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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. 2 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 3 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 4 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. 5 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. 6 Economic Update 6/30/2016 Disclaimers Important Information DoubleLine has no obligation to provide revised assessments in the event of changed circumstances. While we have gathered this information from sources believed to be reliable, DoubleLine cannot guarantee the accuracy of the information provided. Securities and sectors discussed are not recommendations and are presented as examples of issue selection or portfolio management processes. They have been picked for comparison or illustration purposes only. No security presented within is either offered for sale or purchase. DoubleLine reserves the right to change its investment perspective and outlook without notice as market conditions dictate or as additional information becomes available and assumes no duty to update the recipients of this presentation. Important Information Regarding Risk Factors Investment strategies may not achieve the desired results due to implementation lag, other timing factors, portfolio management decision-making, economic or market conditions or other unanticipated factors. The views and forecasts expressed in this material are as of the date indicated, are subject to change without notice, may not come to pass and do not represent a recommendation or offer of any particular security, strategy, or investment. All Investments involve risks. Please request a copy of DoubleLine’s Form ADV 2A to review the material risks involved in DoubleLine’s strategies. Past performance is no guarantee of future results. Important Information Regarding DoubleLine In preparing the client reports (and in managing the portfolios), DoubleLine and its vendors price separate account portfolio securities using various sources, including independent pricing services and fair value processes such as benchmarking. 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Since markets can remain inefficiently priced for long periods, DoubleLine’s performance is properly assessed over a full multi-year market cycle. Important Information Regarding Client Responsibilities Clients are requested to carefully review all portfolio holdings and strategies, including by comparing the custodial statement to any statements received from DoubleLine. Clients should promptly inform DoubleLine of any potential or perceived policy or guideline inconsistencies. In particular, DoubleLine understands that guideline enabling language is subject to interpretation and DoubleLine strongly encourages clients to express any contrasting interpretation as soon as practical. Clients are also requested to notify DoubleLine of any updates to Client’s organization, such as (but not limited to) adding affiliates (including broker dealer affiliates), issuing additional securities, name changes, mergers or other alterations to Client’s legal structure. The views expressed here are those of the individual investment analyst and do not represent the views of DoubleLine, any other individual investment analyst, portfolio manager, or other investment professional at DoubleLine. DoubleLine® is a registered trademark of DoubleLine Capital LP. All other marks belong to their respective owners. © 2016 DoubleLine Capital LP 7 Economic Update 6/30/2016