Download Irrational Exuberance?

April 2017
Irrational Exuberance?
With spring now in full bloom, so too is the season for
optimism, raising hopes that the third longest economic
recovery in U.S. history has the strength to continue.
But things are never that tidy or simple. When everyone is
optimistic, the shock effect of any downside surprise could
wreak havoc. By definition, it’s impossible to see where a
surprise might come from. If history is any guide, outside
forces are the most likely candidates. Indeed, the geopolitical
backdrop is particularly volatile now, given the uprising of
populist sentiment that is threatening mainstream governing
parties among developed countries. The biggest risk is that
protectionist policies will gain traction, leading to diminished
trade and immigration that crimps global growth and stokes
inflation. The most significant concern, however, are the
situations regarding North Korea, Syria, Russia, China, and
Afghanistan that have forced the president’s emerging foreign
policy to take center stage. Yet, at least for the moment,
the markets have resisted any significant reaction.
That said, the domestic economic backdrop remains stable.
The unemployment rate continues to decline even as job
creation slowed and failed to meet expectations in March.
Business sentiment is favorable, which portends greater
Continued next page
First Quarter Results: The Bull Marches On
David R. Schedler,
Vice President, Senior
Investment Advisor
P 920.967.5028
As March sauntered out like a lamb,
we marked the eight-year anniversary
of a bull market that started in March
2009. For reference, the definition of
a bull market is a sustained period of
rising stock prices producing a gain of
20% or more that follows a prior low for
a major stock index. Bulls don’t officially
end until the market suffers a 20%
drop from its most recent closing high.
The current bull market is the second
longest in history, reaching 2,945 days
through the end of March. The longest
bull market lasted 4,494 days from
December 1987 until March 2000.
This bull is showing great perseverance despite a number of
obstacles in 2016 that could have slowed its progress: China’s
feared meltdown and currency devaluation, sagging oil prices,
and the Brexit vote, to name a few. In terms of magnitude, it is the
fourth best performer ever as measured by price changes in the
S&P 500 Stock Index®, and has gained a cumulative return of
314% over the last 96 months.
While external factors can impede a bull market at any point,
the fundamentals are currently strong. The economy is growing
at a moderate pace; progress continues toward the Fed’s goal of
maximum employment; and most importantly, the long-awaited
recovery of corporate earnings appears to have arrived. Fourth
quarter earnings were 4.9% higher compared to the same quarter
in 2015, and continued growth is expected in 2017.
The ‘Trump Bump’
as measured by the S&P 500 Index®:
Since election to March 31, 2017:
9.01%
First Quarter 2017 results:
6.07%
The current wave of optimism since the presidential election
pushed the stock market to record highs, but a partial retraction
occurred in the second half of March. At Legacy, we believe the
stock market has the potential to continue to move higher, largely
due to the expected increase in corporate earnings. We remain
vigilant, however, in watching for indicators that could signal
conditions are weakening. Increased stock market volatility is
likely when the president’s proposed policies to reform the tax
code and other federal regulations move through Congress and
could be diluted, delayed, or abandoned when agreement can’t
be reached. Outside of the U.S., we see investment opportunities
in foreign stocks as the global economy improves, both in
developed and emerging countries.
While the fiscal policy story plays out, it will be important to
monitor the actions of the Federal Reserve regarding monetary
policy. After the interest rate increase in March, the high
probability of two to three additional increases this year could put
pressure on the stock market and dampen expected economic
growth. It is always a challenge for the Fed to use monetary policy
to cap inflation without interrupting the progress of the economy.
We will be anticipating the Fed’s next addendum to the story
when they meet again in early May.
Continued from front
capital spending and sustained hiring. Consumer sentiment is
healthy and the financial markets have held on to most of the
price gains achieved during the first quarter. Even the Federal
Reserve’s decision to hike rates on March 15th did not upset
investors who viewed the decision as a vote of confidence
in the economy’s resilience. But there is still a gap between
reality and expectations, which continues to portray far more
strength in the economy than has been demonstrated so far
or is likely to evolve in the immediate future. Some believe
that “animal spirits” unleashed since the election can close the
gap and keep the party going. These spirits, however, derive
largely from expected fiscal policies – large tax cuts, increased
Federal spending, and deregulation – that are far from certain to
materialize. Unless the hard data begins to justify the heightened
expectations that are boosting household and business spirits,
the reasons for celebration may soon fizzle.
