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Economic Update
Second Quarter 2016
DoubleLine Macro-Asset Allocation Team
Sam Garza, Portfolio Manager
Fei He, Quantitative Analyst
Ryan Kimmel, Analyst
333 S. Grand Ave., 18th Floor || Los Angeles, CA 90071 || (213) 633-8200
Economic Update
Global Markets Review
Figure 1: Performance of Asset Classes
As of June 30, 2016
35%
1H 2016
30%
2Q 2016
25%
20%
15%
10%
down Fed rate hike expectations for the year. In the
aftermath of the Brexit vote, the market nearly completely
priced out the probability of a rate hike in 2016 (Figure 2).
Figure 2: Probability of Another Fed Rate Hike
July, September, December 2016 & February 2017
Jul-16
Sep-16
Dec-16
Feb-17
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
Source: Bloomberg, DoubleLine
The European Central Bank (ECB) and Bank of Japan (BoJ)
abstained from boosting monetary stimulus in the second
quarter following adverse market reactions to prior moves
to take interest rates negative. Most notably, negative rates
have decimated both the European and Japanese banking
sectors (Figures 3 and 4).
Figure 3: ECB Deposit Rate & Eurostoxx Banks vs. Eurostoxx
As of June 30, 2016
0
0%
-0.05
-5%
-0.1
-10%
Source: Bloomberg, DoubleLine
*Please see appendix for index definitions.
ECB Deposit Rate (%)
5%
0.05
0.045
-0.15
0.04
-0.2
-0.25
-0.3
-0.35
0.035
ECB Deposit Rate (LHS)
Eurostoxx Banks/Eurostoxx
Banks/Eurostoxx Ratio
In the second quarter, developed market (DM) central
banks took a back seat to geopolitics. The United Kingdom
(UK) unexpectedly voted to leave the European Union (EU)
while anti-establishment candidates Donald Trump and
Bernie Sanders gained traction in their respective political
parties with Trump clinching the Republican presidential
nomination. The fallout from the Brexit vote has yet to be
realized, but the process of the UK seceding from the EU
will elevate macroeconomic and geopolitical uncertainties
in Europe over the medium term. Despite a spike in global
financial market volatility directly following the Brexit vote,
risk assets snapped back in the following weeks with global
equities returning to pre-Brexit levels. In particular, U.S.
equities rallied to a record high. Global yields declined to
record lows in many countries. The yield on 10-year U.S.
Treasuries touched an intra-day low of 1.32%, while
German 10-year yields declined to -0.20%, and Japanese to
-0.29%. The dearth of yield in global bond markets incited a
mad dash for higher-yielding assets, with U.S. Corporate
High Yield and Emerging Market Debt outperforming
equities and treasuries during the quarter (Figure 1).
0.03
-0.4
The Federal Reserve (Fed) retreated to a more dovish
posture in the second quarter as labor market data
softened, with the 3-month trailing average of monthly jobs
added during the quarter dropping to the lowest level since
the third quarter of 2012. At the June 2016 Federal Open
Market Committee (FOMC) meeting, the Fed highlighted
the increased level of uncertainty in global markets, guiding
-0.45
0.025
Source: Bloomberg, DoubleLine
*LHS = Left Hand Side
Please see appendix for index definitions.
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Economic Update 6/30/2016
Economic Update
Figure 4: BoJ Policy Rate & Topix Banks vs. Topix
As of June 30, 2016
0
0.15
0.14
-0.04
0.13
-0.06
-0.08
BoJ Policy Rate (LHS)
Topix Banks/Topix
0.12
Banks/Topix Ratio
BOJ Policy Rate (%)
-0.02
0.11
-0.1
-0.12
0.1
Source: Bloomberg, DoubleLine
*LHS = Left Hand Side. Please see appendix for index definitions.
Outlook
Politics will continue to be the center of attention in the
second half of the year as the political response to Brexit
takes shape and the U.S. presidential election cycle plays
out through November. For Europe, the main concern will
be the UK-EU negotiations for UK secession. Risks of
additional countries defecting from the EU are rising. Italy
could be a candidate to make such a move with a
referendum vote on constitutional reform scheduled for
October.
The U.S. presidential election brings an elevated level of
uncertainty that could keep the Fed from hiking rates until
after the election. It is our view that the Fed is inclined to
stay on hold and wait for more information on jobs, growth
and financial stability. Such an environment is poor for U.S.
bonds, and consequently we have turned cautious on
duration. Long-end bond yields are trading at all-time lows.
Having produced the highest year-to-date (YTD) returns in
nearly 30 years (Figure 5), the risk-reward proposition for
adding duration at these levels is incredibly poor. In other
words, adding duration offers little upside if rates decline
and large drawdowns if rates move back up. With the Fed
on hold, the front-end should be relatively anchored and
therefore the U.S. Treasury curve should steepen.
