Chap quoit A Division of Dynamic Portfolios

Presentation of

Managing the Risk of a Looming U.S. During 2020

May 10, 2020

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Impact of on Investments

Virtually all recessions are accompanied by a large market drawdown.

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S&P500 Daily-Close Maximum Drawdowns In Last 10 Recessions: 7 Bear Markets, 3 Corrections

Black Monday 1987. of 66. Computerized selling Long-Term Capital of 62. in dictated by portfolio and Fund US Steel Price Bond Markets. insurance hedges. Redemptions Surprise.

Bear Market Line

Correction Line

Shading represents US economic recessions as defined by the National Bureau of Economic Research (NBER). Chap quoit A Division of Dynamic Portfolios

Managing 2020 Recession Risk Topics For Discussion

➢ Definition of a Recession ➢ Primary Factor for Declaring Dates for a Recession ➢ Historical Causes of Recessions ➢ Indicators to Help Estimate Timing of Recessions ➢ Current Recession Outlook ➢ Impact of Recessions on Investments ➢ Conventional-Wisdom Investments for Recessions

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Definition of a Recession

The National Bureau of Economic Research (NBER) Defines a Recession as:

“A significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.”

Rule of thumb: Real GDP declines in two negative quarters.

Official Recession Dates are declared by the NBER Business Cycle Dating Committee.

-December 1, 2008, announced its most recent U.S. recession started December 2007, a full year after the recession began.

-September 20, 2010, announced the ending of its most recent U.S. recession in June 2009, 16 months after the recession ended.

-Beginning of the 1990-91 recession was announced one month after the ultimately- determined completion of the recession, completely missing the event.

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First Primary Factor for Declaring Recessions Annualized Real GDP Growth

Quarterly Percent Change in Real GDP

Source: Bank of St. Louis, https://fred.stlouisfed.org/series/A191RL1Q225SBEA, Retrieved: May 10, 2020

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Second Primary Factor for Declaring Recessions Industrial Production

Annual Percent Change in Industrial Production

Source: of St. Louis, https://fred.stlouisfed.org/series/INDPRO#0, Retrieved: April 18, 2020

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Leading Factors for Recessions

• Monetary and Fiscal Policy Decisions • Trade Wars • Bursting of Investment Bubbles • Deflationary Influences

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Recessions Lead by Monetary and Fiscal Policy Decisions Examples

• Raising interest rates to fight (1980)

• Ill-conceived (S&L Crisis in 1990)

• Wage/Price controls (1973-1975)

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Recessions Lead by Trade Wars Examples • Smoot-Hawley Act 1930 – Originally conceived to protect agricultural prices. – The act raised tariffs on over 20,000 imported goods. – Exports were down 66% in 1933 from 1929 levels. • The Oil embargo of 1973-1974 was a trade war employing reduced exports by OPEC versus imposed tariffs. • Trade tariff skirmishes since 1950 had negligible impact on exports. 10 Chap quoit A Division of Dynamic Portfolios

Annual Percent Change in US Exports

Annual Percent Change in US Exports

•Trade Resumption After WWII

Auto Spat with Japan

Chicken Spat Pasta/Citrus with Europe Spat with EEC Steel Spat with World

• • • • • • 11% Increase in • • Worldwide Value of Dollar Great WWII Recession & Wood Spat Recession • with Canada Smoot-Hawley ++ 1930

Source: Federal Reserve Bank of St. Louis, https://fred.stlouisfed.org/series/EXPGSA#0, Retrieved: April 18, 2020 11 Chap quoit A Division of Dynamic Portfolios

Recessions Lead by Bursting of Investment Bubbles Examples

• crash of 1929 (1929-1933) – Only 10% required to buy • 1990s Dot-com bubble (2001) – Irrational investing in companies with no earnings • 2000s Housing price bubble (2007-2009) – Caused by lax lending practices for sub-prime mortgages and derivatives based on overvalued mortgage debt

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Recessions Lead by Deflationary Influences Examples

• Deflation -wait to buy at lower prices (1929-1933) • Dust Bowl droughts of 1930s dropped grain crop export levels and put farmers on unemployment. • Post-war drop in war materiel production – WWI (1920-1921) – WW2 (1945) – Korea (1953-1954)

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Leading Indicators of Economic Activity That Assist in Forecasting Recessions

