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Q 2 QUA RT E R LY U PDAT E–S E C ON D QUA RT E R , 2 016 “You can’t build a wall around a village. The sun and the wind will always find their way in.” – Igor Goldkind, American author and poet U.S. financial markets enjoyed a mild, pleasant rally for most of the second quarter, leaving behind the anxieties of the first. A better outlook for the U.S. economy and the Federal Reserve’s shift to a benign attitude triggered several positive impacts: the U.S. dollar eased, the S&P 500 approached its record high and Treasury bond yields slowed their descent. Late in the quarter, financial markets were shaken when the citizens of the U.K. surprisingly voted to leave the European Union (EU). Global investors quickly turned away from risk, sending equity markets sharply lower and prices for safe assets higher. By quarter end, some of the referendum-induced anxiety had calmed such that the S&P 500 recovered and earned a modest gain for the quarter. High quality fixed income also had positive returns since prices for Treasury bonds continued to rise (taking yields lower). off until 2030 due to business disruptions. We are watching for early indications that British and European businesses and consumers are cutting back on spending during this limbo period. THE U.S. REASSURES Our portfolios are predominately invested in U.S. assets and thus have some insulation from the upset in Britain. During the quarter, investors became more confident in the U.S. economy which helped draw more global capital into our financial markets. Consumers remained upbeat as unemployment remained low and retail sales grew briskly in April and May (rising 2.4% over the prior year and beating expectations). Housing prices are up in general and workers may start to see wage increases both of which should keep consumers in a positive mood through the balance of 2016. Manufacturing, which has been lagging, also reported good news – recent surveys indicated a mild upturn remains intact. Investors were pleased to see the U.S. economy demonstrate resilience from poor conditions overseas. BRITAIN’S VOTE TRIGGERS POLITICAL UNCERTAINTY Although the referendum was only advisory, the domestic political climate turned unstable in the wake of the result. Leaders of both the campaign to stay (Prime Minister David Cameron) and the campaign to leave (Boris Johnson and Nigel Farage) stepped down from their roles. Plus, the leader of the opposition party (Jeremy Corbyn) lost a confidence vote within the Labour party. Some forward progress was made subsequent to quarterend; Home Secretary Theresa May became Britain’s new prime minister in mid-July. Ms. May will decide Britain’s next steps to leave the EU and address Scotland’s and Northern Ireland’s strong preference to stay. It’s very difficult to anticipate the timing and the terms of Britain’s potential exit, if it occurs. An actual exit, or progress towards one, is widely expected to pull the U.K. into recession for at least two years while new trade and cross-border investment policies are renegotiated. Some economists believe the U.K. economy would not be better QUA RT E R LY U PDAT E RETURNS FOR U.S. EQUITIES LEAD GLOBAL DEVELOPED EQUITIES When the week of the British referendum began, the S&P 500 Index opened near 2095, within 1% of its all-time high, and returned to that level within five trading days, after a quick two day drop. For the quarter, the S&P gained 2.5%. For the same period, the MSCI EAFE Index lost 1.5% and the MSCI Emerging Market Index earned 0.7%. Several factors contributed to the favorable performance of U.S. equities. Stock prices rose as the economy regained strength and corporate earnings were generally better than expected. Sentiment for equities improved due to the rise in crude oil prices and the slightly lower U.S. dollar. An unusual boost came from bond investors turning to — 1 — J U N E 3 0 , 2 016 Q 2 QUA RT E R LY U PDAT E–S E C ON D QUA RT E R , 2 016 stocks for their dividend yield. Areas of the stock market which tend to pay rich dividends - utilities, REITs and preferred stocks - outperformed the S&P 500 for both