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Economic Update

Fourth Quarter 2016

DoubleLine Macro-Asset Allocation Team

Sam Garza, Portfolio Manager

Fei He, Quantitative Analyst

Ryan Kimmel, Analyst

2

Economic Update

Economic Update 12/31/16

The fourth quarter of 2016 was

defined by the U.S. presidential

election, paving Donald Trump’s

ascendency to the White House.

While the anti-establishment

candidate’s victory was a surprise to

many investors, we at DoubleLine

believed Mr. Trump’s likelihood of

being elected was much higher than

was represented in the polls and

prediction markets. In the final hours

of the presidential race, it became

clear that a large cohort of the voter

base was underrepresented in the

polls.

The overnight shift (literally) in market

sentiment towards a Trump

presidency shows how fast financial

markets can augment perspectives.

After being limit down overnight, U.S.

equities staged an impressive rally the

day after the election. The market

found comfort in Trump’s prospective

pro-growth policies and ambition to

deregulate. The Republican sweep of

the House and Senate decreased the

probability of political gridlock in

Washington, supporting risk assets

further.

Trump’s victory underscored a change

that was already underway since the

third quarter of 2016, a shift from a

deflationary to reflationary

environment. As we noted in the third

quarter, inflation expectations were

likely to increase as the negative

effects from oil prices rolled off and

eventually would become positive

contributors to headline inflation.

Trump’s plan to bring manufacturing

back to the U.S. by increasing the

costs of imports along with tax reform

and infrastructure spending should

increase the price of goods

domestically. Over the course of the

second half of 2016 breakeven

inflation rates increased sharply. See

Figure 1. The increase in inflation

Global Markets Review

Figure 1: U.S. Breakeven Inflation Rates As of December 31, 2016

0.5

0.7

0.9

1.1

1.3

1.5

1.7

1.9

2.1

2.3

2.5

10-year Breakeven

5-year Breakeven

Source: Bloomberg, DoubleLine

Source: Bloomberg, DoubleLine

Figure 2: ISM Manufacturing & Services Purchasing Managers’ Indices (PMI) As of December 31, 2016

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35

40

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60

65 ISM Manufacturing Index

ISM Services Index

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Economic Update

Economic Update 12/31/16

expectations and stronger growth

elevated nominal bond yields with 10-

year yields rising more than 100 basis

points (bps) from the lows reached in

July. The U.S. Dollar (USD) rallied on

the Trump victory from a combination

of potential value-add tax adjustment

and supportive yield differentials,

particularly versus the Japanese Yen

and the Euro. The USD was also

supported by the Federal Reserve

(“Fed”) shifting to a more hawkish

tone at the December Federal Open

Market Committee meeting. The Fed

raised the Federal Funds Rate by 25

bps, which was expected by the

market, and hinted it may raise the

rate three times instead of twice in

2017.

Economic growth measures

continued to improve in the fourth

quarter with Institute of Supply

Management’s (ISM) Manufacturing

and Services Indices accelerating into

expansion territory. See Figure 2 on

the previous page. Small business

optimism, as measured by the

National Federation of Independent

Business (NFIB), also improved to the

highest level in over a decade. CEO

and U.S. consumer confidence

exuded the same level of confidence.

See Figures 3 and 4. The U.S. was not

the only country to see an uptick in

economic growth indicators: the

global Purchasing Managers’ Index

edged higher in the fourth quarter,

and China’s growth indicators picked

up with the China Li Keqiang Index at

highest level since third quarter 2013.

See Figure 5 on the following page.

As global economic growth improved,

commodities followed. Crude, as

measured by West Texas

Intermediate (WTI), rallied 11%

during the fourth quarter to market a

45% increase in 2016. The

combination of increased global

Figure 3: NFIB Small Business Optimism Index As of December 31, 2016

Figure 4: CEO and Consumer Confidence As of December 31, 2016

Source: Bloomberg, DoubleLine *RHS = Right hand side

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eve

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NFIB Small Business Optimism

Source: Bloomberg, DoubleLine *RHS = Right hand side, MoM = month-over-month

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CEO

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Consumer Confidence

CEO Confidence (RHS)*

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Economic Update

Economic Update 12/31/16

growth expectations and the OPEC

production cut supported higher oil

prices benefitting asset classes that

had come under pressure at the

beginning of the year. Cross asset

class performance for the fourth

quarter and 2016 can be seen in

Figure 6.

