U.S. Bank's 2015 Outlook

2015 OUTLOOK In a year when economic growth on a global level was mixed, both the U.S. economy and stock market proved to be bright spots during 2014.

The United States saw advancing economic growth and an improved job market.

This environment seemed to create a sweet spot for domestic investors—sufficient growth to support a continued bull market in stocks and low inflation to create a favorable setting for bonds.

• The U.S. economy gained enough traction in 2014 to allow the Federal Reserve (Fed) to finally scale back its efforts to bolster economic growth. Late in the year, the Fed ended its most recent quantitative easing strategies, convinced that the economic expansion could build on its own strength. Consumers continue to be the driving force. While an improved jobs market contributed to growth in consumption, so did a significant drop in energy prices that stemmed from a glut in oil supplies.

• A variety of challenges confronting nations around the globe are a concern. China’s fastgrowing economy faces modest headwinds as it implements structural reforms. Japan’s economy suffered a modest recession in 2014 in the process of trying to implement tax increases to reduce its burdensome government debt. The new tax policy will likely hamper growth prospects for Japan in

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2015 as well. Europe is still struggling to find solid economic footing. The odds of another recession in Europe are rising, particularly as its two largest economies, Germany and France, are slowing.

• Prospects for equity investors in 2015 will be largely tied to the fortunes of the economy.

Corporate earnings have continued to improve, paving the way for higher stock prices. If earnings remain positive, the bull market in stocks may continue on course. Bond markets, after a surprisingly strong 2014, may be in for more challenges because bond yields are likely to begin rising again, but perhaps only modestly. In our view, real estate and commodity markets may generate mixed results throughout the year since these sectors are impacted by a variety of factors.

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GLOBAL ECONOMIC VIEWS • We believe U.S. growth seems poised • Inflation pressures will continue to slow to cruise through 2015 around across emerging market economies, 2.5 percent to 3 percent, if there meaning 2015 is likely to see little continues to be solid consumer uptick in growth. Commodity-producing spending, no fiscal drag and some lift economies will continue to struggle with from business investment. Housing lower raw material prices. Commoditycontinues to recover from the financial consuming economies will see some crisis, but is not yet strong enough to lift from lower prices, but relatively drive investment growth. Export growth is constrained monetary policy to combat a risk to our forecast, with weaker growth inflation implies that relatively slow growth outside the United States. may remain the order for the year.

• Deleveraging for Europe and Japan may continue to constrain growth, with Europe likely slipping into recession in 2015, but significant monetary accommodation supporting modest levels of growth in Japan. Both the European Central Bank and Bank of Japan will be required to continue monetary accommodation to support economic activity.

Robert L. Haworth, CFA Senior Investment Strategist

“This is a year that begins with many parts of the world experiencing economic challenges,” says Rob Haworth, Senior Investment Strategist. “Europe is struggling, Japan continues to try to put long-term reforms in place and China is focused on implementing much-needed structural changes. Emerging markets are a bifurcated story, with commodity producers likely to suffer, while consuming countries fare better.” Rob anticipates that all of these factors are likely to limit growth on a global scale in 2015.

By contrast, the U.S. economy picked up momentum through 2014. “We expect gross domestic product (GDP) growth in the 2.5 percent to 3 percent range for 2015,” says Rob. “A strong, stable consumer is one key to continued growth. Another is that the federal government is no longer cutting spending. The primary concern for the domestic economy,” says Rob, “is that the housing market remains a question mark. It is not recovering as fast as we’d hoped.”

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EQUITY MARKET VIEWS “U.S. equities seem poised to continue

• We expect equities to trend higher in 2015, albeit at a moderate pace.

grinding higher in 2015,” according to Terry Sandven, Chief Equity Strategist. “An environment of rising earnings, persistent low interest rates, contained inflation and few compelling alternatives to stocks seem supportive of a positive environment for equity markets.”

At the same time, Terry anticipates a more volatile market environment.

“Our bias remains largely with cyclical sectors and companies that tend to perform well in an environment of slow global growth,” says Terry. “We favor stocks of companies that offer investors both dividend income and price appreciation potential.” Terry says one of the major concerns is the risk created by slowing global growth. “If that trend continues, it could create a headwind for earnings of U.S. multinational companies and potentially dampen prospects for equities.”

