Bond Yields Around a First Rate Hike September 2, 2014

Last week’s Federal Reserve (Fed) news was a reminder that the Fed remains on course to raise interest rates about one year from now. The release of minutes from the July 29 – 30, 2014, Fed meeting and Fed Chair Janet Yellen’s remarks at the Fed’s annual Jackson Hole Symposium were less market friendly than anticipated. The double dose of new information from the Fed was a modest disappointment for bond investors who expected a more market-friendly tone. Bond markets remain mispriced for an eventual Fed rate hike, and last week’s rise in high-quality bond yields was a reminder of the interest rate risk facing bond investors.

A rate hike remains about one year away, according to both Fed guidance and interest rate futures markets, but it still raises the question of when bond markets will move forcefully in response to Fed interest rate hikes. Yields have declined for most bonds, year-to-date, but expectations for higher interest rates have not wavered.

When Will Rates Rise?

So when will bond yields really move in response to Fed rate hikes? Over the last 20 years, bond yields began to increase approximately four to six months ahead of the Fed’s first interest rate increase [Figure 1]. The 2-year Treasury note is among the most sensitive to Fed changes to the fed funds target rate and therefore is a useful guide to market reaction.

A steadier rise in interest rates occurs once the first rate hike has passed, but in 1994, that steady rise began roughly two months before the first increase. Figure 1 shows the number of trading days, so adding back weekends gets us to calendar days and the four- to six-month period mentioned above.

The reaction among longer-term bonds, such as the 10-year Treasury, is similar but not identical. In 1994, the reaction in the 10-year yield came closer to three months prior to the Fed’s first rate hike, while in 1999 and 2004, the reaction came similarly four to six months before [Figure 2]. Like the 2-year yield, the rise in the 10-year yield was steadier just after the first rate increase in 1994 and 1999, but in 2004, a 1.0% rise in the 10- year yield was constrained to a period just before and after the first rate hike.

In 2004, the 10-year Treasury yield began to decline again despite ongoing Fed rate hikes leading a befuddled Alan Greenspan to famously label it a “conundrum.” Intermediate and long Treasury yields, however, resumed their rise in 2005, in response to continued Fed interest rate hikes before peaking in 2006.

Another takeaway from Figure 2 is that the rise in 10-year yields was more limited in time span. In 1999 and 2004, the 10-year yield peaked within one to three months after the first rate increase — a reminder that longer-term bonds are less influenced by the Fed and more by economic growth and inflation expectations. In 1994, the 10-year Treasury yield peaked 10 months after the first rate hike — perhaps a reflection of an aggressive and quick Fed rate hike schedule (which is not expected in the current environment) and the Fed continuing to emphasize a go-slow approach.

Caveat Emptor

Of course, every historical period is unique, reaction may not follow historical form, and investors need to beware. The prevailing environment is quite different from others and involves a range of Fed stimulus that may be halted or reversed as the Fed gradually attempts to normalize policy. Bond purchases are expected to end in October 2014, and the Fed may eventually change its guidance from being on hold for a “considerable” period to signaling that a rate hike is drawing near. Both events may act as a catalyst to higher yields.

Other Fed tools, such as paying interest on excess bank reserves and the reverse repurchase facility, cloud potential market reaction. Additionally, the latest indication from the Fed is that it may maintain an overnight interest rate range, rather than set a specific rate, which may soften the potential market reaction.

We believe the rise in interest rates may begin sooner in anticipation of an interest rate hike. Bond valuations, although off the peak of early May 2013, remain very expensive by historical comparison, and the bond market has already priced in a Fed that may take longer than anticipated to raise interest rates. Along with lower yield levels compared with history, this makes the bond market vulnerable to rising rates. Timing such a move is very difficult, even with history as a guide. We favor a defensive stance in the bond market capitalizing on year-to-date strength and positioning with short to intermediate bonds to protect against the threat of rising interest rates.

 

 

IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide or be construed as providing specific investment advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. The fast price swings of commodities will result in significant volatility in an investor’s holdings. International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.

Not FDIC/NCUA Insured | Not Bank/Credit Union Guaranteed | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit

Member FINRA/SIPC

 

Sentiment & Positioning January 28, 2014

A widely expected move higher in bond yields has yet to materialize in 2014, and those expectations actually may help explain why yields have declined. Financial markets occasionally “zig” just when a growing majority expects a “zag.” Bonds are no exception, and many investors have been caught off guard by early 2014 bond strength. Although profit taking hit bonds on Monday, January 27, 2014, the Barclays Aggregate Bond Index is still up over 1% year to date. After dropping as low as 2.71% last Friday, the 10-year Treasury yield closed Monday, January 27, 2014 at 2.76%, still 0.27% lower in just over three weeks of trading this year — a significant move.

Lopsided sentiment can often drive contrarian moves by financial markets, especially in the bond market. One indicator that captured the overwhelmingly negative sentiment on bonds was the Commitments of Traders report, which is issued weekly by the U.S. Commodity Futures Trading Commission (CFTC). The CFTC Commitments of Traders report includes the net positioning of speculative investors across a variety of futures contracts. Observing whether speculative investors are net long (betting on higher prices) or net short (betting on lower prices) can reveal positioning of institutional speculative investors.

In late 2013, the CFTC report showed one of the largest net short positions on record in 10-year Treasury futures, indicating that the market was expecting rates to rise. The near 200,000 net short position was a level witnessed only rarely over the past 10 years [Figure 1]. These extremes have

often coincided with contrarian rallies as evidenced by the shaded areas. As prices rise and yields decline, speculative investors scramble to cover their short positions for fear of incurring losses. The rush to exit positions can be a powerful force and, here in early 2014, the subsequent buying has helped propel the bond market higher.

This contrarian indicator can help explain pullbacks as well. The buildup of long positions in early 2013 to some of the highest levels of the past few years coincided with the 2013 bond pullback and rise in yields.

At the same time, the indicator is not foolproof, and a significant net long position prior to the 2007 – 08 financial crisis coincided with a long decline in yields. In addition, the CFTC data are released with a slight lag meaning sentiment may have shifted, but it does help explain market moves. The CFTC report is just one tool to assess sentiment that may be offside and a lead to a contrarian move in the markets, but it needs to be evaluated in conjunction with other data.

Positioning

Positioning of short-term speculators is far from the only factor driving bond prices, and investor positioning appeared to corroborate the negative sentiment at the start of the year. The firm Stone & McCarthy Research Associates conducts a survey of bond investors to assess whether they are positioned short, neutral, or long relative to their broad benchmarks. A short or long bias would reveal investor expectations of rising or falling interest rates, respectively. In mid-January, Stone & McCarthy’s survey revealed investors on average were at 96.6% of their target interest rate sensitivity, or duration, the most defensive reading since the third quarter of 2008.

As bond prices rise and interest rates fall, defensively positioned investors may see their portfolios likely lag benchmark performance. Investors then would likely buy to get closer to their benchmark in order to limit underperformance to a benchmark. Bond buys to get portfolios closer to neutral may have aided bonds in early 2014.

When coupled with fundamental drivers, positioning and sentiment can be a potent combination. In early January 2014, a weaker-than-expected employment report sparked questions about the strength of the economy and bonds rallied, setting in motion a buying spree as wrong-footed investors reversed bets on lower bond prices. Pension investors also took advantage of yields near two-and-a-half-year highs and also gave bond prices a boost to start 2014 (please see blog post Why Own Bonds? 1/21/14 for more details).

Recent momentum was aided by a host of emerging market (EM) issues spurring buys of higher-quality assets like Treasuries. Weaker-than-expected economic growth from China, Turkey’s central bank’s attempt to stabilize its currency, political instability in the Ukraine, and Argentine currency devaluation all contributed to US Treasury demand.

EM currency fears appear contained for now, however, with no signs of disruption in domestic intra-bank lending markets. The TED spread, a key gauge of inter-bank lending pressures during the 2007 – 08 financial crisis and several times during the European debt fears of recent years, has served as an early warning signal but is near a post-recession low for now [Figure 2], indicating no global contagion from EM currency weakness.

Where Do We Go From Here?

Although EM concerns may support high-quality bonds during the current week, the offside positioning in the bond market has been largely reversed. Figure 1 illustrates that while speculators may still be net short, positioning is much closer to neutral and away from an extreme. The most recent J.P. Morgan investor duration survey shows fewer participants “short” and a greater number now “neutral.”

This suggests that the fuel for additional price gains will likely need to come from fundamental data. The preponderance of economic data suggests the U.S. economy continues to expand near our expected pace of 3% (as measured by real gross domestic product) and that the weak employment report may have been an outlier, suggesting further bond gains may be limited. Bond investors may refocus on economic data now that positioning and sentiment appear more balanced.