Despite U.S. equities trading at all-time highs we maintain
our less constructive view on the asset class. We see the
rally in risk assets as driven by an enormous liquidity
injection, with $13 trillion of global government bond yields
trading negative, pushing investors further out the risk
spectrum. If equity valuations have been supported by
declining interest rates then higher interest rates could
become a headwind for the asset class. Not to mention
equities face fundamental headwinds from lackluster topline growth, vulnerable profit margins, and valuations being
well above historical averages (Figure 6).
Figure 6: S&P 500 Forward P/E Ratio & Bollinger Bands
As of June 30, 2016
28
26
24
Price-to-Earnings (P/E) Ratio
10-year Average
1st Standard Deviation
2nd Standard Deviation
22
20
18
16
14
Figure 5: 30-Year U.S. Treasury Total Return By Year
January 1988 to June 2016
12
10
Cumulative Performance
150
140
2008
2011
130
2014
120
1995
2016
110
100
2015
90
2013
80
2009
0
10
20
30
40
50
60
70
80
90
100
110
120
130
140
150
160
170
180
190
200
210
220
230
240
250
260
70
Trading Days
Source: Bianco, Bloomberg, DoubleLine
Source: Bloomberg, DoubleLine
Please see appendix for index definition.
We remain cautious on credit as a back-up in rates may
reduce demand from yield-starved investors. Fundamentals
are still deteriorating for U.S. corporates with rising
leverage as default rates increase (Figure 7 on following
page). Recovery rates are likely to be lower in the next
default cycle than in previous cycles. We are less
constructive on investment grade (IG) credit as the sector
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Economic Update 6/30/2016
Economic Update
Figure 7: U.S. High Yield Default Rates
As of June 30, 2016
18
BofA/Merrill Lynch High Yield
16
LTM Issuer Default Rate (%)
attractive diversifier in the portfolio and should perform well
in a risk-off environment, especially a risk event caused by a
loss in confidence in global central banks. Over the nearterm, gold may underperform if yields move higher, but we
would see a sell-off as a buying opportunity.
BofA/Merrill Lynch High Yield ex-commodities
14
12
10
8
6
4
2
0
1999
2001
2003
2005
2007
2009
2011
2013
2015
Source: Bank of America Merrill Lynch
Please see appendix for index definition.
could be impacted by negative ratings migrations.
Furthermore, the asset class’s higher duration is
unattractive in the current low-yield environment. In other
words, income generated by IG corporate credit offers
inadequate compensation or cushion for the risk of price
depreciation in the event of higher interest rates. In the
credit sector, we prefer structured credit, as the asset class
has not rallied nearly as much as corporate credit during
the year and the U.S. consumer is in much better health
than in past cycles thanks to much lower leverage levels
(Figure 8).
Over the next couple months, the environment is likely to
become bond-unfriendly, which is a deterrent for adding
duration given that interest rates are near all-time lows. We
prefer investments that benefit from yields moving higher.
This could mean playing for reversals in assets that have
performed well YTD as bond yields collapsed; Utilities, real
estate investment trusts (REIT) and low volatility strategies
seem like prime candidates for a reversal. Even
underperforming Japanese equities could benefit relative to
other equities from a reversal in interest rates and a rally of
the U.S. Dollar versus the Japanese Yen. Corporate credit
could get hit from two sides as interest rates rise and credit
spreads widen. While gold could sell off on a squeeze higher
in yields, we like gold’s diversification characteristics for
equity/bond portfolios and would look to add gold on
weakness. As we noted earlier, the political environment
will be the main focus for global financial markets over the
near to medium term. We continue to monitor
developments closely. Good luck.
Figure 8: U.S. Household Debt-to-Disposable Income Ratio (%)
As of March 31, 2016
U.S. Household Debt-to-Disposable Income Ratio (%)
140
130
120
110
100
90
80
Source: DoubleLine
For a medium-term horizon, we maintain our constructive
view on gold as the commodity should perform well in a
world awash with negative-yielding assets owing principal
and interest to be paid back in fiat currencies. Gold is an
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Economic Update 6/30/2016
Economic Update
Author Biographies
Samuel M. Garza
Portfolio Manager, Macro-Asset Allocation
Mr. Garza joined DoubleLine in 2009. Prior to DoubleLine, Mr. Garza was a Senior Vice President at
TCW since 2000 where he held several positions over the years ending with his last promotion to Senior Vice President in 2005. Prior to TCW, Mr. Garza worked at Union Bank of California in the Commercial Banking Group where he was involved with corporate loan underwriting. Mr. Garza holds a BA in
Business Economics from the University of California, Santa Barbara and an MBA from the Anderson
School of Management at the University of California, Los Angeles.
