Perspectives S TAY I N F O R M E D. B E E M P O W E R E D.

Market Commentary

FOURTH QUARTER 2016

Equity investors retained a risk-on stance despite a mixture of good and bad news during the third quarter, while fixed income markets were somewhat more subdued. In this issue of Perspectives, our fourth quarter outlook for equity and fixed income markets considers a number of potential market-moving events waiting in the wings: the upcoming presidential election; the gap between income and economic productivity; and global developments that may impact the bond market. The question that remains is: how will equity and fixed income markets react?

Economic Overview Perhaps just as surprising as the UK’s vote to leave the European Union (EU) in late June was how quickly financial markets seemed to shrug off such a significant negative development in the geopolitical landscape. Quick responses by global central banks once again served to soothe the fears of investors, sending capital back into risk assets and restarting the momentum that began following the market lows of early February. Even European equity markets that presumably would be most adversely affected by “Brexit” enjoyed strong performance during the third quarter. Once again, the resilience of risk assets in the face of turmoil highlights the power of monetary policy to influence investor sentiment, while raising the question of “how much longer will it continue to work”? Signs of diminishing returns from aggressive monetary policy are showing up in weakening global economic activity indicators. In order to avoid a liquidity trap, a growing chorus of voices is calling for a coordinated fiscal policy response to take the baton from central banks. A lack of political will and already high sovereign debt levels, however, will challenge such a movement.

What—me worry? Alfred E. Neuman, the fictional mascot of the satirical magazine, Mad, has been periodically offered as a candidate for president under the slogan “You could do worse… and always have!” It sounds humorous until political polarization reaches the extremes it has during this presidential election cycle and you begin to wonder if a real candidate might use such a slogan. Interestingly, third party candidates (not named Neuman) could become a swing factor in this election given the current tightness of the race and the high levels of unpopularity among the two major party candidates. With the primaries in the rearview mirror and Election Day in sight, investors may now turn their focus to a narrower set of potential outcomes. In the past, the investment implications of both parties’ establishment candidates followed traditionally favorable, or unfavorable, storylines. However, the populist drumbeat has changed that paradigm in a meaningful way. THE PRIVATE BANK

In the second quarter’s Market Commentary, we examined

any changes to the party makeup of Congress, will be

the populist movement within both parties. Donald Trump

just as important as which candidate is ultimately elected.

emerged as the Republican nominee, while Bernie Sanders

To be sure, the investment implications of the political

fought a close, but ultimately losing, campaign to the

landscape are only increasing. When limits of monetary policy

Democratic Party insider, Hillary Clinton. The success of

effectiveness are tested, more is expected from the fiscal side

populist candidates underscores the rising dissatisfaction

of the economic equation.

with the status quo of both parties among the electorate. Tepid economic growth and rising income inequality

Cycle-ology

appear to be the main culprits. This dynamic is true not only

Since the end of the global financial crisis, U.S. equity

domestically but also abroad as evidenced by the success of the Brexit campaign.

investors have consistently looked past a host of worrisome developments that could have spelled the end of the expansion phase of the current economic cycle. Above-

At least in the short-term, the status quo represents some level of certainty in the eyes of market participants, whereas the implications of a party’s populist movement raise many questions. Donald Trump’s protectionist trade policy proposals have turned the traditionally businessfriendly mindset of the Republican Party upside down. At the same time, the deregulation mantra and other aspects of his campaign platform have a sweet sound to investors. On balance, Trump still represents more uncertainty than certainty to financial markets and will likely drive volatility higher, at least in the near term, if his chances of reaching the oval office rise.

average historical domestic equity valuations in the face of realized and expected below-average economic growth have become justifiable in the eyes of market participants due to historically easy monetary policy and a lack of recessionary signals from economic data. Be it Brexit, a potential hard landing for China, or weakness in the oil patch, any resulting “risk-off” trade quickly evaporated with the market reaching new highs shortly after the contagion concerns of a particular issue abated. Meanwhile, the domestic bond market has been less optimistic, albeit more heavily influenced by central bank activity than a dire