Over the course of the next few

months the focus will be on Trump’s

presidential transition and his success

working with Congress to pass his

agenda. The market seems to be

pricing in a flawless transition with

equities trading near all time highs

and elevated valuations relative to

history. While Trump has strong

negotiation tactics, we expect bumps

along the way. It is likely Trump will

expand the deficit to build out

infrastructure and expand the military

which should support economic

growth over the near term. It is still

unclear how tax reform and trade

policies will play out and their effects

on the economy, though many of the

economic indicators we monitor

support higher economic activity with

little risk of an imminent recession.

While a protectionist stance on trade

may create jobs in the U.S., it may also

increase the cost of goods and

services domestically and have

adverse implications for global trade.

Inflation expectations will likely

continue to increase over the next few

months. Headline Consumer Price

Index (CPI) should continue to edge

higher over the next few months as

the positive base effects from energy

prices peak. If WTI crude remains

around current prices, headline CPI

could reach 3% year-over-year (YoY)

in the first quarter of 2017. Inflation

has also picked up in Europe and

Japan. Inflation could increase further

2017 Outlook

Source: Bloomberg, DoubleLine

Figure 5: China Li Keqiang Index and Global PMI As of December 31, 2016

Figure 6: Performance of Asset Classes As of December 31, 2016

Source: Bloomberg, DoubleLine

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50%

2016

4Q 2016

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China Li Keqiang Index

Global PMI (RHS)

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Economic Update

Economic Update 12/31/16

in these regions, particularly Germany,

as base effects become positive. With

yields still very low in these regions,

yields could edge higher as well. See

Figure 7.

Given the expected uptick in growth

and inflation expectations, the Fed is

likely to hike between two to three

times in 2017. It is still unclear

whether the Fed will hike in March,

but it is more likely that the Fed will

make their moves in June and the

second half of the year as Trump’s pro

-growth policies come to fruition.

Higher wage inflation may prompt

more aggressive Fed action. See

Figure 8. Wage inflation should be

monitored closely in 2017.

While the European Central Bank

(ECB) and Bank of Japan (BoJ) were

relatively quiet in the fourth quarter,

it will be interesting to see if these

central banks continue with asset

purchases in the face of rising growth

expectations and higher inflation. If

the ECB and BoJ signal a tapering of

asset purchases, then European and

Japanese bond yields will have to

reprice higher and the euro and

Japanese Yen could appreciate vs.

USD.

Given the dramatic move in U.S.

government bonds in the fourth

quarter, we believe Treasuries could

stage a countertrend rally as growth

expectations are reigned in and short

positions get squeezed. According to

the U.S. Commodity Futures Trading

Commission (CFTC) data, net short

positions in Treasury futures are at all-

time highs. Ten-year Treasury yields

are likely to drop to around 2.25% in

the first quarter. However, as Trump’s

policies become reality and deficit

spending increases, yields should

move higher toward 3% in the second

half of the year. With inflation Source: Bloomberg, DoubleLine *BLS = Bureau of Labor Statistics

Figure 7: German 10-Year Yield & German CPI YoY As of December 31, 2016

Source: Bloomberg, DoubleLine

Figure 8: U.S. Wage Growth YoY As of December 31, 2016

Views on Assets

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German CPI YoY

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5.5BLS Average Hourly Earnings YoY

Atlanta Fed Wage Growth Tracker

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Economic Update

Economic Update 12/31/16

expectations remaining elevated, we

continue to like Treasury Inflation-

Protected Securities (TIPS) versus

nominal bonds.

If bond yields head lower over the

near term, then the USD should

decline. While a tightening Fed is

positive for the USD, one must

consider the policies in other major

economies. If the ECB and BoJ signal a

tapering of asset purchases, then USD

could potentially weaken versus the

Euro and Japanese Yen.

Trump’s tax reform and deregulation

should benefit corporate earnings

while at the same time higher yields

could reduce price-to-earnings

multiples. For equities, we are neutral;

however, there is likely to be

significant sector dispersion in 2017

with definite winners and losers.

Duration proxies should underperform

as yields move higher. We remain

cautious on consumer discretionary,

particularly retail, as import tariffs and

higher wages would impact margins.

