SVB Asset Management Economic Report Q1 2014

Quarterly Economic Report 2014

Q1

http://www.svb.com/assetmanagement/

Table of Contents

Thoughts from our CIO 03

Overview 04

Domestic Economy 07

Federal Reserve 17

Special Topic: U.S. Banks 20

Markets & Performance 24

Global Economy 34

Portfolio Management Strategy 40

2 SVB Asset Management | Quarterly Economic Report Q1 2014

January and February presented a continuing challenge for economic forecasters. Was the U.S. economy slowing or was inclement weather simply pushing activity from one month to the next? Even now, it's difficult to say with confidence which is correct, but across all sectors we are seeing signs of growth. Consistent with the prevailing mantra, the growth we are seeing is not as strong as we would like, but there is growth nonetheless.

Overall, GDP in the first quarter will slow to around 1.5–2 percent. However, the growth components of consumer activity, lower fiscal restraint, and gains in employment and housing are poised to continue into future quarters. Consumer spending slowed in the quarter from a blistering 3.3 percent pace in the final quarter of 2013, the fastest in three years. Recent income growth will likely support further activity in this sector.

Internal measures of the job market have turned positive. We are seeing higher full-time employment, better attitudes and increased turnover associated with a healthy labor market.

Housing activity and prices remain well below the peak, but the trend is moving favorably. Though higher mortgage rates provided an initial shock, continued improvement in the labor market should overcome a further 1-2 percent increase in rates from here.

Janet Yellen's first FOMC meeting caused some headlines when she implied the first rate increases could happen as early as next summer. However, the Fed also made clear, it plans to keep rates lower than normal even after the economy achieves its goal of balanced employment and inflation.

Our special topic in this quarter’s report looks at how the banking industry is managing its balance sheet in order to prepare for higher interest rates by shifting assets from "available for sale" to "hold to maturity”. This effort will assist in stabilizing reported earnings even as long-term investments are marked down by higher yields.

The bond markets came back into favor this quarter as emerging market fears reignited the old "risk off" trade. Flows into bond funds and performance by bonds in general led the way, once again solidifying the value of diversification despite today's low rate environment.

Europe moved into the growth column even as deflationary fears increased. In contrast, the outlook for a slower China is damaging many emerging markets that have relied on China as an importer of raw materials and goods.

The Russia-Ukrainian issue seems to be fading, but only because the West is reluctant to react significantly. Uncertainty around Putin's next move must be built into the market outlook, although many seem to believe this potential crisis has passed

Looking ahead, expect continued stability in the markets as the Fed reigns in QE, the ECB considers initiating QE and Japan is left analyzing the effects of higher taxes meant to pay for past QE. We won't believe we are fully past the storm until we can leave such artificial stimulus behind.

Joe Morgan, Chief Investment Officer 3

Thoughts from our CIO

Shrugging Off the Weather

SVB Asset Management | Quarterly Economic Report Q1 2014

4

The U.S. economy continues to expand thanks to the consumer and less fiscal drag. (p. 7)

The consumer has benefited from rising home prices and equity markets. The first quarter could see a pull back on personal consumption due to extraordinarily cold weather in the Northeast. (p. 8)

The rise in household net worth boosted spending and overall sentiment. Household worth continues to hit all-time highs. (p. 9)

Most measures of the housing and employment markets confirm improving trends; however, the pace of improvement is slower than we prefer. (p. 10-13)

Inflation continues to run well below the Fed’s target measure of 2 percent. (p. 14)

Domestic Economy The Fed continues to taper at a pace of $10 billion per month. Fed Chair, Janet Yellen, has stated that tapering is not on a set course, although at this rate tapering will be complete by fall of 2014. (p.16)

In the March FOMC meeting there was a change to forward guidance, removing the 6.5 percent unemployment target and shifting to more qualitative measurements. (p. 16)

In addition, in the March FOMC meeting, Yellen said that rates could be increased as soon as six months after tapering ends. (p. 16)

Markets reacted to the March FOMC meeting by selling off and increasing volatility. (p. 16)

The Fed

Overview


Overview

5

Money market fund assets are hitting a dip, while bond funds show signs of renewed interest. (p. 24)

Bond investors continue to look to the short end as a safe haven to hedge near to intermediate term interest rate risk. Therefore, short end yields for agencies, corporates and structured products will continue to be anchored on the low end. (p. 25)

Credit finished the first quarter on a very strong note due to tighter spreads and a relatively stable interest rate environment. (p. 26)

Income returns from credit continues to provide the majority of the overall returns. (p. 27)

Inclement weather and domestic production are affecting energy commodities and metal investors continue to monitor the conditions in China. (p. 29)

Markets/Performance Global Economy

Banks typically make up a significant portion of short-term investment portfolios. (p. 20)

With interest rates rising, what will be the impact on the U.S. banks’ balance sheet? (p. 20)

U.S. banks’ balance sheets have strengthened since the financial crisis, but an upward movement in interest rates may translate to unrealized losses. (p. 21)

One of the steps taken by banks is to recognize that these are unrealized losses and shift the securities to hold-to-maturity (HTM) bucket to minimize accounting losses. (p. 22)

