U.S. Equities Surge* QUARTERLY UPDATE FOURTH QUARTER, 2016 INTEREST RATES SPIKE ANTICIPATION FOR HIGHER PROFITS SPURS U.S. EQUITIES. Jul-16

Q 4 QUA RT E R LY U PDAT E – F OU RT H QUA RT E R , 2 016 The outcome of the U.S. presidential election resounded through global financial markets ...
Author: Magnus Benson
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The outcome of the U.S. presidential election resounded through global financial markets during the fourth quarter. Investors quickly concluded that the Republicans would use their new authority to enact very pro-business policies. President-elect Trump’s proposed plans include removing regulations, cutting both personal and corporate taxes and embarking on a new infrastructure plan. If enacted, these initiatives could result in faster U.S. GDP growth and corporate profits, which would benefit U.S. equities. We have seen dramatic moves in the financial markets ahead of Inauguration Day. On the newfound U.S. business optimism, the S&P 500 steamed higher for the quarter, although sector results varied widely. Small cap stocks barreled up even more as investors stampeded into U.S. equities. However, bonds sold off due to the anticipated larger federal deficits and higher inflation under a Trump administration. Overseas investments had mixed results. The risk of new trade barriers hit emerging market equities while their developed market cousins held up a little better. Put simply, investors pivoted on November 9, 2016. Here, we first recap quarterly results for the major asset categories. Our initial thoughts for 2017 follow.

inflation, and more enthusiasm for equities, investors sold bonds in droves. Third, the Federal Reserve said in December that it expected to make three rate hikes in 2017, one more than previously anticipated. Investors added in this new increment to the outlook for rising U.S. interest rates. The municipal bond market was hit by a fourth factor following the election – the prospect for tax cuts from President-elect Trump. The Trump campaign proposed to significantly lower personal and corporate tax rates. The benefit of tax-exempt interest declines as the tax rate declines. Consequently, many investors pulled money from the municipal bond market. During the fourth quarter, bond investors feared the worst case would play out under the Trump administration. U.S. Equities Surge* 2300 2250

2016 U.S. Election

2200 2150 2100 2050 2000 1950 1900 1850

During the quarter, interest rates rose sharply in both the Treasury and municipal markets. Interest rates for the longer maturities increased the most. The 10-year Treasury yield rose from 1.59% on September 30 to 2.45% at year end. Likewise, the 10-year yield for triple-A rated municipal bonds rose from 1.52% to 2.31%. High-quality fixed income had a loss for the quarter as interest rates rose. Several catalysts were behind the sharp rise in interest rates. First, interest rates had begun to rise prior to the election since U.S. economic data improved. However, the sell-off in bonds intensified following the November 8 elections. Since Trump had campaigned on deficitfinanced spending and tariffs on imports, inflation expectations jumped after his victory. Sensing higher

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INTEREST RATES SPIKE

*S&P 500 Composite Price Index Source: Thomson Reuters Datastream

ANTICIPATION FOR HIGHER PROFITS SPURS U.S. EQUITIES

Enthusiasm for U.S. equities surged on high expectations for tax cuts, deregulation and fiscal stimulus to come from the Trump administration and the Republicans. The S&P 500 returned 3.8% in the fourth quarter and reached eight record highs in five short weeks after the election. Small cap stocks soundly beat their large cap cousins with the Russell 2000 Index up 8.8%.



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The drivers behind large cap performance tend to have a magnified effect on small cap stocks. For example, small cap companies have a higher effective tax rate on average than large cap firms. Therefore, small cap stocks could see a significantly bigger benefit from tax reform. In the fourth quarter, investor appetite for stocks broadly translated into passion for small cap stocks. Expectations for Trump’s policies also drove significant differences in sector results. Cyclical industries (those linked to economic growth) tended to outperform mostly due to the outlook for new policies from President-elect Trump. His promises to spend on infrastructure and rollback regulations sparked significant rallies in energy, banking and constructionrelated companies. In contrast, investors shifted out of defensive industries, such as consumer staples and utilities. In short, industries expected to benefit the most under a Trump administration rallied the most.

exports and thus a lower yen tends to lift the outlook for corporate profits. A cheaper yen makes Japanese exports more competitive abroad and lifts their profits when earnings abroad are repatriated. Also, the prospect for faster U.S. economic growth added more fuel to Japan’s equity rally. Fourth Quarter 2016 Returns in Local Currency Japan

Energy Telecommunications Materials Consumer Discretionary Information Technology Utilities Consumer Staples Health Care 10

15

20

25

5.4%

(0.4)%

U.K.

