GDP)

BOJ 63.43

-44.5% -18.6% -17.5% -12.1% -12.1% -11.9% -11.5% -11.1% -10.3% -9.1% -8.4% -8.0% -5.9% -5.7% -4.7% -4.7% -3.5% -2.3%

50% 40% Fed 25.88 BoE 22.27

30%

ECB 22.15

20% 10% 0%

'07

'08

'09

'10

'11

Source: Federal Reserve, BOE, BOJ, ECB

'12

'13

'14

©FactSet Research Systems

Russian Ruble Norwegian Krone Swedish Krona Japanese Yen Euro Danish Krone Mexican Peso Brazil Real Swiss Franc South African Rand Canadian Dollar Austrilian Dollar British Pound Taiwan Dollar Singapore Dollar New Zealand Dollar South Korean Won Indian Rupee

Source: Bloomberg

During the year, the trade-weighted USD appreciated near 9% against major currencies. Most of this appreciation occurred during the last quarter of the year, coinciding with the drop in oil prices. Outside of the yen, some of the steeper currency declines occurred in developed nations that export oil. The most dramatic drop was endured by the Russian ruble which suffered under the combination of an already slowing economy, U.S. and European economic sanctions related to Ukraine and Crimea, and the steep fall in the price of their prime export, oil. Other developing countries that export oil (such as Venezuela), face increasing debt burdens as their export revenues decline while their currency depreciates vis-à-vis the U.S. dollar.

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Economic and Market Review Fourth Quarter 2014 Regarding oil prices, the price declines started mid-year when WTI crude prices were near $105 per barrel, then dropped to around $90 at the end of the third quarter. Price declines accelerated during the fourth quarter to the mid $50s.

12,000 11,000

U.S. Oil Production & Imports (MOV 4W) U.S. Crude Oil Field Production (Thousand Barrels Per Day) (MOV 4W) Weekly U.S. Crude Oil Imports (Thousand Barrels Per Day)

2.5

Oil Supply & Demand Imbalances vs. Oil Prices WTI Crude Oil ($/bbl) - Logarithmic Scale (Right) World Crude Balance (Million Barrels Per Day) (Left)

2.0 1.5

10,000 12/26/2014 9125.75

9,000

12/31/2014 53.27 12/31/2014 0.52

1.0 0.5

8,000 7531.25 7,000

0.0

6,000

-0.5

5,000

-1.0

4,000

-1.5

100 90 80 70 60 50 40 30

3,000

'90 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10 '12 '14 Source: Department of Energy

©FactSet Research Systems

-2.0

20

10 '95

'97

'99

'01

'03

Source: Energy Information Agen cy

'05

'07

'09

'11

'13

©FactSet Re se arch Systems

The cause of the decreases in oil can be traced back to supply and demand. Capital market investment into energy producers over the past few years has led to significant increases in oil production capacity domestically resulting in decreases in oil imports. During the fourth quarter, OPEC decided not to cut oil production, likely to force out the marginal high cost producer and triggered the significant declines in oil prices during December. The decline in oil prices had several effects that have spilled into the capital markets and broad economy. In the capital markets, currencies of oil producers have been negatively impacted, equity returns of energy companies have significantly underperformed other sectors, and credit spreads of energy-related companies have drastically widened, especially in the high yield markets. Conversely, on the economic front, consumers of energy are the clear beneficiaries, both households and companies. Households receive a tax-cut effect from the lower costs, especially lower-income households where energy prices represent a higher percentage of disposable income. Households may spend this windfall, driving consumption higher, or save the proceeds – it was not too long ago that gas prices were near $4.00. Depending on whether they are a producer or consumer of oil, U.S. corporations have both headwinds and tailwinds from the energy and stronger dollar scenario. Lower energy prices will likely have an impact on other input prices. This could lead to further profit margin expansion from already elevated levels. The industries that will most likely benefit from the drop in oil prices include those where transportation fees are a significant part of expenses such as airlines, trucking, freight, and railroads. Consumer discretionary related industries such as restaurants, hotels, apparel, and other consumer goods will benefit from lower gasoline prices. Construction will also benefit from lower input costs of raw and building materials made from oil and oil-related products. Multinational corporations with end markets in countries where currencies have depreciated versus the U.S. dollar may see slight headwinds in sales growth. Additional negative impacts to corporate profitability could come from lower capital spending activities from energy-specific companies or derivate sectors such as industrials, utilities, and materials.