For long-term investors, the bigger question is what either candidate can actually accomplish with an increasingly partisan Congress unwilling to compromise on even the smallest issues. As such, the margin of victory, along with

outlook for the economy. So, if exogenous shocks like those mentioned above and others won’t knock the U.S. bull market off its tracks, what might it take for investors to lose faith and send stocks into

Declining Projected Median Federal Funds Rate (%) 4.0% 3.5% 3.0%

2.40%

2.5% 2.0% 1.5% 1.0%

1.10%

0.5% 0.0%

At YE 2016 12/15 poll

At YE 2017 3/16 poll

At YE 2018 6/16 poll

In Long Run 9/16 poll

*Projections of the 17 Federal Reserve Board members and Federal Reserve Bank Presidents at four points in time; e.g. in December 2015 rates were expected to be 2.4% by the end of 2017, but when polled in September 2016, the median forecast was 1.1%. Source: Federal Reserve Board

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a bear market? Given the tone and actions of the Federal Reserve (Fed), there seems to be little risk of monetary policy becoming too restrictive any time soon. In fact, as shown in the chart on the previous page, the Fed has materially eased off its original projections for rate hikes this year and beyond based on soft economic data. While it may be too early to tell if a recession is on the horizon, some emerging signs may indicate that the end of the cycle may be closer than many assume. This could cause investors to rethink current equity valuations. Among the most visible and cautionary signs are U.S. real GDP growth for the first half of the year, which came in at just over 1% annualized and well below the already subdued average for this expansionary cycle. Other more forward-looking signals also indicate weakness in certain key segments of the U.S. economy, particularly in the area of construction spending which, as shown in the chart below, has been flirting with contraction in 2016 after recovering strongly from the end of the recession. A flattening yield curve and a slowdown in commercial loan growth also add to the picture of an economy that may be nearing an inflection point. Despite the gloom of some of these data points, the services sector remains relatively healthy and should act as a strong, yet solitary, counterbalance to areas of the economy that are no longer thriving. Clarity on the political landscape and renewed fiscal stimulus efforts may also help prolong the expansion cycle as a new administration takes office early next year. For now, investors should take the less sanguine signals as a ‘yellow light’ worthy of close attention as 2016 comes to a close.

Hanging up the Hammer?

20% 15% 10% 5% 0% -5% -10% -15% -20%

2006

2007

2008

2009

2010

2011

2012

2013

2014

2016

2016

U.S. Total Construction Spending*

*Monthly, Percent change from one year ago, Seasonally adjusted Source: Federal Reserve Bank of St. Louis

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Economic highlights A few highlights from the third quarter include: •  Robust job growth continued as non-farm payroll growth averaged over 214,000 between July and August, while the unemployment rate remained steady at 4.9%. • The Conference Board’s Consumer Confidence Index rose to a nine-year high of 104.1 in September, up from 101.8 in August, suggesting that the presidential election campaign is not having a detrimental effect on consumer sentiment. • Second quarter U.S. GDP growth of 1.4% nearly doubled from the first quarter’s 0.8%, but fell below expectations and recent historical trends. A decrease in inventories offset another strong quarter for consumer spending. • Year-over-year inflation as measured by CPI grew at just 1.1% through August, held back primarily by a decline in food prices. Excluding food and energy, prices rose at a more robust 2.3% rate.

Economic Forecasts

2016e

2017e

U.S. GDP (Y/Y Real) (%)

1.75 – 2.25

2.00 – 2.50

PCE* Inflation (Y/Y) (%)

1.80 – 2.10

1.90 – 2.20

Unemployment Rate (%)

4.80

4.70

Fed Funds Target (%)

0.50 – 0.75

1.00 – 1.50

10-Year Treasury Yield (%)

1.75 – 2.00

2.00 – 2.25

S&P 500 Target

2175 – 2225

2225 – 2325

* Personal Consumption Expenditure Core Price Index Source: HighMark Asset Allocation Committee, Bloomberg

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Equity Outlook Bridging the gap—pay versus productivity

shown in the chart below, productivity growth since 2007

In mid-September 2016, the U.S. Census Bureau released

has been half that of the prior pre-recession period. This is significant, not just in itself, but also because business