the quarter and year to date. We believe this trend may persist since currently two-thirds of the equities within the S&P 500 have a dividend yield above 1.36% (the 10-year Treasury bond yield on July 8, 2016). Looking ahead, we expect U.S. equities to stay in a broad range, but with increasing bouts of volatility. Interest rates are low and inflation is subdued. The U.S. economy is growing, but slow enough and with enough uncertainty from overseas to keep the Fed on the sidelines. overseas central banks combining to push overseas yields below zero. DEVELOPED OVERSEAS MARKETS DISAPPOINT The MSCI EAFE Index showed a loss for the quarter (down 1.5% in U.S. dollar terms) from its direct exposure to British and European equities. Bank stocks were especially volatile due to the anticipated strain on earnings from the negative interest rates in Europe and Japan. Since the EU and Japan have massive banking sectors (as a percent of GDP), the fall in bank stocks had a material impact on investment returns from developed overseas markets. HIGH QUALITY BONDS BUFFER Japanese stocks earned a small 1.0% PORTFOLIO RETURNS gain in U.S. dollar terms for the quarter, The fixed income classes we follow but this was due to exchange rates (in local “We expect U.S. generated broadly positive returns for the currency, the MSCI Japan Index lost equities to stay in quarter with the Barclays U.S. Treasury 7.8%). Contrary to the longstanding 5–10 Year Index delivering a 2.3% a broad range, but efforts of the Japanese government and quarterly return. Fixed income gains central bank, the yen has rapidly strengthwith increasing bouts were earned since the U.S. Treasury ened in 2016 as investors sought safe of volatility.” prices rose (with yields declining) over havens and unwound foreign currency the course of the quarter. Safe-haven positions predicated on a weak yen. In late demand (especially after the surprise June, the yen tested its strongest level British referendum results), negative against the U.S. dollar in nearly two years, interest rates in Europe and Japan and the Federal reversing a good portion of its drop under Prime Minister Reserve’s shift to a dovish attitude also contributed to Abe’s 4-year economic program. lower U.S. interest rates. At the beginning of the second In light of the higher uncertainty for Britain and quarter, the benchmark 10-year Treasury was 1.78%. Europe, plus the unabated rise in the yen, we are reviewing In the days following the referendum, it dropped as low our holdings of developed international equities. as 1.42% and, after a brief increase, fell to a new record SHORT-TERM THREATS TO EMERGING MARKETS EASE low in the first week of July. We don’t see a catalyst to reverse the trends of Emerging market equities, as measured by the MSCI “low and slow” in the global economy and interest rates. Index, gained 0.7% for the second quarter in U.S. dollar In fact the trend toward low (or lower) interest rates may terms, bringing the year to date gain to 6.4%. Similar to intensify since the Bank of England has started to signal developed market equities, the U.S. dollar boosted returns an interest rate cut and the ECB and Bank of Japan stand in emerging market equities. ready to provide more liquidity if needed. We believe Emerging market equities have performed better in the longer-term rates are likely to stay range bound but with last six months as several significant sources of risk have pockets of volatility - due to the outlook for slowing dissipated. Relative to January, the threats to emerging global growth, very low inflation and easing from market equities from a looming hard landing in China, QUA RT E R LY U PDAT E — 2 — J U N E 3 0 , 2 016 Q 2 QUA RT E R LY U PDAT E–S E C ON D QUA RT E R , 2 016 rising U.S. interest rates, falling crude oil prices and declining commodity prices generally have each been reduced. Plus, the U.S. dollar is also off its peak, relieving another pressure point on emerging market nations. An allocation to emerging market equities can benefit investment portfolios over the long term through their diversification properties and their prospects for faster growth