Furthermore, this week’s auctions of new two-, five-, and seven-year Treasury securities may give investors pause after the recent run-up in prices. Add a Federal Reserve (Fed) meeting, and a bond market breather is likely until new information is digested. The Fed is also widely expected to announce a further $10 billion reduction in bond purchases at the conclusion of Wednesday’s Fed meeting. Both factors augur for higher yield probability over the course of the year.

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IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. Unmanaged index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance of any investment. Past performance is no guarantee of future results.

This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise, and bonds are subject to availability and change in price.

Treasuries are marketable, fixed-interest U.S. government debt securities. Treasury bonds make interest payments semi-annually, and the income that holders receive is only taxed at the federal level.

Government bonds and Treasury bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of fund shares is not guaranteed and will fluctuate.

International and emerging market investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.

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INDEX DESCRIPTIONS

The Barclays Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment-grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.

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This research material has been prepared by LPL Financial.

To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is not an affiliate of and makes no representation with respect to such entity.

Not FDIC/NCUA Insured | Not Bank/Credit Union Guaranteed | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit

Member FINRA/SIPC

Why Own Bonds? January 21, 2014

Strong equity market performance in 2013 and still-low yields may cause investors to overlook the fact that bonds can still serve as an effective diversification tool. Following a year in which stocks returned 30% and bonds posted their worst return since 1994*, investor sentiment for stocks remains positive while bond sentiment is poor. The divergence in sentiment is evident in actual investment dollars. Inflows into stock mutual funds totaled $168 billion in 2013 versus a rare outflow for bonds, which totaled $82 billion. Our 2014 forecast calls for 10% to 15% returns for stocks and another challenging year for bonds with returns roughly flat^{^.}

The case for stock investing is strong but pullbacks can arrive without warning. As mentioned in our

Outlook 2014, we expect more volatility this year. In 2013, the stock market experienced only one brief pullback of just over 5%. Historically such calm is rare. Looking beyond 2014 the case for stocks over bonds is compelling, but for investors with shorter-term horizons protection against an equity market sell-off is prudent. After all, the average annual peak-to-trough decline in the S&P 500 from 1960 to 2013 has been 16%, and pullbacks can arrive without warning. Investors need to be prepared and bonds can help provide a buffer.

A look back at prior stock market pullbacks illustrates how bonds have historically provided good diversification benefits. Figure 1 shows all equity market pullbacks of 5% or more lasting three weeks or more over the past 10 years and the corresponding return for stocks and high-quality bonds. Figure 1 also illustrates the hypothetical return of a balanced 60% stock/40% bond portfolio and the dampening impact bonds can have on stock weakness. During stock market pullbacks in excess of 5%, bonds outperformed stocks on average by a double digit margin, a significant difference. Excluding the historic mid-2008 to early-2009 sell-off, the performance differential narrows but is still notable at a 9.6% advantage in favor of high-quality bonds.

In a few cases, both stocks and bonds declined together. This is a troubling outcome and reflects a failure of diversification, but it is rare. Still, bonds managed to outperform stocks on those occasions. In 2008, high-quality bonds provided a buffer but not without volatility, as investment-grade corporate bonds declined for the year and even high-quality mortgage-backed securities (MBS) suffered brief declines. While not all segments of the bond market perform similarly every time, an allocation to high-quality bonds has proven effective at offsetting stock market weakness.

Not About Yield

Today’s low-yield environment does not negate the diversification potential of bonds. During 2012, the stock market suffered two pullbacks greater than 5%, and bonds rose more than 1% over each period. The 10-year Treasury yield varied between 1.4% and 1.9% during the 2012 equity market sell-offs, much lower than today’s level.

In fact, during each stock market pullback in Figure 1 bond market performance is fairly consistent, averaging 1%, despite varied levels of interest rates. Two of the bond market’s strongest gains during stock market sell-offs occurred in 2010 and 2011, a post-recession period in which yields had already declined sharply.

Over short-term periods, price movement, not interest income, is the primary driver of bond performance. Interest income accrues slowly and although the primary driver of long-term bond returns, price changes, up or down, often overwhelm the impact of interest income over short periods of time. Therefore, a low-yield environment does not preclude bonds acting as a diversification tool.

Pension Buyers

Pension plans represent another investor group that can use bonds to address a specific objective. Pension investors, who have a very long time horizon and are therefore less sensitive to interest rate movements, use bonds to offset their long-term liabilities. Robust equity market gains in 2013 improved pension funding ratios broadly and reduced the need to take on additional risk to achieve investment goals. Following a year in which equities gained 30%, pension buyers took advantage of long-term Treasury yields near 4% and long-term corporate bond yields above 5% to better balance the risk-reward profile of their investment portfolios [Figure 2]. Pension buying, which has been a steady source of demand so far in 2014 and one reason why bonds are off to a good start, illustrates another way in which bonds can address specific investor objectives.

Conclusion

Low yields will likely translate into lower long-term bond returns, and therefore the hurdle for stock investors to beat bond performance over the long term is lower. However, for investors with shorter horizons or those simply unwilling to endure stock market swings, bonds can play a diversification role even in today’s low-yield environment. In conjunction with sectors that historically hold up better against rising rates, such as high-yield bonds and bank loans, an allocation to core bonds makes sense to help protect against potential stock market weakness.

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IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. Unmanaged index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance of any investment. Past performance is no guarantee of future results.

This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise, and bonds are subject to availability and change in price.

Stock and mutual fund investing involves risk including loss of principal.

Corporate bonds are considered higher risk than government bonds but normally offer a higher yield and are subject to market, interest rate and credit risk as well as additional risks based on the quality of issuer coupon rate, price, yield, maturity and redemption features.

Mortgage-backed securities are subject to credit, default risk, prepayment risk that acts much like call risk when you get your principal back sooner than the stated maturity, extension risk, the opposite of prepayment risk, and interest rate risk.

Treasuries are marketable, fixed-interest U.S. government debt securities. Treasury bonds make interest payments semi-annually, and the income that holders receive is only taxed at the federal level.

Government bonds and Treasury bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value.

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INDEX DESCRIPTIONS

The Barclays Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment-grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.

The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

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This research material has been prepared by LPL Financial.

To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is not an affiliate of and makes no representation with respect to such entity.

Not FDIC/NCUA Insured | Not Bank/Credit Union Guaranteed | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit

Member FINRA/SIPC

2014 Municipal Bond Outlook December 10, 2013

Municipal bond investors may face another challenging year in 2014, as we believe yields are likely to continue to move higher and bond prices lower. In most cases, we expect flat to marginally positive returns as interest income offsets price declines, but losses are likely if yields rise to the high end of our forecast. Similar to our outlook for the taxable bond market, we expect municipal yields to move higher by 0.3% to 0.8% compared to our outlook of a 0.5% to 1.0% increase for Treasuries. The smaller rise in yields compared to taxable bonds reflects our belief that municipal bonds will prove more resilient to rising interest rates in 2014 compared to Treasuries. Still, municipal bond prices will not be immune to rising interest rates in response to improving economic growth, reduced Federal Reserve (Fed) bond purchases, and the likelihood of an interest rate hike in 2015.

Early Headwinds

Municipal bond investors may face headwinds early in 2014 that may give way to potential opportunities later in the year. Three factors may contribute to early headwinds for municipal bonds.

• A difficult seasonal period. Late February to early April marks a historically difficult seasonal period in the municipal bond market. Investors often sell municipal bonds to pay for  capital gains taxes ahead of tax day, April 15. Since 2013 is shaping up to be a strong year for equity gains, tax-related selling is more likely to occur in 2014 and may pressure municipal bond prices lower.
• Lackluster demand.  Mutual fund outflows continue and may linger through the start of the New Year. Mutual fund outflows alone do not necessarily lead directly to price declines or preclude an increase in bond prices. However, fund flows are reflective of individual investor demand, which comprises 75% of the municipal bond market, and the persistence of outflows indicates that overall investor demand may still be soft to start 2014.
• Higher valuations.  Finally, municipal bond valuations have improved over recent months relative to Treasuries. Municipal-to-Treasury yield ratios are at the lower end of a six-month range [Figure 1], even if they remain elevated on a longer-term basis. As Figure 1  illustrates, municipal-to-Treasury ratios have failed to fall further in recent months after reaching current levels, leaving municipal bonds more sensitive to Treasury price movements. While ratios are still indicative of an attractive valuation over the longer term, the combination of continued outflows and the approach of a difficult seasonal period suggests limited scope for further valuation improvement at the start of 2014 to offset any price weakness.

Tailwind Opportunities

Early weakness may give way to tailwinds and buying opportunities later in the spring and summer of 2014. In 2013, price swings were often exacerbated by illiquid markets, and creating pockets of opportunity. The same may hold true in 2014 as liquidity remains constrained. Traditional taxable bond buyers entered the municipal bond market at times to take advantage of more extreme valuations and yields at or near 5% on high-quality bonds. Strong demand for long-term municipal bonds emerge as a greater number of high-quality municipal bond yields approach 5%. The 5% yield level has often brought out buyers and may do so once again [Figure 2].

