market performance, u.s. - morningstar,...

× Market Performance, U.S.

× Market Performance, International

× Economy

× Interest Rates and Inflation

About the Morningstar Markets Observer

This material is being provided by Morningstar Investment Services. All material in this presentation was created and published by our parent company, Morningstar, Inc. Morningstar Investment Services, Inc. is a registered investment advisory and wholly owned subsidiary of Morningstar, Inv.

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Table of Contents

Market Overview, U.S.

Market Dashboard Most of the major equity and fixed-income indexes posted reasonable returns so far in 2015. On the equity side, developed international stocks led the way, followed by U.S. small caps. High-yield and emerging-markets debt landed in the top fixed-income spots, as credit spreads were relatively unchanged. Commodities rallied in the second quarter of 2015, starting to reverse the long -term trend.

Source: Morningstar Direct. U.S. Aggregate—Barclays U.S. Aggregate Bond Total Return, U.S. Corporates—Barclays U.S. Corporate 5-10 Year Total Return, High Yield—Bank ofAmerica Merrill Lynch U.S. High Yield Master II Total Return, Municipals—Barclays Municipal Total Return, Fixed Income Emerging Markets—JPMorgan EMBI Global Diversified Total Return, Gold—London Fix Gold PM Price Return. © 2015 Morningstar. All Rights Reserved. As 0f 06/30/15.

U.S. Market Downturns, Recoveries, and Expansions

There have been 8 market downturns since 1926, the most severe one being, without doubt, the Great Depression. More recently, during the “lost decade,” two consecutive downturns with little to no expansion all but discouraged U.S. investors. However, the mar ket returned an impressive 57.0% since the expansion started in March 2012 and, as the chart illustrates, there is ample potential for future growth.

As of 06/30/15. Source: Stocks—Ibbotson Associates SBBI U.S. Large Stock Index. © 2015 Morningstar. All Rights Reserved.

Trailing 12-Month Performance of Major Asset Classes

Despite increased volatility, U.S. stocks performed well over the past year, substantially outperforming all other asset clas ses. Commodities posted a substantial loss but managed to flatline in the past six months. International developed- and emerging-markets stocks started the second quarter off strong, but weakened with the Greek debt crisis and China’s stock -market selloff.

Source: U.S. stocks—Morningstar U.S. Market Index. Developed-markets stocks—Morningstar Developed Markets ex-U.S. Index. Emerging-markets stocks—Morningstar Emerging Markets Index. U.S. bonds—Morningstar Core Bond Index. Commodities—Morningstar Long-Only Commodity Index. © 2015 Morningstar. All Rights Reserved. As of 06/30/15.

Asset-Class Winners and Losers

Year-to-date, international developed- and emerging-market stocks bounced back from a poor 2014. In terms of USD-translated returns, these international categories landed in first and second place, but in terms of local-currency returns their performance was even stronger. Over the entire period, small U.S. stocks performed the best, and large U.S. stocks, which started 2000 extremely overvalued, performed the worst.

Source: Small stocks—Morningstar Small Cap Index. Large stocks—Morningstar Large Cap Index. International-developed stocks—Morningstar Developed Mkts ex-U.S. Index.Emerging-market stocks—Morningstar Emerging Mkts Index. Intermediate-term govt bonds—Morningstar Interm. U.S. Govt Bond Index. Intermediate-term corp. bonds—Morningstar Interm. Corp. Bond Index. High-yield bonds—Barclays U.S. High Yield Corp. Bond Index. Commodities—Morningstar Long-Only Commodity Index. The Moderate Portfolio is a 60/40 portfolio based on the Morningstar Moderate Target Risk Index. © 2015 Morningstar. All Rights Reserved. As of 06/30/15.

Performance of Risk-Based Portfolios As expected, an aggressive portfolio with a larger allocation to stocks was able to deliver superior returns than its moderat e and conservative counterparts over all time periods analyzed. However, it did so while assuming a greater risk level. Nevertheless, a multi -asset portfolio may be a better idea than a single-asset portfolio that has no exposure to a diversifying asset class.