2015 data showing that median household income posted

investment growth, historically the major determinant of

its first significant increase in over eight years. U.S. median household income rose 5.2% in real, inflation-adjusted terms in 2015, marking the first meaningful increase since 2007, the year before the Great Recession began. The official poverty rate fell as well, to 13.5% in 2015, down from 14.8% in 2014.

overall productivity growth, has largely been absent as the current business cycle matures. What does this mean for equity markets? If productivity improves, real growth rates would increase, and company profit margins would rise as well – all positive news for equity

Improving median income, particularly coupled with the low unemployment rate, has been positive for the domestic equity market. However, the problem that remains is that U.S. labor market strength has not yet translated into strength for the wider economy as measured by GDP growth. In fact, increases in household income and subsequent boosts in

markets. A more likely, albeit gloomier, scenario would be that productivity does not improve in the near term. If this occurs, corporate profitability would decline, which would force companies to slow or freeze hiring. If companies cut back on hiring, this would potentially adversely impact consumer spending. This, combined with a decline in

consumer spending have been among the only positive

corporate profitability, would be negative for equity markets.

contributors to tepid U.S. GDP growth. How then do we reconcile these seemingly conflicting data – a strong labor

While productivity growth may return, it seems unlikely to

market yet weak GDP numbers?

materialize in the near term. Since labor productivity is an important driver of market performance and economic

While hiring and median incomes have increased, productivity has not. Productivity growth, one of the pillars of the economy, remains below historical averages and is likely to remain low, creating challenges for both economic growth and equity markets if this trend does not correct course. As

growth, a lot depends on its eventual resurgence. As such, we continue to monitor productivity and growth data, incorporating these into our risk/reward analyses and market outlooks.

Earning More, Producing Less?

Average annual percent change

4.0%

3.0%

2.8%

2.6% 2.2%

2.0% 1.5%

1.3%

1.2% 1.0%

0.0% 1947-1973

1973-1979

1979-1990

1990-2000

2000-2007

2007-2015

Source: U.S. Bureau of Labor Statistics (U.S. Productivity Change, Nonfarm Business Sector, 1947-2015)

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Correlations upside down Historically, investors have come to expect stock prices and bond yields to rise and fall in tandem. Bond prices and bond yields move in opposite directions: when bond yields go up, prices go down and when bond yields go down, prices go up. For example, a move up in the 10-year Treasury yield indicates negative fixed income market performance, whereas a move down indicates positive fixed income market performance. It is unusual for equity and fixed income market prices to move together. Traditionally, this is how diversification in a portfolio is meant to work; when one asset class declines, others go up. However, since the end of the Great Recession, as the chart below illustrates, this traditional relationship has been disintegrating, with equity prices and bond yields tending to move in different directions. The most straightforward explanation for this divergence is that markets are extremely focused on global central bank policies and lower expectations for “normal” rates have helped push up equity prices and driven Treasury bond yields down. While unusual correlations between stocks and bonds may be a useful market signal, we believe a more important question is: in the event of another downturn, would stocks and bonds sell off together? What is a rational investor to do when confronted with this anomaly? We suggest remaining grounded in core investment beliefs, built upon the faith that corporate fundamentals and more appropriate valuations will guide markets in the long term. We believe that current market conditions and correlations are aberrations that should normalize over time, but investors will need patience and confidence during the speed bumps ahead.

Correlation Confusion 2500

8% 7%

2000

5%

1500

4% 1000

Yield (%)

S&P 500 Price Level

6%

3% 2%

500

1% 0 2000

2001

2002

2003 2004

2005 2006

2007

S&P 500 Price Level (LHS)

2008

2009

2010

2011

2012

2013

2014

2015

2016

0%

10-Yr Treasury Yield (RHS)

