mid year review 2015

I N V E S T M E N T S T R AT E G Y G R O U P

© 2015, JANNEY MONTGOMERY SCOTT LLC

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Non-inflationary growth continues in the U.S. Sub-trend but positive economic activity should continue as consumer spending is steady. Accommodative monetary settings will help to keep global bond and cash yields in check.

Full equity valuations in the U.S. increase vulnerability to corrective bouts. Multiple expansion is unlikely requiring profit growth to boost share prices. Volatility will increase given cross currents in the rate and oil markets.

Currency movement will remain influential in market behavior. The dollar is likely to push higher if at a slower pace. Change in dollar crosses will be more subdued and nuanced going forward.

Federal Reserve policy will graduate toward tightening albeit slowly. Lift-off from zero bound probably occurs in the September-December period. The slope of rate hikes will be shallow.

Foreign central banks will continue to operate a reflationary monetary policy. Many countries are struggling with weak or weakening economies and disinflation. Cutting rates and using non-conventional tools is increasingly endorsed.

Talking Points


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Economic growth will remain positive, but at or below trend

Source: Janney ISG, BEA

Source: Janney ISG ISM

Source: Janney ISG, Conference Board

Source: Janney ISG ISM

6 years and beyond!

No sign of losing momentum


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Job growth will drive consumer confidence and spending

Source: Janney ISG, BLS

Source: Janney ISG Conference Board

Source: Janney ISG, BEA

Source: Janney ISG BEA

The key to a self reinforcing expansion

Above pre-recession levels Economic driver

Albeit slowly, wages are picking

up


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The housing market will further support economic activity

Source: Janney ISG, NAHB

Source: Janney ISG U.S. Census Bureau

Source: Janney ISG, U.S. Census Bureau

Source: Janney ISG Federal Reserve

Creating more homeowner

equity


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Two-thirds of global GDP, represented by the U.S., Euro area, Japan, and China, is expanding. Disappointing growth in China is a risk worth monitoring, however, neither U.S. nor world growth is in jeopardy. Suffice it to say the expansion story is not homogeneous. • Growth has returned in Europe but not uniformly.• Japan is growing again and deflation has been arrested.• China has yet to steady but there are nascent signs of a turn.

Recent signs point to mixed conditions abroad

Source: Janney ISG Citigroup Source: Janney ISG, Citigroup Source: Janney ISG Citigroup


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Lean toward large company stocks.– High conviction sectors include:

Financials– In the event the Federal Reserve raises rates, bank, brokers, and insurers

stand to benefit.– Underweight REITs

Healthcare – Powerful demographic tailwind benefits medical device, pharmaceutical, and

select biotech.– Demanding valuations hold risk for the biotech space.

Consumer Discretionary– Consumer strength will provide the horsepower for spending in restaurants,

on autos and homes.– The new “disciplined” consumer may not share discretionary wealth evenly.

What to own in the U.S. equity market


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Our favorites are:– European equities

Sentiment has improved but enough skeptics remain to climb a wall of worry. Valuations are still reasonable. Business and household loan activity is expanding. Earnings growth is accelerating.

– Japanese equities (hedged) Price-to-cash flow is below global markets. Profit growth is climbing rapidly. Policy officials continue to promote shareholder-friendly reforms. Government Pension Investment Fund is buying domestic and foreign equities to

fulfill its revised asset allocation targets.

Non-U.S. equity markets are still attractive


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Eurozone: Restoring the Flow if Credit is a Prerequisite for Recovery

As credit rises, so does GDP, followed by corporate earnings

AQR stress tests announced

AQR announcement

Credit isFlowing


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• Japanese equities bounced to the devalued yen but now rally on improving fundamentals.

• Bank of Japan will remain vigil in using monetary policy as a tool to boost economic activity.

• The $1.2 trillion Government Pension Investment Fund made a significant shift to weigh more in equities.

• Tactically buy Japanese equities hedged to negate the dollar/yen cross.

Japanese equities are not just a “yen” story anymore

The Yen has lost over 45% of its value against the U.S. Dollar in 2 years

Japanese equities have nearly doubled in 2 years

Source: Janney ISG, Bloomberg

Source: Janney ISG Bloomberg


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No inflation on the horizon and expectations remain well anchored


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OPTIMISTIC CASE – 25% PROBABILITY

Economy and MarketsThe economy continues to provide unambiguous evidence that the expansion is intact, helped by modestly improving conditions abroad. While the Fed begins to lift interest rates, it is well-telegraphed, and expected to be gradual. With bond markets medicated by the Fed’s explicit forward guidance, yields drift higher but glacially, exerting little pressure on earnings expectations. The P/E multiple expands to 18/19 on $132 of earnings, and the S&P 500 melts up to 2,400. Approaching this level engenders talk of a “bubble” in equity prices. It may warrant scrutiny for profit-taking opportunities because history is replete with bubbles ending badly.

