2016 MID YEAR UPDATE

“IT’S THE END OF THE WORLD AS WE KNOW IT” –R.E.M CIRCA 1987R.E.M. and their lead singer Michael Stipe certainly weren’t referring to the present day with their song about the end of the world, nor do we think it is applicable. The world isn’t ending, however, we are undoubtedly entering a paradigm shift and there is little in the historical record that anyone can draw upon for guidance on what the future holds in store. Thus the emphasis from the song title on “As We Know it”.

To illustrate just how bizarre the world has become consider the following:• $12 Trillion in global debt is currently trading at a negative

yield1, a stark contrast to 2014 when no bonds had a negative yield.

• The U.K. voted to leave the European Union, where it has been a member since the EU’s formation in 1993 and a member of the EU’s predecessor, the European Community since 1973.

• The U.S. 10 year treasury has recently traded below 1.4% for the first time in history3

• And finally, according to Bank of America, global interest rates are the lowest they have been in 5000 years2, which is basically the entire history of civilized man.

The unprecedented nature of the current macroeconomic background makes it difficult to make forecasts since, as we have outlined, there are so few precedents that we can draw upon to build any statistically significant models. Central Banks continue to push the boundary of their mandates and have stretched traditional monetary policy tools to the point of ineffectiveness.

It can be argued, and we are certainly in this camp, that the global cabal of central bankers has replaced interest rate policy with currency as the tool of choice. We certainly agree that the two are inextricably linked; however, it would appear that the most effective transfer mechanism in a world of global trade isn’t the various target rates but the devaluation of currencies. Cheaper currencies certainly prop up export markets, assuming you have any product to export, thereby making it easier to stabilize domestic growth at a minimum, with the eventual aspiration of actually achieving economic growth. This relationship is a key reason why the European Union is under assault. The centralization of a common currency doesn’t allow the various member countries and their separate economies to manipulate their currency locally to try to improve their situation. Instead the weak economies of Southern Europe are hostage to the strong Euro policies of Northern Europe where countries like Germany are still wary of an inflation menace from a bygone error. Of course this is not the only structural issue that plagues are friends across the pond, but it is a certainly large factor that is impacting the socioeconomic demographics of much of Europe.

Speaking of Europe, no discussion about the second quarter would be complete without a mention of Brexit. As we wrote just after the vote last month, there is very little information upon which to begin formulating an investment thesis. The U.K. parliament has not officially held a vote to invoke article 50 of the Lisbon Treaty and as such, no formal action for actually leaving the union has taken place.

Source: 1) Bank of America/Merrill Lynch, 2)Wall Street Journal, 3)Bank of America/Merrill Lynch

We do have slightly more insight in that David Cameron’s term as Prime Minister is officially over and Theresa May’s has begun after running unopposed. We think the following are particularly interesting points, not solely for what they may imply going forward, but for the sheer irony of the situation: • Theresa May is from the Conservative party, which stood in

opposition to the “Leave” campaign, the same party which outgoing PM David Cameron belonged to.

• Prime Minister May was unopposed in seeking the PM position

• Non of the leaders from the “Leave” movement could garner enough support to run against her.

• Boris Johnson, the former Mayor of London, and part of the “Leave” movement will be the British Foreign Secretary.

Yes, the truth is sometimes stranger than fiction.

While domestically, our situation is marginally better from an economic standpoint, Janet Yellen and the other members of the FOMC have come to the conclusion that U.S. monetary policy has implications which are much further reaching than bank deposit rates and domestic consumption. It appears that the Fed is now interpreting that part of the scope of their price stability mandate now includes the impact of interest rate policy on global currency rates. Again, this is further evidence in our minds that currencies are the tool of choice for central banks. As such, Janet Yellen and the other voting members of the FOMC voted to hold rates steady in June, out of caution for the subsequent Brexit vote, but also due to concerns about the May jobs report which implied a slowdown of economic growth.

Our forecast remains that the Fed will be on hold through the balance of 2016 since the implications of Brexit continue to unfold and remain ambiguous at best and since we have inconclusive evidence of stability in the job market. Adding to the uncertainty is the U.S. election cycle which will begin with much fan-fare next week when the Republican Convention officially kicks off. We can only hope that MacBeth wasn’t right and all that sound and fury coming from both parties signifies more than nothing.