4.2%

(0.9)%

EAFE*

7.1%

(0.7)%

MIXED RESULTS IN NON-TRADITIONAL ASSETS

Pe rc e n t

Prices for specific commodities sharply diverged in the quarter. Prices for gold and silver dropped by doubledigits as demand for safer assets ebbed following the U.S. election. The increase in U.S. interest rates also lessened the appeal of gold, which does not pay a cash return. Sugar prices also slumped, down 15% for the quarter. Several analysts projected that sugar supplies will increase next year with some expecting record production levels. However, prices for oil, nickel, copper and other industrial commodities rose from the anticipated demand from Trump’s infrastructure promise. Plus, the potential for an end to persistent deflation was positive for commodity prices.

Source: Morningstar

STRONG U.S. DOLLAR HURTS RETURNS FROM OVERSEAS

Outside the U.S., equity returns in U.S. dollar terms fared worse in the aftermath of the election with the MSCI EAFE Index losing 0.7% for the quarter. However, the decline was mostly due to strength in the U.S. dollar, which neared a 14-year high against its major rivals. The jump in U.S. interest rates fueled the U.S. dollar’s sprint during the quarter. The currency impact was especially strong for stocks in Japan. Stocks there climbed to a 12-month high in early December and returned 15% for the quarter in local currency. Japan’s economy is relatively dependent on

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Europe

Prices for emerging market assets plummeted in the wake of Trump’s victory and fared worse than developed non-U.S. equity markets. As a candidate, Trump often repeated his intentions to undo trade agreements and take protectionist actions, both of which would hurt emerging economies. Plus, rising U.S. interest rates and a stronger U.S. dollar also put pressure on the developing world. Consequently, the MSCI Emerging Market Index lost 4.2% in U.S. dollar terms for the quarter.

Industrials

5

(0.2)%

BRISK SELL-OFF IN EMERGING MARKET EQUITIES

Financials

0

15.0%

*Europe, Australasia and Far East Based on the MSCI Index for the country or region listed

Fourth Quarter 2016 Sector Returns

-5

Returns in U.S. Dollars



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Real Estate Investment Trusts (REITs) lost 3.0% for the quarter as measured by the MSCI US REIT Index. With their generous dividends, REITs had become ever more perceived as an income source in a yield-hungry world. In the fourth quarter, rising interest rates took away some of the allure of REITs. The more macrosensitive sectors such as lodging and office space held up better in anticipation of improved economic times ahead. Master Limited Partnerships (MLPs) gained 2.0% for the quarter, bringing the year-to-date return to 18.3%. MLPs had favorable tailwinds from both Trump’s promises to reduce regulation in the energy industry and expected reductions in supply. At the November 30 OPEC meeting, major oil producers led by Saudi Arabia agreed to cut output. This accord was followed shortly thereafter by a non-OPEC producer agreement to trim their production. As a result, West Texas Intermediate oil crossed above $53 per barrel, levels last seen in the summer of 2015.

the Affordable Care Act. In our view, the direction is clear; the magnitude, timing and detail are the major open items. However, we think the final impacts of the Trumpsponsored legislation are likely to occur later and be smaller than many investors now believe. The legacy of the Tea Party likely limits how far the budget deficit can be stretched. This puts a relative cap on how far Trump can concurrently increase fiscal spending and reduce taxes. Trump and the traditional Republicans are even further apart on trade policy. Therefore, we believe policy changes aren’t likely to be as fast or as severe as candidate Trump proposed. Yet, uncertainty remains and we can expect the political process to be bumpy. Therefore, we see 2017 as a year of transition. In this climate, diversification remains critical. We favor a general tilt towards U.S. investments with broad diversification across asset classes. U.S. economic conditions are already relatively stronger than those abroad and Trump’s pro-growth policies are very likely to build on this base. Plus, our elections are behind us; Europe’s cycle is still underway. This political uncertainty is one reason overseas assets appear cheap relative to the U.S. However, we are more cautious. As always, please reach out to your portfolio manager with any questions or to review your specific financial goals. Staying disciplined and focused on your particular wealth objectives is the best strategy for a successful investment plan.

2017: A YEAR OF TRANSITION

Global asset prices diverged during the quarter as investors reset their expectations for U.S. federal policy. Normally, investors look forward and try to anticipate new directions. We think the President-elect and the Republicans in Congress will make the most progress on their shared legislative priorities. We may not know the details, but we think the Republicans are highly likely to spend more, reduce taxes, lighten regulations and amend