As of 06/30/15. Source: Stocks—Morningstar Global Total Return Index. Bonds—Morningstar Core Bond Total Return Index. Returns for periods longer than 1 year are annualized. Portfolios are rebalanced annually. © 2015 Morningstar. All Rights Reserved.

U.S. Sector Performance After the collapse of energy prices in the fourth quarter of 2014, the sector somewhat stabilized in the first two quarters, but still posted a negative return. Health care continued its winning streak, posting the highest trailing one-year return among all sectors. Rising interest rates drove some investors away from the two high-yield sectors, real estate and utilities, resulting in poor performance this past quarter.

As of 06/30/15. Source: Morningstar Sector Indexes. © 2015 Morningstar. All Rights Reserved.

Morningstar Price to Fair Value Distribution, U.S. Equity Today, U.S. equities appear to be fairly valued on a median basis, with a narrow distribution by historical standards. The di stribution band of Price to Fair Value can yield a richer interpretation of market valuation than a single average. In 2005, for example, the me dian U.S. stock was moderately overvalued, but the extent of the overall market overvaluation was substantial, as evidenced by the wide orange bands.

As of 06/30/15. Source: Morningstar quantitative and analyst fair value data. © 2015 Morningstar. All Rights Reserved.

Morningstar Median Quantitative Price to Fair Value, U.S. Equity The current market is fairly valued, at –1.8%. The most undervalued opportunities appear to be in large and small value in the s ize/style box, and in wide-moat stocks (particularly of medium uncertainty) in the moat/uncertainty box. After a five-year bull market, revenue growth is weak across the board, driving investors toward growth opportunities and pushing valuations higher in the growth category.

As of 06/30/15. Source: Morningstar quantitative and analyst fair value data. Style boxes based on market-cap weighted data. © 2015 Morningstar. All Rights Reserved.

Morningstar Price to Fair Value Distribution by U.S. Sector Among U.S. equity sectors, energy and healthcare were the two most undervalued at the median (basic materials also, but to a lesser extent). Market-cap weighted averages, however, can paint a different picture. In the healthcare sector, for example, most large companies appear to be overvalued, pushing the market-cap weighted average up while the median stays low.


U.S. Versus International Stock Performance

For most of the 2000–2010 “lost decade,” international stocks outperformed. However, U.S. stocks have retaken and maintained the performance lead since mid-2010. Over the past three years, U.S. stocks have outperformed by 7.2% on an annualized basis. This outperformance was caused by an improving U.S. economy, a strong U.S. dollar, and economic weakness in the rest of the world.

As of 06/30/15. Source: Morningstar Indexes. © 2015 Morningstar. All Rights Reserved.

Total Yield of S&P 500 Close to 5%

Dividend yield has been fairly stable over time, but buyback yield has fluctuated a lot more because companies are not compel led to maintain buybacks during tough economic times. The buyback yield has accelerated over the last year, because corporations are near record profitability and have chosen to reward investors with buybacks instead of increasing dividends or reinvesting the profits back in the business.

As of 06/30/15. Source: Morningstar Indexes. © 2015 Morningstar. All Rights Reserved.

U.S. Dollar Maintains Its Strength After a dramatic ascent started in 2013, the U.S. dollar fell slightly against the euro in the first quarter of 2015. However, with the potential for rising interest rates in the U.S. and QE in place in Europe and Japan, the dollar is very likely to remain strong against these two currencies going forward.

As of 06/30/15. Source: The Federal Reserve © 2015 Morningstar. All Rights Reserved.

Market Performance, International

U.S. Shines as World Growth Rates Slashed Again World growth rates have dropped from 4%–5% in the early 2000’s to just 3%–4% during the current recovery. A slowing Chinese growth engine, unfavorable demographics, and falling commodity prices have all contributed to the reduced growth potential.

As of 06/30/15. Source: International Monetary Fund, World Economic Outlook Database. © 2015 Morningstar. All Rights Reserved.