• Expectations of Quarterly Change in Real GDP • Treasuries Yield Curve - 10 Year minus 3 Month • Treasuries Yield Curve - 10 Year minus 2 Year • Calculated Probably of a Recession • Change in Leading Economic Indicators Index • Consumer Confidence Differential

– Expectations minus Present Situation 14 Chap quoit A Division of Dynamic Portfolios

Anticipating Recessions Negative Yield Curve Spread (12-Month Recession Lag from Yield Curve Inversion)

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Failed Recession Predictions

Source: Federal Reserve Bank of New York, https://www.newyorkfed.org/research/capital_markets/ycfaq.html#/interactive, Retrieved: April 18, 2020

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Calculated Probability of Recession By Federal Reserve Bank of New York

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Probability of Recession Over 30% Failed Recession Correctly Predicted 7 out of 8 Last Predictions Recessions to Occur in 12 Months

Source: Federal Reserve Bank of New York, https://www.newyorkfed.org/research/capital_markets/ycfaq.html#/interactive, Retrieved: April 18, 2020

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Anticipating Recessions with Yield Curve 10 Year Treasury – 2 Year Treasury (12-Month Recession Lag from Yield Curve Inversion)

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Mid-Month (Aug 27, 2019) -.04%

Source: Federal Reserve Bank of St. Louis, https://fred.stlouisfed.org/series/T10Y2YM, Retrieved: April 18, 2020 17 Chap quoit A Division of Dynamic Portfolios

Reasons for the Yield Curve to Invert

• Real Interest Rates are expected to fall. • Inflation is expected to fall. • Economic growth is expected to weaken. • An overly-tight is in place. • Demand for long government bonds has increased. • Value of corporate bonds is expected to decrease. • Dollar is strengthening.

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Leading Economic Index and Recessions Conference Board Consumer Leading Economic Index – LEI 6-Month Moving Average of 6-Month Rate of Change

First Month of Recession Shown in Callouts

Leading Economic Index Includes Average weekly hours, manufacturing Average weekly initial claims for unemployment insurance Manufacturers’ new orders, consumer goods and materials ISM® Index of New Orders Manufacturers' new orders, nondefense capital goods Building permits, new private housing units Stock prices, 500 common stocks Leading Credit Index™ Interest rate spread, 10-year Treasury bonds less Average consumer expectations for business conditions

Source: Conference Board, https://www.conference-board.org/data/bciarchive.cfm?cid=1, Released: April 17, 2020, Retrieved: April 21, 2020 19 Chap quoit A Division of Dynamic Portfolios

Consumer Confidence and Recessions

Conference Board Consumer Confidence Expectations Minus Present Situation

First Month of Recession Shown in Callouts

Source: Conference Board, https://www.conference-board.org/press/index.cfm?pagenumber=2&sort=Date, Released April 28, 2020, Retrieved: May 10, 2020 20 Chap quoit A Division of Dynamic Portfolios

Coincident Indicators of Economic Activity That Assist in Confirming Recessions

• Actual Quarterly Change in Real GDP • Industrial Production – 12 Month Percent Change • ISM Manufacturing Orders Index • Advance Retail Trade Sales – Annual % Change • Unemployment Rate – Annual % Change

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ISM New Manufacturing Orders Index

First Month of Recession Shown in Callouts

Source: Institute for Supply Management, https://www.instituteforsupplymanagement.org/ISMReport/MfgROB.cfm?SSO=1, Released May 1, 2020, Retrieved: May 10, 2020 22 Chap quoit A Division of Dynamic Portfolios Factors Confirming Recession

(Annual Percent Change)

Source: Federal Reserve Bank of St. Louis, https://fred.stlouisfed.org/series/RSXFS#0, Released April 15, 2020. Retrieved: April 21, 2020

(Annual Percent Change)

Source: Federal Reserve Bank of St. Louis, https://fred.stlouisfed.org/series/UNRATE#0, Released: May 8, 2020, Retrieved: May 10, 2020 23 Chap quoit A Division of Dynamic Portfolios

Real GDP Change Expectations

Source Q1 2020 Q2 2020 Q3 2020 Q4 2020 Yr 2020 Goldman Sachs (Mar 31) -9.0% -34.0% 19.0% 17.8% -6.2% J.P. Morgan (Apr 9) -10.0% -40.0% 23.0% 13.0% -14.0% Morgan Stanley (Apr 3) -3.4% -38.0% 20.7% 15.2% -5.5% Conference Board (Apr 9) -5.8% -33.3% 0.1% 27.4% -6.5% Average -7.0% -36.3% 15.7% 18.4% -8.0%

Sources: Publicly-available reports from the cited organizations.