Despite all of this, returns across most asset classes during the 2nd quarter were positive. Out of the 3 major U.S. equity indices, the S&P 500 and the Dow Jones Industrial Average managed to return 2.5% and 2.1% respectively. Only the growth heavy Nasdaq Composite was unable to show a positive return, losing 0.6%. The MCSI All Countries Global equity index gained 1%, benefitting mostly from the gains in the U.S. stock indices. The Barclays Aggregate Bond Index gained 2.2%, while commodities as measured by the DJ AIG Commodity Index gained an astounding 12.8%, driven by gold’s almost 7.5% return over the quarter.

We stipulated at the beginning of the year that a large component of the total return for equities in 2016 was likely to be from dividends and to a lesser extent capital appreciation. This certainly seems to be the case midway through the year as the total return of the S&P 500 of 2.5% contains a roughly 1% return from dividends. As we look out over the landscape for the remainder of the year, we continue to believe that this relationship will hold true and that a slant towards value over growth is merited. To that end, we remain in favor of large caps that are domestically focused as the same currency headwinds that made 4th quarter 2015 earnings difficult are likely to rear their heads again. We believe that small and mid caps should also benefit since they typically don’t garner large portions of their revenues overseas.

Key Dates in the quarter ahead

• Republican National Convention, July 18th-July 21st

• Democratic National Convention, July 25th-July 28th

• FOMC Decision, July 27th

• ADP July Employment Report, August 3rd

• July Non-Farm Payrolls Report, August 5th,• August ADP employment Report, August 31st

• August Non-Farm Payrolls, September 2nd

• FOMC Decision, September 21st

Away from the equity segment, the landscape becomes much more difficult. Certainly the risk/reward profile of investing in fixed income looks skewed to the negative since interest rates around the world are approaching or in many instances breaching the zero bound. This is primarily a consideration in government bonds, whereas, corporate bonds continue to offer some opportunities. Corporate spreads remain well off the lows seen in 2014, but the increase in the rate of high yield bankruptcies means that the asset class merits increased scrutiny.

One area of the economy that we think is becoming increasingly constructive is housing. (Pardon our pun) Since the great recession of 2007, consumer preferences (mainly millennials) have emphasized renting over buying. This has driven up the cost of rents around the country and we feel that with interest rates as low as they currently are, we are on the verge of a tipping point. It becomes increasingly hard to justify paying rent with annual increases of 3% or more, when one can purchase a home and avoid the effect of inflation on the cost of shelter by locking in the cost with a 15 or 30 year fixed rate mortgage. Our slides on page 12 and 13 show this in more detail. To date, homebuilders have primarily been focused on the high end of the home market and that will need to change going forward to meet the demand for entry level homes from first time home buyers. We think this bears watching and could very well be an area of strong growth for the domestic economy in the near to intermediate term.

J.P. Yarusinski, CFA July 14th, 2016

FALLING YIELDS, FALLING CURRENCIES, RISING GOLD

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• 10 year yields on German Bunds and Japanese Bonds went negative during the quarter

• U.S. 10 year Treasury recorded the lowest yields since WWII during the quarter and subsequent to quarter end, the lowest in history as of this writing

• The currency wars have bolstered the price of gold as fiat currencies struggle for footing amidst continued pressure from low interest rates

• Gold reached a YTD high of $1324/troy ounce on June 24th

• The current price is still well short of the highs seen in 2011 when gold was near $2000/troy ounce

Source: Federal Reserve Bank of Saint Louis (FRED)

CORPORATE CREDIT SPREADS STILL ENTICING

Source: Federal Reserve Bank of Saint Louis (FRED), 1) Fitch

• Despite interest rates falling to new lows, credit spreads are still off their 2014 tights

• Much of this can be attributed to the breakdown of fundamentals in the oil/gas sector in the early part of this year

• Investors should increase scrutiny at this stage though as credit is beginning to deteriorate

• Trailing 12 month high yield bond default rate rose to 4.9% at the end of June, the highest since May 20101

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BAML Corporate Master Index OAS (Left Axis) BAML High Yield Index OAS (Right Axis)

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CHOPPY JOBS DATA LIKELY TO KEEP FED IDLE

Source: Federal Reserve Bank of Saint Louis (FRED)

• The Fed continues to remain data dependent with a seemingly great deal of weight placed on the pace of job creation

• June’s Non Farm Payroll showed an increase of 287k jobs, the highest reading since November 2014

• This followed May’s reading of only 11k jobs, the lowest reading since September 2010

• The 3 month average which smooths the volatility month to month shows a disturbing trend with a reading on only 147k jobs per month, the 2nd slowest pace since February 2014

• We are likely to need more data point to determine if the 1 month data is a change in trend or if the 3 month average is still the primary trend. As such, volatility around these data releases is likely to stay elevated

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OIL – PUTTING IN A BOTTOM?