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Terry D. Sandven Chief Equity Strategist

– In the United States, equities are entering 2015 near all-time highs.

The current bull market began in 2009 following the financial crisis, with equities at that time being propelled higher by Fed-driven liquidity and price-earnings (P/E) multiple expansion. With the Fed winding down its stimulus programs and market multiples being modestly above historical levels, earnings have become the primary driver of higher equity prices. For 2015, we estimate earnings growth for the S&P 500 of approximately 8 percent, with prices appreciating in similar fashion. Our current 2015 price target for the S&P 500 is 2,240 based on a P/E ratio of 17.5 times our 2015 earnings estimate of $128.

– Macro, fundamental and political environments seem supportive of higher U.S. equity prices in 2015.

Favorable market fundamentals of

rising earnings, low interest rates, restrained inflation, reasonable valuations and less-compelling alternatives continue to push equity prices higher. And, following the 2014 midterm elections, the political landscape has shifted toward bipartisan governance, implying possible increased political wrangling, but not necessarily budget battles, which will have a meaningful negative impact on economic growth.

• Among international equities, the outlook for 2015 is somewhat less clear and perhaps less sanguine. The tepid pace of economic growth in developed markets such as Europe and Japan, and slowing in the rate of growth among emerging markets such as China, suggest that the performance of the broad international markets is likely to continue to lag in 2015, at least during the first half of the year. This may also suggest that U.S. multinational companies are unlikely to get a significant boost to earnings from their offshore operations until the global economic climate improves.

FIXED INCOME MARKET VIEWS • We believe primary drivers of monetary policy • We expect interest rates to continue to going forward will be inflation and wage rise gradually as the domestic economy growth. We expect that the earliest the Fed and labor markets continue to improve. As will begin to lift the fed funds rate (meaning we move closer to the eventual increase in when rates may begin to increase) is June the policy rate, the yield curve may flatten 2015, with the risks skewed to a September further. An increasing fed funds rate is liftoff. Although we believe the trajectory of likely to drive short yields up. Meanwhile, improvement in the labor markets will validate global interest in the long end of the an increase in the policy rate next year, we do curve may remain high given the safety not see that occurring without the additional and attractive yield offered by the U.S. participation of inflation and wage growth.

Treasury market versus other developed markets, which is likely to keep a lid on upward • Our view on inflation is that it will struggle to movement in the long end of the curve. approach levels that justify a policy rate shift.

We would expect the gradual improvement • In our view, high-yield fixed income bonds in wage growth and inflation to continue in will continue to outperform investment-grade 2015, reaching levels supporting a change in options. We believe new issuance in high the Fed stance by midyear. yield may dip in 2015 because there are few maturities until 2016 and 2017.

• The pace of policy normalization may be slower than the Fed’s current summary • We believe dollar-denominated emerging of economic projections, because we debt may also be well-positioned for believe global growth and inflation concerns outperformance in 2015. Currency reserves abroad will likely be headwinds to the and credit quality of the sector has been domestic economy. gradually improving. In addition, current spread levels remain appealing relative to U.S. debt sectors.

“The downward trend of interest rates and the fact that rates stayed low were both surprising developments in 2014,” says Jennifer Vail, Head of Fixed Income Research “A lot of negative geopolitical risk was priced into the market in the past year. Some of those concerns will carry over into 2015.” A big factor that could affect Jennifer L. Vail Head of Fixed Income Research

bond markets, according to Jennifer, is the direction of inflation. “If we don’t see significant wage growth, there may not be much impetus for rates to move up quickly. The Fed is likely to raise rates at a very measured pace in that kind of environment,” she says.

Looking around the globe, Jennifer sees little chance of a dramatic change in current rate trends. “We mainly see challenges abroad. Yields are at record lows and most currencies are weak compared to the dollar. This may limit attractive opportunities outside of Great Britain and select emerging market economies that issue dollardenominated bonds.”

