333 S. Grand Ave., 18th Floor || Los Angeles, CA 90071 || (213) 633-8200

Economic Update

Second Quarter 2016

333 S. Grand Ave., 18th Floor || Los Angeles, CA 90071 || (213) 633-8200

DoubleLine Macro-Asset Allocation Team

Sam Garza, Portfolio Manager

Fei He, Quantitative Analyst

Ryan Kimmel, Analyst

2

Economic Update 6/30/2016

Global Markets Review

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).

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

Economic Update

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).

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 1: Performance of Asset Classes

As of June 30, 2016

Figure 2: Probability of Another Fed Rate Hike

July, September, December 2016 & February 2017

Source: Bloomberg, DoubleLine

Source: Bloomberg, DoubleLine *Please see appendix for index definitions.

Figure 3: ECB Deposit Rate & Eurostoxx Banks vs. Eurostoxx

As of June 30, 2016

Source: Bloomberg, DoubleLine *LHS = Left Hand Side Please see appendix for index definitions.

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100% Jul-16

Sep-16

Dec-16

Feb-17

0.025

0.03

0.035

0.04

0.045

0.05

-0.45

-0.4

-0.35

-0.3

-0.25

-0.2

-0.15

-0.1

-0.05

0

Ban

ks/E

uro

sto

xx R

atio

ECB

De

po

sit

Rat

e (

%)

ECB Deposit Rate (LHS)

Eurostoxx Banks/Eurostoxx

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

35%1H 2016

2Q 2016

3

Economic Update 6/30/2016

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

Economic Update 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 top-

line growth, vulnerable profit margins, and valuations being

well above historical averages (Figure 6).

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

Figure 4: BoJ Policy Rate & Topix Banks vs. Topix

As of June 30, 2016

Figure 5: 30-Year U.S. Treasury Total Return By Year

January 1988 to June 2016

Figure 6: S&P 500 Forward P/E Ratio & Bollinger Bands

As of June 30, 2016

Source: Bloomberg, DoubleLine *LHS = Left Hand Side. Please see appendix for index definitions.

Source: Bianco, Bloomberg, DoubleLine

70

80

90

100

110

120

130

140

150

0

10

20

30

40

50

60

70

80

90

10

0

11

0

12

0

13

0

14

0

15

0

16

0

17

0

18

0

19

0

20

0

21

0

22

0

23

0

24

0

25

0

26

0

Cu

mu

lati

ve P

erf

orm

ance

Trading Days

2015

2008

2011

2014

2013

2009

20161995

Source: Bloomberg, DoubleLine Please see appendix for index definition.

0.1

0.11

0.12

0.13

0.14

0.15

-0.12

-0.1

-0.08

-0.06

-0.04

-0.02

0

Ban

ks/T

op

ix R

atio

BO

J P

olic

y R

ate

(%)

BoJ Policy Rate (LHS)

Topix Banks/Topix

10

12

14

16

18

20

22

24

26

28Price-to-Earnings (P/E) Ratio

10-year Average

1st Standard Deviation

2nd Standard Deviation

4

Economic Update 6/30/2016

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).

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

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 near-

term, gold may underperform if yields move higher, but we

would see a sell-off as a buying opportunity.

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.

Economic Update Figure 7: U.S. High Yield Default Rates As of June 30, 2016

Figure 8: U.S. Household Debt-to-Disposable Income Ratio (%) As of March 31, 2016

Source: DoubleLine

Source: Bank of America Merrill Lynch Please see appendix for index definition.

80

90

100

110

120

130

140

U.S

. Ho

use

ho

ld D

eb

t-to

-Dis

po

sab

le In

com

e R

atio

(%

)

0

2

4

6

8

10

12

14

16

18

1999 2001 2003 2005 2007 2009 2011 2013 2015

LTM

Issu

er

Def

ault

Rat

e (

%)

BofA/Merrill Lynch High Yield

BofA/Merrill Lynch High Yield ex-commodities

5

Economic Update 6/30/2016

Economic Update

Author Biographies

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.

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 Sen-

ior Vice President in 2005. Prior to TCW, Mr. Garza worked at Union Bank of California in the Commer-

cial 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 join-

ing 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 mar-

kets 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 Uni-

versity in Beijing with a BS in Biological Sciences & Biotechnology and is a CFA charterholder.

6

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 current-

ly 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 struc-

tures, 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 transpor-

tation, 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, Argen-

tina, 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. Treas-

ury

“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. dollar-

denominated 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.

7

Economic Update 6/30/2016

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