2011

1.6%

–0.5

2.7

3.9

4.3

6.6

9.3

3.0

1.6

1.7

6.2

4.2

2016*

1.7

1.2

3.2

0.7

0.2

7.5

6.3

2.1

3.0

2.4

4.7

3.8

2015*

1.5

0.8

2.8

–1.5

–3.4

7.5

6.8

1.5

2.5

2.1

4.2

3.3

2014

0.8

-0.1

2.7

0.1

0.6

7.3

7.4

2.4

2.4

1.8

4.6

3.4

2013

–0.4

1.6

2.1

2.7

1.3

6.9

7.7

2.0

2.2

1.4

5.0

3.4

2012

–0.8

1.8

3.6

1.8

3.4

5.1

7.8

1.9

2.3

1.2

5.2

3.4

World GDP Growth Rates

International Stock Market Performance The QE-driven European stock-market rally was derailed by the Greek debt crisis last quarter. The U.K., enjoying the benefits of QE but not tied to the euro and therefore not obligated to bail out Greece, posted the strongest return for the quarter. Latin America and Eastern Europe bounced back a little, but systemic problems still threaten long-term returns.

As of 06/30/15. Source: Morningstar Sector Indexes. © 2015 Morningstar. All Rights Reserved.

China’s Slowdown More Dramatic Than Once Expected China has been unable to regain the heady 10% growth rates of earlier this decade, as demographics and increased competition have put a lid on growth. Increased emphasis on the internal consumption engine and less on exports and fixed investment have increase d long-term stability and reduced inflation at the expense of higher growth.

As of 06/30/15. Source: International Monetary Fund. © 2015 Morningstar. All Rights Reserved.

G7 Employment Situation Improves, France Still Stuck in a Rut

The employment situation in G7 nations continued to improve as Italy has now begun to see a falling unemployment rate. The fi rst batch of QE countries, namely the U.S. and the U.K., have seen their unemployment rates improve the most over the past 12–24 months. France is the only exception among G7 countries, seeing its unemployment rate worsen over the past year.

As of 06/30/15. Source: Eurostat, Japan Statistics Bureau, Statistics Canada, Bureau of Labor Statistics. © 2015 Morningstar. All Rights Rese rved.

Current Holders of Greek Debt Limit Contagion Potential

Unlike in 2010, most Greek debt is now owned by large government-related entities as opposed to fragile banks, corporations, or individuals. The large government agencies have either deep pockets or the ability to print money. That means that a Greek default is unlikely to create cascading financial failures.

As of 06/30/15. Source: The Wall Street Journal. © 2015 Morningstar. All Rights Reserved.

European Quantitative Easing Results Yet to Show in Improved Lending Conditions While very modest improvements have taken place in recent months, year-over-year growth in business and consumer lending is still minuscule. Although the ECB is increasing money supply growth, banks are still keeping a lid on lending. New, more restrictive capital requirements have generally kept banks sidelined despite greater reserves.

As of 06/30/15. Source: The Federal Reserve © 2015 Morningstar. All Rights Reserved.

Morningstar Price to Fair Value Distribution by Region China’s stock market began to collapse at the end of June, but despite the decline, the country is still at the top of the ov ervalued list. Undervalued opportunities can be found in Greece and Middle-Eastern countries, but all come with significant risks and should probably be avoided by most investors. In fact, eight of the ten countries on the undervalued list are either emerging or frontier markets.


Morningstar Price to Fair Value by Country Significantly undervalued opportunities are few and far between across the regions analyzed, with Asia highly overvalued, dri ven by China. Among developed countries, Australia appears the most undervalued, but its export-based economy is closely tied to Chinese growth, which increases the risk level.


Economy

Negative U.S. Real GDP Growth in Q1 2015 No Reason For Panic Real GDP contracted 0.2% in the first quarter of 2015. The sharp decline in net exports, due to a rising dollar, slowing worl dwide growth and port issues, was the primary cause of the fall. This is the second consecutive 1st-quarter GDP decline, suggesting that seasonality might have been a strong factor too. Nonetheless, the full-year real GDP growth should still fall within the 2.0%–2.5% range, as it has for the past three years.

