INVESTMENT OUTLOOK – First Quarter 2016 Heritage Market Brief

SECURITY SELECTION COMMITTEE VIEWPOINTS

First Quarter 2016

THEMES

  • The Federal Reserve raised rates by 25 basis points in December 2015 for the first time in nearly 10 years, signaling confidence in the U.S. economy.
  • Despite recent interest rate increases, the FOMC remains committed to gradual increases while balancing long-term goals of maximum employment and inflation of 2%.
  • Inflation remains below target as indicated by the year-over-year core Personal Consumption Expenditures Index (PCE less food and energy) reading of 1.33%.
  • The U.S. economy added 292,000 jobs in December, and the unemployment rate remained unchanged at 5%.
  • While wage inflation moderated some in 2015, wages still advanced a respectable 4.5%.
  • Consumers appear healthier as year-over-year real disposable income increased 3.1%, and consumers are saving income at a 3-year high of 5.5%.
  • While consumer health has improved, declining consumer confidence from 99.1 in October to 90.4 in November has kept consumers from spending discretionary income saved from lower oil prices and higher wages.
  • In November 2015, manufacturing entered contraction territory for the first time in 36 months as the strong dollar continues to weigh on exports.
  • While interest rates remain range bound, individual bonds held to maturity should continue to provide downside protection.
  • It is likely that volatility will continue as the Federal Reserve is expected to continue raising interest rates, S&P 500 stocks no longer appear cheap relative to earnings, and revenue growth remains challenging.
  • Emerging market economies remain at risk to rising U.S. interest rates; however, the asset class should be additive to long-term returns as demographics are favorable and the sub- asset class remains attractively valued at under 11 times next year’s estimated earnings.
  • Structural unemployment as well as a slow recovery from a severe recession may be playing a key part in the lowest labor force participation rate in nearly 40 years.

ASSET ALLOCATION

Even after the Federal Reserve raised interest rates for the first time in nearly a decade in December 2015, we expect the central bank to remain committed to an accommodative monetary policy which should keep current yields low relative to historical levels. Thus, we believe an overweight in stocks relative to bonds is appropriate from a risk/return perspective. Our focus on valuations

has led us to believe that U.S. small-cap stocks are becoming more attractive
after underperforming their large-cap counterparts for the last two calendar years. We are still maintaining our underweight to U.S. small-cap equities
but to a lesser degree than over the past couple of years. Despite weaker growth outside the U.S., we remain disciplined and maintain a strategic allocation to foreign markets, especially emerging markets where valuations appear much more attractive. Foreign small-cap stocks should be additive to the portfolio return in the long-run as small-cap companies tend to enjoy higher earnings and cash-flow growth relative to large-cap companies. Since, much of our small-cap exposure is in European small-cap companies, European accommodative policy should prove to be beneficial in the long-run as well. While our fixed income exposure remains underweight due to the current risk/return profile, we continue to purchase individual fixed income securities as bonds play a vital role in the portfolio.

We believe alternative exposure remains vital to portfolio diversification. While
we maintain a position in U.S. REITs, we have taken the opportunity to trim where necessary due to our belief that the asset class has potentially reached overvalued territory after outstanding growth throughout the recovery.

These views represent the opinion of the Security Selection Committee which are based on qualitative as well as quantitative factors. These quantitative factors are primarily driven by valuation research which then forms our subjective assessment of the relative attractiveness of asset classes and subclasses over a 3- to 5-year time horizon.