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REAL ESTATE MARKET VIEWS “The level of recovery in the housing market was disappointing in 2014,” according to Ed Cowling, Director of Specialty Assets. “The rise in mortgage rates at the end of 2013 and the very long winter that extended well into 2014 took a lot of steam out of the market. It never warmed up after that,” says Ed. “While the fundamentals of the job market are solid, tepid wage Edgar W. Cowling, Jr., CCIM growth has limited activity Director of for homebuyers.” The apartment Specialty Assets market is a different story, because many potential homebuyers have demonstrated a preference for renting. “Demand is high and there is a fair amount of building in the multifamily market,” says Ed. The commercial market looks to be in a stronger position for 2015.

“Manufacturing is rebounding, homebuilding is firming and economic growth beyond the coastal markets appears to be favorable,” says Ed. “As the economy continues to grow, we should see further strength in the commercial real estate market.”

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• The housing recovery is likely to continue but at a modest pace. Increases in prices have retreated from previous double-digit year-over-year rates and the expectation is for single-digit growth in 2015. Rising mortgage rates will serve as a headwind but may be offset by employment growth, low inflation and basic economic improvements.

– Permits and starts of new homes will continue on an upward trend, but still fall significantly below the levels experienced in the years prior to the recession.

– We expect existing home sales to continue the advancing trend that began during the second half of 2014, with more stabilized pricing in general.

– Substantial student loan debt overhang and concerns about employment and the economy may keep the number of transactions by first-time homebuyers below historical averages.

– Rental growth in some markets may taper somewhat as supply catches up to demand, but we do not expect overbuilt conditions.

• Based upon continued improvement in the economy and underlying fundamentals of U. S. commercial real estate, we believe this asset class should move through the recovery cycle, with gains in both the number of transactions and in prices.

– Investors will look to an improving economy and property fundamentals, such as leasing and operating efficiency, to support valuations and transactions.

– Investments with an opportunity to increase occupancy, raise rents or otherwise improve the financial bottom line are considered to be the best prospects. The shift from primary to secondary markets is expected to continue.

– Demand for downtown office and housing should continue to draw occupants and investor attention.

• As the eurozone economic outlook faltered in late 2014, there was a corresponding downturn in the public real estate market.

Re-emergence may be sensitive to economic corrections.

COMMODITIES MARKET VIEWS • The broad commodity complex is likely to remain under pressure in 2015, driven by a stronger U.S. dollar, weak global economic growth and the overhang from relatively high inventories across the complex. Prices could see gains based on weather- or conflictrelated supply shocks, or if global growth starts to improve.

• Relatively weak global growth and strong oil production will likely pressure prices at the beginning of 2015. As we transition into spring, demand should improve and producers will likely adjust output based on lower prices, stabilizing the market and leading to a modest lift in prices for the full year 2015.

• Looming Federal Reserve interest rate increases in the second half of 2015 and a stronger U.S. dollar will keep pressure on gold prices throughout the year. The gold market could see rallies if demand improves for physical gold, but weaker growth in much of the world may temper such prospects.

Robert L. Haworth, CFA Senior Investment Strategist

“A key question with the commodities market is whether demand will rise as prices continue to decline,” says Rob Haworth, Senior Investment Strategist. One of the biggest stories in 2014 was the dramatic drop in oil prices. “The falloff in demand combined with plentiful supply created this trend, and that isn’t likely to change, at least in the first part of 2015. Unless we see faster economic growth in Europe, China and India, we won’t see a situation where demand outstrips supply in the oil market.” Similarly, says Rob, gold has been in a bear market for some time. “This trend is likely to continue as physical demand for gold remains muted.”

The market will turn at some point, according to Rob. “We may see prices become more attractive to investors, and that could begin a turnaround in the market. I would still encourage investors to build diversification into portfolios, with a modest position in commodities when appropriate.”

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POTENTIAL 2015 FORECAST Our forecasts are based on what we believe is the best information available and represent what we see as the most likely scenarios to develop as we go through 2015. Of course, there are always surprises—circumstances that can send the investment markets in unpredictable directions. We think it is helpful to consider how alternative scenarios may play out if events should move in an unpredictable way. Outlined are selected situations that could occur and how they might impact the investment environment.