International equities look relatively

attractive versus U.S. equities as

overseas valuations are cheaper and

margins are less vulnerable. However,

there are key risks in Europe

stemming from German and French

general elections in 2017. Emerging

market equities are also attractive

given their low valuations, though

vulnerable to a rising USD and

tightening global financial conditions.

In credit we prefer structured credit

relative to corporate credit as

structured credit tends to have lower

duration. Structured credit is

attractive in rising rate environments

as amortizing principle can be

reinvested to take advantage of higher

yields. Rising corporate leverage in the

face of rising default rates also keeps

us cautious on the asset class.

Commodities put in a multi-decade

bottom in 2016. With growth and

inflation expectations increasing and a

potentially range-bound USD,

commodities could be an attractive

addition to a multi-asset portfolio.

2017 will be defined by Trump’s ability

to navigate the political process and

work with Congress to get his agenda

through. As a chief negotiator, Trump

should be able to strike some deals to

get his priorities implemented. While

tax cuts and corporate tax repatriation

policies will likely support growth and

inflation over the near-term, Trump’s

infrastructure plan will likely take

some time to impact the real

economy. Regardless, higher growth

expectations should lead to higher

yields in 2017. With inflation

expectations continuing higher, TIPS

will likely outperform nominal bonds.

Risk assets should do well in this

environment, but there will be

significant sector dispersion and

higher volatility. Reflationary sectors

ought to outperform while duration

proxies come under pressure.

International equities look relatively

attractive compared to U.S. equities;

however, relative performance is

largely dependent on the path of the

USD. A stronger USD could undermine

emerging markets equities and could

tighten global market financial

conditions. A stronger USD could have

significant impacts on inflation,

geopolitics and central bank action.

Needless to say, in 2017 we will be

watching the USD closely. Good luck.

7

Author Biographies

Economic Update 12/31/16

Ryan Kimmel

Analyst, Macro-Asset Allocation

Ryan Kimmel is an Analyst for DoubleLine Capital’s Multi-Asset Growth Strategy. Mr. Kimmel joined Dou-

bleLine in 2012. Prior to DoubleLine, Mr. Kimmel was a Proprietary Trader at The Gelber Group, trading

currencies for the Foreign Currency Group. Before Gelber, Mr. Kimmel was an Investment Banking An-

alyst in Morgan Stanley’s Mergers and Acquisitions Group. Mr. Kimmel holds a BA in Business Economics

from the University of California, Los Angeles and holds an MBA from the Anderson School of Manage-

ment at the University of California, Los Angeles.

Samuel M. Garza

Portfolio Manager, Macro-Asset Allocation

Mr. Garza joined DoubleLine in 2009. Prior to DoubleLine, Mr. Garza was a Senior Vice President at TCW

since 2000 where he held several positions over the years ending with his last promotion to Senior Vice

President in 2005. Prior to TCW, Mr. Garza worked at Union Bank of California in the Commercial Bank-

ing Group where he was involved with corporate loan underwriting. Mr. Garza holds a BA in Business

Economics from the University of California, Santa Barbara and an MBA from the Anderson School of

Management at the University of California, Los Angeles.

Fei He, CFA

Quantitative Analyst, Macro-Asset Allocation

Mr. He joined DoubleLine’s Macro-Asset Allocation team in 2014 as a quantitative analyst. Prior to join-

ing the firm, he worked at PIMCO for three and half years as a quantitative research analyst where he

began in client analytics, advising clients on strategic asset allocation and later moved to emerging mar-

kets and commodities. Mr. He began his career at Absolute Return Capital Advisors as a portfolio/

research associate. He has published papers, including the Financial Analysts Journal. Mr. He holds an

MS in Financial Engineering from UCLA Anderson School of Management and a PhD in Molecular &

Medical Pharmacology from UCLA David Geffen School of Medicine. He graduated from Tsinghua Uni-

versity in Beijing with a BS in Biological Sciences & Biotechnology and is a CFA charterholder.