Fei He, CFA
Quantitative Analyst, Macro-Asset Allocation
Mr. He joined DoubleLine’s Macro-Asset Allocation team in 2014 as a quantitative analyst. Prior to joining the firm, he worked at PIMCO for three and half years as a quantitative research analyst where he
began in client analytics, advising clients on strategic asset allocation and later moved to emerging markets and commodities. Mr. He began his career at Absolute Return Capital Advisors as a portfolio/
research associate. He has published papers, including the Financial Analysts Journal. Mr. He holds an
MS in Financial Engineering from UCLA Anderson School of Management and a PhD in Molecular &
Medical Pharmacology from UCLA David Geffen School of Medicine. He graduated from Tsinghua University in Beijing with a BS in Biological Sciences & Biotechnology and is a CFA charterholder.
Ryan Kimmel
Analyst, Macro-Asset Allocation
Ryan Kimmel is an Analyst for DoubleLine Capital’s Multi-Asset Growth Strategy. Mr. Kimmel joined
DoubleLine in 2012. Prior to DoubleLine, Mr. Kimmel was a Proprietary Trader at The Gelber Group,
trading currencies for the Foreign Currency Group. Before Gelber, Mr. Kimmel was an Investment
Banking Analyst in Morgan Stanley’s Mergers and Acquisitions Group. Mr. Kimmel holds a BA in Business
Economics from the University of California, Los Angeles and holds an MBA from the Anderson School of
Management at the University of California, Los Angeles.
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Economic Update 6/30/2016
Definitions
BofA/Merrill Lynch U.S. Cash Pay High Yield Index (J0AO) - An index that tracks the performance of below investment grade corporate debt currently in a coupon paying period. Eurobonds and debt issuer from countries designated as emerging markets (e.g. Argentina, Brazil, Venezuela, etc.) are
excluded, but Canadian and global bonds (SEC registered) of issuers in non-EMG countries are included. Original issue zeroes, step-up coupon structures, 144-As and pay-in-kind (PIK, as of October 1, 2009) are also included.
Bollinger Bands - A technical indicator of volatility using bands that are plotted two standard deviations away from a moving average to find a n
upper and lower bound.
Consumer Price Index (CPI) - A measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care. The CPI is calculated by taking price changes for each item in the predetermined basket of goods and averaging them;
the goods are weighted according to their importance. Changes in CPI are used to assess price changes associated with the cost of living.
Eurostoxx Index - A stock index of Eurozone stocks designed by STOXX, an index provider owned by Deutsche Borse Group and SIX group, with the
goal of providing a blue-chip representation of Supersector leaders in the Eurozone.
Morgan Stanley Capital International All Country World Index (MSCI ACWI) - A market-capitalization-weighted index designed to provide a broad
measure of stock performance throughout the world, including both developed and emerging markets.
“Emerging Markets” - Morgan Stanley Capital International Emerging Markets Index (MXEF) - A float-adjusted market capitalization index designed
to measure equity market performance in global emerging markets. The index consists of 26 emerging economies, including but not limited to, Argentina, Brazil, China, India, Poland, Thailand, Turkey, and Venezuela.
Nikkei 225 Index - A price-weighted index comprised of Japan's top 225 blue-chip companies on the Tokyo Stock Exchange. The Nikkei is equivalent to
the Dow Jones Industrial Average Index in the U.S.
Shiller CAPE® Ratio - CAPE® stands for Cyclically Adjusted Price-Earnings. The CAPE® Ratio is a valuation metric that takes the current price of an
equity or index divided by its inflation adjusted average of ten years of earnings.
Standard & Poor’s U.S. 500 Index (S&P 500) - A capitalized-weighted index of 500 stocks chosen for market size, liquidity an dindustry grouping,
among other factors. This index is designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large
cap universe.
Tokyo Price Index (TOPIX) - An index that measures the performance of 150 highly liquid securities selected from each major sector of the Tokyo
market.
“U.S. Treasuries” - Barclays U.S. Treasury Index - An index that measures U.S. dollar-denominated, fixed-rate, nominal debt issued by the U.S. Treasury
“U.S. Corporate IG” - Barclays U.S. Aggregate Corporate Index - An index that measures the investment grade, U.S. dollar-denominated, fixed-rate
taxable bond market, including Treasuries, government-related and corporate securities.
“U.S. Corporate HY” - Barclays U.S. Corporate High Yield Index - An index that measures the U.S. dollar-denominated, high yield, fixed-rate corporate
bond market.
“EM Sovereign” - Barclays Emerging Markets Sovereign Index - A hard currency EM index that includes fixed and floating-rate U.S. dollardenominated debt issued by sovereign EM issuers.
U.S. Dollar Spot Index (DXY) - DXY is the US Dollar Index (USDX) indicates the general value of the US dollar. Average exchange rates between the US
dollar and six major world currencies.
An investment cannot be made in an index.
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Economic Update 6/30/2016
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Economic Update 6/30/2016