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Economic and Market Review Fourth Quarter 2014 Market Review During the fourth quarter, some non-traditional assets stood out on both the positive and negative ends of asset class return spectrum. Real Estate Investment Trusts (REITs) returned a staggering 12.4% for the quarter, bringing the one-year return to 27.2%. On the opposite end of the return spectrum, the S&P GSCI fell 27.7% during the quarter and ended the year down -33.1%. Within the commodity complex, energy-related indices led the declines, while livestock commodities posted low double-digit gains for the year. Both precious and industrial metals ended the year lower. Within the traditional asset classes, domestic equities outperformed international equities during the quarter and year. The MSCI EAFE index fell 3.5% during the quarter and lost 4.5% for the year. The MSCI Emerging Market index lost 4.4% during the fourth quarter, but lost 1.8% during the year. Domestically, the Russell 2000 small cap index returned 9.7% during the fourth quarter and outperformed the S&P 500 large cap index which returned a respectable 4.9%. At the end of the third quarter, the small cap index had lost nearly 5%, and with the gains during the fourth quarter the index finished the year up 4.9%.

Total Returns Asset Allocation/ Balanced

Trailing 1 Month

Trailing 3 Months

Trailing 1 Year

Trailing 3 Year*

Trailing 5 Year*

Trailing 10 Trailing 15 Year* Year*

S&P 500

-0.25%

4.93%

13.69%

20.41%

15.45%

7.67%

4.24%

Russell 2000

2.85%

9.73%

4.89%

19.21%

15.55%

7.77%

7.38%

Index Benchmarks:

MSCI EAFE (USD)

-3.44%

-3.53%

-4.48%

11.56%

5.81%

4.91%

2.97%

MSCI Emerging Market (USD)

-4.56%

-4.44%

-1.82%

4.41%

2.11%

8.78%

7.38%

Barclays Aggregate

0.09%

1.79%

5.97%

2.66%

4.45%

4.71%

5.70%

Barclays High Yield

-1.45%

-1.00%

2.45%

8.43%

9.03%

7.74%

7.49%

Barclays 3M Treasury Bill

0.00%

0.00%

0.05%

0.09%

0.11%

1.59%

2.04%

S&P GSCommodity Index

-13.63%

-27.67%

-33.06%

-12.86%

-6.54%

-4.79%

1.04%

12.44%

27.15%

16.39%

16.63%

FTSE NAREIT Index

1.09%

Source: S&P, Russell, MSCI, Barclays Capital, FTSE * Annualized

7.50% As of: 12/31/2014

12.29%

Large cap equities saw two corrections during the second half of the year. The first correction began prior to the end of the third quarter when the S&P 500 price index broke 2,000 then fell 7.4% bottoming in the middle of October at the 1,860 level. The index then rallied over 11% into early December, before the second correction occurred. Despite the near 5% pullback, the S&P 500 reached an all-time high of 2,090 at the end of the year returning 13.7% for 2014. Within large cap equities, several defensive sectors performed well during the year while several cyclical sectors underperformed. Utilities and Health Care sectors were the best two performers during the year and nearly outperformed the S&P 500 by two fold. Information Technology, Consumer Staples, and Financials also were notably outperforming sectors. On the other side, the Energy sector stood out as a significant underperformer as oil producers were punished. Telecom and Materials were two other underperformers during the year. Fixed income instruments largely produced gains during 2014. The Barclays Aggregate index rose 1.8% during the quarter and 6.0% during the year. The Barclays Treasury index returned 5.1% during the year, but there was a large return differential between long duration issues and short issues as the yield curve flattened during the year. The Intermediate Treasury index returned 2.6% during the year and significantly underperformed the Long Treasury index which returned 25.1% as global deflation concerns set in.

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Economic and Market Review Fourth Quarter 2014 Total Returns S&P 500 Sectors

S&P 500 Price Level

2,150 2,100 2,050

6/30/2014 1960.2

2,000 1,950 1,900

9/30/2014 1972.3

12/31/2014 2058.90

12/31/2013 1848.4

1,850 1,800

3/31/2014 1872.3

1,750 1,700

Jan Feb Mar Apr May Jun Source: Standard & Poors

S&P 500 Price Level Jul Aug Sep Oct Nov Dec ©FactSet Research Systems

Consumer Disc. Consumer St. Energy Financials Health Care Industrials Info. Tech. Materials Telecom. Utilities S&P 500 Source: Standard & Poors

Trailing 1 Trailing 3 Trailing 1 Month Months Year 0.97% 8.74% -1.04% 8.15% 0.50% -10.68% 1.81% 7.25% -1.32% 7.48% -0.14% 6.76% -1.70% 5.24% -0.67% -1.80% -6.13% -4.16% 3.52% 13.19% -0.25% 4.93% As of: 12/31/2014

9.68% 15.98% -7.78% 15.20% 25.34% 9.83% 20.12% 6.91% 2.99% 28.98% 13.69%

Credit issues largely outperformed comparable to Treasury issues. The U.S. credit index and corporate investment grade indices each returned near 1.75% during the fourth quarter and 7.5% during the year. Like equities, the Utility sectors outperformed both Industrial and Financial sectors. The U.S. securitized index slightly outperformed corporates during the quarter returning 1.7%, but underperformed during the year returning 5.9%. U.S. MBS outperformed CMBS and ABS.

