Third Quarter 2016

Capital Markets

outlook

The Atlanta Fed is projecting 2.7% annualized growth for the second quarter. To put this number into context, the average growth rate since 1965 is 2.8%, while the current expansion has averaged 2.1%. Consensus economist forecasts suggest that long run lower-and-slower

economic growth may be the new normal at around 2%.

In the longer run, aging populations and lower birthrates in the developed world portend secular stagnation. This, combined with torpid productivity growth, sums to lower real GDP growth than Americans are accustomed to. The end of June concluded the seventh year of the post-crisis expansion. The U.S. will experience a recession at some time in the future, but current indicators do not suggest an imminent end. The Eurozone is still staggering along in its recovery as second-quarter GDP growth is projected around 0.3%. Half of the BRIC economies contracted in the first quarter (Brazil -5.4%, Russia -1.2%), while India and China were leaders in emerging markets with 7.9% and 6.7%, respectively.

Developed Market Fixed Income Dynamics

The Economy

Source: Bloomberg, J.P. Morgan Asset Management; (Right) BofA/Merrill Lynch. Guide to the Markets – U.S. Data are as of June 30, 2016.*Target policy rates for Japan are estimated using EuroYen 3m futures contracts less a risk premium of 6bps. Government bond index is the BofAML Global Government Bond Index, which includes investment-grade sovereign debt denominated in the issuer’s own domestic currency. The index includes all Euro members, the U.S., Japan, the UK, Canada, Australia, New Zealand, Switzerland, Norway and Sweden.

6 North Park Drive | Suite 208 Hunt Valley, MD 21030

Tel 410-528-8282 | Fax 410-528-8305

mail@assetstrategyconsultants.com www.assetstrategyconsultants.com

n Baltimore n Boston n Charleston n Harrisburg n Raleigh/Durham

For a quarter-century, Asset Strategy Consultants has been providing investment

management consulting to fiduciaries of endowments,

foundations and retirement plans.

We are dedicated to: developing and implementing customized

solutions for each client portfolio; achieving superior investment performance; reducing risks;

controlling expenses; and providing an exceptional level of client service.

Market expectations for target policy rate*

Government bonds with low or negative yields

% of government bond index with negative yields

Capital Markets Outlook is published quarterly by Asset Strategy Consultants.

Disclaimer and Sources: The material contained in Capital Markets Outlook is based upon consensus information published by the following sources and does not represent any specific recommendation:

Barron’s, BlackRock, Bridge Investment Group, Callan, Capital Group, Capital Economics, Eurekahedge,

Goldman Sachs, JP Morgan, Loomis Sayles, Morningstar, Northern Trust, Pitchbook, Preqin, Rockwood,

Schwab, SIT and T. Rowe Price.

Asset Strategy Consultants

Capital Markets Outlook Third Quarter 2016

2

InflationHeadline Personal Consumption Expenditures (what the Fed looks at when it targets 2% inflation) read 0.9% in May, but this is attributable to the year-over-year measurement period. If prices were to remain the same from now until the end of 2016, headline PCE will be very near 2.0%. Core PCE has been slowly drawn upwards (1.6% in May) by tightening in the labor market – something observers expect to continue. v

Capital Markets

Domestic EquitiesDomestic equities were able to weather the Brexit announcement and post positive returns for 2Q. The S&P gained 2.46% and now has returned 3.84% for the year. The second quarter marked a turnaround for styles as value outperformed growth across all cap ranges with the most pronounced difference in large caps. All sectors within the S&P had positive returns other than Information Technology (-2.8%) and Consumer Discretionary (-0.9%). The top performing sector was Energy (+11.6%) as oil prices had a nice rebound during the quarter. In a low interest rate environment, Telecommunications (+7.1%) and Utilities (+6.8%), both defensive sectors with a dividend component, continued their strong performance and now have year-to-date returns of 24.8% and 23.4% respectively. The Brexit/EU-related uncertainty is likely to be felt in both the consumer and business channels. Although consumer confidence was dented, there remains continued support for consumer spending, including low interest rates, higher wages, better housing data, and a healthy employment picture. Second quarter earnings may be taken lightly as they were “pre-Brexit” so, it remains to be seen if companies have altered their plans with the outcome that occurred. There are signs of financial and economic stabilization which have set the stage for an improved domestic equity climate for the second half of the year. However, this depends heavily on the stability of energy prices. Returns remain constrained as earnings growth is dampened by a modest economic growth environment and starting valuations remain elevated as shown by an S&P forward P/E ratio for the quarter ending 6/30/16 at 16.6x which is ahead of the 25 year average of 15.9x.