A favorable longer-term supply-demand balance failed to benefit municipal bonds in 2013 but may provide support in 2014. According to recently released Fed data, overall municipal bond market growth remains stagnant [Figure 3], and through September 2013, the market of outstanding municipal bonds is almost $90 billion smaller than its peak during the fourth quarter of 2010. The municipal market is expected to show no growth in 2014, restricting the size of the market. This favorable supply-demand dynamic may give municipal bond prices a lift once early year challenges subside.

A Modest Improvement

While 2014 may be challenging, we expect an improvement over 2013. Average high-quality municipal bond yields are closer to the 5% level now than at the start of 2013. Yields may have less room to rise, and price weakness may be more limited compared to 2013. Therefore, we expect a modest performance improvement in 2014 versus what investors are on pace to experience for 2013.

We expect high-quality municipal bond returns to be flat to marginally positive in 2014 as interest income essentially offsets price declines associated with higher interest rates. We place a lower probability on yields rising by 0.8%, the top end of our forecast, since such an increase would require the Fed to indicate an earlier start to increasing rates than their current mid-2015 guidance. We think it is more likely the Fed may wait longer than mid-2015 to raise interest rates, which supports a more modest rise in municipal bond yields of 0.3% to 0.6%. Depending on maturity, interest income may offset price declines associated with rising interest rates.

Finding the Middle Ground

We favor intermediate municipal bonds due to better protection against rising interest rates while also providing upside potential. Long-term municipal bonds, although attractively valued relative to Treasuries, present greater interest rate risk. High-yield municipal bonds may also be impacted by rising rates. Unlike taxable high-yield bonds, tax-free high-yield bonds do possess much more interest rate risk. While a diversified portfolio of municipal bonds should contain long-term and high-yield municipal bonds, we believe more attractive entry points may arise over the course of 2014, and we focus on intermediate-maturity municipal bonds.

Getting Credit

Credit quality continues to improve on a broad basis for state and local governments. State and local governments have begun to add workers for the first time in years, and the state of California is projecting a surplus for the current fiscal year for the first time in almost a decade. The improving fiscal picture should keep defaults in check. Unique situations, such as Detroit’s financial failures, are likely to remain isolated and are not representative of the broad municipal bond market. The number of defaulted issuers is on pace to finish lower for a fourth consecutive year in 2013 according to Municipal Securities Rulemaking Board (MSRB) data and is likely to remain very subdued in 2014.

Not So Taxing

The topic of tax reform will overhand the municipal market, but odds of substantive reform remain very low for 2014. In an election year, a divided Congress is once again likely to struggle to find legislation that satisfies both parties. Furthermore, both Democrats and Republicans appear to better understand the role of the municipal bond market and the lack of viable alternatives to traditional tax-exempt financing for state and local governments. Eliminating the tax exemption of municipal bond interest may fail to raise desired revenues and have negative consequences for state and local governments.

______________________________________________________________________________________________________________________________

IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indexes are unmanaged and cannot be invested into directly.

This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise, and bonds are subject to availability and change in price.

Government bonds and Treasury bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of fund shares is not guaranteed and will fluctuate.

Municipal bonds are subject to availability, price, and to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rate rise. Interest income may be subject to the alternative minimum tax. Federally tax-free but other state and local taxes may apply.

Treasuries are marketable, fixed-interest U.S. government debt securities. Treasury bonds make interest payments semi-annually, and the income that holders receive is only taxed at the federal level.

International and emerging market investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.

High-yield/junk bonds (grade BB or below) are not investment grade securities, and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors.

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INDEX DESCRIPTIONS

The Barclays Treasury index is an unmanaged index of public debt obligations of the U.S. Treasury with a remaining maturity of one year or more. The index does not include t-bills (due to the maturity constraint), zero coupon bonds (Strips), or Treasury Inflation Protected Securities (TIPS).

The Barclays Municipal Bond Index is a market capitalization-weighted index of investment-grade municipal bonds with maturities of at least one year. All indices are unmanaged and include reinvested dividends. One cannot invest directly in an index. Past performance is no guarantee of future results.

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This research material has been prepared by LPL Financial.

To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is not an affiliate of and makes no representation with respect to such entity.

Not FDIC/NCUA Insured | Not Bank/Credit Union Guaranteed | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit

Member FINRA/SIPC

2014 Fixed Income Outlook December 3, 2013

In 2014, interest rates are likely to continue to move higher and bond prices lower in response to improving economic growth, reduced Federal Reserve (Fed) bond purchases, and the likelihood of an interest rate hike in 2015. Even though a Fed rate hike is a 2015 event, bond prices are likely to decline and yields increase as valuations remain expensive to historical averages and forward-looking markets prepare for a rate hike. We view the start of interest rate hikes as more important than the pace of tapering, but tapering will mark the first step in bond prices and yields returning to historical norms. We see a defensive investment posture focused on less interest rate sensitive sectors as the most prudent way to invest in 2014.

Yielding to Growth

Longer-term bond yields have historically tended to track the change in gross domestic product (GDP) growth absent the influence of Fed actions. Our expectation for a 1% acceleration in U.S. GDP over the pace of 2013 suggests a similar move for the bond market. This would prompt a rise in the yield on the 10-year Treasury from around 2.75% as of mid-November 2013 to about 3.25% to 3.75% in 2014.

On the Horizon

While investors may see the Fed end direct involvement in the bond market in 2014 as the bond-buying program comes to a close, the Fed may make its presence felt again in 2015 with a series of rate hikes. The expectation for rate hikes in 2015 may also lead to rising pressure on bond yields in 2014. Each period of Fed interest rate hikes is different, but by evaluating key metrics such as short-term Treasury yields, the shape of the yield curve, and inflation-adjusted yields prevalent at the start of prior Fed rate hikes, we can approximate the trajectory of yields in 2014 as the market braces for a potential interest rate hike in 2015.

Given the Fed’s current guidance for a mid-2015 start to interest rate hikes, supported by our outlook for stronger GDP and job growth in 2014, we may expect at least an 18-month path of reduced Fed involvement in the bond market from around the start of 2014 to mid-2015. This reinforces the fundamental case for the 10-year Treasury yield rising by 0.5% to 1.0% as yields rise to more “normal” valuation levels that would translate to a 10-year Treasury yield at the end of 2014 of 3.25% to 3.75%. Total returns may be roughly flat under that scenario  [Figure 1].

It is possible that yields could increase by 1.0% to 3.75% should inflation-adjusted yields return to more normal levels. Under that scenario, high-quality bond total returns would be negative, as indicated by Figure 1.  However, we see a move of this magnitude as less likely unless the markets expect an earlier start to Fed rate hikes. Instead, we think it is more likely the Fed may wait longer than mid-2015 to raise interest rates, which supports a more modest rise in the 10-year of 0.50% to 0.75%.

A number of factors indicate yields may rise less than our forecasts, and this is the primary risk to our bond outlook.

• Low Inflation. Inflation is an enemy of bondholders since it makes fixed payments worth less over time. While inflation is likely to pick up modestly in 2014, fortunately, it is likely to remain historically low. Bond valuations may therefore remain historically expensive. The lower the pace of inflation, the less bond yields will need to rise in response.
• Disappointing growth.  Slower-than-expected growth may reinforce the low inflation environment and delay the timing of eventual Fed rate hikes — both of which are positives for bond prices. Should the economy grow at a slower pace than anticipated in 2014, bond prices may similarly prove more resilient.
• Fed delays.  Our interest rate forecast is based upon the Fed gradually tapering bond purchases in 2014 and market participants’ expectation for a potential interest rate hike in June 2015. If these are pushed back, yields may rise less than our base forecast and bond prices may prove more resilient. Low single-digit returns may result if it becomes clear the Fed may wait longer than mid-2015 to raise interest rates.

Stay in the Middle

Among high-quality bonds we prefer intermediate-term bonds, which possess far less interest rate risk compared with long-term bonds [Figure 2].  The yield curve remains relatively steep today. A positive factor for intermediate-term bonds is that they include the steepest portion of the yield curve. A yield curve is a chart of bond yields from the shortest-maturity issues to the longest-maturity ones. The steepest point is that which offers the biggest increase in yield per additional increase in term.

While short-term bonds offer the least interest rate risk, their low yields make them less attractive. We believe intermediate-term bonds possess a better combination of interest rate risk mitigation and reward in the form of yield under a range of outcomes.

Intermediate-term bonds have the ability to generate modestly positive returns despite a fair rise in interest rates. Importantly, given their position on the yield curve, intermediate-term bonds can also provide some defensive properties to a portfolio [Figure 3].  Immediate-term, high-quality bond returns turn negative with a 1.0% rise in interest rates — just above the high end of the most likely range we expect for intermediate-term bonds in 2014. However, they can produce mid-single-digit gains if interest rates are unchanged or even decline slightly — driven by disappointing economic growth or a negative event causing investors to take a temporary defensive stance. In that event, intermediate-term bonds may provide a gain offsetting losses in the event of a stock market pullback — a key reason for holding bonds in a portfolio.