As of 06/30/15. Source: Bureau of Economic Analysis, Morningstar Calculations. Percentage breakdowns might not add up to their totals due to rounding differences. © 2015 Morningstar. All Rights Reserved

Job Openings Remain at an All-Time High Job openings rose to 5.4 million in May, a new all-time high. Job openings continue to rise rapidly, while hiring struggles to keep up with a wide array of new job postings. This has been the trend since early 2014, reinforcing our thesis that labor scarcity issues could begin to intensify in the near future.

As of 06/30/15. Source: Bureau of Labor Statistics. © 2015 Morningstar. All Rights Reserved

Employment Growth Normalizes, Reflects Overall Course of Economy After a spectacular fourth quarter last year and a below-average growth in the first quarter of 2015, job growth has now stabilized at a rate that is more supportive of 2.0%–2.5% GDP growth, a pace at which the U.S. economy has grown since 2012.

As of 12/31/14. Source: Bureau of Labor Statistics, Morningstar Calculations. © 2015 Morningstar. All Rights Reserved.

As Wages and Incomes Edge Higher, Consumer Spending Will Follow Increased employment and higher wages are slowly pulling up consumption. Accelerating employment data, low gasoline prices, and an unusually high savings rate should drive consumption higher.

As of 06/30/15. Source: Bureau of Economic Analysis, Morningstar Calculations. © 2015 Morningstar. All Rights Reserved

Commodities Remain a Mixed Bag Since the 2010–2011 period commodities have been under persistent pressure, primarily because of slow world growth rates, especially in China. After a particularly rough end of 2014, most commodities haven’t moved significantly from where they started at the be ginning of the year. However, the notable exceptions, energy and grains, were up 10% or more in the second quarter.

As of 06/30/15. Source: Morningstar Direct. Data represented by Bloomberg Commodity Indexes. © 2015 Morningstar. All Rights Reserved.

Home Prices Begin to Heat Up Amid Low Inventories According to the FHFA, U.S. home price growth stood at 5.3% year-over-year in April. It appears that after a period of slowing growth, home prices are now accelerating again. One of the main reasons for the higher price growth was unusually low inventories of exist ing homes. Now, home inventories have been increasing, supporting our view that home price growth will stabilize at a 5.0%–6.0% rate in 2015.

As of 06/30/15. Source: Federal Housing Finance Agency. © 2015 Morningstar. All Rights Reserved.

Housing Construction In Good Shape, Multi-Family Boom Exaggerates Reality Both starts and permits picked up in June, as multi-family activity rose sharply amid expiring construction tax incentives for developers in the New York City area. As a result, the housing construction revival is probably not as strong as the numbers seem to currently sugg est. Nonetheless, the year-over-year improvements for single-family construction look healthy, and continue to trend up closer to the 10% rate.

As of 06/30/15. Source: Census Bureau, Morningstar Calculations. © 2015 Morningstar. All Rights Reserved.

Manufacturing Industry Stabilizes After 5-Month Decline The manufacturing sector boomed in 2014 as a perfect storm of auto production, energy related equipment, and exports combined . That boom ended in late 2014 and growth continued to slow in the first half of 2015. Now, it appears that manufacturing has begun to stabilize.

As of 06/30/15. Source: Institute for Supply Management, The National Bureau of Economic Research. © 2014 Morningstar. All Rights Reserved.

Auto Industry Offers Little Upside Growth Potential, All Eyes On Housing After bottoming in 2009, the auto industry had a great run, marking a complete recovery in early 2014. As a result, the auto sales year-over-year growth rates will soon begin to peak, making autos a minuscule contributor to the overall economic growth. Housing starts, on the other hand, have been stuck in slow and steady mode for years now, giving housing still plenty of room for further growth.