Year GDP Worst 2008 -2.5% Historical Years 1946 -11.6% Back to 1930 1932 -12.9%

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Current Recession Outlook Dashboard of Leading Indicators for a Recession

Recession Current Value Factor Comment Indication Value Date

Real GDP -34.20% First Negative estimate Below 0 2Q 20 Change Expectations estimate of -7.0 In Q1 2020 12-Month Recession Treasury Spread 10Yr - 3Mo Below 0 0.57% May 8, 20 signal in June 2019 12-Month Recession Treasury Spread 10Yr – 2Yr Below -.05% 0.53% May 8,20 signal in August 2019 Highest 12-Month of Probability of Recession 12Mo Above 30% 18.47% Mar 20 37.93% in August 2019 First Negative in Conference Board LEI Change Below 0 -1.65% Mar 20 January 2020 Consumer Confidence Below -50 17.40 Apr 20 Below -50 for 28 Months Expectations - Present

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Current Recession Outlook Dashboard of Coincident Indicators for a Recession

Recession Current Value Factor Comment Indication Value Date

First negative of -0.18 Industrial Prod 12 Mo %Chg Below 0 -5.48% Mar 20 In September 2019 First Month below 50 ISM Manufacturing Orders Below 50 27.1 Apr 20 of 47.2 in August 2019 First Negative Month Volume Retail Trade Sales Below 0 -3.82% Mar 20 in March 2020

Unemployment 12 Mo % Chg Above 3% 308.33% Apr 20 April 2020 is a record

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Expected Beginning of a 2020 Recession Based on historical lags from first indication Earliest Average Latest Factor Recession Recession Recession Start Start Start

Real GDP Pct Change Estimate Nov 2019 Apr 2020 Sep 2020

Treasury Spread 10Yr - 3Mo Dec 2019 May 2020 Oct 2020

Treasury Spread 10Yr – 2Yr Jul 2020 Nov 2020 Feb 2021

Probability of Recession 12Mo Feb 2020 Jun 2020 Oct 2020

Conference Board LEI Change Feb 2020 Jul 2020 Apr 2021

Consumer Confidence Nov 2017 Dec 2018 Mar 2021 Expectations - Present 27 Chap quoit A Division of Dynamic Portfolios

S&P500 Drawdowns in Recent Recessions

Relative Month 1960-1961 1969-1970 1973-1975 1981-1982 1990-1992 2000 2007-2009 -12 4.02 -3.89 4.78 6.96 9.03 9.78 1.40 -11 2.40 -0.56 1.40 1.01 1.96 -3.01 1.51 -10 -0.22 -4.47 -1.48 2.94 -0.41 -2.05 -1.96 -9 3.63 3.71 -3.51 2.02 -2.32 2.47 1.12 -8 -1.02 2.38 0.10 10.65 2.04 -1.56 4.43 -7 -4.43 0.01 -3.83 -3.02 2.40 6.21 3.49 -6 1.28 -5.28 -1.63 -4.18 -6.71 -5.28 -1.66 Months Before -5 1.86 -5.74 -0.39 1.74 1.29 -0.42 -3.10 Recession Start -4 2.92 4.29 4.04 4.00 2.65 -7.88 1.50 -3 -6.87 -2.21 -3.41 -1.93 -2.50 0.49 3.74 -2 1.19 4.70 4.26 0.26 9.75 3.55 1.59 S&P500 -1 -1.09 -3.25 0.12 -0.63 -0.68 -9.12 -4.18 Monthly Recession Start 0 -1.45 -1.58 -11.11 0.21 -0.32 -6.34 -0.69 1 2.98 -7.33 1.94 -5.78 -9.04 7.77 -6.00 Drawdown 2 2.24 5.56 -0.70 -4.93 -4.87 0.67 -3.25 Interval 3 -2.19 0.43 -0.05 5.40 -0.43 -2.43 -0.43 Months after 4 2.89 -8.73 -2.01 4.13 6.46 -0.98 4.87 Recession Start 5 -5.74 -5.76 -3.57 -2.56 2.79 -6.26 1.30 6 0.06 -4.65 -3.01 -1.31 4.36 -8.08 -8.43 7 4.31 7.66 -1.12 -5.59 7.15 1.91 -0.84 Limits 8 4.90 4.77 -7.41 -0.52 2.42 7.67 1.45 Of 9 6.58 3.61 -8.62 4.52 0.24 0.88 -8.91 10 2.95 -0.83 -11.46 -3.41 4.31 -1.46 -16.79 Recession 11 2.81 5.04 16.71 -1.50 -4.58 -1.93 -7.17 12 0.64 5.96 -4.89 -1.78 4.66 3.76 1.06 13 2.16 4.32 -1.58 12.14 2.37 -6.06 -8.43 14 -2.63 1.16 12.72 1.25 -1.67 -0.74 -10.65 15 3.51 3.93 6.38 11.51 1.34 -7.12 8.76 16 2.21 3.87 2.54 4.04 -4.03 -7.80 9.57 17 -1.72 -3.90 5.10 1.93 11.44 0.66 5.59 18 3.08 0.33 4.77 3.72 -1.86 -10.87 0.20

