Key Private Bank’s 2016 Market Outlook Market...Key Private Bank’s Investment Management Team follows a rigorous and disciplined process as we evaluate markets and manage client

Key Private Bank’s 2016 Market Outlook

Key Private Bank’s Investment Management Team follows a rigorous and disciplined process as we evaluate markets and manage client portfolios. The 2016 Market Outlook highlights our research and strategy teams’ current thinking on the most important trends likely to shape market behavior this year and serves as a foundation for constructing client portfolios. Read on for our views on the economy, equity markets, and fixed income as we head into 2016.

2016 Market Outlook | 1

Industrial production stabilizes

Stabilization of industrial production is vital for Gross Domestic Product (GDP) growth this year, as the negative impact of contracting energy investment begins to fade. If further deterioration occurs, it would likely weigh on consumer confidence.

Currency challenges continue

A strong dollar will likely remain a challenge for U.S. exporters in 2016. As interest rates move gradually higher in the U.S. while the rest of world keeps rates low or moves them lower, the dollar is expected to strengthen modestly.

Inflation increases modestly

As the benefit of declining energy prices begins to dissipate, inflation will likely increase modestly. Increased industry consolidation and skilled-labor shortages both present risks of increasing price pressures, although we do not expect meaningful increases in the near term.

Slow pace of Federal Reserve rate hikes

Fixed-income markets remain focused on the pace of Federal Reserve rate hikes. Current expectations are for three, or perhaps four, hikes in 2016. As fixed-income investors constantly reevaluate available information for signs that this pacing changes, expect volatility in the markets.

Credit fundamentals weaken

Increased mergers and acquisition activity, combined with management teams using relatively low borrowing costs to boost shareholder returns, will likely lead to a weakening of credit fundamentals as the year progresses.

Equity valuations remain high

Stock prices are relatively expensive versus historical averages, and this condition is likely to continue as earnings growth is expected to be relatively sluggish.

Stocks volatile, outperform bonds

With volatility in markets likely to continue, investors will have ample opportunity to question their commitment to the equity markets. Those that look past the noise are likely to be rewarded with somewhat higher returns than will be available in the fixed-income markets.

Executive Summary


Contents

Economic Outlook . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

Asset Allocation Outlook . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

Equity Outlook . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

Fixed-Income Outlook . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

Timothy Swanson, CFA®

Chief Investment OfficerBruce McCain, CFA,® PhDChief Investment Strategist

Barbara Myers, CFA®

Director of Portfolio Strategy

Kevin Gale Head of Taxable Fixed-Income

Stephen Hoedt Senior Equity Analyst

Contributors


Industrial production will be pivotal for GDP growth in 2016. The industrial sector was rocked in 2015 by sharply contracting energy investment, slowing international trade, dollar strength, and rising inventories. Some have labeled the slide of production an “industrial recession.” If production cannot stabilize, layoffs may increase.

Fortunately, energy’s drag on production should ease. The supply of energy will remain high, but the balance should improve as new supplies quit worsening the glut. Energy development will not rebound quickly, but cuts will no longer offset other growth.

Consumer spending could fuel economic growth.Income growth has improved and should continue to grow as labor markets strengthen. Consumers should also have room to spend more due to lower energy costs. Yet spending growth has not kept pace with improving household cash flow. If consumers feel more confident in 2016, increased spending could drive better economic growth.

International trade will be critical for U.S. production and world growth.Recent reports suggest that international trade is stabilizing. That would be a major relief. Declining trade volumes have caused production cuts and raised fears of broader economic decline.

As with domestic production, deteriorating trade could infect other parts of global economies. Most service economies continue to grow and monetary conditions remain supportive. If trade can simply stabilize, domestic spending should sustain economic growth.

Currency trends will remain challenging, but the dollar’s rise should slow.Currency will likely remain a headwind for U.S. exporters in 2016, as rising interest rates in the United States and

Economic Outlook 2016

stable-to-lower rates overseas drive the dollar higher. The question is how rapidly the dollar will appreciate and how exporters will respond to the currency disadvantage.

U.S. interest rates may rise less than most people think. Most forecasts are heavily anchored in the experience of past cycles when rates rose sharply. In this sluggish cycle, however, those expectations may overestimate what rates will do. And international expectations may also be unrealistic. Europe still resists aggressive monetary infusions and Japanese policy has become more cautious. Hence, the anticipated spread between domestic and overseas rates may fall short of expectations.

The (long-term) inflation firewall may start to erode.Core inflation has remained stable because global overcapacity has restrained price increases. Although inflation will increase in 2016 as the energy decline ends, it should remain modest. Two trends, however, may begin to erode the restraints on inflation.

Early signs of improving labor compensation could reflect a broader shift in the supply and demand balance for workers. Skilled-labor shortages have already developed and seem likely to spread as labor markets tighten. Those shortages will become more significant as baby boomers retire. The tipping point will not come in 2016, but demographic trends suggest that wage inflation could become a problem.