relative to developed economies. However, volatility can be quite high with China and Brazil as the best examples. China’s debt level concerns us, particularly since struggling industrial companies owe a large part of it. Ideally, Beijing will gradually restructure the debt while the Chinese economy very slowly shifts towards consumption and services. rebalance, we continue to emphasize best-in-class MLPs, with intact growth opportunities, low leverage, and high distribution coverage. Real estate investment trusts (or REITs) outperformed the S&P 500 returning 6.8% for the quarter (using the MSCI US REIT Index). The industry is currently benefitting from low vacancies and a rise in rents. REITs have been in demand by investors searching for yield as REITs offer income with some growth potential. INVESTMENT OUTLOOK The surprising result of Britain’s referendum has elevated uncertainty for its business outlook and to a more modest degree in Europe. However, the U.S. economy has improved largely through continued positive developments for consumers. The combination of rising uncertainties overseas, U.S. growth around 2% (annually) and low inflation will likely keep the Federal Reserve on hold into early 2017. These conditions should offer relative support for U.S. equity prices. However, valuations are full and thus we expect volatility to continue. In fixed income, with tepid domestic growth and foreign investor preferences for safety, we favor government and municipal securities for their low credit risk. Fixed income will be valuable as well to ballast to diversified portfolios. As always, please reach out to your portfolio manager with any questions or to update your strategic asset allocation. Staying disciplined and focused on your long-term wealth objectives as opposed to short-term market movements is the best strategy for a successful investment plan. PRECIOUS METALS AND MASTER LIMITED PARTNERSHIPS STAND-OUT WITHIN REAL ASSETS The Bloomberg Commodity Index posted 12.8% for the quarter with very strong gains on natural gas, sugar and precious metals. Precious metals compete for safe haven flows and thus it is not surprising to see gold and silver as cash alternatives in extremely volatile markets and particularly with the preponderance of negative interest rates around the globe. General commodity exposure is relatively unattractive to us as softening demand relative to abundant supplies is putting downward pressure on most commodity prices. Demand for industrial commodities is falling as China shifts from infrastructure and manufacturing towards services and consumerism. Prices for agricultural commodities could be significantly affected by a shift in the weather pattern from El Niño to La Niña. The crude oil market is very gradually moving towards a balance. Supply is gradually tightening through lower U.S. shale oil production and the serious wildfires near oil sand facilities in Canada. Political struggles within Nigeria and Libya are limiting oil exports from each country. Consequently, Master Limited Partnerships (MLPs), as measured by the Alerian Index, had a very strong 19.7% quarterly return and have rebounded by more than +50% off the February 11 lows. As oil supply and demand slowly QUA RT E R LY U PDAT E — 3 — J U N E 3 0 , 2 016 Q 2 FINANCIAL MAR K ET R ETUR NS annualized U.S. Equity Q2 2016 YTD 1 Year 3 Year 5 Year 10 Year 2.1% 4.3% 4.5% 9.0% 10.4% 7.7% -1.1% -3.2% -1.8% 16.4% 15.2% 11.9% S&P 500 TR Index 2.5% 3.8% 4.0% 11.7% 12.1% 7.4% Russell 1000 Index 2.5% 3.7% 2.9% 11.5% 11.9% 7.5% Russell 1000 Growth Index 0.6% 1.4% 3.0% 13.1% 12.3% 8.8% Russell 1000 Value Index 4.6% 6.3% 2.9% 9.9% 11.4% 6.1% Russell Mid Cap Index 3.2% 5.5% 0.6% 10.8% 10.9% 8.1% Russell Mid Cap Growth Index 1.6% 2.2% -2.1% 10.5% 10.0% 8.1% Russell Mid Cap Value Index 4.8% 8.9% 3.2% 11.0% 11.7% 7.8% Russell 2000 Index 3.8% 2.2% -6.7% 7.1% 8.4% 6.2% Russell 2000 Growth Index 3.2% -1.6% -10.8% 7.7% 8.5% 7.1% Russell 2000 Value Index 4.3% 6.1% -2.6% 6.4% 8.1% 5.2% MSCI US REIT Index GR 6.8% 13.6% 24.1% 13.5% 12.5% 7.4% Bloomberg Commodity Index 12.8% 13.3% -13.3% -10.6% -10.8% -5.6% Alerian MLP 19.7% 14.7% -13.1% -5.4% 