Source: Bloomberg

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Equity strategy for Q4 2016 Despite the continued strength of U.S. equity markets, our view remains cautious and defensive and we have positioned ourselves accordingly; remaining underweight to equities, particularly to domestic equities. Our equity positioning, reflected in the table below, continues to favor developed international markets over U.S. markets due to relatively attractive valuations globally and earnings growth potential supported by the early stages of the economic recovery cycle in Europe. On-going Quantitative Easing (QE) programs by the European Central Bank and the Bank of Japan are expected to support asset prices and reinvigorate economic activity. We continue to view developed international markets as having the potential for more risk, but also a more than compensatory potential reward relative to domestic stocks. For the past few years, we have kept a close eye on developments in Emerging Markets, with particular attention to China. While valuations have looked attractive in Emerging Markets for some time, event risk—including a hard landing in China and a rapid, destabilizing Yuan devaluation—seemed too high relative to potential reward. A seemingly successful round of Chinese fiscal and monetary stimulus combined with a pause in U.S. monetary normalization has reduced this risk over the near-term. Additionally, global economic activity is marginally improving as seen in recent purchasing manager surveys and the stabilization of Chinese foreign currency reserves, indicating less pressure on the currency. As a result, we shifted from an underweight position in Emerging Markets to a neutral weight policy.

Country/Region

Q4 2016 Allocation

Q3 2016 Allocation

U.S.

Underweight

Underweight

Europe

Overweight

Overweight

Japan

Overweight

Overweight

Emerging Markets

Neutral Weight

Underweight

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Fixed Income Outlook Goldilocks and the three bears Despite improving income figures from the U.S. Census

remains subdued and below the Fed’s target of 2%. An

Bureau in September, encouraging news of middle-income

uptick in business investment might also push the economy

job creation in August, and generally positive employment

into enough of a “too hot” temperature range that might

data and consumer spending figures over the third quarter,

require a rate hike to cool it down. Outside the U.S., inflation-

the Fed held rates unchanged, again, at the September

boosting efforts continue to bedevil central banks. Inflation

Federal Open Market Committee (FOMC) meeting.

in the Eurozone is at 0.40% and in Japan at a negative 0.50%,

While market expectations earlier this year called for two rate hikes by the end of 2016, most now expect only one increase when the Fed meets in December. Few expect the FOMC to act at their November meeting just a few days before the presidential election.

despite significant QE programs that have sent foreign capital flooding into the U.S. Treasury market.

Could the spigot run dry? Low to negative yields abroad, as shown in the chart below, are one reason for ongoing demand for U.S. Treasuries by

Comments from Chairwoman Janet Yellen after the

non-U.S. investors. While some market pundits claim the

September meeting met the classic definition of a “Goldilocks domestic government bond market is overvalued and poised economy” – one that is “not too hot, but not too cold”. But

for a correction, we disagree: as long as QE continues abroad,

hawks on the FOMC are growing restless and the vote to

demand for U.S. government debt will continue. When

stay the course was seven to three, the narrowest margin of

foreign demand for Treasuries abates, however, the U.S.

victory for the doves in nearly two years. Chairwoman Yellen

10-year Treasury could return to long-term yield averages of

said the FOMC had “struggled” in its deliberations and the

4% to 5% after setting near-daily record lows this year, and

goal of a consensus vote was not reached with the three

the piper will be paid.

bears voting for a 25 basis point hike.

Are there other potential developments beyond central bank

Casting a shadow over the Goldilocks scenario, however,

policies abroad that could trigger a Treasury market sell-off?

is the slow pace of growth in domestic inflation. Despite

We can think of one, which, while hopefully unlikely, bears

good news on multiple economic fronts, inflation growth

watching.

10-Year Government Bond Yields 2.50% 2.00%

Yield (%)

1.50% 1.00% 0.50% 0.00% -0.50% Jan-16

Feb-16

Mar-16

United States

Apr-16

May-16

United Kingdom

Jun-16

Jul-16

Germany

Aug-16

Sep-16

Japan

Source: Bloomberg

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Nowhere But Up?

Chinese Corporate Debt ($m)

$2,500,000

$2,000,000

$1,500,000

$1,000,000

$500,000

$0 2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

Source: Bank for International Settlements and Federal Reserve Bank of St. Louis (Amount Outstanding of Domestic Debt Securities for Non-financial Corporations Issuers, All Maturities, Residence of Issuer in China, Millions of U.S. Dollars, Quarterly, Not Seasonally Adjusted)