The elimination of excess capacity through industry consolidation also alters pricing power. The airline industry illustrates the power of consolidation, as the consolidation of routes and flights has led to higher prices. The same thing is happening in other industries. Cheap money and limited growth opportunities have made consolidations more attractive. Higher interest rates may slow the trend, but it seems likely to continue for some time.

As the Fed raises interest rates for the first time in almost ten years, some observers fear we could be sliding toward recession. Several indicators suggest growth can stabilize, but 2016 will depend heavily on a handful of key trends. With that in mind, we offer five themes to watch as the year unfolds.


Key Takeaways

Neutral Projected growth for mid-cap domestic stocks

does not justify a heavy emphasis in that area, while the trends in the emerging markets do not indicate taking a strong position either way in that segment

of the equities markets.

De-emphasizeAlthough bonds may not suffer serious price

declines, they may be volatile in coming months and the current yields make equities more attractive. Relative to historical growth rates, small-cap U.S.

equities represent a poor value.

EmphasizeEquities, particularly large-cap domestic equities and overseas developed markets, represent the

most attractive areas for investment.

Fundamental trends—Economic and earnings growthEconomies around the world have not shown signs of impending recession, but the deterioration of trade and industrial production has been concerning. The sharp drop in energy development played an important role in the industrial cutbacks. That drop should be ending. Most developed international economies also depend more heavily on services than manufacturing. Thus, production and trade are not as critical as they once were, but continued slowing on the production side could eventually undermine the broader economy. At a minimum, production and trade need to stabilize. A resumption of industrial growth would put 2016 on a much firmer footing.

Market trends—Investor reactions to economic and earnings growthOver the long run, market trends reflect longer-term economic and earnings growth. With a reasonably solid outlook for growth in 2016, the markets should move higher over the course of the year. Progress may come in fits and starts, however. Growth will remain sluggish and valuations are high. Increased volatility seems likely over the course of the year as investors assess the impact of rising rates.

Valuations Equity valuations will probably remain uncomfortably high, particularly relative to sluggish levels of growth. That should not stall the equity rally, but it could amplify market volatility by exaggerating concerns about the normal ebb and flow of growth.

Asset Allocation Outlook 2016

Expectations have come down in recent months and it seems that most forecasters are expecting a continuation of the muted returns we have seen in the past several months. That said, recent trends often dominate ones thinking and it is easy to underestimate what a few macro-economic improvements could do. With limited signs of outright recession on the horizon, 2016 need not be a stellar economic growth year to generate decent investment returns.

When constructing client portfolios, Key Private Bank’s Asset Allocation Team considers a number of metrics, which fall into three broad categories: Fundamentals, Market Trends, and Pricing. We use proprietary analysis to help us quantify the metrics within each category, which our Asset Allocation Team reviews regularly. From that information, we determine which asset classes seem more likely to outperform over the next 12 – 18 months and then tactically position portfolios to take advantage of those opportunities.


Domestic large-cap equitiesMany forecasters have drawn heavily on historical cycles in predicting the path and effects of interest rates in the coming months. The problem is that this remains an unusual cycle and we do not have a clear precedent for how rate hikes will affect this economy. Growth has been below average to this point and is almost certain to remain so. But the strength of the U.S. economy and earnings has allowed U.S. equities to outperform other areas of the world. That advantage should begin to erode in 2016 as rising rates start to curb U.S. growth. If rates rise more slowly than most people expect, however, it will take longer for the advantage to disappear. It may make sense to continue emphasizing larger U.S. equities for much of 2016.

Developed international equitiesMost investors are exposed to international investments through diversified funds that take varying exposures and that are impacted differently by global policies. As rising U.S. rates eroded growth here, stimulative policies in the developed overseas markets were supposed to spur faster growth. That has made several overseas markets top picks for many investors in the coming year. At this point, however, commitments to further easing may be wavering in some of the important overseas economies. While this remains an area to emphasize, the investment advantage might be less than some expect.

Monetary authorities in Japan have backed away from strong commitments to further easing. Some economists still expect more easing, but a sizeable number see no further easing in the foreseeable future. The end of quantitative easing should not have a dramatic effect on the economy, although it will weaken the outlook for accelerating growth. Reduced easing would also ease pressure on the yen, which would eliminate a trade advantage. Solid relative growth in Japan still justifies an emphasis on the developed international region, and additional easing should simply enhance the case.

Europe ex-the United Kingdom has repeatedly overpromised and under-delivered when it comes to monetary easing. There are signs of improving economic activity in the region, which supports emphasizing developed international investments. That case will weaken, however, if European authorities fail to ease more aggressively.