U.S. Treasury Yields

4.5%

30 Year

4.0%

5 Year

Total Returns Fixed Income Indices

2 Year

3.56 3.36

3.5% 3.97 3.0% 2.5%

10 Year

2.73 3.04

2.0% 1.75

1.73

2.53

1.62

3.20

12/31/2014 30 Year 2.75

2.52

10 Year 2.17

1.78

5 Year 1.65

1.5% 1.0% 0.5% 0.0%

0.38

0.44

0.47

0.58

2 Year 0.67

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Source: Federal Reserve

©FactSet Research Systems

Barclays Barclays Barclays Barclays Barclays Barclays Barclays

Aggregate Intermediate Agg. Government/Credit Govt/Credit 1-3 Yr Int. Govt/Credit U.S. Treasury U.S. TIPS

Barclays Barclays Barclays Barclays Barclays Barclays Barclays

Government Agencies Corporate U.S. MBS CMBS ABS High Yield

Source: Barclays Capital * Annualized

Trailing 1 Month

Trailing 3 Months

Trailing 1 Year

0.09% -0.15% 0.08% -0.26% -0.32% 0.14%

1.79% 1.20% 1.82% 0.17% 0.89% 1.93%

-1.13% -0.12% -0.36% 0.06% 0.15% -0.15% -0.22% -1.45%

-0.03% 1.52% 0.71% 1.77% 1.79% 1.45% 0.55% -1.00% As of:

5.97% 4.12% 6.01% 0.77% 3.13% 5.05% 3.64% 6.14% 3.65% 7.46% 6.08% 3.86% 1.88% 2.45% 12/31/2014

High yield bonds faced a tough quarter falling 1.0%, but managed to produce positive gains of 2.5% during the year. High yield energy companies were largely responsible for the losses and fell 10.6% during the fourth quarter and 8.0% during the year. Much of the pressure in high yield came from lower-quality rated issues. The BA-credit rated index produced positive returns of 0.9% during the quarter and 5.4% during the year.

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Economic and Market Review Fourth Quarter 2014

2500

Barclays Corporate High Yield High Yield Option Adjusted Spread (OAS) High Yield Energy High Yield Oil Field Services

Recession Periods

Option Adjusted Spread (OAS)

2000

1500

1015.00

1000

729.00 12/31/2014 483.00

500

0

'05 '06 '07 '08 '09 Source: Barclays Capital

'10

'11

'12 '13 '14 ©FactSet Research Systems

Total Returns Corporate Indices By Ratings Quality: AAA Rated AA Rated A Rated BAA Rated BA Rated B Rated CAA Rated By Sector: Industrial Utilility Financial

Trailing 1 Trailing 3 Trailing 1 Month Months Year 0.73% 0.25% 0.29% -0.25% -0.63% -1.63% -3.00%

3.18% 1.98% 2.20% 1.22% 0.90% -1.52% -3.91%

9.78% 6.35% 7.23% 7.89% 5.37% 1.47% -1.11%

-0.10% 1.45% 0.02%

1.54% 3.41% 1.78%

7.60% 11.45% 6.16%

As of: 12/31/2014

Source: Barclays Capital

Outlook for 2015 U.S. economic growth is expected to continue to outpace our developed peers, with real GDP buoyed by further employment increases, modest wage gains and stimulus from lower energy prices. Real consumption is expected to grow in the 2.5 to 3.0% range. Business investment is expected to be additive although there are some real concerns about energy sector cutbacks. Government is expected to modestly grow after years of slight retrenchment. The export sector could face headwinds due to the stronger U.S. currency and weaker growth abroad.

35x

S&P 500 Price to Operating EPS (Trailing LTM) S&P 500 P/E (Trailing LTM) Reces sion Periods

30x 25x 20x

12/31/2014 17.29x

15x

Avg. 15.24x

10x 5x 0x '28 '34 '40 '46 '52 '58 '64 '70 '76 '82 '88 '94 '00 '06 '12 Sou rce: S&P, Robert J. Shi l ler

©Fa ctSe t Research Systems

Fundamentals Equity Indices

P/E (2015)

S&P 500 Russell 1000 Russell 1000 Value Russell 1000 Growth Russell Mid-Cap Russell 2000 Russell 2000 Value Russell 2000 Growth Russell 3000 MSCI ACWI (USD) MSCI EAFE (USD) MSCI Emerging Market (USD)