Fixed-IncomeThe low global interest rate environment has stoked demand for positive-yielding U.S. dollar denominated assets. During the quarter, the yield curve continued to flatten and it was the longer dated treasuries that generated the strongest absolute returns. Globally, the 10 year Japan and Germany yields were pushed into negative territory. Brexit headline risk will remain a source of bond market volatility, but volatility can create opportunities for long term investors. When the British voted to leave the European Union, it put central banks in an accommodative mode, in part, due to the expectations that global growth will continue

CurrenciesAfter Britain shocked markets by voting to leave the European Union, the Sterling saw its value fall more than 10% against the dollar. Against a trade-weighted basket of currencies however, the dollar sits at the same level as a year ago. The U.K. accounts for less than 6% of U.S. exports and this translates to a minor 0.7% of GDP. Currency markets are highly volatile in the short run, but the U.S. trade deficit should push the dollar down in the long run.

ConsumerConsumption, by far the largest component of GDP at around 70%, looks especially healthy. Real consumption growth is forecast near 4% for the second quarter. Households have shored up their balance sheets since the crisis, and total assets to liabilities now stands at a 7:1 ratio. The University of Michigan’s Index of Consumer Sentiment remained high with a reading of 93.5 in June. This level of confidence has been sustained since the end of 2014, and is reminiscent of the mid-1990s. Improvements in job and wage growth will continue to brighten the outlook.

EmploymentNews of the 287,000 jump in non-farm payrolls in June (well over the sub-200,000 consensus estimate) gave confidence to forecasts of a tightening U.S. labor market. The unemployment rate at the end of the quarter was 4.9%, down from 5.3% last June. Year-over-year annualized hourly earnings changed little at 2.6%. The low level of wage growth is frustrating, but expectations are for a pickup following sustained low unemployment.

Interest RatesGetting to the FOMC’s year-end projection for the fed funds rate (0.9%) would require two increases of 25 bps. Markets are highly skeptical of this and, as of this writing, have the probability of one rate hike by year end at less than 40%. The Fed is very close to its employment and inflation targets – it may never get the global market tranquility that it appears to desire. But the extreme monetary policy is a global phenomenon. The flight to safety ends with government bonds, and for the foreseeable future U.S. Treasuries will be the most attractive for global investors. Yields on the 10-year were driven to a record-low of 1.37% in early July. Real yields have fallen below zero. BofA/Merrill Lynch estimates that 74% of global government bonds have yields below 1%, and 36% are negative. Easy monetary policy has not been the panacea for growth that central bankers wish, but they are certainly reluctant to abandon it.

HousingAverage home prices have crept to within $3,000 of their peak in October 2005. But with such extraordinarily low rates, the average mortgage payment as a percent of household income is well below historical averages. Housing starts have plateaued for about a year now, continuing the low-and-slow theme, and tamping thoughts of another housing bubble.

Capital Markets Outlook Third Quarter 2016

3Asset Strategy Consultants

Alternative Investments

Hedge FundsThe first half of 2016 was a challenging period for most hedge fund managers with volatility spiking at the beginning of the year due to concerns over oil prices and the health of the global economy. Some managers were able to take advantage of the dislocation, but for others, it was a difficult period to operate in. The volatility that occurred toward the end of June compounded an already difficult environment for fundamental stock pickers, particularly those with exposure to the global markets. There was not only severe selling pressure in European financials but also in small and mid-cap stocks after the results of the Brexit vote were announced. The S&P 500 was able to rally back sharply, but many hedge fund managers were not able to recover as quickly. With hedge fund performance still lackluster for the most part, funds are feeling pressure on fees, as many investors are losing patience and either reducing or eliminating entirely their allocations to the asset class. In addition, funds are seeing costs rise associated with increased regulation. YTD through the end of May, the hedge fund industry saw outflows of $8.4B. The largest withdrawals came from credit hedge funds, while multi-strategy funds and CTAs both recorded inflows. Most managers expect continued volatility in the second half of 2016 as continued uncertainties surrounding Brexit and the upcoming U.S. election are expected to impact global markets for the near foreseeable future.

Private EquityAccording to Pitchbook, private equity fundraising activity in the second quarter of 2016 grew over 2Q of 2015. Although the number of funds closing in the quarter was down slightly from last year’s pace, the amount of capital raised ($88.3B) and median fund size ($322.7M) was greater than last year. Notably, Ardian Secondary Fund VII was the largest secondaries fund to reach a final close with $10.8 billion raised. North American funds are over half of the total funds in the market. In 2Q2016, the number of deals declined from 1,850 to approximately 1,325. Also, the level of private equity exit activity has also declined approximately 25% from 2015 levels with approximately 490 companies exited at around $140B for the quarter. However, the level of activity in 2Q2016 was above levels reached in 1Q2016. Preqin notes that buyout gets the highest level of interest from

to be challenged. Global growth expectations have been cut significantly, even in the United States where 2016 real growth consensus estimates fell to 2.0% from 2.8% a year ago. In the U.S., Treasury yields are approaching historically low levels. As of the end of the quarter, the 10 year Treasury yield was 1.49%. However, anticipated Fed tightening may be back on the table in the latter half of the year, a sharp contrast to 4 hikes expected at the end of 2015.