Liquidity can still be obtained for these HTM securities via the large repo market. (p. 22)

Special Topic: U.S. Banks

Europe: Differing growth levels pose upside risk to GBP and downside risk for EUR. (p. 34)

China: The Yuan is deflating on doubts about meeting growth target. (p. 36)

Japan: The BOJ may expand QQE policy to support inflation and growth targets; Yen is slower on improving. (p. 37)

U.S.: Dollar risks upside amid tame inflation, macroeconomic strength, and trimmed QE program. (p. 38)


Domestic Economy

-4.0% -2.0% 0.0% 2.0% 4.0% 6.0% 8.0%

10.0%

GDP on the Right Track GDP

Source: Bureau of Economic Analysis (BEA), Congressional Budget Office (CBO) and SVB Asset Management. Note: GDP values shown in legend are % change vs. prior quarter annualized.

GDP and Components GDP Growth 4Q Average – Long View

The final Q4 2013 GDP reading was revised higher to an annualized 2.6 percent from 2.4 percent.

The upward revision was propelled by the strongest consumer spending seen in three years.

Consumers spent more on services, specifically healthcare, which helped move the expansion forward.

Q1 2014 GDP could experience a pull back due to harsh weather conditions in the Northeast. On the bright side, fiscal headwinds have subsided.

7

-10.0%

-5.0%

0.0%

5.0%

10.0%

U.S. GDP Q-o-Q Trailing 4-Quarter Average


-1.0%

1.0%

3.0%

5.0%

Government Res Investment Inventories Net Exports Bus Fixed Investment Personal consumption exp GDP

Consumption Temporary Slow Down Consumer Sentiment – University of Michigan

Source: U.S. Bureau of Economic Analysis (BEA), Census.gov, University of Michigan / Thomson Reuters - Survey of Consumers, SVB Asset Management.

Retail & Food Services Sales Personal Consumption – % Change

Q1 spending activity pulled back due to extraordinary weather conditions.

Consumers were less optimistic towards the end of the quarter with consumer confidence falling to a four-month low.

Disposable incomes rose the most in February since September 2013 at 2.1 percent year-over-year.

Consumer spending expanded by 3.3 percent in the final quarter of 2013, the biggest increase in three years.

As the winter cold passes consumers will start to feel positive again.

8

40.0

60.0

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Average

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Vehi

cle

Sal

es (M

illio

ns)

Ret

ail &

Foo

d S

ervi

ces

Sal

es (B

illio

ns)

Ex Autos Vehicle Sales

-6.0% -4.0% -2.0% 0.0% 2.0% 4.0% 6.0% 8.0%


Consumption Temporary Slow Down Personal Income

Source: U.S. Bureau of Economic Analysis (BEA), Federal Reserve, SVB Asset Management.

Personal Savings as % of Disposable Income

Household Net Worth

Personal incomes have increased steadily the first few months of Q1.

Savings rates as a percentage of disposable income have been hovering around 4.3 percent.

Post financial crisis household balance sheets have greatly improved.

Household net worth continues to be on the rise benefitting from higher home values and rising equity prices.

The net worth of U.S. households and non-profit groups continues to climb and is currently over $80 trillion, almost a 14 percent year-over-year increase.

9

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

Mon

thly

Per

cent

age

Cha

nge

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

$0.0

$15.0

$30.0

$45.0

$60.0

$75.0

$90.0

Bill

ions


Employment Slowly Improving Employment Landscape

Source: U.S. Bureau of Labor and Statistics (BLS), SVB Asset Management, National Bureau of Economic Research (NBER). Note: The underemployment rate U6 defined as persons marginally attached to the labor force are those who currently are neither working nor looking for work but indicate that they want and are available for a job and have looked for work sometime in the past 12 months.

Full-Time Employment

Job growth remains slow and steady. It has been 3 ½ years since monthly payroll growth was negative.

The Fed has never raised rates with the underemployment rate (U-6) above 10 percent. It currently lies at 12.6 percent.

Full-time jobs have been replacing part-time jobs for about two years, but total full-time jobs remain lower than the 2007 peak.

Worker attitudes continue to mend, evidenced by improving trend in number of “discouraged workers.”

10

-15.0%

-5.0%

5.0%

15.0%

-1,000.0

-500.0

0.0

500.0

1,000.0

Thou

sand

s

Non-Farm Payroll (LHS) Unemployment Rate (RHS) U-6 (RHS)


0.0

5,000.0

10,000.0

50,000.0

70,000.0

90,000.0

110,000.0

130,000.0

Thou

sand

s

Thou

sand

s

Full Time Employment (LHS) Part Time for Economic Reasons (RHS)

0.0 200.0 400.0 600.0 800.0

1,000.0 1,200.0 1,400.0

Thou

sand

s

Discouraged Workers Not in Labor Force

Employment Slowly Improving Conference Board Consumer Confidence

Source: U.S. Bureau of Labor Statistics (BLS), SVB Asset Management.

ADP Employment Survey by Industry (Rebased to 100)

Hires and Quits Remain Depressed Consumers are gaining confidence in the jobs market with “jobs plentiful” trending up and “jobs hard to get” trending down.

Hires and quits remain low, but are also trending in the right direction. Greater turnover is a strong sign of job market confidence.