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FINANCIAL MAR K ET R ETUR NS

annualized

U.S. Equity

Q4 2016

1 Year

3 Year

5 Year

10 Year

Dow Jones Industrial Average

8.7%

16.5%

8.7%

12.9%

7.5%

NASDAQ Composite Index

1.7%

8.9%

10.1%

17.1%

9.5%

S&P 500 TR Index

3.8%

12.0%

8.9%

14.7%

6.9%

Russell 1000 Index

3.8%

12.1%

8.6%

14.7%

7.1%

Russell 1000 Growth Index

1.0%

7.1%

8.6%

14.5%

8.3%

Russell 1000 Value Index

6.7%

17.3%

8.6%

14.8%

5.7%

Russell Mid Cap Index

3.2%

13.8%

7.9%

14.7%

7.9%

Russell Mid Cap Growth Index

0.5%

7.3%

6.2%

13.5%

7.8%

Russell Mid Cap Value Index

5.5%

20.0%

9.5%

15.7%

7.6%

Russell 2000 Index

8.8%

21.3%

6.7%

14.5%

7.1%

Russell 2000 Growth Index

3.6%

11.3%

5.1%

13.7%

7.8%

Russell 2000 Value Index

14.1%

31.7%

8.3%

15.1%

6.3%

MSCI US REIT Index GR

-3.0%

8.6%

13.2%

11.9%

5.0%

Bloomberg Commodity Index

2.7%

11.8%

-11.3%

-9.0%

-5.6%

Alerian MLP

2.0%

18.3%

-5.8%

2.2%

8.0%

annualized

International Equity

1 Year

3 Year

5 Year

-0.7%

1.0%

-1.6%

6.5%

0.7%

1.2%

7.9%

3.1%

9.4%

3.6%

MSCI AC World Ex US Index ($USD, net)

-1.3%

4.5%

-1.8%

5.0%

1.0%

MSCI Emerging Markets Index ($USD, net)

-4.2%

11.2%

-2.6%

1.3%

1.8%

MSCI BRIC Index ($USD, net)

-3.8%

12.1%

-1.9%

0.8%

0.9%

MSCI EAFE Index ($USD, net) MSCI AC World Index ($USD, net)

Q4 2016

10 Year

annualized

Fixed Income

Q4 2016

1 Year

3 Year

5 Year

10 Year

Bloomberg Barclays US Treasury 1– 3 Year Index

-0.5%

0.9%

0.7%

0.6%

2.1%

Bloomberg Barclays US Treasury 5 –10 Year Index

-4.6%

1.2%

3.1%

1.6%

5.0%

-11.7%

1.3%

7.8%

2.5%

6.7%

Bloomberg Barclays US Treasury US TIPS Index

-2.4%

4.7%

2.3%

0.9%

4.4%

Bloomberg Barclays US Govt/Credit Intermediate Index

-2.1%

2.1%

2.1%

1.8%

3.8%

BofAML Municipals 1–12 Year Index

-2.5%

0.0%

2.2%

2.0%

3.7%

1.8%

17.1%

4.7%

7.4%

7.5%

BofAML Preferred Stock Fixed Rate Index

-3.8%

2.3%

8.3%

6.8%

2.7%

JPMorgan GBI EM Global Diversified Index

-6.1%

9.9%

-4.1%

-1.3%

3.8%

Bloomberg Barclays US Long Treasury Index

Bloomberg Barclays US Corporate High Yield Index

Source: Morningstar

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INDEX DEFINITIONS

MSCI US REIT Index: is a free float-adjusted market capitalization index that is comprised of equity REITs. The index is based on MSCI USA Investable Market Index (IMI) which captures large, mid and small cap securities

U.S. EQUITY

Dow Jones Industrial Average: is a price-weighted average of 30 actively traded blue-chip U.S. stocks NASDAQ Composite Index: is a market capitalization index of approximately 3,000 common equities listed on the NASDAQ exchange

Bloomberg Commodity Index: tracks the futures contracts on over 20 different physical commodities on the commodity markets. The Index is weighted to account for economic significance and market.

S&P 500 TR Index: is a type of equity index that tracks both the capital gains of the equities in the S&P 500 and assumes any cash distributions (dividends) are reinvested back into the index

Alerian MLP: is a composite of the 50 most prominent energy Master Limited Partnerships (MLPs) that provides investors with an unbiased, comprehensive benchmark for the asset class

Russell 1000 Index®: measures the performance of the 1,000 largest companies in the Russell 3000 Russell 1000 Growth Index®: measures the performance of those Russell 1000 companies with higher price-to-book ratios and higher forecasted growth values

FTSE NAREIT All REITs: is a comprehensive family of REIT-focused indexes that span the commercial real estate industry, providing market participants with a range of tools to benchmark and analyse exposure to real estate across the U.S. economy at both a broad industrywide level and on a sector-by-sector basis

Russell 1000 Value Index®: measures the performance of those Russell 1000 companies with lower price-tobook ratios and lower forecasted growth values

INTERNATIONAL EQUITY

MSCI EAFE Index: is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the US & Canada