Harvesting Yield

A rising interest rate environment presents a challenge to bond market investors. Investors must seek to minimize interest rate driven losses and at the same time focus opportunistically on sectors that have traditionally produced gains during rising rate environments.

High-yield bonds and bank loans are two sectors that have historically proven resilient and often produced gains during periods of rising interest rates. In 2013, both sectors were among the leaders of bond sector performance during a year of higher interest rates.

High-yield bonds and bank loans are attractive bond sectors for 2014. Deteriorating credit quality and rising defaults are the key risks to investors in these lower-rated bonds, but we believe these risks will be manageable in 2014 as growth picks up. The global speculative default rate was a low 2.8% at the end of October 2013 — well below the historical average of 4.5%. Moody’s forecasts a low default environment to persist through 2014, a forecast we agree with given the limited number of maturing bonds in 2014. In addition to a low default environment, both high-yield bonds and bank loans remain supported by good fundamentals. Company leverage has increased over recent quarters, but the cost to service that debt remains quite manageable with interest coverage near post-recession highs.

High-yield bonds and bank loans are likely to produce low- to mid-single-digit returns in 2014. High-yield bond valuations are more expensive heading into [Figure 4]. As 2014 progresses, yield spreads may increase as investors begin to demand greater compensation for a potential  increase in defaults in 2015. Bank loans may also be impacted by investors bracing for higher defaults, but less than high-yield bonds due to their shorter-term nature and higher  seniority.

Among high-quality bonds we favor investment-grade corporate and municipal bonds. Investment-grade corporate bonds are likely to be impacted by rising interest rates, but still yield, on average, 1.3% more than comparable Treasuries. In a rising rate environment, interest income can be a buffer against price declines associated with rising interest rates. The higher yield potential of investment-grade corporate bonds, which remain supported by good credit quality fundamentals, may therefore be able to provide better protection than Treasuries.

Corporate bond sectors, both investment-grade and high-yield, have historically provided better protection against rising interest rates [Figure 5].  During periods of rising Treasury yields, corporate yields tend to rise less and corporate bond prices have been more resilient.  Figure 5 illustrates how the yield differential, or spread, between Treasuries and  investment-grade corporate bonds and high-yield bonds has generally narrowed when Treasury yields rose. Since 2000, investment-grade corporate bond yield spreads have narrowed in all but two periods of rising Treasury yields and all but one for high-yield bonds.

Among high-quality bonds, we also find municipal bonds attractive, favoring intermediate-term rather than traditional long-term municipal bonds.

International Debt

Emerging market debt (EMD) is another way to add higher income generating potential to portfolios. In general, EMD issuers have lower debt burdens and stronger economic growth than their developed market peers. In addition, valuations are attractive as 2013 winds down with an average yield spread of 3.6% to comparable Treasuries, near the upper end of a four-year range. Better valuations set the foundation for a better 2014, following a difficult 2013. However, not all EMD issuers are alike. In the face of relatively sluggish global demand in recent years, some emerging market countries have relied on extraordinary liquidity provided by the world’s central banks to grow their economies at the cost of running current account deficits as they increasingly borrow to import more than they export. As global credit conditions tighten and developed market bond yields rise, some EMD issuers have suffered as investors find more attractive yields in more financially secure markets. As these EMD issuers adjust to the lessened liquidity provided by central banks, they become increasingly attractive. Emerging market debt is increasingly attractive in 2014, but we remain cautious on developed foreign bond markets given weak growth and unattractive valuations.

Opportunities in a Less Liquid Market

Like 2013, 2014 may also provide investors with opportunities created by volatility. In 2013, the 10-year Treasury yield fell as low as 1.6% and also rose as high as 3.0% — a remarkably wide range given the steady and sluggish pace of economic growth and lack of abrupt changes by the Fed. Although these movements may seem dramatic in a historical context, they may become the norm as recent financial regulations discourage traditional market-making firms from participating in the bond market. As a result, these less liquid markets can experience sharp swings up or down and temporarily take prices and yields beyond levels warranted by fundamentals. Tactical investors may harvest opportunities that could arise in a low-return, volatile market. This may be experienced more dramatically in less liquid markets, such as emerging market debt and municipal bonds among others.

______________________________________________________________________________________________________________________________

IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indexes are unmanaged and cannot be invested into directly.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise, and bonds are subject to availability and change in price.

Gross Domestic Product (GDP) is the monetary value of all the finished goods and services produced within a country’s borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments and exports less imports that occur within a defined territory.

Government bonds and Treasury bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of fund shares is not guaranteed and will fluctuate.

Treasuries are marketable, fixed-interest U.S. government debt securities. Treasury bonds make interest payments semi-annually, and the income that holders receive is only taxed at the federal level.

International and emerging market investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.

Preferred stock investing involves risk, which may include loss of principal.

High-yield/junk bonds (grade BB or below) are not investment grade securities, and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors.

International and emerging market investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.

Preferred stock investing involves risk, which may include loss of principal.

 ______________________________________________________________________________________________________________________________

INDEX DESCRIPTIONS

The Barclays Capital Aggregate Bond Index is an unmanaged market capitalization-weighted index of most intermediate-term U.S. traded investment-grade, fixed rate, non-convertible and taxable bond market securities including government agency, corporate, mortgage-backed, and some foreign bonds.

The Barclays Capital High Yield Index covers the universe of publicly issued debt obligations rated below investment-grade. Bonds must be rated below investment-grade or high-yield (Ba1/BB+ or lower), by at least two of the following ratings agencies: Moody’s, S&P, Fitch. Bonds must also have at least one year to maturity, have at least $150 million in par value outstanding, and must be US dollar denominated and nonconvertible. Bonds issued by countries designated as emerging markets are excluded.

______________________________________________________________________________________________________________________________

This research material has been prepared by LPL Financial.

To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is not an affiliate of and makes no representation with respect to such entity.

Not FDIC/NCUA Insured | Not Bank/Credit Union Guaranteed | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit

Member FINRA/SIPC

Another Step Forward November 5, 2013

The past weekend marked the end of daylight savings time, and time to set your clocks back, but for the bond market there was no step back in October. The bond market took another step forward during October 2013, with broad-based gains as the recent rebound continued. Future gains may be more limited as investors await further clarity on the economy and the path of the Federal Reserve (Fed) — a process that may take some time and sets up a range-bound environment through year-end.

Bond market returns were led by more credit-sensitive sectors in October such as high-yield bonds, corporate bonds, and preferred securities [Figure 1]. The limited economic data released in October showed an economy with little impact, so far, from the 16-day government shutdown during the month. Relief that a more adverse impact had been avoided for now supported corporate bonds as did good news from earnings reporting season. With just over half of S&P 500 companies having reported, third quarter 2013 S&P 500 earnings are on pace to grow 5% over the prior year, while revenues are 3% higher.

A further reduction in Fed tapering fears was a key catalyst in October bond performance. Market expectations that the Fed may wait longer before reducing the pace of bond purchases increased during October due to the government shutdown. The economic impact of the government shutdown, although negligible so far, may not become fully apparent before the Fed’s December meeting. Furthermore, the continuing resolution that ended the recent government shutdown will expire in mid-January 2014, setting up another potential shutdown that may motivate the Fed to hold off on reducing bond purchases even longer and perhaps until March 2014. Emerging market debt (EMD) is a potential beneficiary of a delayed start to Fed tapering, as Fed bond purchases help foster market liquidity and therefore reduce risks for less liquid market segments such as EMD.

Mixed economic data, in addition to government shutdown implications, also supported October bond strength. The uneven economic data, including a subpar September employment report released on October 22, 2013, led market participants to question whether economic improvement had stalled and if it warranted the Fed to taper bond purchases as soon as this December. Together, the government shutdown and mixed economic data suggested the Fed would maintain the current pace of bond purchases for longer.

Range-Trade

Will the bond market witness a third straight month of gains in November? Gains, if any, are likely to be more limited as we see a range-bound trading environment develop. The rise in bond prices and subsequent decline in yields from September 5, 2013 through the end of October has factored in much of the uncertainty over when the Fed will begin to reduce bond purchases as well as fiscal uncertainty from Washington. More importantly, the bond market has priced in what we believe is a more realistic view of when the Fed may begin to raise interest rates. In our view, the timing of the Fed’s first interest rate hike is much more important to the direction of bond prices and yields than the start of tapering.

According to fed fund futures, the first interest rate hike is expected by September 2015 — three months beyond the Fed’s current guidance of approximately June 2015. Futures pricing shows the bond market believes the Fed will wait longer to ultimately raise rates. The overly aggressive rate hike fears that led to bond weakness in the spring and summer have been largely reversed, leaving more balanced expectations [Figure 2]. At the same time, a further delay in the timing of a first rate hike, which may push bond yields lower still, seems unlikely absent an additional catalyst.