ADP survey shows small companies have already replaced all dismissed workers during the downturn, while larger companies have more to go.

11

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

Job Hire Rate Job Quit Rate


0.0%

20.0%

40.0%

60.0%

0.0%

10.0%

20.0%

30.0%

40.0%

Conference Board Consumer Confidence Jobs Plentiful Conference Board Consumer Confidence Jobs Hard to Get

85.0

90.0

95.0

100.0

105.0

1-49 50-499 500+

U.S. Housing Market Plugging Along Home Sales & Supply

Source: National Association of Home Builders (NAHB), Census.gov, S&P, and SVB Asset Management.

Housing Starts Home Prices – Indexed to 100

Total housing sales have suffered from recent uptick in rates.

Housing starts have improved recently, but have far to go given continued population growth. Starts are most important to the overall economy due to associated purchases and economic transactions.

Home prices remain in an upward trend, but momentum has paused recently. If employment continues to grow, look for housing statistics to also continue moving upward.

12

0.0

5.0

10.0

15.0

3.0

5.0

7.0

9.0

Hom

e S

uppl

y (M

onth

s)

Hom

e S

ales

(Mill

ions

)

Total Sales (new & existing) Existing Home Supply

90

140

190

240

Case Schiller 20 City FHFA Purchase Median Home Price


0.0

100.0

200.0

300.0

400.0

0.0

500.0

1,000.0

1,500.0

2,000.0

2,500.0

Pop

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ion

(Mill

ions

)

Hou

sing

Sta

rts

(Tho

usan

ds)

Housing Starts U.S. Population

U.S. Housing Market Plugging Along Homeownership Rate

Source: Census.gov, National Association of Realtors and SVB Asset Management.

Housing Affordability Composite Index

Home Ownership and Foreclosures The homeownership rate seems to be bottoming, providing significant support for all aspects of the housing sector.

Home affordability has struggled in the recent quarter. However, it would take a significant jump in mortgage rates to make home ownership markedly less affordable.

Foreclosures continue to drop quickly as resolutions to REO holdings are offered by alternative investors.

13

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

100.0

150.0

200.0

250.0

Affo

rdab

ility

Inde

x

Housing Affordability 30 Year Fixed Mortgage Rates

62.0%

64.0%

66.0%

68.0%

70.0%


0.0%

2.0%

4.0%

6.0%

60.0%

65.0%

70.0%

Homeownership Quarterly Rate Foreclosures as a % of Total Loans

Inflation Still Nowhere In Sight Component Distribution

Source: U.S. Bureau of Economic Analysis (BEA), U.S. Bureau of Labor Statistics (BLS) and SVB Asset Management.

Core PCE - % Change from Prior Year

Consumer Price Index - % Change from Prior Year Producer Price Index

14

-5.0%

0.0%

5.0%

10.0%

15.0%

CPI Ex Food & Energy CPI

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

Core PCE Fed Target Monetary Policy Threshold

-10.0%

-5.0%

0.0%

5.0%

10.0%

15.0%

% c

hang

e fro

m p

rior y

ear

PPI Ex Food & Energy PPI


41.5%

16.4%

14.9%

7.6%

7.1% 5.8%

2.7% 4.1%

Housing

Transportation

Food & Bev.

Medical Care

Educ. & Comm.

Recreation

Apparel less footwear

Other

CPI Components 12-month ChangeFood & Bev. 1.4%Housing 2.5%Apparel less Footw ea -0.4%Transportation -2.2%Medical Care 2.3%Recreation 0.3%Educ. & Comm. 1.1%Other 1.9%Headline CPI 1.1%Less:

Energy -2.5%Food 1.4%

Core CPI 1.6%

Inflation Still Nowhere In Sight Wage Growth – Average Hourly Earnings

Source: U.S. Bureau of Labor Statistics (BLS), U.S. Energy Information Administration (EIA), University of Michigan / Thomson Reuters - Survey of Consumers and SVB Asset Management.

Crude Oil – Spot & Futures

Univ. of Michigan Survey of Inflation Expectations Core PCE continues to be well below the Fed’s target of 2 percent.

The Fed has acknowledged that inflation has been running below its long-term objective.

Despite being on the tapering track, the Fed is still open to accommodative monetary policy.

The Fed plans to monitor inflation developments carefully in search of evidence that inflation will move towards its target.

15

1.5%

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4.0%

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ual P

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hang

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Pric

e pe

r Bar

rel

Crude Oil Crude Oil Futures


1.5%

2.5%

3.5%

4.5%

5.5%

1 Year Ahead 5-10 Years Ahead

The Federal Reserve

Federal Reserve Diminished Returns Are Record Low Mortgage Rates Helping?

Source: National Association of Home Builders (NAHB), Census.gov, S&P, and SVB Asset Management.

Will the Wealth Effect be Sustainable? Low Participation Rate Impacts the Unemployment Rate

The stock market has been the biggest benefactor of quantitative easing with the S&P 500 and Dow Jones Industrial Average closing at all-time highs and NASDAQ reaching levels not seen in 13 years.

Mortgage rates are still at very low levels even though they have been ticking up as the economy improves and the end of QE is in sight.