Developed EquitiesAfter a rocky start, the market rallied for the good part of the first half of 2016, until June 23rd when British voters narrowly approved a referendum to leave the EU. Brexit reignited the uncertainly and volatility. Global bond yields fell to record lows, the British pound fell to a 31-year low versus the dollar with an intra-day swing of more than 10%, and global equity markets plunged but quickly gained back much of what they lost over a period of a week. Brexit was clearly a disruption to the outlook for Eurozone economic growth and has increased the level of downside risks to the growth outlook. But long term economic fallout for continental Europe is likely to be manageable. The European Central Bank expects Brexit to cost the Eurozone 0.5% of its GDP growth over the next three years. Europe’s economy had been improving, the currency declines will provide support, and equity market valuations are reasonable in both UK and EU regions. But given the uncertainty surrounding the UK referendum, the IMF has lowered Eurozone growth from 1.7% for this and next year to 1.6% and just 1.4%, respectively. On the other hand, a gain in inventory helped Japan’s economy from shrinking more than expected albeit with a weakness in capital spending. Japan continues to face growing challenges from a strengthening yen and its 2% inflation goal remains elusive. Central banks in Europe and Japan have introduced negative interest rates to combat deflationary pressure. The IMF expects the Japanese economy to grow by 0.7% in 2016 and 0.4% in 2017. Japan may expand its stimulus as it struggles with the deflationary pressure but the key component to Prime Minister Abe’s program is the third arrow, structural reform. Japan has exhausted all its options to stimulate growth and needs structural reforms to raise productivity and stimulate long-term growth. Looking ahead, amid the volatility, the global economy is on a path for slow growth.

Emerging MarketsThe path to a 5% return in the first half of 2016 was anything but smooth for emerging market equities. The dips along the way were driven by falling commodity prices and speculation of another Fed rate hike. Winners within emerging markets for the first-half of 2016 include Peru, up 49%, Brazil, up 44%, and Colombia, up 25%. Brexit has led to a resumption in dollar strength, which has historically been a headwind for emerging markets. However, an expected hiatus in Fed rate rises bodes well for beaten down emerging market assets. Areas of the emerging markets that are particularly attractive include Southeast Asian countries. These

countries are experiencing domestically led growth, especially in the tech and fast growing services sectors. The cyclical challenges that led to poor emerging market returns in recent years are now reversing. Weaker currencies have led to improving trade balances. Oil prices and China’s slowing economy have stabilized. Market unfriendly governments have been ousted in key economies such as Brazil. v

6 North Park Drive | Suite 208 Hunt Valley, MD 21030

Capital Markets Outlook Third Quarter 2016

Alternative Investments, continued from page 3

institutional investors followed closely by venture capital and growth strategies. Geographically, Europe has the highest level of interest from investors looking to make new commitments, with 56% targeting the region followed closely by North America at 48% of institutional investors.

In venture capital, the lack of exit activity has been the main story in the first half of 2016. 2Q2016 saw IPO activity finally resume with 24 IPOs taking place, up significantly from the first quarter. Twillio, a cloud computing platform, was the largest to come to market, raising more than expected with a valuation result in excess of $1 billion. Fundraising activity continued at levels on par with 2015 levels. The number of funds closed (101) was similar to 2Q2016, with median fund size increasing to above $100 million, but still well below pre-financial crisis levels. 2Q2016 was also good for company valuations as they increased by almost 40% over 1Q2016 levels in funding rounds.

Dry powder held by private equity funds reached an estimated $800 billion globally according to Preqin. Venture capital funds had the greatest percentage growth at 15%, but the absolute level of dry powder is approximately $160 billion, a smaller percentage of the overall level.

Real EstateWith interest rates low and negative in many parts of the world, U.S. property markets should continue to be able to attract capital

from investors throughout the world, whether it be for safety, high relative yield, capital appreciation, or some combination of the aforementioned. Finding good values may be quite challenging for managers, especially with the increased number of investors that have entered the market. Dry powder has risen to record levels as of June 2016 ($236B). This “wall of capital” is pushing up the price of real estate and making it increasingly difficult for managers to get competitive pricing. Values of office buildings in central business districts and apartments are at all-time highs, roughly 40-45% higher than they were at the peak of the last real estate cycle according to Moody’s Analytics and Real Capital Analytics. Many managers are looking outside of the traditional real estate sectors to source attractive opportunities. There has been a recent pick up in the number of senior and student housing deals, with strong demographics supporting this niche sector. Also notable is the number of portfolio transactions that are coming to market. This is another way for managers to uncover value that others may overlook or may not have the resources to be able to execute on. Some managers have begun to shy away from larger deals and are focusing attention on smaller properties as a way to avoid the high level of competition for trophy assets, finding under the radar opportunities. v