Equity Outlook 2016

The United Kingdom has lagged other international markets for some time. Growth in the economy has been reasonably strong, but earnings growth has been weaker than for other regions. Thus, U.K. equities have underperformed and that country does not appear to contribute much to the prospects of the developed international segment.

Australia and the other countries of the Pacific ex-Japan have held up reasonably well given Australia’s weight in the region and the role that raw materials play in that economy. Commodity prices have declined precipitously over the last year and as yet have shown few signs of bottoming out. Until they do, the Pacific ex-Japan investments will remain under pressure.

Oil affects Canada more strongly. A better balance of supply and demand for that commodity should develop in 2016. As new supply winds down and the depletion of current production erodes excess supply, major suppliers like Saudi Arabia may act to raise prices. Prices should stabilize and potentially strengthen from current levels. A rise in oil prices of up to $60 a barrel is possible without generating a disruptive flow of new supply, and that would be very good for Canada’s economy.

Emerging Markets equitiesSeveral Emerging Markets economies have a very strong exposure to commodities. Oil producers, such as Russia and Mexico, may get some relief, but Brazil and other commodity producers will likely see little improvement. The excess of global manufacturing capacity has also hit the Emerging Markets hard, where China and other exporting economies were benefitting substantially from the build-out of new production. Improved domestic demand may replace industrial growth in China and other exporting economies, although that transition will take some time.

Domestic small- and mid-cap equitiesSmaller domestic equities continue to generate solid growth, but not enough to justify paying their premium price. While a strong dollar could give the domestically focused smaller stocks more advantage, that may not be as likely as many expect.


Credit OutlookCredit fundamentals are likely to weaken in 2016. Increased M&A activity and companies looking to increase equity returns through shareholder-friendly activities could lead to further deterioration in credit fundamentals.

Banking Sector – Profitability and meeting capital requirements will be the main focus within the banking sector in 2016. Banks will face another stress test in 2016 that will require higher capital reserves. Most companies have factored that into their capital allocation plans and are already in compliance. Overall, we continue to have a favorable opinion of the banking sector from a credit perspective based on improvements in asset quality, funding sources, and restrictions on M&A and shareholder-friendly activity.

Pharmaceutical Sector – The pharmaceutical space is expected to perform well in 2016 based on a continuation in M&A activity and a slowdown in patent expirations. M&A activity has been driven by a combination of patent expirations, tax inversions, and cost reductions. These are likely to continue in 2016, but at a slower pace than 2015. We have a favorable view of the pharmaceutical space based on expected cost savings from prior M&A deals, a shift toward equity-funded acquisitions, and a reduction in patent expirations.

Technology Sector – Performance in the technology sector is expected to vary depending on product line and pressure from shareholders. Software and cloud-based companies should benefit from increased corporate IT spending, continued technology-based outsourcing, and a slowdown in restructuring costs. Companies that have large overseas businesses may receive pressure from

Fixed Income Outlook 2016

shareholders to find a way to utilize their cash balance to create shareholder value. We have a preference for cloud and software companies that have subscription-based revenue focused on helping companies outsource functions and reduce costs.

Municipal bondsMunicipals performed relatively well in 2015, despite the never-ending call from pundits for higher rates. Investors that reached out on the curve beyond three years and into 5 – 7 years were rewarded with higher returns as the much-anticipated first Fed rate hike in December dampened returns in the short end of the curve. As our 2016 macro forecast calls for slightly higher rates in the treasury market, with the yield on the 10-year note rising to near 3.00%, we also expect to see modestly higher rates in the municipal market.

Overall credit concerns remain relatively contained in our view. However, we do expect defaults and/or major restructuring in the debt of various issuers in Puerto Rico. This should not be major news to investors in the municipal bond community that have followed the headlines the last couple of years. When this happens, we do expect a lot of media coverage which may put pressure on all municipals if investors panic and pull money out of open-end municipal mutual funds. Much of the debt from Puerto Rico has transitioned to hedge funds and away from traditional municipal investors, which should help to dampen the impact of a default.

As far as municipal performance versus treasuries, we would generally call for an outperformance of municipals given our bias toward higher rates. Typically when rates rise, they rise faster in the treasury market than

2015 was a challenging year in the fixed-income markets as investors waited until December for the first interest rate hike since 2006. Concerns over liquidity weighed on the asset class as well as increasing concerns over weakening credit fundamentals. With the prospects of higher interest rates in a fairly stagnant economic environment, uncertainty over liquidity and the health of the overall credit markets, we do not believe that 2016 will differ much from 2015 for the fixed-income markets. We expect a gradual rise in interest rates with the Fed Fund rate ending the year around 1.00% – 1.25% and the 10-year Treasury note rising to 2.75% – 3.00%.