The unemployment rate has been dropping, but largely due to a drop in the participation rate. The participation rate peaked in 2000.

As the Fed moves towards ending quantitative easing the markets will pull back.

17

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600

900

1,200

1,500

1,800

2,100

$150.0

$170.0

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$250.0

Home Prices (LHS) S&P 500 (RHS)


0.0%

5.0%

10.0%

15.0%

62.0% 63.0% 64.0% 65.0% 66.0% 67.0% 68.0%

Labour Force Participation Rate (LHS) Unemployment Rate (RHS)

0.0%

2.0%

4.0%

6.0%

8.0%

$11.0

$12.0

$13.0

$14.0

$15.0

Bill

ions

Mortgage Outstanding (LHS) 30 Year Fixed Mortgage Rates (RHS) 10 Year Treasury (RHS)

Federal Reserve on the Taper Track

Tapering is on a roll, currently at the pace of $10 billion a month. Despite clear rhetoric that there is no pre-set course, if the economy continues to improve this latest round of QE will end by fall.

In the March meeting the Committee did away with the 6.5 percent unemployment rate threshold. In the place of an unemployment target the Fed added a more qualitative approach to forward guidance. This change will make communications from the Fed less clear.

Fed Chair, Janet Yellen, also announced in the March statement that the Fed remains committed to the 2 percent inflation target.

The recent changes to monetary policy created some volatility in markets and more is expected as the year passes.

Source: Federal Reserve and SVB Asset Management.

Recent Balance Sheet Trends


$0.0

$0.5

$1.0

$1.5

$2.0

$2.5

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$3.5

$4.0

Trill

ions

Other Fed Reserve Assets Central Liquidity Swaps Other Aurora Maiden Lane III Maiden Lane II Maiden Lane I TALF AIG Seasonal Credit Secondary Credit Primary Credit Other Loans Treasury Currency Outstanding Special Drawing Gold Stock MBS Federal Agency Debt Securities U.S. Treasury Securities

Special Topic: U.S. Banks’ Balance Sheets

U.S. Banks’ Balance Sheet Aftermath of Crisis

Source: FDIC, SVB Asset Management

FDIC Banks’ Loans to Deposits Ratio vs. Securities Held on Balance Sheet


70.0%

72.0%

74.0%

76.0%

78.0%

80.0%

82.0%

84.0%

86.0%

88.0%

$2.0

$2.2

$2.4

$2.6

$2.8

$3.0

$3.2

Tril

lions

Securities (LHS) Loans to Deposits (RHS)

At the short end of the curve, financials make up a large percentage of the securities outstanding.

Banks have taken strides to improve their balance sheet position since the height of the financial crisis.

Cognizant of the fact that liquidity was the first issue of the crisis, most banks sought to improve the liquidity of their balance sheet.

One key ratio, the loans to deposits ratio, improved markedly from 86.4 percent as of early 2009 to 70.5 percent as of December 2013.

With limited room for loan growth, most banks parked the increased deposits in securities, which grew from $2.2 trillion to $3.0 trillion in five years.

U.S. Banks’ Balance Sheet What Happens if Rates Rise? Impact of Upward Interest Movements on Securities Portfolio

Source: FDIC, SVB Asset Management’s Estimates

Average annual net income for the last five years since the crisis was $95.8 billion for the FDIC banks.

Assume a portfolio duration of 4.7 years on the securities portfolio of all FDIC securities.

It will take an estimated 68 basis points increase in interest rates and will take out the entire year’s of profits for the banks.

Banks will need to expand earnings by one and a half to sustain a parallel upward shift of 100 basis points to the yield curve without impacting capital ratios.

With the need to maintain strong capital ratios and a Tier-1 leverage ratio of 9.41 percent as of December 2013, there is limited room to maneuver.

However, we note that the losses are unrealized losses unless the banks are forced to exit out of their positions.


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50 100 150 200 250 300

Bill

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Basis Points Potential Unrealized Loss Average Annual Profit

68 bps

U.S. Banks’ Balance Sheet The Accounting Shift Banks Shifting from Available for Sale to Hold-to-Maturity

Source: FDIC, SVB Asset Management

AFS HTM

Guideline Generally default category Intend to buy and hold until fixed future maturity date

Valuation Marked to market Original cost and amortized/ accrete as required

Change in Fair Value

Attribute gains and losses through stockholders equity

No impact

Drawback Fluctuations in capital levels depending on market movements

Banks unable to sell until maturity date due to tainting issue

Available for Sale (AFS) vs. Hold to Maturity (HTM) Size of U.S. Tri-Repo Market based on Collateral Value

To mitigate the impact of probable interest rate increase, banks are beginning to shift securities into the HTM bucket.

This will prevent banks from being required to report fluctuations in market value in their capital levels.

A drawback is that banks would be unable to sell the securities. However, banks can rely on the repo market and other ways to obtain liquidity from these high quality assets.


0.0%

5.0%

10.0%

15.0%

20.0%

78.0% 80.0% 82.0% 84.0% 86.0% 88.0% 90.0% 92.0% 94.0%

% of AFS of Securities (LHS) % of HTM of Securities (RHS)

Source: FDIC, Federal Reserve Bank New York, SVB Asset Management

$0.0

$0.5

$1.0

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$2.0

$2.5

Trill

ions

Markets & Performance

Funds Flow Bond Funds Refuel

Source: Bloomberg , Investment Company Institute, MSCI, and SVB Asset Management.