Furthermore, the decline in yields has reached a key resistance barrier represented by a 2.5% yield on the 10-year Treasury. In the midst of the sell-off in late June and mid-July of this year, the yield on the 10-year Treasury dropped to 2.5% three times but was unable to fall below that level. In late October, the 10-year Treasury yield once again reached this barrier and bounced modestly higher, temporarily at least halting the bond rally [Figure 3].

Higher valuations may limit demand from investors and provide another reason that returns are likely to slow. In the high-yield bond market, valuations have improved and are approaching early May levels [Figure 4]. Earnings season has so far confirmed the good fundamentals underlying corporate bond issuers, and defaults are likely to remain isolated, but higher valuations will still restrain additional investment, leaving interest income the primary driver of return.

We believe another catalyst may be needed to take bond prices higher and yields still lower. The modest decline in bond prices and rise in yields to start November shows the bond market does maintain some sensitivity to tapering fears as top-tier economic reports are being released. Signs of weaker economic data, the prospect of a more protracted government shutdown, or more concrete signs the Fed will take even longer to start tapering and/or raise interest rates are likely needed to promote another run higher in bond prices. The government shutdown has delayed the release of multiple economic reports and clouded the interpretation of many others. The Fed’s next meeting is not until mid-December, and the threat of another government shutdown will not be known until early 2014. All three factors will take weeks or perhaps months to assess, and a range-bound trading environment may result.

______________________________________________________________________________________________________________________________

IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. Unmanaged index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance of any investment. Past performance is no guarantee of future results.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Yield is the income return on an investment. This refers to the interest or dividends received from a security and is usually expressed annually as a percentage based on the investment’s cost, its current market value or its face value.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise, and bonds are subject to availability and change in price.

Government bonds and Treasury Bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of fund shares is not guaranteed and will fluctuate.

Municipal bonds are subject to availability, price, and to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rate rise. Interest income may be subject to the alternative minimum tax. Federally tax-free but other state and local taxes may apply.

Treasuries are marketable, fixed-interest U.S. government debt securities. Treasury bonds make interest payments semi-annually, and the income that holders receive is only taxed at the federal level.

Corporate bonds are considered higher risk than government bonds but normally offer a higher yield and are subject to market, interest rate and credit risk as well as additional risks based on the quality of issuer coupon rate, price, yield, maturity and redemption features.

Preferred stock investing involves risk, which may include loss of principal.

International and emerging market investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.

______________________________________________________________________________________________________________________________

INDEX DESCRIPTIONS

The Barclays Capital Aggregate Bond Index is an unmanaged market capitalization-weighted index of most intermediate-term U.S. traded investment-grade, fixed rate, non-convertible and taxable bond market securities including government agency, corporate, mortgage-backed, and some foreign bonds.

The Barclays Capital High Yield Index covers the universe of publicly issued debt obligations rated below investment-grade. Bonds must be rated below investment-grade or high-yield (Ba1/BB+ or lower), by at least two of the following ratings agencies: Moody’s, S&P, Fitch. Bonds must also have at least one year to maturity, have at least $150 million in par value outstanding, and must be US dollar denominated and non-convertible. Bonds issued by countries designated as emerging markets are excluded.

The Barclays Treasury Index is an unmanaged index of public debt obligations of the U.S. Treasury with a remaining maturity of one year or more. The index does not include T-bills (due to the maturity constraint), zero coupon bonds (Strips), or Treasury Inflation Protected Securities (TIPS).

The Barclays Corporate Index is an unmanaged index of publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and quality requirements. To qualify, bonds must be SEC-registered. The index includes both corporate and non-corporate sectors.

The Barclays U.S. Corporate High Yield Index covers the USD-denominated, non-investment grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below. The index excludes emerging markets debt. The index was created in 1986, with index history backfilled to January 1, 1983. The U.S. Corporate High Yield Index is part of the U.S. Universal and Global High Yield Indices.

J.P. Morgan Emerging Markets Bond Index Global (EMBI Global) tracks total returns for U.S. dollar denominated debt instruments issued by emerging market sovereign and quasi-sovereign entities: Brady bonds, loans, Eurobonds. Currently, the EMBI Global covers 188 instruments across 33 countries.

The Barclays Municipal Bond Index is a market capitalization-weighted index of investment-grade municipal bonds with maturities of at least one year. All indices are unmanaged and include reinvested dividends. One cannot invest directly in an index. Past performance is no guarantee of future results.

The Barclays Capital High Yield Municipal Bond Index is an unmanaged index made up of bonds that are non-investment grade, unrated, or rated below Ba1 by Moody’s Investors Service with a remaining maturity of at least one year.

The Citigroup Non-U.S World Government Bond Index (Un-hedged) is calculated on a market-weighted basis and includes all fixed-rate bonds with a remaining maturity of one year or longer and with amounts outstanding of at least the equivalent of U.S. $25 million. The Index excludes floating or variable rate bonds, securities aimed principally at non-institutional investors and private placement-type securities.

The Citigroup World Government Bond Index is a market-capitalization-weighted index consisting of the government bond markets. Country eligibility is determined based on market capitalization and investability criteria. All issues have a remaining maturity of at least one year.

The Barclays U.S. Treasury TIPS Index is a rules-based, market value-weighted index that tracks inflation protected securities issued by the U.S. Treasury. The U.S. TIPS Index is a subset of the Global Inflation- Linked Index, with a 36.0% market value weight in the index (as of December 2007), but is not eligible for other nominal treasury or aggregate indices. In order to prevent the erosion of purchasing power, TIPS are indexed to the non-seasonally adjusted Consumer Price Index for All Urban Consumers, or the CPI-U (CPI).

The Barclays Mortgage-Backed Securities Index includes 15- and 30-year fixed-rate securities backed by mortgage pools of the Government National Mortgage Association (GNMA), Federal Home Loan Mortgage Corporation (FHLMC), and Federal National Mortgage Association (FNMA).

The Merrill Lynch Preferred Stock Hybrid Securities Index is an unmanaged index consisting of a set of investment-grade, exchange-traded preferred stocks with outstanding market values of at least $50 million that are covered by Merrill Lynch Fixed Income Research. The Index includes certain publicly issued, $25- and $100-par securities with at least one year to maturity.

______________________________________________________________________________________________________________________________

This research material has been prepared by LPL Financial.

To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is not an affiliate of and makes no representation with respect to such entity.

Not FDIC/NCUA Insured | Not Bank/Credit Union Guaranteed | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit

Member FINRA/SIPC

 

Municipal Ups and Downs October 22, 2013

We continue to find municipal bonds one of the more attractive sectors in the bond market even after a modest pullback to start the fourth quarter of 2013. Over the first half of October, selling pressure has increased as investors used September gains as a reason to exit the municipal bond market following the spring and summer 2013 sell-off. We do not view selling in October as the start of another leg down but rather a reflection of the choppy up-and-down trading that typically follows a significant sell-off.

Headwinds

An increase in selling weighed on municipal bond prices in early October. Data from the Investment Company Institute (ICI) showed that municipal bond mutual fund outflows exceeded $1 billion for the week ending October 9, 2013 for the first time since September 18, 2013, contributing to the increase in bonds for sale before dropping last Friday, October 18, 2013 [Figure 1]. The increase in selling inventory is modest compared to the spike in June and again in late August but still enough to put the brakes on the
nascent municipal bond recovery.

Municipal bond mutual fund outflows continue to be a headwind but are showing signs of selling exhaustion. According to ICI data, municipal bond funds have now recorded 20 consecutive weeks of outflows totaling $47 billion.

During the 2010 – 2011 municipal bond sell-off, which was similar in impact to the recent pullback, outflows totaled $45 billion but over a slightly longer 26 week period, based on ICI data. Typically, outflows do not preclude a bond rally (as was the case in September) but still present a headwind for the sector.

The increase in selling supply pressure may gather steam from a pickup in new issuance. The summer rise in municipal bond yields has kept new issuance subdued in September and at the start of October, as fewer municipal bond issuers find it economical to refinance existing issues given the recent rise in yields. However, the current week, starting October 18, 2013, involves a slightly above-average $8 billion scheduled to come to market with the forward 30-day calendar increasing to $12.6 billion (according to The Bond Buyer), the highest level since mid-July 2013. Taken together, supply will be a headwind for the municipal bond market over the  coming few weeks.

Poor liquidity is adding to the near-term supply challenge for municipal bonds as bond dealers remain reluctant to fully participate in markets. While many investors remain sidelined, the municipal bond market could benefit from greater bond dealer participation but — for reasons discussed in last week’s Bond Market Perspectives: Liquidity, You Don’t Miss It until It’s Gone — remain hesitant to hold bonds. Federal Reserve (Fed) data show that bond dealer holdings of municipal bonds remain relatively low and with year-end approaching are unlikely to increase materially.