As of 06/30/15. Source: The Federal Reserve, Bureau of Economic Analysis, Bureau of Labor Statistics, Morningstar Calculations. © 2015 Mornin gstar. All Rights Reserved

U.S. Oil Production Shrinks The 2010 oil boom has helped the U.S. economy in a number of ways. It spurred job creation, contributed to the reduction in t he trade deficit, and helped to keep inflation under control. Going forward, U.S. oil production will not be as big of a contributor as it was in the past, as the growth is likely to plateau much sooner than previously expected, especially after the recent collapse in oil prices.

As of 06/30/15. Source: Energy Information Agency, Morningstar Estimates. © 2015 Morningstar. All Rights Reserved.

Demographics Will Limit Long-Term Economic Growth GDP growth generally trends 1%–2% above population growth rates. With population growth dropping from 1.8% in the 1960s to 0.7% currently, theoretical economic potential growth has dropped from 2.8–3.8% to just 1.7%–2.7%. Lower fertility rates and tighter immigration policies could further limit potential economic growth.

As of 12/31/14. Source: Census Bureau, Bureau of Economic Analysis. © 2015 Morningstar. All Rights Reserved.

Interest Rates And Inflation

Long-Term Interest Rates Declined Over the Past Year

During the past year, the U.S. Treasury yield curve steepened at the short end and flattened at the long end, reflecting inve stors’ expectations that short-term rates will rise and that inflation will stay below average in the long term. However, in the second quarter, short-term rates fell slightly, and only long-term rates rose. The 10-year Treasury yield went from 1.96% to 2.35%.

As of 06/30/15. Source: 10-Year US Treasury Bonds—Barclays US Treasury 7-10 Year Bond Index. 20+ Year US Treasury Bonds—Barclays US Treasury 20+ Year Bond Index. US Corporate Bonds—Morningstar Corporate Bond Index. US High Yield Bonds—Barclays US Corporate High Yield Bond Index. US Mortgage Bonds—Morningstar Mortgage Bond Index. USD EM Bonds—Morningstar EM Composite Bond Index. Local Currency EM Bonds—Barclays EM Local Currency Broad Bond Index. © 2015 Morningstar. All Rights Reserved.

Corporate Credit Spreads

All corporate credit spreads spiked in 2007–2009 during the financial crisis, but have generally been on the decline since then. Spreads are currently at or just below their long-term averages. Calm credit markets, for the moment, signify that investors don’t foresee any credit shocks on the horizon.

As of 06/30/15. Source: Federal Reserve, Morningstar Calculations. © 2015 Morningstar. All Rights Reserved.

What Will Happen to Bonds if Interest Rates Rise?

Projections from three different sources agree that U.S. interest rates may very well begin to rise this year. A rise in the fed funds rate may influence, but does not necessarily imply, an accompanying rise in long-term rates. For example, were 30-year rates to rise by 1%, an investor holding a 30-year Treasury would see a drop in value of 16.9%.

As of 06/30/15. Source: Federal Reserve, Wall Street Journal, Chicago Mercantile Exchange, Morningstar Calculations. © 2015 Morningstar. All Rights Reserved.

Fixed-Income Winners and Losers Interest rates rose in 2013, so short duration categories like high-yield, bank loans, and short-term bonds posted the only positive returns. In 2014, interest rates declined, so the longer duration categories were the top performers. This year, the picture looks much like 2013 again, with bank loans and high yield leading the way because of stable credit spreads.

As of 06/30/15. Source: Long-term gov’t—Morningstar LT U.S. Gov’t Bond Index. Intermediate-term gov’t—Morningstar IT U.S. Gov’t Bond Index. Long-term corp—Morningstar LT Corp Bond Index. Short-term—Morningstar Short-Term Core Bond Index. Municipal—Barclays Municipal Bond Index. International—Citigroup WGBI Non-USD 5+ Year Bond Index. Emerging-market—JPM EMBI Global Bond Index. High-yield—Barclays U.S. Corp High Yield Bond Index. Bank loans—S&P/LSTA Leveraged Loan Index. Aggregate—Morningstar Core Bond Index. © 2015 Morningstar. All Rights Reserved.

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