Equity Flows & Stock Performance

Net New Fund Flows Money Market Fund Flows

Outflows from bond funds into equity funds continued until the end of Q1 2014 where bond funds began to see increased inflows.

Equity inflows continued to outpace returns as investors continued to look for high yielding investments in a low interest rate environment and the uncertainty of rising rates.

With the continued reduction of government bond purchases we expect less funds to flow into riskier assets and more into to less risky assets.

Money market fund flows have started to decline once again as the SEC inches closer to finalizing their regulatory reform on the industry.


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Total Equity Total Bond

-20.0%

-10.0%

0.0%

10.0%

20.0%

-$40.0

-$20.0

$0.0

$20.0

$40.0

Bill

ions

Net New Cash Flow (LHS) Total Return on Equities (RHS)

$2.4

$2.5

$2.5

$2.6

$2.6

$2.7

Trill

ions

MMF AUM

Bond Sector Spreads Low End of the Range

25

Source: Bloomberg, BoAML , Barcap Live, Citigroup and SVB Asset Management.

Spread Performance by Asset Class


Bond investors continue to look to the short end as a safe haven to hedge the risk of higher interest rates in the near future. Therefore, short-end yields for agencies, corporates and structured products will continue to be anchored on the low end.

Based on five-year averages, bond-spreads (over U.S. Treasuries) for each asset class are trading well below their averages and are right at or close to the lows of their respective ranges.

Near-term spread volatility is expected to be low as investors stay short of their benchmarks awaiting the Federal Reserve’s next move.

26

Source: Bloomberg, BoAML , Barcap Live, Citigroup and SVB Asset Management.

Total Return by Sector


Market Returns Juice From Spread Products

Year-to-date returns for U.S. Investment grade corporates is 0.41 percent in 2014, making this market the second best performer behind commercial mortgage-backed securities.

One- to three-year corporate bonds and Auto ABS continue to outperform U.S. Treasuries and agencies in the 1st quarter.

Additionally, these sectors have posted strong results as fundamentals remain favorable — near zero default rates and less supply.

Market Returns Income Still in Play

Income return is still the main driver of positive total returns for the bond markets.

Price returns continue to exhibit negative returns as higher benchmark rates impact bond pricing.

Source: Bloomberg, BoAML and SVB Asset Management.


Benchmark Performance

Investment Performance Where’s the Horsepower? Ticker Q1 2014 2013 2012 2011 2010 2009 2008 2007

Short Benchmarks 3-month Treasury Bill G0O1 0.012 0.073 0.111 0.103 0.126 0.207 2.057 5.004 3-month Citi/Salomon CD SBMMCD3 0.050 0.204 0.307 0.289 0.310 0.822 3.442 5.448 6-month Treasury Bill G0O2 0.044 0.180 0.171 0.268 0.365 0.579 3.582 5.607 6-month Cit/Salomon CD SBMMCD6 0.070 0.272 0.488 0.389 0.437 1.611 3.756 5.459 1-yr Treasury Bill G0O3 0.052 0.277 0.204 0.496 0.792 0.813 4.746 5.948 Treasury 1-3 yr Treasury G1O2 0.138 0.358 0.434 1.554 2.348 0.785 6.609 7.317 3-5 yr Treasury G2O2 0.427 -0.913 1.577 6.229 5.695 -0.672 12.153 9.836 Corporate/Govt (A Rated and Above) 1-3 yr Corp/Govt B1A0 0.246 0.705 1.478 1.562 2.818 3.835 4.693 6.872 3-5 yr Corp/Govt B2A0 0.698 -0.158 3.817 5.415 6.231 6.400 4.577 7.846 Agencies 1-3 yr Agencies G1P0 0.170 .0.424 0.847 1.536 2.338 2.189 7.034 6.735 3-5 yr Agencies G2P0 0.587 -0.531 2.588 5.290 4.900 3.223 8.971 8.261 Municipals - Tax Exempt 1-3 yr Pre-refunded U1AF 0.160 0.807 0.520 1.800 0.923 3.189 5.875 4.710 3-7 yr Pre-refunded U2AF 0.242 0.952 1.539 4.951 2.087 5.345 7.992 5.390 Auto Asset Backed Securities ABS, Autos, Fixed Rate, (1.45 yrs) R0U0 0.406 0.802 2.291 1.689 3.077 14.845 -0.682 5.723 Other Indices** Dow Jones Industrial Average INDU -0.266 23.591 7.257 5.544 11.023 3.116 -33.762 6.432 S&P 500 SPX 2.010 26.390 13.405 2.110 12.783 23.454 -38.486 3.530 NASD CCMP 2.190 34.198 15.906 -1.799 16.910 43.888 -40.541 9.812 MSCI World Index MXWO 1.362 21.478 13.184 -7.615 9.262 27.283 -42.081 7.093 CRB Index (Commodities) CRY 7.742 -5.837 -3.372 -8.264 15.430 23.563 -39.450 16.679

28

Source: Bloomberg, BoAML, Morgan Stanley. * Past performance is not a guarantee of future results. ** Analyzed returns


Commodities China Slows Down, While U.S. Speeds Up Crude Futures – Per Barrel

Source: Bloomberg and SVB Asset Management.