We believe the biggest drivers for the fixed-income markets in 2016 will be: 1) the pace of Fed rate hikes 2) liquidity 3) increasing defaults in the High Yield markets 4) Mergers & Acquisitions (M&A) activity and 5) weakening credit fundamentals.


in the municipal market, leading to outperformance in municipals. However, 2015 finished the year with muni/treasury ratios at much richer levels than where they started the year. At year-end 2015, the muni/treasury yield ratio was 84% in the 10-year part of the curve. This ratio started the year around 94% and went above 100% during the middle of 2015. We believe that these relatively rich ratios at the start of 2016 will hamper the ability of municipals to outperform treasuries during the year.

Investment grade (IG) bondsPerformance of U.S. IG bonds remained subdued in 2015, which was a year of re-leveraging. Debt-funded M&A activity and shareholder-friendly activities led to heavy supply and deteriorating credit fundamentals, leading to pressure on credit spreads.

We remain comfortable on IG bonds from a valuation standpoint at current spread levels. We would not be surprised to see overall spread levels finish the year wider. However, we expect any spread widening to be offset by roll-down and carry.

We remain overweight intermediate-duration credit (5 – 10 year maturities) and would consider adding longer-term positions (10+ years) as we expect the yield curve to flatten as rates slowly rise. In shorter-dated credit (1 – 3 year), we prefer floating-rate notes versus fixed-rate instruments as we expect short-term treasury rates to rise faster than longer-term rates over the next 12 – 18 months.

High Yield corporate bonds2015 was a very challenging year for the High Yield market, with returns dipping into negative territory for the first time since 2008. One of the dominant news stories in High Yield throughout 2015 was energy and commodity-related credits, both of which underperformed and account for approximately 18% of the High Yield market. The other major news story in High Yield, and more broadly in fixed income, was liquidity.

In 2016, we expect another challenging year for the High Yield asset class as liquidity concerns are likely to spill over into the first quarter. We could see significant future redemptions from High Yield mutual funds as well as from hedge funds in the first quarter of 2016, leading to another sell-off. Volatility is likely to remain elevated for the asset class for the first half of the year.

Until we get more stability in the High Yield market and we gain more comfort with the strength of the U.S. economy, we remain very cautious on the High Yield market. For investors looking to remain exposed to the High Yield market, we prefer loans over bonds. The Leveraged Loan market offers the benefit of first lien securities as well as a significantly lower exposure to the energy sector.

Mortgage backed (MBS) and asset backed securities (ABS) Mortgages closed 2015 on a strong note, outperforming their treasury counterparts. Going into the new year, we continue to prefer mortgages over treasuries as we believe higher rates will help agency mortgages (MBS) outperform duration matched treasuries. During previous

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Any opinions, projections or recommendations contained herein are subject to change without notice and are not intended as individual investment advice. Investment products are:

© 2016 KeyCorp. 151220-24139

NOT FDIC INSURED • NOT BANK GUARANTEED • MAY LOSE VALUE • NOT A DEPOSIT • NOT INSURED BY ANY FEDERAL OR STATE GOVERNMENT AGENCY

rate hikes, agency MBS outperformed their treasury counterparts consistently and by wide margins.

Overall we remain positive on mortgage backed and asset backed securities going into 2016. We believe economic growth and low unemployment should be positive for both MBS and ABS. Additionally, we expect the Fed to keep tapering its MBS purchases, which could lead to spread widening.

International developed and emerging market debtMost major developed fixed-income markets saw yields plummet throughout 2015 as concerns over slowing global GDP, declining inflation, and consumer pessimism led investors to the relative safe haven of high-quality sovereign bonds. While performance in local currency was strong, in U.S. dollar terms returns were abysmal.

Over the coming year we expect divergence in the United States’ and other developed markets’ policy trends. The U.S. economy remains in a strong position to continue accelerating, largely as a result of solid consumer and business spending, and a strengthening

labor market. We expect the Eurozone and Japanese central banks to continue their unconventional policy, but expect little in terms of fiscal help. Our expectation is for the U.S. dollar to continue to appreciate against other major currencies.

Emerging markets (EM) have been going through a rough period as of late; a combination of declining commodity prices, a slowing Chinese economy, and investor pessimism have all created headwinds. We are, however, optimistic 2016 will likely mark the start of emerging market recovery. We expect that 2016 EM growth will accelerate for the first time since 2010.

As we go into 2016, emerging markets will see considerable headwinds from Fed rate hikes, lower commodity prices, and a stronger dollar. However, during the second half of 2016, as the Fed settles in and the U.S. dollar appreciation runs its course, these headwinds should ease. We remain pessimistic in the case of local EM debt, and expect continued volatility in that market. However, as the dollar settles into a higher relative value, we might see better opportunities during the second half of the year.

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Key Private Bank’s 2016 Market Outlook Market...Key Private Bank’s Investment Management Team follows a rigorous and disciplined process as we evaluate markets and manage client