Nonetheless, these challenges were evident following prior sell-offs and do not preclude a turnaround, as we saw during the 2010 – 2011 period. In fact, the lead up into the recent sell-off, the sell-off itself, and the aftermath are so far closely tracking the experience of the municipal bond market in 2010 – 2011 [Figure 2]. In 2010 – 2011, credit quality fears sparked a sharp sell-off while Fed tapering fears produced significant weakness in 2013. In both cases, markets overshot with valuations becoming attractive. The road to improvement was not a straight line in 2010 – 2011 but choppy, and a similar experience may be unfolding in 2013.

The modest pullback in October 2013 therefore could be part of the choppy up-and-down trading that typically follows a period of significant weakness.

Tailwinds

Despite the near-term supply challenges, we believe there is a good case for longer-term optimism. ƒ

• Government shutdown uncertainty. The 16-day government shutdown is over, but now market participants await the data that will reveal the impact. Standard & Poor’s has estimated the shutdown will reduce fourth quarter economic growth by 0.6%. Slower growth tends to be supportive of bonds overall and may help support municipal bond prices.

• Fed tapering delay. On a related note, the current resolution to fund the government expires in mid-January 2014, opening the door for another shutdown. The Fed will likely be hesitant therefore to taper bond purchases at the December meeting and may wait longer than  anticipated, perhaps until March 2014, before reducing bond purchases. Fed tapering risks continuing to fade are also supportive of high-quality bond prices including municipal bonds. 

• Attractive valuations. The municipal soft spot has led to more attractive valuations, as municipal bonds have failed to keep pace with Treasuries [Figure 3]. Valuations, as measured by AAA-rated municipal-to-Treasury yield ratios, are not back to the summer peaks but indicative of longer-term value. The higher the municipal-to-Treasury yield ratio the more attractively municipal bonds are to Treasuries and vice versa.

Keeping It in Perspective

The October soft spot is part of the ups and downs municipal investors experience following a significant pullback.  The current episode is following the 2010-2011 experience and is part of the recovery process.  We caution, however, that the robust municipal gains witnessed over the second half of 2011 are unlikely to be repeated over the end of 2013 and into 2014.  The better economic backdrop now and eventual Fed exit from its bond purchase program argue for more limited returns compared to 2011.  The headwinds suggest a quick improvement is unlikely, but the positive factors may help drive low to mid-single-digit gains over the coming six to 12 months, led by interest income and improving valuations.  Among high-quality bonds we find municipal bonds one of the more attractive investment options.

_____________________________________________________________________________________________________________________________

IMPORTANT DISCLOSURES
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. Unmanaged index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance of
any investment. Past performance is no guarantee of future results.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Yield is the income return on an investment. This refers to the interest or dividends received from a security and is usually expressed annually as a percentage based on the investment’s cost, its current market value or its face value.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise, and bonds are subject to availability and change in price.

Government bonds and Treasury Bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of fund shares is not guaranteed and will fluctuate.

Municipal bonds are subject to availability, price, and to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rate rise. Interest income may be subject to the alternative minimum tax.Federally tax-free but other state and local taxes may apply.

Treasuries are marketable, fixed-interest U.S. government debt securities. Treasury bonds make interest payments semi-annually, and the income that holders receive is only taxed at the federal level.

INDEX DESCRIPTIONS
The Barclays Treasury index is an unmanaged index of public debt obligations of the U.S. Treasury with a remaining maturity of one year or more. The index does not include t-bills (due to the maturity constraint), zero coupon bonds (Strips) , or Treasury Inflation Protected Securities (TIPS).

The Barclays Municipal Bond Index is a market capitalization-weighted index of investment-grade municipal bonds with maturities of at least one year. All indices are unmanaged and include reinvested dividends. One cannot invest directly in an index. Past performance is no guarantee of future results.

Bond Market Perspectives June 25, 2013

When Will the Selling Stop?

The past week brought about the summer solstice, the official start of summer, but for bond investors it feels more like the dead of winter. Bond weakness continued in response to a Federal Reserve (Fed) that remains fixated on slowing, or tapering, bond purchases following last week’s policy meeting.

A review of several bond metrics may help answer the question at the forefront of bond investors’ minds: “when will the selling stop?” Although we believe bond market weakness is overdone, we have to respect market action and evaluate how high yields may rise. A look at economic growth, Fed rate hike expectations, and the slope of the yield curve may help investors determine how high bond yields may rise in a more adverse scenario. The measures discussed below are simplistic guides but can still help triangulate how high yields may rise.

Economic growth and Treasury yields – The pace of economic growth has historically been one of the primary drivers of Treasury yields. The yield on the 10-year Treasury note has been roughly similar to annualized economic growth, as measured by nominal gross domestic product (GDP), over long periods of time [Figure 1]. The relationship has changed over the years as market confidence in a persistent low inflation-environment has grown, which has caused the 10-year Treasury to frequently yield less than annualized GDP growth over the past 10 years, but the two remain correlated.

Over the past 10 years, annualized nominal GDP growth has averaged 0.43% more than the 10-year Treasury yield. Assuming this relationship holds, subtracting 0.43% from annualized nominal GDP growth of 3.40% produces a 10-year Treasury yield of 2.97%. However, the Fed has been applying extraordinary stimulus for just under five years. Over the past five years, the 10-year Treasury yield has averaged 0.57% less than annualized nominal GDP growth, which implies a 2.83% 10-year Treasury yield, based upon the metric above. Since the Fed will remain active with bond purchases and remains committed to refrain from raising interest rates, this latter reading may be more appropriate. However, if the bond market is transitioning to a more “normal” state, free of Fed influence, then the2.97% 10-year Treasury yield provides a guide according to the GDP growth-Treasury yield relationship.

Rate hike expectations – The bond market continues to confuse “taper” with “rate hike.” Therefore, assessing market expectations for a first interest rate hike can may help determine how much more weakness is in store. According to fed fund futures, one of the better gauges of assessing market expectations of Fed interest rate changes, the first 0.25% interest rate hike is fully priced in by February 2015. This is a dramatic increase from just a few weeks ago, when fed fund futures indicated a late 2015/early 2016 as the mostly likely timing of a first rate hike.

Should the market move to fully price in a first rate hike by the fourth quarter of 2014, we believe bond selling pressure may subside. Last week, Fed Chairman Ben Bernanke outlined a broad plan to remove stimulus that begins with tapering bond purchases “later this year,” then ending bond purchases completely by mid-2014 (assuming the unemployment rate drops to 7.0% by then), followed by raising interest rate hikes by mid-2015 (assuming a further decline in the unemployment rate to 6.5%). By moving to price in a late-2014 first rate hike, bond market pricing would be more aggressive compared to the Fed’s game plan, while also providing a buffer should the Fed not stay true to its word or the labor market improve more quickly than currently anticipated. Furthermore, a fourth quarter 2014 rate hike would be a relatively short turnaround from the time of ending bond purchases. The Fed has stated in the past that a substantial period of time would elapse between the time bond purchases end and the time when interest rates will be increased.

To determine whether a fourth quarter 2014 rate hike is fully priced in, we can observe the fed fund futures contract expiring on December 2014. As of June 24, 2013, the December 2014 contract was priced to reflect a 0.40% fed funds rate, meaning that a 0.25% rate increase to 0.50% was not fully priced in. From Wednesday through Friday of last week (June 19, 2013 through June 21, 2013) the 10-year Treasury yield rose by 0.34% to 2.53% compared to a 0.12% rise in the implied yield of the December 2014 contract, a ratio of roughly three-to-one. Therefore, if the implied yield of the December 2014 fed fund futures increases by another 0.1%, to reflect a 0.5% fed funds rate, it would translate to an approximate 0.3% increase to the 10-year Treasury yield, taking it to 2.83%.

The yield curve – Over the past five years, the yield differential between the 2-year and 10-year Treasuries has peaked twice at 2.9% [Figure 2]. A greater differential is indicative of a “steep” yield curve, and a low differential represents a “flat” yield curve. At a current yield differential of 2.15%, the 10-year Treasury yield would have to increase by an additional 0.65% to reach the prior yield curve peak of 2.9%, as measured between 2- and 10-year Treasury yields. A 0.65% increase in the 10-year Treasury yield would imply a further increase to a 3.19% 10-year Treasury yield (approximately) based upon Monday’s close of 2.54%. Should the 2-year Treasury yield rise as well, then the 10-year Treasury yield may rise further. Nonetheless, the yield curve relationship indicates a 10-year Treasury yield in the low 3% range.