Max Drawdown -8.26 -29.09 -42.57 -15.09 -14.70 -44.73 -50.94 Source: S&P Global Ratings (previously Standard & Poor’s) 28 Chap quoit A Division of Dynamic Portfolios Investing in 10+ Year Govt Bonds

Relative Month 1960-1961 1969-1970 1973-1975 1981-1982 1990-1992 2000 2007-2009 -12 -1.17 -3.63 2.26 -3.70 2.29 3.29 -2.18 -11 -0.06 -2.06 -2.29 -4.30 -2.64 -0.87 -0.81 -10 0.10 0.42 -0.15 -2.68 0.40 -0.41 2.95 -9 0.60 0.10 0.32 -2.35 3.98 2.32 -1.08 -8 -0.41 4.27 -0.26 0.87 0.81 1.57 0.82 -7 -0.57 -4.90 0.79 3.34 -0.12 2.30 -1.83 -6 1.50 2.14 -0.17 -0.91 -3.42 -1.14 -0.90 Months Before -5 -1.19 0.79 -0.45 -3.79 -0.42 1.61 2.43 Recession Start -4 -1.59 -0.69 -3.58 2.92 -0.21 3.22 1.94 -3 1.12 -5.31 1.93 -5.32 -2.57 2.50 0.42 -2 2.04 3.65 3.51 6.31 4.67 0.14 1.44 S&P500 -1 2.82 -2.43 0.61 -1.91 2.29 1.67 4.18 Monthly Recession Start 0 -1.70 -0.68 0.06 -3.14 1.02 -0.50 -0.08 1 1.52 -0.21 -1.57 -4.16 -4.32 -2.65 2.52 Drawdown 2 1.73 5.87 1.11 -1.60 1.25 0.28 0.15 Interval 3 3.68 -0.68 -0.43 7.42 2.24 0.65 1.10 Months after 4 -0.67 -4.13 -2.90 11.10 4.17 3.85 -1.81 Recession Start 5 0.75 -4.68 -1.58 -4.85 2.15 1.91 -2.12 6 -0.28 4.86 0.80 0.19 1.14 0.99 1.62 7 -0.66 3.19 -0.85 1.98 0.43 4.91 -0.05 8 2.79 -0.19 -0.99 2.35 0.29 -4.67 2.24 9 -1.07 2.28 -2.45 3.44 1.32 -1.91 0.47 10 2.00 -1.09 1.61 0.81 0.02 1.24 -3.38 11 -0.38 7.91 5.13 -2.31 -0.81 1.28 11.78 12 1.15 0.84 3.17 4.89 1.53 -4.11 9.26 13 -0.46 5.06 0.99 7.76 3.53 3.77 -8.65 14 -0.75 -1.63 2.11 6.41 3.08 0.46 -0.74 15 0.35 5.26 1.85 8.53 0.30 1.71 4.51 16 -0.38 -2.83 -2.24 -0.26 0.49 3.26 -4.72 17 1.29 -0.06 -1.65 2.44 5.97 4.18 -2.69 18 0.71 -1.59 2.13 -2.76 -3.21 4.11 0.62

Bonds 11.75 -8.02 -4.80 14.43 2.35 29.51 15.93 Source: Merrill Lynch ICE Database 29 Chap quoit A Division of Dynamic Portfolios

Comparison of Bonds versus Stocks In S&P500 Recession Drawdowns With Perfect Hindsight

Recession Years → 1960-1961 1969-1970 1973-1975 1981-1982 1990-1992 2000 2007-2009 Median