3.2% 9.5% Q2 2016 YTD 1 Year 3 Year 5 Year 10 Year -1.5% -4.4% -10.2% 2.1% 1.7% 1.6% Dow Jones Industrial Average NASDAQ 100 Index annualized International Equity MSCI EAFE Index ($USD, net) MSCI AC World Index ($USD, net) 1.0% 1.2% -3.7% 6.0% 5.4% 4.3% -0.6% -1.0% -10.2% 1.2% 0.1% 1.9% MSCI Emerging Markets Index ($USD, net) 0.7% 6.4% -12.1% -1.6% -3.8% 3.5% MSCI BRIC Index ($USD, net) 3.1% 4.5% -16.5% -1.0% -5.6% 2.9% Q2 2016 YTD 1 Year 3 Year 5 Year 10 Year Barclays US Treasury 1– 3 Year Index 0.5% 1.4% 1.3% 1.0% 0.8% 2.5% Barclays US Treasury 5 –10 Year Index 2.3% 6.5% 7.8% 4.5% 4.5% 6.1% Barclays US Long Treasury Index 6.4% 15.1% 19.3% 10.5% 10.3% 8.8% Barclays US Treasury US TIPS Index 1.7% 6.2% 4.4% 2.3% 2.6% 4.7% Barclays US Govt/Credit Intermediate Index 1.6% 4.1% 4.3% 3.0% 2.9% 4.5% BofAML Municipals 1–12 Year Index 1.4% 2.6% 4.8% 3.5% 3.3% 4.3% Barclays US Corporate High Yield Index 5.5% 9.1% 1.6% 4.2% 5.8% 7.6% BofAML Preferred Stock Fixed Rate Index 3.4% 5.1% 10.6% 7.8% 7.1% 3.9% JPMorgan GBI EM Global Diversified Index 3.0% 14.3% 2.2% -3.5% -2.2% 5.7% JPMorgan EMBI+ Index 6.0% 12.3% 13.2% 7.1% 6.4% 8.0% MSCI AC World Ex US Index ($USD, net) annualized Fixed Income Source: Morningstar QUA RT E R LY U PDAT E — 4 — J U N E 3 0 , 2 016 Q 2 INDEX DEFINITIONS Russell 2000 Growth Index®: measures the performance of those Russell 2000 companies with higher price-to-book ratios and higher forecasted growth values U.S. EQUITY Dow Jones Industrial Average: is a price-weighted average of 30 actively traded blue-chip U.S. stocks Russell 2000 Value Index®: measures the performance of those Russell 2000 companies with lower price-to-book ratios and lower forecasted growth values NASDAQ 100 Index: measures the performance of the 100 largest domestic and international non-financial companies listed on The NASDAQ Stock Market based on market capitalization 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 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 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. 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-tobook ratios and higher forecasted growth values 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 Value Index®: measures the performance of those Russell 1000 companies with lower price-to-book ratios and lower 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 industry-wide level and on a sector-by-sector basis 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 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 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 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 2000 Index®: measures the performance of the 2,000 largest companies in the Russell 3000 index QUA RT E R LY U PDAT E — 5 — J U N E 3 0 , 2 016 Q 2 INDEX DEFINITIONS 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 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 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 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 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 BofAML Preferred Stock Fixed Rate Index: this index is designed to replicate the total return of a diversified group of investment-grade preferred securities 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 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 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 JPMorgan EMBI+ Index: tracks total returns for traded external debt instruments (external meaning foreign currency denominated fixed income) in the emerging markets. The regular EMBI index covers U.S. dollardenominated Brady bonds, loans and Eurobonds. The EMBI+ expands upon J.P. Morgan’s original Emerging Markets Bond Index 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 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 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 QUA RT E R LY U PDAT E — 6 — J U N E 3 0 , 2 016 Q 2 DISCLOSUR E First Republic Private Wealth Management encompasses First Republic Investment Management, Inc. (“FRIM”), an SECregistered 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. QUA RT E R LY U PDAT E — 7 — J U N E 3 0 , 2 016