However, prior peaks in the yield curve occurred before the Fed’s commitment to refrain from raising interest rates, and therefore, a return to the prior peak level is unlikely. The Fed’s commitment to refrain from raising interest rates, in conjunction with Fed bond purchases, helped “flatten” the yield curve as investors extended maturity into higher-yielding investments, putting downward pressure on longer-term bond yields. As the Fed removes stimulus it is natural that the yield curve would steepen, but since the Fed’s commitment to refrain from raising interest rate remains intact, a return to prior peaks of yield curve slope remain unlikely. Furthermore, early 2010 and early 2011, the last two times the slope of the yield curve was at this maximum steepness, turned out to be very good buying opportunities for bond investors. High-quality bonds returned 4.7% and 7.4%, respectively, over the remainder of 2010 and 2011, as measured by the Barclays Aggregate Bond Index, from March of each year through the remainder of the calendar year. We doubt the bond market will provide such an easy opportunity for investors, and therefore, the rise in yields is likely to fall short of the target implied by the slope of the yield curve.

Conclusion: Cautious Until Signs of Stability Emerge

These three approaches may provide a guide as to a realistic high end of the range for bond yields. Collectively, they suggest the 10-year Treasury yield could find support between 2.75% and 3.00%, should the rise in bond yields continue.

Our belief is that Treasury yields may begin to stabilize near current yield levels. Bond price declines have been exacerbated by very illiquid trading conditions that, in some cases, pushed bond prices lower than justified by intrinsic value. Two of the more illiquid segments of the bond market, emerging market debt and municipal bonds, have therefore borne the brunt of recent weakness, but no sector has been immune. As a result, more evidence is needed to confirm yields have stabilized. Ultimately, we believe the rise in Treasury yields will likely stop short of the 2.75-3.00% range, since economic growth remains sluggish and inflation remains very low.

Some opportunities are emerging in fixed income markets due to the highest yields in over two years, but illiquid trading conditions, the approach of quarter-end this week which may foster risk aversion, and new issuance in Treasury and municipal bond markets may weigh on the bond market this week. We take a cautious view on the fixed income markets until additional signs of stability emerge.

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IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indexes are unmanaged and cannot be invested into directly.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Yield is the income return on an investment. This refers to the interest or dividends received from a security and is usually expressed annually as a percentage based on the investment’s cost, its current market value or its face value.

Gross domestic product (GDP) is the monetary value of all the finished goods and services produced within a country’s borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments and exports less imports that occur within a defined territory.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise, and bonds are subject to availability and change in price.

Bonds given an investment grade rating indicate a relatively low risk of default.

Municipal bonds are subject to availability, price, and to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rate rise. Interest income may be subject to the alternative minimum tax. Federally tax-free but other state and local taxes may apply.

Government bonds and Treasury bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of fund shares is not guaranteed and will fluctuate.

Treasuries are marketable, fixed-interest U.S. government debt securities. Treasury bonds make interest payments semi-annually, and the income that holders receive is only taxed at the federal level.

Emerging market debt portfolios invest primarily in sovereigns, agencies, local issues, and corporate debt of emerging markets in the following regions: Americas, Europe, Middle East, Africa, and Asia.

Futures and forward trading is speculative, includes a high degree of risk, and may not be suitable for all investors.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

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INDEX DESCRIPTIONS

The Barclays Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment-grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.

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This research material has been prepared by LPL Financial.

To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is not an affiliate of and makes no representation with respect to such entity

Not FDIC/NCUA Insured | Not Bank/Credit Union Guaranteed | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit

Member FINRA/SIPC

Tapering Tantrum Take Two May 28, 2013

The bond market suffered through another week of tapering tantrums with yields closing higher for a fourth consecutive week and near the highs of 2013. Federal Reserve (Fed) Chairman Ben Bernanke did little to clear the uncertainty over the timing of reducing, or tapering, bond purchases in Congressional testimony last week. Although his prepared testimony was very dovish and suggested a continuation of current bond purchases, investors focused on responses in the question and answer portion of his testimony, which fueled additional uncertainty. Bernanke suggested that tapering could begin “in the next few meetings” if labor market data continued to improve, and when asked whether the Fed may taper purchases before Labor Day, Bernanke said he did not know and that it depended on the economic data. Bernanke’s comments echoed those of the normally dovish Bill Dudley, the influential New York Fed President, who also seemed to acknowledge there is ongoing debate among Fed members about when to taper bond purchases.

The response from financial markets, as is typically the case when investors are presented with uncertainty, was lower prices and bonds, across the board, were not spared. Treasury yields continued their ascent, with the 10-year Treasury breaching the 2% yield barrier before closing the week at 2.01%, just below the 2.06% peak of 2013.

The response from financial markets, as is typically the case when investors are presented with uncertainty, was lower prices and bonds, across the board, were not spared. Treasury yields continued their ascent, with the 10-year Treasury breaching the 2% yield barrier before closing the week at 2.01%, just below the 2.06% peak of 2013.

Unlike prior rounds of bond purchases, such as QE1 and QE2, which were marked by specific end dates, QE3 is open-ended and allows for a reduction in the pace of purchases. This presents a new twist for the bond market, and pushing yields higher appeared to be a precautionary move by investors. However, the bond market is adapting quickly. Primary dealers, financial firms that are required to make markets in all Treasury securities, began to move their forecasts for timing QE tapering to the September 2013 Fed meeting, up from a prior consensus of the December 2013 Fed meeting.

A press conference follows the September 2013 Fed meeting and would allow the Fed Chairman to explain the rationale for tapering purchases. A press conference also follows the June 2013 Fed meeting, but it appears unlikely the Fed will move that soon, given the benign remarks in Bernanke’s testimony and the relatively dovish tone of meeting minutes from the May 1, 2013 Fed meeting. Should the Fed announce that tapering will begin at the end of June or in July, bond prices may decline further, and yields may rise more since the bond market has not fully priced in that outcome.

Uncertainty is likely to linger for at least another week and may exert additional upward pressure on bond yields. The current week is very light on economic data, and there are few Fed speakers of note. Investors will likely have to wait until the May 2013 employment report, which will be released on Friday, June 7, 2013, to receive additional clarity. The Fed is clearly focused on labor market gains regarding when to begin tapering bond purchases.

The past week’s events suggest the Fed appears to be focusing more on labor market improvements rather than the lower inflation witnessed so far in 2013, as measured by both the core Consumer Price Index (CPI) and core Consumer Personal Expenditures Index, which may decelerate to a record 1.0% when personal income data for April are released Friday, May 31, 2013, according to the Bloomberg consensus forecast.

We do not expect the Fed to announce a tapering of bond purchases at the June 2013 Fed meeting and therefore expect any additional rise in rates to be limited. Still-high long-term valuations suggest that Treasury weakness could continue. The sooner the Fed begins to reduce bond purchases and the more quickly bond purchases come to an ultimate end, the more rapid the potential rise in bond yields. Nonetheless, we expect the Fed to take a gradualist approach. The following factors also suggest that any rise in rates may also be limited.

• A change in the relationship between economic data and bond yields. Recent economic data have frequently failed to meet consensus forecasts, as reflected by the Citigroup Economic Surprise Index [Figure 1]. The strength of the economy can be an important driver of bond yields. Note the close relationship between Treasury yields and whether economic data is surprising higher or lower over the years. A gap developed between the two series starting in 2011, due to the Fed’s extraordinary measures (e.g., its commitment to refrain from raising interest rates for a specified period of time), but directionally the pace of economic data is still evident as a driver of Treasury yields. Recently, the relationship between Treasury yields and economic data changed as bond investors have focused on tapering. We do not believe this change will last long and the bond market will refocus on economic data, which in our view is still too sluggish to reflect sharply lower bond prices and higher yields.

• The Fed remains on hold. Fed interest rate hikes, or cuts, have been one of the key drivers of bond yields. Without an actual rate hike, the increase to short and intermediate yields in particular may be limited.
• A tapering does not mean an end to easing. Even in the event of a tapering, the Fed will still be providing stimulus, and downward pressure on interest rates, by continuing bond purchases even if at a reduced rate.
• Prior QE conclusions resulted in lower Treasury yields. Bond yields actually declined following the end of prior QE bond purchases [Figure 2]. Investors feared an economic slowdown absent the Fed’s stimulus, and stocks and high-yield bond prices declined while Treasury prices gained.

Should the rise in bond yields continue without corroboration by weaker economic data or additional clues that the Fed may reduce bond purchases as early as June 2013, a buying opportunity may emerge among high-quality bonds. In the meantime, the cautionary bond market tone may persist over the short term.

___________________________________________________________________________________________________________________________________________

IMPORTANT DISCLOSURES
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indexes are unmanaged and cannot be invested into directly.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Yield is the income return on an investment. This refers to the interest or dividends received from a security and is usually expressed annually as a percentage based on the investment’s cost, its current market value or its face value.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise, and bonds are subject to availability and change in price.

Bonds given an investment grade rating indicate a relatively low risk of default.

High-yield/junk bonds are not investment-grade securities, involve substantial risks, and generally should be part of the diversified portfolio of sophisticated investors.