14.8x 15.0x 14.0x 16.2x 16.7x 18.9x 16.3x 22.4x 15.3x 13.5x 12.9x 10.0x

Source: Bloomberg Estimates

Relative EPS P/E to Growth Dividend S&P 500 ('15/'14) Yield 1.0x 1.0x 0.9x 1.1x 1.1x 1.3x 1.1x 1.5x 1.0x 0.9x 0.9x 0.7x

12.0% 12.6% 11.7% 13.6% 14.3% 23.8% 19.6% 30.4% 13.2% 12.0% 11.0% 13.2%

2.06% 2.00% 2.39% 1.62% 1.69% 1.27% 1.91% 0.62% 1.94% 2.63% 3.43% 3.04%

As of: 1/2/2015

Valuations for domestic large cap indices are not stretched, but are above long-term averages. Revenue growth year-overyear has been in the low-single digits for the past few years, consistent with nominal GDP growth. EPS growth year-over-year has achieved low-double digit growth as operating margins continue to expand. Our belief is that continued operating margin expansion is limited and that year-over-year EPS growth expectations for CY 2015 will be revised downward as company management guides analysts lower.

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Economic and Market Review Fourth Quarter 2014 For 2015 we expect volatility to continue to be a primary theme underscoring the importance income as it relates to total return. For our base case we expect large cap equities to produce low to mid single digit gains predicated on consensus 3% real GDP, benign inflation of 1.5%, a 2% dividend yield, stable valuations, and slight profit margin compression. In an upside scenario, albeit less likely in our view, large cap equities could produce low double digit returns resulting from positive surprises in the economy coupled with P/E ratios expanding. The clear risk to our base case comes from continued global deflation concerns. In our downside case, large cap equities could see single digit losses, if economic growth falls, global deflation fears persist, margins continue to fall and P/E ratios compress nominally. In aggregate, below average equity returns are likely the prudent call for 2015 given the run up in equities against an anemic economic backdrop as well as an inability to drive further earnings gains through expanding profit margins. Small cap index valuations continue to trade at a premium relative to large caps and continue to trade above longer-term averages. We favor actively managed small-cap portfolios where our experienced investment teams select companies with relatively more attractive valuations than the index and more favorable return prospects. Outside the U.S., international equity indices are relatively inexpensive versus domestic equities, but earnings may not have bottomed. As with small-cap, we favor actively managed portfolios where our international equity team can assess the economic environments where they are selecting portfolio candidates. Market-based indicators suggest short-term interest rates in the U.S. will increase during the second-half of the year. Over the next few years, fixed-income returns may look similar to the 1950-1960 period when interest rates increased from the lowsingle digits. Total returns over that time period were low to negative as rates increased. During certain years, rates increased more sharply than other years and this generated several years of losses in the fixed income markets. Investors should understand both credit and duration exposure within their fixed-income portfolios as risks in both areas have increased as long-term risk-free interestrates fell during the year and credit spreads widened.

Rising Interest Rates & Total Returns

10%

Moody's BAA Corporate Bond Yield

8% 6% 4%

2% Yield

0% 20% 15%

Long-Term Corporate Bond Returns

5%

4% 3%

2%

5%

0% -5% -10%

9%

9%

10%

0% -2%-1%

-3% 1950

Source: Ibbotson(R) SBBI, Federal Reserve

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8% 5%

-7% 1955

2%

5%

3%

0%

0% -5%

1960 1965 Annual Return Rolling 5 Year (Annualized) Rolling 10 Year (Annualized)

-8%

Economic and Market Review Fourth Quarter 2014

This publication is for informational purposes only and reflects the current opinions of PNC Capital Advisors, LLC. Information contained herein is believed to be accurate, but cannot be guaranteed. Opinions represented are not intended as an offer or solicitation with respect to the purchase or sale of any security and are subject to change without notice. Statements in this material should not be considered investment advice, a forecast or guarantee of future results. To the extent specific securities are referenced herein, they have been selected by the author on an objective basis to illustrate the views expressed in the commentary. Such references do not include all material information about such securities, including risks, and are not intended to be recommendations to take any action with respect to such securities. Indices are unmanaged, do not reflect the deduction of any fees normally associated with an investment management account, including investment advisory fees. Indices are not available for direct investment. This publication has been prepared without taking into account your objectives, financial situation or needs. Before acting on this information, you should consider its appropriateness having regard to your objectives, financial situation or needs. Past performance is no guarantee of future results. This publication is the property of PNC Capital Advisors and is intended for the sole use of its clients, consultants, and other intended recipients. It should not be forwarded to any other person. Contents herein should be treated as proprietary information. This material may not be reproduced or used in any form or medium without express written permission. PNC Capital Advisors is a registered investment advisor and subsidiary of The PNC Financial Services Group, Inc.

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