S&P500 Drawdown Relative Begin -3 -12 -10 -3 -1 -6 -1 -3

S&P500 Drawdown Relative End 5 6 10 12 3 19 14 10

Months for Drawdown 9 19 21 16 5 26 16 16

S&P500 Drawdown Amount -8.26 -29.09 -42.57 -15.09 -14.70 -44.73 -50.94 -29.09

Months to Recover S&P500 Loss 12 28 42 19 9 75 53 28

Long Govt Bond in Same Interval 11.75 -8.02 -4.80 14.43 2.35 29.51 15.93 11.75

Bonds - S&P500 in Same Interval 20.01 21.07 37.77 29.52 17.05 74.24 66.87 29.52

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Why should Investors Seek to Avoid Large Losses?

Time for S&P500Time for to S&P500 Return to on Return Track on toTrack Target Returns From 50.94% Monthly Drawdown Beginning November 2007 2,500  2,000 

1,500   1,000 

500

Oct-07 Apr-08Oct-08 Apr-09Oct-09 Apr-10Oct-10 Apr-11Oct-11 Apr-12Oct-12 Apr-13Oct-13 Apr-14Oct-14 Apr-15Oct-15 Apr-16Oct-16 Apr-17Oct-17 Apr-18

Target Return S&P500 5% Growth 6% Growth 7% Growth 8% Growth Mar 2012 Dec 2013 Aug 2014 May 2017 Jan 2018 Time to get back on-track 53 Months 74 Months 82 Months 115 Months 123 Months 31 Chap quoit A Division of Dynamic Portfolios

Conventional-Wisdom Investments to Consider for Use in Recessions • 10-Year Government Bonds • 2-Year Government Bonds • 90-Day Treasury Bills • Utility Stocks • Consumer Staples Stocks • Gold • Real Estate • Pharmaceuticals • Consistent Dividend Stocks 32 Chap quoit A Division of Dynamic Portfolios

Conventional-Wisdom Recession Portfolio Implementation Challenges

• When and if to invoke a defensive portfolio

• When to lift a defensive portfolio

• Asset allocation to employ

• Does asset allocation depend on other Macroeconomic Factors?

• Should asset allocation change with time?

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Conclusions Regarding a Possible Recession in 2020

• Q1 & Q2 2020 projected to have negative GDP Changes

• Therefore, a recession has already begun

• The starting date will be declared to be ~April 2020

• Monthly S&P500 drawdown began in Jan 2020

• Drawdown will likely persist until July - September

• Monthly Maximum drawdown through April is 19.60%

• The median historical recession drawdown is 29.09%

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Definitions

The Federal Reserve Bank of St. Louis provides data and graphs on a database referred to as FRED. This data is collected for FRED comes from a wide number of sources. Use of the data is permitted for research and presentation purposes. Citations for individual data have been provided throughout this presentation where practicable.

The Federal Reserve Bank of New York has developed a publicly-available model that uses the slope of the yield curve, or “term spread,” to calculate the probability of a recession in the United States twelve months ahead.

The Goldman Sachs Group, Inc. (Goldman Sachs), JP Morgan Chase (J.P. Morgan), and Morgan Stanley are investment banks providing a range of financial services. As part of those services, they provide publicly-available forecasts of financial and economic variables including Changes in Real U.S. Gross Domestic Product.

The Conference Board is a non-profit business membership and research group organization. It conducts economic and business management research and publishes several widely tracked economic indicators. These indicators include publicly-available Changes in Real U.S. Gross Domestic Product, the Leading Economic Index, and various surveys of Consumer Confidence.

The Institute for Supply Management (ISM) is a not-for-profit educational association that serves professionals and organizations with a keen interest in supply management. As a part of its activities, ISM conducts surveys including the publicly-available ISM New Manufacturing Orders Index.

S&P Global Ratings (previously Standard & Poor’s) 500 Total Return Index ("S&P 500") is a broad-based unmanaged index of 500 stocks, which is widely recognized as representative of the equity market in general.

The U.S. Government 10+ year Merrill Lynch bond index (GOVT 10+ Year ML Bond Index) is the return on an index of U.S. Treasuries and Agencies with duration greater than 10 years reported by Bank of America Merrill Lynch ICE Database.

Maximum Drawdown is a statistical measure of investment performance that measures the largest peak-to-valley loss suffered by an investment before it returns to the value it held before the drawdown began.

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Important Disclosures

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