Source: Federal Reserve Bank of Saint Louis (FRED), 1) EIA

• West Texas Intermediate continued to rebound during the quarter, finishing at $48.17, after closing Q1 at $36.82

• However, the number of North American Rotary Rigs in operation has grown to 440 from a low of 404.

• While not dramatic, the supply demand dynamics don’t yet justify an increase in production. Especially with a deal by OPEC to reduce overall output.

• According to the latest Data from the EIA (Energy Information Agency) Global supply still outstripped demand in the 2 nd quarter by over 1 million barrels per day, calling into question the sustainability of any rally in oil prices 1

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U.S. Oil/Gas Rig Count (Left Axis) WTI Price (Right Axis)

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DIVERGENCE IN THE EQUITY INDICES

Source: Federal Reserve Bank of Saint Louis (FRED)

• The S&P 500 and the Dow Jones Utility index both pushed up near new highs during the 2nd quarter. However, the Dow Jones Transport Index remains 11% below it’s 52 week high

• Typically economic expansions and subsequent equity bull markets show a tandem move between broad industrial indices like the Dow Jones Industrial average and the S&P 500 and the Transportation index as typically increased production and consumption go hand in hand with increase movement of goods. However, the dramatic drop in energy prices has decreased the shipments of oil, coal, and petroleum products.

• The signal from this indicator at this point is ambiguous at best and perhaps even irrelevant under the current conditions.

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Dow Transports S&P 500 Dow Utilities

S&P 500 VALUATIONS GETTING STRETCHED

Source: Professor Robert Shiller, Yale University

• The cyclically adjusted PE ratio pioneered by Robert Shiller is now trading at a value of roughly 26 times adjusted earnings.

• This is more than 1 standard deviation away from the mean which has been calculated since 1900, and is a cautionary warning given that the last time that valuations became this stretched were the periods preceding the recessions and equity corrections in 2007 and 2000.

• Given that the 10 year Treasury is now trading at or near an all time low, some degree of Price to Earnings multiple expansion can be expected, however, this signal certainly bears watching and should curtail excessive risk taking

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Case Shiller Cyclically Adjusted PE RatioShaded area is 1 Standard Deviation around the mean

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WILL RISING RENTS LEAD TO A RISE IN RATES OR DEMAND FOR NEW HOMES• Recent data on the Consumer Price Index stripping out food and energy costs shows a modest uptick in prices

since 12/31/15

• However, the pressure in the index seems to be coming from owner’s equivalent rent, a component of the CPI that attempts to quantify the cost of shelter

• Rising rent and equivalent rental prices are indicative of the challenges that a still recovering housing market faces. Limited supply of new homes and the continued preference on the part of consumers to rent versus purchase are likely near a tipping point and should lead to increased demand for single family homes

Source: Federal Reserve Bank of Saint Louis (FRED)

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HOUSING INVENTORY REMAINS NEAR HISTORICAL LOWS

Source: Federal Reserve Bank of Saint Louis (FRED), 1) National Association of Realtors

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Housing Starts in Thousands (Right Axis) Monthly Supply of Houses in the U.S. (Left Axis Inverted)

• Based on current demand, there is roughly only 5.3 months of inventory of existing homes for sale

• New home starts will likely need to increase to accommodate pent up demand

• Falling interest rates are working to offset the increase in property values keeping home price affordability at roughly the same level as 1 year ago1

The views expressed in this material are solely those of the author and do not necessarily reflect those of Advisory Services Network, LLC. All information contained herein is derived from sources deemed to be reliable but cannot be guaranteed. All economic and performance data is historical and not indicative of future results. This material is for informational purposes only. This is neither a solicitation nor a recommendation to purchase or sell any investment and should not be relied upon as such.

Indexes are unmanaged and do not incur management fees, costs, or expenses.  It is not possible to invest directly in an index.