Russell Mid Cap Index®: measures the performance of the 800 smallest companies in the Russell 1000 index Russell Mid Cap Growth Index®: measures the performance of those Russell Midcap companies with higher price-to-book ratios and higher forecasted growth values. The stocks are also members of the Russell 1000 Growth index

MSCI AC World Index: is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets

Russell Mid Cap Value Index®: measures the performance of those Russell Midcap companies with lower price-to-book and lower forecasted growth values. The stocks are also members of the Russell 1000 Value index

MSCI AC World Ex US Index: captures large and midcap representation across 22 of 23 developed marketing countries (excluding the US) and 23 Emerging Markets countries MSCI Emerging Markets Index: is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets

Russell 2000 Index®: measures the performance of the 2,000 largest companies in the Russell 3000 index Russell 2000 Growth Index®: measures the performance of those Russell 2000 companies with higher price-to-book ratios and higher forecasted growth values

MSCI BRIC Index: is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance across the following 4 emerging market country indexes: Brazil, Russia, India and China

Russell 2000 Value Index®: measures the performance of those Russell 2000 companies with lower price-tobook ratios and lower forecasted growth values

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INDEX DEFINITIONS

Barclays US Corporate High Yield Index: measures the USD-denominated, high-yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody’s, Fitch and S&P is Ba1/BB+/BB+ or below. Bonds from issues with an emerging markets country of risk, based on Barclay’s EM country definition, are excluded

FIXED INCOME

Barclays US Treasury 1– 3 Year Index: measures the performance of U.S. Treasury securities that have a remaining maturity of at least one year and less than three years Barclays US Treasury 5 –10 Year Index: measures the performance of U.S. Treasury securities that have a remaining maturing of at least five years and less than 10 years

BofAML Municipals 1–12 Year Index: is a subset of the BofAML U.S. Municipal Securities Index and includes all securities with a remaining term to final maturity greater than or equal to one year and less than 12 years and rated AAA through AA3, inclusive

Barclays US Long Treasury Index: includes all publicly issued, U.S. Treasury securities that have a remaining maturity of 10 or more years, are rated investment grade, and have $250 million or more of outstanding face value

BofAML Preferred Stock Fixed Rate Index: this index is designed to replicate the total return of a diversified group of investment-grade preferred securities

Barclays US Treasury US TIPS Index: the index includes all publicly issued U.S. Treasury inflationprotected securities that have at least one year remaining to maturity, are rated investment grade, and have $250 million or more of outstanding face value

JPMorgan GBI EM Global Diversified Index: is an investable benchmark that includes only those countries that are directly accessible by most of the international investor base. This index exclude countries with explicit capital controls, but does not factor in regulatory / tax hurdles in assessing eligibility

Barclays US Govt/Credit Intermediate Index: the index measures the performance of the USDdenominated U.S. Treasuries, government-related and investment grade U.S. corporate securities that have a remaining maturity of greater than one year and less than ten years

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DISCLOSUR E

First Republic Private Wealth Management encompasses First Republic Investment Management, Inc. (“FRIM”), an SEC-registered investment advisor, First Republic Securities Company, LLC (“FRSC”), Member FINRA/SIPC, First Republic Trust Company (“FRTC”) and First Republic Trust Company of Delaware LLC (“FRTC-DE”). FRIM, FRSC, and FRTC-DE are wholly owned subsidiaries of First Republic Bank. FRTC is a division of First Republic Bank. Investment advisory services are provided through FRIM. Securities brokerage services are provided through FRSC. Trust and fiduciary services are provided through FRTC and FRTC-DE. This document is for information purposes only and is not intended as an offer or solicitation, or as the basis for any contract to purchase or sell any security, or other instrument, or to enter into or arrange any type of transaction as a consequence of any information contained herein. All analyses and projections depicted herein are for illustration only, and are not intended to be representations of performance or expected results. The results achieved by individual clients will vary and will depend on a number of factors including prevailing dividend yields, market liquidity, interest rate levels, market volatilities, and the client’s expressed return and risk parameters at the time the service is initiated and during the term. Past performance is not a guarantee of future results. Investors should seek financial advice regarding the appropriateness of investing in any securities, other investment or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Investors cannot invest directly in an index. The indexes referred to do not reflect management fees and transaction costs that are associated with some investments. Although information in this document has been obtained from sources believed to be reliable, we do not guarantee its accuracy, completeness or fairness, and it should not be relied upon as such. This document may not be reproduced or circulated without our written authority. Investment, Insurance and Advisory products and services are not deposits of, or guaranteed by, any bank, are not insured by the Federal Deposit Insurance Corporation, the Federal Reserve Board, or any other government agency, entity or person and are subject to investment risks including the possible loss of principal.

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