Eurozone problems become more significant

U.S. strength ignites an inflation surprise

The United States catches a cold from weaker global growth

If economic growth and wage growth in the United States show fasterthan-expected improvement, it could rekindle inflation threats, an issue the domestic economy has rarely faced in the past two decades. If this occurs, the Federal Reserve may be forced to tighten monetary policy and raise short-term interest rates more quickly than expected. That could result in challenges for both the stock and bond markets and also result in higher mortgage rates that could affect housing market activity.

Although the U.S. economy seems to be on solid ground going into 2015, it is not fully decoupled from the world economy. If global issues become

The potential for a financial crisis in China China’s continued efforts to restructure its economy could lead to disappointing growth in what has been one of the fastest-growing economies in the world. If policy mistakes occur because of the nation’s government trying to reform its shadow banking system, it could lead to a financial crisis that would potentially have an impact in other parts of the global economy.

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Europe continues to contend with the challenges of being an economic union where countries maintain control over their own fiscal policies. Restrictions make it difficult for central bankers to execute a quantitative easing program similar to what occurred in the United States. Even the strongest economies—France and Germany—have encountered challenges, and if they face a more significant downturn, the effects could be felt on a global scale.

more significant as the year progresses, it could slow U.S. economic growth, leading to weaker domestic demand and raising deflationary pressures.

The Federal Reserve, already holding short-term interest rates at near zero percent, has few options available to revive economic growth. Bond yields would remain low, the housing market could weaken and stocks could lose ground as corporate earnings are negatively impacted by reduced demand.

2015 OUTLOOK If you have questions regarding this information or wish to receive definitions of any of the terms used in this commentary, please contact your Wealth Management Advisor or Portfolio Manager.

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These views are as of December 2014. This information represents the opinion of U.S. Bank Wealth Management and is not intended to be a forecast of future events or guarantee of future results. It is not intended to provide specific advice or to be construed as an offering of securities or recommendation to invest. Not for use as a primary basis of investment decisions. Not to be construed to meet the needs of any particular investor. Not a representation or solicitation or an offer to sell/buy any securities. Investors should consult with their investment professional for advice and information concerning their particular situation. The factual information provided has been obtained from sources believed to be reliable, but is not guaranteed as to accuracy or completeness. These views are subject to change at any time based upon market or other conditions and are current as of the date indicated on these materials. Any organizations mentioned in this publication are not affiliates of U.S. Bank.

Past performance is no guarantee of future results. All performance data, while deemed obtained from reliable sources, are not guaranteed for accuracy. Indexes mentioned are unmanaged and are not available for investment. The S&P 500 Index is an unmanaged, capitalization-weighted index of 500 widely traded stocks that are considered to represent the performance of the U.S. stock market in general.

Based on our strategic approach to creating diversified portfolios, guidelines are in place concerning the construction of portfolios and how investments should be allocated to specific asset classes based on client goals, objectives and tolerance for risk. Not all recommended asset classes will be suitable for every portfolio.

Equity securities are subject to stock market fluctuations that occur in response to economic and business developments. The value of large-cap stocks will rise and fall in response to the activities of the company that issued them, general market conditions, and/or economic conditions. Stocks of small-capitalization companies involve substantial risk. These stocks historically have experienced greater price volatility [8]

than stocks of larger companies and may be expected to do so in the future. International investing involves special risks, including foreign taxation, currency risks, risks associated with possible difference in financial standards and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility. Investing in fixed income securities are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. Investment in debt securities typically decrease in value when interest rates rise. The risk is usually greater for longer-term debt securities. Investments in lower-rated and non-rated securities present a greater risk of loss to principal and interest than higher-rated securities. Investments in high-yield bonds offer the potential for high current income and attractive total return, but involve certain risks. Changes in economic conditions or other circumstances may adversely affect a bond issuer’s ability to make principal and interest payments. The municipal bond market is volatile and can be significantly affected by adverse tax, legislative or political changes and the financial condition of the issuers of municipal securities. Interest rate increases can cause the price of a bond to decrease. Income on municipal bonds is free from federal taxes, but may be subject to the federal alternative minimum tax (AMT), state and local taxes. There are special risks associated with an investment in commodities, including market price fluctuations, regulatory changes, interest rate changes, credit risk, economic changes, and the impact of adverse political or financial factors. Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates, and risks related to renting properties (such as rental defaults). Š 2014 U.S. Bank N.A. (12/14)

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