Government bonds and Treasury bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of fund shares is not guaranteed and will fluctuate.

Intermediate bonds are characterized by a maturity that is set to occur in the next three to 10 years.

Treasuries are marketable, fixed-interest U.S. government debt securities. Treasury bonds make interest payments semi-annually, and the income that holders receive is only taxed at the federal level.

Quantitative easing is a government monetary policy occasionally used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

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INDEX DESCRIPTIONS
Personal Consumption Expenditures is the measure of price changes in consumer goods and services. Personal consumption expenditures consist of the actual and imputed expenditures of households; the measure includes data pertaining to durables, non-durables and services. It is essentially a measure of goods and services targeted toward individuals and consumed by individuals.

Citigroup Economic Surprise Index (CESI) measures the variation in the gap between the expectations and the real economic data. This research material has been prepared by LPL Financial.

The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.

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This research material has been prepared by LPL Financial.

To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is
not an affiliate of and makes no representation with respect to such entity.

Not FDIC/NCUA Insured | Not Bank/Credit Union Guaranteed | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit

Listening to the leaders May 14, 2013

Leading Indicators Continue to Point to Slow Economic Growth, but no Recession

The April Index of Leading Economic Indicators (LEI), due out on Friday, May 17, 2013, caps off a busy week for economic reports in the United States. This week includes reports on:

• The consumer: Retail sales for April 2013 and the University of MichiganIndex of Consumer Sentiment for early May 2013;
• Housing: Housing starts and building permits for April 2013 and the National Association of Homebuilders sentiment index for May 2013;
• Manufacturing: Empire State Manufacturing Index for May, the Philadelphia Fed Manufacturing Index for May 2013, industrial production and capacity utilization for April 2013; and
• Inflation: Consumer Price Index (CPI) and Producer Price Index (PPI) for April 2013.

On balance, these reports are likely to continue to show that the U.S. economy is growing at around 2.0% in the second quarter of 2013, that inflation remains muted, and that the odds of a recession in the next year to 18 months remains low. Policymakers at the Federal Reserve (Fed) will digest all of this data, and likely conclude that its quantitative easing (QE) program — the purchase of $85 billion per month of Treasury securities — should continue over the remainder of 2013.

LEI Updates

If you have not seen the LEI lately, there have been several changes made to its components, although as before, virtually all of the components of the LEI are known before the data are actually released. So in theory, the LEI itself should not be a surprise to market participants, the media, or pundits. Of course, that will not prevent anyone from ascribing movements in financial markets on Friday, May 17 to the LEI data, but we are always quick to point out that the S&P 500 itself is a component in the LEI.

In December 2011, the Conference Board, the private “think tank” that compiles and releases the data each month, made four changes to the LEI:

• The Conference Board’s proprietary “Leading Credit Index” (LCI), an aggregate of several well-known financial market and credit market metrics like swap spreads, investor sentiment, margin account, etc., replaced the inflation adjusted M2 money supply.
• The Institute for Supply Management’s (ISM) New Orders Index replaced the ISM’s Supplier Deliveries Index.
• The U.S. Department of Census’ new orders for non-defense capital goods excluding aircraft replaced new orders for non-defense capital goods.
• A combination of consumer expectations and business and economic conditions replace the University of Michigan’s Consumer Expectations Index.

LEI Places Very Low Odds of Recession in Next 12 Months

According to the consensus estimates compiled by Bloomberg News, the LEI is expected to post a 0.2% month-over-month gain in April 2013. The expected 0.2% month-over-month gain would put the year-over-year gain in the LEI at 2.1%. The LEI is designed to predict the future path of the economy, with a lead time of between six and 12 months. Since 1960 — 640 months or 53 years and four months — the year-over-year increase in the LEI has been at least 2.1% in 397 months. Not surprisingly, the U.S. economy was not in recession in any of those 397 months. Thus, it is highly unlikely that the economy was in recession in April 2013, despite the impact of the sequester, the fiscal cliff (spending cuts, payroll tax increases, income tax rate increases, etc.), the recession in Europe, or the slowdown in China.

But the LEI is designed to tell market participants what is likely to happen to the U.S. economy, not what has already happened. Three months after each of the 397 months that the LEI was up 2.1% or more, the economy was in recession in just two of the 397 months — both in 1973. Six months after the LEI was up by 2.1% or more on a year-over-year basis, the U.S. economy has been in recession in just six of the 397 months or 2% of the time. Looking out 12 months after the LEI was up 2.1% or more, the economy was in recession in just 27 of the 397 months, or 7% of the time. Based on this relationship, the odds of a recession within the next 18 months and two years increase to between 10% and 15%.

On balance, the LEI says the risk of recession in the next 12 months is negligible (7%), but not zero. We would agree. But, the still-fragile state of the economy, and the uncertainty surrounding domestic fiscal policy, the recession in Europe, and the ongoing slowdown in China are telling us that the risk of recession is much higher than 7%. Our view remains that — aided by the Fed’s QE program, the early stages of a housing recovery, and a nascent manufacturing recovery — the U.S. economy is likely to grow at around 2.0% this year. The full impact of the sequester, the looming debate over the federal debt ceiling, weak exports, and ongoing contraction in both federal and state and local government spending are all acting to restrain growth, and these factors are likely to be in place for most of this year. A dramatic deterioration of the fiscal and financial situation in Europe, a fiscal or monetary policy mistake here in the United States or abroad, or an exogenous event (a major terror attack, natural disaster, etc.), among other events, may cause us to change our view.

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IMPORTANT DISCLOSURES
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

* Over the last three quarters (third quarter of 2012, fourth quarter of 2012, and first quarter of 2013) , real GDP growth has averaged 2.0%.

Gross domestic product (GDP) is the monetary value of all the finished goods and services produced within a country’s borders in a specific time period, though GDP is usually calculated on an annual basis. It includes all of private and public consumption, government outlays, investments and exports less imports that occur within a defined territory.

The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Stock investing involves risk including loss of principal.

Quantitative easing is a government monetary policy occasionally used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.

The Federal Open Market Committee (FOMC) , a committee within the Federal Reserve System, is charged under the United States law with overseeing the nation’s open market operations (i.e., the Fed’s buying and selling of U.S. Treasury securities).

The Congressional Budget Office is a non-partisan arm of Congress, established in 1974, to provide Congress with non-partisan scoring of budget proposals.

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INDEX DESCRIPTIONS
The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.

The Empire State Manufacturing Index is a seasonally-adjusted index that tracks the results of the Empire State Manufacturing Survey. The survey is distributed to roughly 175 manufacturing executives and asks questions intended to gauge both the current sentiment of the executives and their six-month outlook on the sector.

The Institute for Supply Management (ISM) index is based on surveys of more than 300 manufacturing firms by the Institute of Supply Management. The ISM Manufacturing Index monitors employment, production inventories, new orders, and supplier deliveries. A composite diffusion index is created that monitors conditions in national manufacturing based on the data from these surveys.

The index of leading economic indicators (LEI) is an economic variable, such as private-sector wages, that tends to show the direction of future economic activity.

The Leading Credit Index constitutes financial market indicators including bond market yield curve data, interest rate swaps, and Fed bank lending survey data.

The NAHB/Wells Fargo Housing Market Index gauges builder perceptions of current single-family home sales and sales expectations for the next six months as “good,” “fair” or “poor.” The survey also asks builders to rate traffic of prospective buyers as “high to very high,” “average,” or “low to very low.” Scores from each component are then used to calculate a seasonally adjusted index where any number over 50 indicates that more builders view conditions as good than poor.

The Philadelphia Fed Manufacturing Index is a survey produced by the Federal Reserve Bank of Philadelphia, which questions manufacturers on general business conditions. The index covers the Philadelphia, New Jersey, and Delaware region. Higher survey figures suggest higher production, which contribute to economic growth. Results are calculated as the difference between percentage scores with zero acting as the centerline point. As such, values greater than zero indicate growth, while values less than zero indicate contraction.

The Producer Price Index (PPI) program measures the average change over time in the selling prices received by domestic producers for their output. The prices included in the PPI are from the first commercial transaction for many products and some services.

Purchasing Managers’ Index (PMI) is an indicator of the economic health of the manufacturing sector. The PMI index is based on five major indicators: new orders, inventory levels, production, supplier deliveries, and the employment environment.

The University of Michigan Consumer Sentiment Index (MCSI) is a survey of consumer confidence conducted by the University of Michigan. The Michigan Consumer Sentiment Index (MCSI) uses telephone surveys to gather information on consumer expectations regarding the overall economy.

______________________________________________________________________________________________________________________________________________

This research material has been prepared by LPL Financial.
To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that LPL Financial is
not an affiliate of and makes no representation with respect to such entity.

Not FDIC/NCUA Insured | Not Bank/Credit Union Guaranteed | May Lose Value | Not Guaranteed by any Government Agency | Not a Bank/Credit Union Deposit