8

Definitions

Economic Update 12/31/16

BofA/Merrill Lynch U.S. Cash Pay High Yield Index - An index that tracks the performance of below investment grade corporate debt currently in a coupon paying

period. Eurobonds and debt issuer from countries designated as emerging markets (e.g. Argentina, Brazil, Venezuela, etc.) are excluded, but Canadian and global bonds

(SEC registered) of issuers in non-EMG countries are included. Original issue zeroes, step-up coupon structures, 144-As and pay-in-kind (PIK, as of October 1, 2009) are

also included.

Bollinger Bands - A technical indicator of volatility using bands that are plotted two standard deviations away from a moving average to find a n upper and lower

bound.

Capital Expenditure (CapEx) - Payments made in cash or cash equivalents during a particular period to acquire or improve a company's physical or fixed assets.

China Li Keqiang Index - An index that utilizes three indicators (rail cargo volume, bank lending & electricity consumption) to measure China’s economy.

Consumer Price Index (CPI) - A measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, fo od and

medical care. The CPI is calculated by taking price changes for each item in the predetermined basket of goods and averaging them; the goods are weighted according to

their importance. Changes in CPI are used to assess price changes associated with the cost of living.

Eurostoxx Index - A stock index of Eurozone stocks designed by STOXX, an index provider owned by Deutsche Borse Group and SIX group, with the g oal of providing a

blue-chip representation of Supersector leaders in the Eurozone.

Institute for Supply Management (ISM) Global Purchasing Managers Index- A composite index based on five of the individual indexes with the following weights: New

Orders - 0.3, Output - 0.25, Employment - 0.2, Suppliers' Delivery Times - 0.15 and Stock of Items Purchased - 0.1. Purchasing Managers' Index surveys are available for 32

countries and also for key regions including the Eurozone.

Institute for Supply Management (ISM) Manufacturing Purchasing Managers Index - An index made up of data from 300 manufacturing firms collected by the Insti-

tute of Supply Management (ISM). It indicates the economic health of the manufacturing sector.

Institute for Supply Management (ISM) Services Purchasing Managers Index - An index made up of data from 400 non-manufacturing firms collected by the Institute of

Supply Management (ISM).

Morgan Stanley Capital International All Country World Index (MSCI ACWI) - A market-capitalization-weighted index designed to provide a broad measure of stock

performance throughout the world, including both developed and emerging markets.

“Emerging Markets” - Morgan Stanley Capital International Emerging Markets Index (MXEF) - A float-adjusted market capitalization index designed to measure equity

market performance in global emerging markets. The index consists of 26 emerging economies, including but not limited to, Argentina, Brazil, China, India, Poland, Thai-

land, Turkey, and Venezuela.

Nikkei 225 Index - A price-weighted index comprised of Japan's top 225 blue-chip companies on the Tokyo Stock Exchange. The Nikkei is equivalent to the Dow Jones

Industrial Average Index in the U.S.

Shiller CAPE® Ratio - CAPE® stands for Cyclically Adjusted Price-Earnings. The CAPE® Ratio is a valuation metric that takes the current price of an equity or index divided

by its inflation adjusted average of ten years of earnings.

Standard & Poor’s U.S. 500 Index (S&P 500) - A capitalized-weighted index of 500 stocks chosen for market size, liquidity an dindustry grouping, among other factors.

This index is designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large cap universe.

Tokyo Price Index (TOPIX) - An index that measures the performance of 150 highly liquid securities selected from each major sector of the Tokyo market.

“U.S. Treasuries” - Barclays U.S. Treasury Index - An index that measures U.S. dollar-denominated, fixed-rate, nominal debt issued by the U.S. Treasury

“U.S. Corporate IG” - Barclays U.S. Aggregate Corporate Index - An index that measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market,

including Treasuries, government-related and corporate securities.

“U.S. Corporate HY” - Barclays U.S. Corporate High Yield Index - An index that measures the U.S. dollar-denominated, high yield, fixed-rate corporate bond market.

“EM Sovereign” - Barclays Emerging Markets Sovereign Index - A hard currency EM index that includes fixed and floating-rate U.S. dollar-denominated debt issued by

sovereign EM issuers.

U.S. Dollar Spot Index (DXY) - DXY is the US Dollar Index (USDX) indicates the general value of the US dollar. Average exchange rates between the US dollar and six major

world currencies.

An investment cannot be made in an index.

9

Disclaimers

Economic Update 12/31/16

Important Information Regarding This Report

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