Gold Prices – An Ounce Iron Ore Futures – Per Ton

Following the decline in late 2013, commodities have begun to stabilize in 2014 as weather becomes a factor. Price volatility will be impacted by the U.S. recovery and continued interest rate uncertainty.

Domestic oil and gas production rose during 2013, decreasing demand for imports as fracking continues to increase supply. Oil price per barrel continues to hover around $100.

Iron ore prices have been volatile due to uncertain China demands and future iron ore surpluses in the region.

29 SVB Asset Management | Quarterly Economic Report Q4 2013-

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$1,800.0

$100.0

$120.0

$140.0

$160.0

Loan Market Fundamentals

Source: Thomson Reuters Loan Pricing Corp and SVB Financial Group

Credit Spreads Continue to Run Below 2009 Peak

Fundamentals Remain Steady 3-Month LIBOR Remains at Historic Lows

Credit spreads have fallen since the 5.6 percent peak in January 2009, but remain higher than the sub-2.0 percent levels before the financial crisis.

Lenders are still deciphering the impact on the leveraged loan market a year after the finalized Leveraged Lending Guidance was put in place, as well as assessing the implications for internal practices. It is unclear how the regulators are applying the guidance and what consequences or penalties will be imposed if lenders fall short.

Secondary loan prices continue to peak in the first quarter of 2014, at levels not seen since late 2009.


65.0

75.0

85.0

95.0

105.0

LPC LCDX (Secondary Loan Price Index - Par = 100)

0.0% 1.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 3 Month LIBOR

February 2014 0.26%

0.0%

2.0%

4.0%

6.0%

10 YR BBB Yield - 10 YR Treasury Yield

February 2014 2.4%

January 2009 5.6%

High Yield Market Fundamentals High Yield Funds Dip Notably in June

Source: Thomson Reuters Loan Pricing Corp., Lipper FMI and SVB Financial Group

Issuance conditions remain optimal. While volatile, last week benchmark Treasury yields were still below recent highs. According to the BAML HY Master II Index, HY spreads have contracted to the year’s lowest level, a level not seen since July 2007.

Lipper reported a $196 million outflow from high-yield funds in the week that ended on March 26, with a heavy ETF outflow of $426 million, erasing a $230 million inflow to mutual funds. However, inflows in the year-to-date totaled $2.8 billion.

Lower-rated credits took advantage of investors' hunger for yield at the end the first quarter 2014. Accounting for 42 percent of the week’s volume, three triple-C rated deals hit the market. In the first two weeks of March, double-B rated deals led the way and accounted for 68 percent of issuance volume while triple-C rated deals made up just $1 billion of the first half of the month’s $17.5 billion issuance volume.

High Yield Take-Outs of Bank Debt


$0.0

$10.0

$20.0

$30.0

$40.0

$50.0

$60.0

Issu

ance

($B

illio

ns)

$0.0

$100.0

$200.0

$300.0

$400.0

Net

Ass

ets

($B

illio

ns)

Loan Funds HY Bond Funds

Overall Loan Market Overview Historical Syndicated Loan Volumes

Source: Thomson Reuters Loan Pricing Corp and SVB Financial Group

Excluding refinancings, leveraged loan volume stood at a seven-year high of $102.2 billion in the first quarter, fortified by $83.1 billion issuance of institutional paper, up from $77.4 billion/$53 billion in the fourth quarter and $71.1 billion/$56.2 billion during the first quarter of 2013.

Strong market technicals signaled robust lender capacity and demand for yield as a series of cross-border syndications and large M&A credits worked through a market heavily weighted toward opportunistic refinancings in 2013. Despite the record issuance however, just over 36 percent, or $1.45 billion, represented new loan assets, compared to 55 percent in 2007.

M&A-related loan volume flourished in the first quarter, inching to a post-2007 high of $65.9 billion, including $53.5 billion of institutional tranches, from $61.4 billion/$39.6 billion during the fourth quarter of 2013.

The core issues in 2014 continue to be refinancing and releveraging. Refinancing activity will remain strong amid record low rates and releveraging related activity to finance LBOs should continue to increase.

Pro Rata Lending Exceeds Institutional Loans


$0.0

$500.0

$1,000.0

$1,500.0

$2,000.0

$2,500.0

Issu

ance

($B

illio

ns)

Leverage I-Grade Other

$0.0 $20.0 $40.0 $60.0 $80.0

$100.0 $120.0 $140.0 $160.0

Leve

rage

d lo

an v

olum

e ($

Bill

ions

)

Pro rata Institutional

Global Economy

Eurozone Real GDP

Source: Eurostat, MarkIt, Bloomberg and SVB Asset Management.

Discontinuous growth within the Euro zone is transitioning to steady growth, albeit at marginal levels. Fourth quarter GDP was positive for the first time in almost two years. Germany, France, and Portugal registered gains, while Italy, Spain, and Greece remained in contraction.