Investment StrategyStocks prosper as investors project further profit gains and lack of competition for risk-based capital from other asset classes. Favor large cap dividend “Aristocrats” in the areas of technology, financials, and health care. Consumer-facing companies should be owned as well. Bonds struggle in price, but generally cover any loss in principal by the yield. Avoid gold.

Scenario Analysis (S&P price is 2,094 as of this writing)

BASE CASE – 65% PROBABILITY

Economy and MarketsThe “goldilocks” economy continues to print positive growth. Job growth and spending fuel a reinforcing expansion cycle, and global activity stabilizes. The Fed debates a mid-year liftoff in the fed funds rate but defers—deciding to err on the side of allowing any overheating it might generate to occur. The conflict for market participants about when the Fed might pull the punch bowl away creates anxious moments and increased market volatility. Corrective bouts are common but do not disrupt the long-lasting bull market. Stocks beat bonds as the S&P rallies through occasional pullbacks to 2,175.

Investment Strategy Stocks should be at or above weight against portfolio targets. Bond prices waver, but global disinflationary forces and the arbitrage by country agnostic yield-seekers tame bond market volatility. Hedges may be helpful to temper swings in equity prices. Low or non-correlated instruments may be augmentative within a portfolio construct, including alternative investments, gold, and the U.S. dollar.


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PESSIMISTIC CASE – PROBABILITY – 10%

Economy and MarketsThe economy slips well below forecast as employment gains slow, while foreign economies fail to reaccelerate. Businesses are unwilling to invest ahead of visible demand, and the consumer saves the oil price “tax cut” rather than spends it. Withering profit expectations cause a de-rating in equity prices. Earnings grow only by low-mid single digits year/over-year, and markets resolve the disappointment by showing little gains. The S&P trades in a range around 2,050. Bond prices rally, and returns rival or exceed that which come from stocks. Income is the driver of results, so dividend stocks and corporate bonds deliver attractive yields and total returns.

Investment Strategy Blue chip stocks with predictable growth are rewarded. Defensive sectors such as Utilities and Staples should perform. Stocks should be reduced to target weight or slightly below, as return risk is elevated. Higher-quality bonds hold relative appeal, and duration targets should be extended. Cash, alpha generating hedge strategies, and real assets may be best-suited to augment an unrewarding environment for traditional asset classes.

A weighted blend of these scenarios establishes an achievable price target for the S&P 500 of 2,219.

Scenario Analysis

Risks Worth Monitoring

Valuation-agnostic cash and underperforming investors chase the stock market significantly higher. S&P 500 2,500 plus.

Lending activity in Europe slows and fails to ignite and demand remains muted, causing the economy to weaken and equities there to suffer.

The Fed tightens policy more quickly than anticipated, and jars complacent markets. 2013’s “taper tantrum” is replayed in earnest.

Oil prices fall well below the cost of production, and the U.S. energy renaissance stalls costing jobs and business investment.

China’s debt problems are unmasked, and worries escalate about its sustainable growth rate and global economic contribution.

Russia remains an aggressor in Eastern Europe, and more imposing tit-for-tat sanctions weigh on market confidence.

Japan loses its fight to reignite growth as reinvigorating economic policies are thwarted—causing the yen to rally hard.

Central bank policies overstep investor confidence, leading to a redo of the Fragile Five currency losses expanding to infect others.

A terrorist movement in the Middle East interferes with the oil supply chain, driving prices markedly higher—hurting the global economy.

An attack on U.S. soil, physical, cyber, or otherwise, or an ebola-like pandemic scare, darkens consumer sentiment and curbs spending.


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Disclosure

This is for informative purposes only and in no event should be construed as a recommendation by us or as an offer to sell, or solicitation of an offer to buy, any securities. The information given herein is taken from sources that we believe to be reliable, but is not guaranteed by us as to accuracy or completeness. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation, or needs of individual investors. Employees of Janney Montgomery Scott LLC or its affiliates may, at times, release written or oral commentary, technical analysis, or trading strategies that differ from the opinions expressed here.

Returns reflect results of various indices based on target allocation weightings. Weightings are subject to change. Index returns are for illustrative purposes only and do not represent the performance of any investment. Index performance returns do not reflect any management fees, transaction costs, or expenses. Indexes are unmanaged, and you cannot invest directly in an index.

Performance data quoted represents past performance and is no guarantee of future results. Current returns may be either higher or lower than those shown.

mid year review 2015

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