Corporate debt bingeing in China At nearly $27 trillion and five-times the level of just a decade ago, China’s debt load approaches two-and-a half times domestic GDP—a level slightly higher than the U.S. and Germany. In addition to concerns about total Chinese government debt, corporate debt, as shown in the chart above, has ballooned in the past 10 years, hitting some $2.5 trillion at the beginning of this year. With much of the corporate debt coming from China’s property sector and related industries, many of them state-owned, some economists worry that slowing growth in China may lead to accelerated corporate debt defaults. But if much of the debt is issued from Chinese state-run banks to state-run enterprises active in real estate, one line of reasoning goes, the concerns over debt levels are overblown as the government will be inclined to offer bailouts. But if the central bank steps in to prevent defaults, pressure on U.S. and other foreign currencies and government debt could result if the need for additional Yuan currency rises. While China has slowed recent sales of U.S. Treasuries, the trend might be reversed if China embarks on their own bank “bail-out” program to counter the impacts of slowing growth.

Fixed income strategy for Q4 2016 There are no changes to our fixed income positioning this quarter. As shown in the table on the next page, the modest overweight to investment-grade corporate bonds with solid fundamentals and balance sheets remains. As has been the case for some time, investment grade corporate bond spreads continue to offer compelling yield advantages over U.S. Government Bonds.

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We continue to underweight mortgage-backed securities. These instruments trade at unattractive and narrow spreads due to the Fed’s on-going purchases of mortgagebacked debt through reinvesting the proceeds from maturing issues. We will continue to monitor the Fed’s mortgage-backed purchases for signs of a slow-down in their program as yields can be expected to rise once they unwind the pace of reinvestment. Sector

Q4 2016 Allocation

Q3 2016 Allocation

Municipal Bonds

Neutral Weight

Neutral Weight

U.S. Corporate Bonds

Modest Overweight

Modest Overweight

High-Yield Bonds

Neutral Weight

Neutral Weight

U.S. Government Bonds

Underweight

Underweight

Mortgage-Backed Securities

Underweight

Underweight

Conclusion Investors move into the fourth quarter in an environment of increasing anxiety and potential volatility. Uncertainty stems from many sources including: the outcome of a presidential election that pits an establishment candidate against an anti-free trade populist; mixed economic indicators; a breakdown of long-term equity/bond correlations; and a Fed that is increasingly split between hawks and doves in terms of the timetable for and the extent of rate hikes. We lean defensive in our overall positioning, as these risks appear to be tilted towards the downside. Careful attention to asset allocation in the midst of less-than-clear market direction will be critical in the months to come. David Wines, President & CEO James St. Aubin, Head of Investment Strategy Todd Lowenstein, Director of Research HighMark Capital Management, Inc.

For more information, speak to your relationship manager or visit us at unionbank.com/theprivatebank S&P 500 The S&P 500 Index is a capitalization weighted index of 500 stocks, representing all major industries, designed to measure performance of the broad domestic economy. It reflects the risk/return characteristics of equities in the large cap universe. Perspectives is a publication of HighMark Capital Management, Inc. (HighMark). This publication is for general information only and is not intended to provide specific advice to any individual. Some information provided herein was obtained from third-party sources deemed to be reliable. HighMark and its affiliates make no representations or warranties with respect to the timeliness, accuracy, or completeness of this publication and bear no liability for any loss arising from its use. All forward-looking information and forecasts contained in this publication, unless otherwise noted, are the opinion of HighMark and future market movements may differ significantly from our expectations. HighMark, an SEC-registered investment adviser, is a wholly owned subsidiary of MUFG Union Bank, N.A. (MUB). HighMark manages institutional separate account portfolios for a wide variety of for-profit and nonprofit organizations, public agencies, public and private retirement plans, and personal trusts of all sizes. It may also serve as sub-adviser for mutual funds, common trust funds, and collective investment funds. MUB, a subsidiary of MUFG Americas Holdings Corporation, provides certain services to HighMark and is compensated for these services. Past performance does not guarantee future results. Individual account management and construction will vary depending on each client’s investment needs and objectives. Investments employing HighMark strategies are NOT insured by the FDIC or by any other Federal Government Agency, are NOT Bank deposits, are NOT guaranteed by the Bank or any Bank affiliate, and MAY lose value, including possible loss of principal. ©2016 MUFG Union Bank, N.A. All rights reserved. Member FDIC. Union Bank is a registered trademark and brand name of MUFG Union Bank, N.A. unionbank.com

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