The Euro zone Composite PMI index for March 2014 denoted growth for the ninth consecutive month, with indications the expansion will continue in the upcoming months, as new orders and backlogs increased at a healthy pace.

Euro zone financial conditions continue to improve, allowing Greece to potentially return to the bond market with an offering by the middle of the year.

Crimea’s defection to Russia and fears of additional part of Ukraine falling to Russian control heightened geopolitical risk, but will not be enough to materially derail continued economic progress as a political solution is expected.

An upset of the banking sector could be an upcoming speed bump as the EU banking stress test may reveal additional bad loans and push banks to raise significant additional capital.

Eurozone Composite PMI

SVB Asset Management | Quarterly Economic Report Q1 2014 34

Europe Ending Discontinuous Growth

Europe Euro & Pound May Diverge Currency Performance

Source: Eurostat, Bloomberg and SVB Asset Management.

Sustained economic activity continues to push the GBP higher, while the EUR has been kept afloat by low inflation, improving financial stability, and providing a persistent current account surplus. Domestic consumption is largely driving economic activity in the UK, while the Euro zone is more reliant on exports.

UK home price appreciation continued to intensify, reaching 9.5 percent in March 2014. The housing market is supporting solid retail sales, with spending on food and internet purchases particularly strong. Manufacturing and service activity continued to expand, though volatility in emerging markets helped soften export activity. The BOE refocused forward guidance from unemployment to economic slack.

The euro remains firm even as the ECB threatens additional easing if inflation endures below its 2014 target of 1 percent. Inflation preliminarily measured 0.5 percent in March 2014, though the low level is primarily attributed to fickle energy and food components. Generally, a current account surplus is keeping the euro at levels higher than the ECB may desire, and compel action later this year.

The EUR is expected to linger within the 2013 range, though it is poised to fall due to potential ECB easing and a stronger U.S. economy. Conversely, the GBP risks drifting marginally higher due to anticipation of a BOE rate hike late in the year. The BOE may refrain if inflation remains below 2 percent, even as unemployment and economic slack shrinks.

Euro Zone Inflation


EU

R /

US

D

GB

P/U

SD

China Growth Decline Quickens Chinese Yuan

Source: National Bureau of Statistics of China, Markit, Bloomberg and SVB Asset Management.

Trade Balance Manufacturing PMI

The PBOC doubled the range to 2 percent that the Yuan may stray from the daily reference rate, to increase flexibility of investment capital movement.

The Yuan declined the most (on a quarterly basis) in 20 years during the first quarter of 2014 as weak manufacturing, retail sales and export data inflamed slower growth fears.

The government officially set its growth target at 7.5 percent, similar to last year. Fiscal stimulus to subsidize meeting the growth target may help to slow the Yuan’s fall.


6

6.1

6.2

6.3

6.4

CN

Y/U

SD

-$25.0

$25.0

$75.0

$125.0

$175.0

Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 Jan-14

Bill

ions

US

D

Trade Balance Exports Imports

>50

= E

xpan

sion

; <5

0 =

Con

tract

ion

Asia Inflation Slowing Declining – Yen Continues, Rupee Moderates

Source: Japan Ministry of Internal Affairs and Communications, India Central Statistical Organisation, Bloomberg and SVB Asset Management.

India Consumer Price Index

Japan Household Spending Japan: The Bank of Japan (BOJ) took no new action at its March meeting and reiterated its commitment to the ‘Quantitative-Qualitative Easing’ (QQE) program. The BOJ reduced its view of exports while being more positive on industrial production and capital expenditures. A 3 percent sales tax hike that took effect in April may slow domestic demand, and brake inflation from moving towards the BOJ’s 2 percent target. This may push the BOJ to enact further measures, which, along with the Fed’s continued reduction of balance sheet growth, will prevent the yen from strengthening.

India: After hiking the repo rate 25 bps in January the third interest rate hike in four meetings, the Reserve Bank of India (RBI) refrained from increasing interest rates at its April meeting as a drop in vegetable prices helped to moderate inflation to 8.1 percent in February. Growth remains vulnerable after hitting a decade low in March. Rupee volatility may decline in the near-term if inflation continues to moderate and election results in May avoids political uncertainty.


90.0

95.0

100.0

105.0

53.0

58.0

63.0

68.0

JPY

/US

D

INR

/US

D

INR JPY

-8.0% -6.0% -4.0% -2.0% 0.0% 2.0% 4.0%

The U.S. Dollar Upside Risk 1-Year Implied 1-Year Forward Treasury Rate

Source: Bloomberg and SVB Asset Management.

The Federal Reserve continued to reduce its bond purchase program at its March 2014 meeting. The pace of reduction is anticipated to be maintained throughout 2014, which will effectively end ‘QE3’ by November 2014.

The Fed may next reduce or end its policy to reinvest principal payments from its agency debt and mortgage securities holdings. The ending of reinvestments would effective contract the Fed’s balance sheet and tighten monetary conditions without raising the Fed funds rate.

Forward guidance provided by the Fed at its March 2014 meeting, along with comments by Chair Janet Yellen, sparked a sell-off in Treasury rates from speculation that an interest rate hike may occur sooner than expected. Implied 1-year forward 1-year rate climbed to price in at least 50 basis points of higher rates by March 2015.

The federal funds rate may not change until the second half of 2015, despite strengthening economic fundamentals, as core inflation remains below target. The USD has strengthening upside risk, as U.S. growth (within the context of benign inflation) may outpace other developed countries, particularly the Euro zone.

DXY USD Index


78 79 80 81 82 83 84 85

DX

Y In

dex

Leve

l

Portfolio Management Strategy

Portfolio Strategy Tying It All Back

Short duration benchmark (3 & 6 month)

Intermediate duration benchmark (1 yr)

Long duration benchmark (2 yr+)

Duration Targets Longer than benchmark

Neutral to benchmark

Shorter than benchmark

Sector Overweights Financials, Commercial Paper, MMFs

Financials, Industrials, Commercial Paper

Short Maturity Financials, Long Maturity Industrials, ABS

Sector Underweights

Treasuries, Agencies, Industrials

Treasuries & Agencies

Agencies


2014 Portfolio Strategy Outlook We anticipate that the FOMC will continue their tapering of Treasury and mortgage-backed securities purchases, bringing an end to the large scale asset purchases (LSAP) by the end of the year. As we head into year end, the market views will shift focus from tapering to predicting the timing of the first federal funds rate hike.

Strong credit fundamentals persist which will benefit the corporate bond market.

There is strong institutional demand for corporate bonds even in a rising interest rate environment.


ABS Corporate Bonds: Industrial Sector

Sector Overview

We anticipate lower yields in the first half of 2014 and a gradual rise of rates into year end

Agency yields are right on top of comparable maturity Treasuries thereby not offering much incremental yield

End of first quarter 2014 Approximate Yields: - 2 yr Treasury: 0.42% - 2 yr Agency: 0.42%

Treasuries & Agencies

Industrials continue to have strong balance sheets and positive earnings

Due to lack of supply in the short end and strong balance sheets, spreads over Treasuries are tight

We favor longer industrials for price performance stability

End of 1st quarter 2014 spreads/yields: - 2 yr A-rated Industrials: ~+22 / ~0.65 % - 2 yr A-rated Industrials: ~+33 / ~0.75 %

Strong fundamentals for the auto and credit card ABS sectors

Very stable spreads

Active new issue and secondary markets

We favor prime auto ABS with durations under 2 years as they offer a yield pick-up over comparable AAA-rated securities and strong credit performance

End of first quarter 2014 spreads/yields: - 2 yr Auto ABS Spread: Swaps ~+17 / ~0.72 %

Corporate Bonds: Finance Sector

Banks and brokers offer the best value as both regulators and the industry are incentivized to build capital. Additionally, earnings continues to be strong

Active new issue market and very strong and liquid secondary market

In the short end, Financial companies account for close to 40 percent of issues outstanding

End of 1st quarter 2014 spreads/yields: - 2 yr A-rated Finance:

~+43 / ~0.85 % - 2 yr A-rated Finance:

~+60 / ~1.02 %

Our Team

42

Managing Director

Jeff Schnitz [email protected]

Chief Investment Officer

Joe Morgan, CFA [email protected]

Head of Credit Research

Melina Hadiwono, CFA [email protected]

Portfolio Managers

Eric Souza [email protected] Paula Solanes [email protected] Renuka Kumar, CFA [email protected] Jose Sevilla [email protected]

Credit and Risk

Sook Kuan Loh, CFA [email protected] Tim Lee, CFA [email protected] Kyle Balough [email protected]

Silicon Valley Bank Partners

Susan Winters Kelly Caviglia Priyanka Raju Girish Mallya Sudhakar Pattabiraman

Head of Portfolio Management

Ninh Chung [email protected]


This material, including without limitation the statistical information herein, is provided for informational purposes only. The material is based in part upon information from third-party sources that we believe to be reliable, but which has not been independently verified by us and, as such, we do not represent that the information is accurate or complete. The information should not be viewed as tax, investment, legal or other advice nor is it to be relied on in making an investment or other decision. You should obtain relevant and specific professional advice before making any investment decision. Nothing relating to the material should be construed as a solicitation or offer, or recommendation, to acquire or dispose of any investment or to engage in any other transaction.

All material presented, unless specifically indicated otherwise, is under copyright to SVB Asset Management and its affiliates and is for informational purposes only. None of the material, nor its content, nor any copy of it, may be altered in any way, transmitted to, copied or distributed to any other party, without the prior express written permission of SVB Asset Management. All trademarks, service marks and logos used in this material are trademarks or service marks or registered trademarks of SVB Financial Group or one of its affiliates or other entities.

©2014 SVB Financial Group. All rights reserved. Silicon Valley Bank is a member of FDIC and Federal Reserve System. SVB>, SVB>Find a way, SVB Financial Group, and Silicon Valley Bank are registered trademarks. SVB Asset Management, a registered investment advisor, is a non-bank affiliate of Silicon Valley Bank and member of SVB Financial Group. Products offered by SVB Asset Management are not FDIC insured, are not deposits or other obligations of Silicon Valley Bank, and may lose value. B_SAM-14-13308 Rev. 04-14-2014.


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SVB Asset Management Economic Report Q1 2014

Economy & Finance