This Time, The Fed Means It
It may not rise to the level of the “crying-wolf” syndrome,
but on multiple occasions over the past several years the central
bank indicated that it was almost ready to start raising interest
rates, but then failed to follow through. To be sure, there was
always a good reason to back down: the economy was too
weak; inflation was too low; financial markets were too skittish;
or external threats were too imminent. Even after it finally
put through the first increase since the summer of 2006 – the
quarter-point hike in December 2015 – it failed to follow up
with the three more increases that were planned for 2016.
Again, the Fed had good reason to go back on its word because
the economy struggled during the first half of last year and
inflation remained dormant.
So it’s understandable when the Federal Reserve hiked
the federal funds rate by a quarter-point for the second time
in December 2016, its expressed plan to raise rates three
more times this year was met with a good deal of skepticism.
The widespread view was that the Fed would at most hike
twice, and the first would probably not occur before June.
This time, however, the central bank wasn’t crying wolf as
it raised rates three months later with another quarter point
increase on March 15. Not only did the latest rate increase
come earlier than thought possible, few now dispute that three
increases this year are in the cards; some even believe that a
fourth might be snuck in.
What changed? Unlike the earlier failed attempts, the
stars aligned correctly this time. Keep in mind that the Fed’s
dual mandate is to bring about maximum employment in a
stable price environment. The targets for both since the Great
Recession have been just under 5% for the unemployment rate
and 2% for inflation. While the unemployment rate hit 5% in
Targets are Almost Hit
Percent
12.0
10.0
Unemployment Rate
8.0
6.0
Personal Consumption Deflator
(12-month % Change)
4.0
2.0
0.0
-2.0
06
07
08
09
10
11
12
13
14
15
16
17
late 2015, it did so amid lackluster growth that put a lid on
inflation and inflation expectations. The Fed’s preferred inflation
gauge, the personal consumption deflator, was running closer
to zero than 2%, keeping deflation fears front and center. But
by the middle of last year, the deflator finally climbed above
1% on a sustainable basis and has since moved steadily higher,
thanks to rebounding oil and other commodity prices. With the
labor market continuing to tighten and inflation finally hugging
the 2% target for the first time since April 2012, the Fed is
understandably more confident that it is close to meeting its
dual mandate.
Aligning Policy with Fundamentals
Clearly, the Fed’s latest rate increase was justified on a number
of fronts. The improved job and inflation backdrop was no
doubt the most important. But equally significant is that the
prior hike on December 15 did not entirely accomplish what
it set out to do. Usually, when the Fed moves to tighten policy,
a predictable sequence occurs: long-term interest rates increase
in anticipation of more tightening moves and the currency
markets drive the dollar higher as higher rates make U.S. assets
more attractive.
However, neither occurred this time; bond yields actually
drifted lower after the December increase and the dollar
weakened against major currencies. Hence, along with another
rise in the stock market, financial conditions actually eased,
not tightened, which dilutes the impact of the Fed’s rate hike.
The reason for this atypical reaction is unclear. It may be that
investors and currency traders were not as confident in the
economy’s strength as the Fed, viewing the December increase
as a one-off affair rather than the next installment in a series of
tightening moves.
One thing is clear, the central bank’s latest rate hike, as well
as the one before in December, was taken to align monetary
policy with evolving economic conditions, not to slow down
growth. It is hard to believe Fed officials feared that growth was
Meet Mary Jovanovich
Legacy Team Spotlight
Mary Jovanovich joined Legacy shortly after the
company opened in 2004, having worked for more
than two decades in the trust department of a large
regional bank. As a senior client representative, she
works closely with clients to manage many of their
account service needs. Mary’s clients enjoy her
cheerful personality and rely on her 30 years of trust
administration experience.
Mary L. Jovanovich,
Senior Client Representative
P 920.967.5038
As a lifelong Wisconsin resident, Mary, her husband,
and their three grown children, all graduated from
Neenah High School (Go Rockets!). Never idle for very
long, Mary can often be found peddling her bike along
area trails and spending weekends doing outdoor
activities with her four grandchildren. She is a longtime
volunteer and organizer of the Neenah Summer Fun
Run, a series of free running events for children 14
overshooting expectations. While the job market is on solid
ground and the increase in inflation has obliterated deflation
fears, the broader economy has yet to grow fast enough to
justify a more aggressive tightening policy. Indeed, data through
February indicate that growth in GDP is on track to slow
from the fourth quarter’s 2.1% pace, with many pegging it at a
meager 1%. Consumer spending, the main growth driver, has
shown much less vigor so far this year than over the last half
of 2016.
Fiscal Priorities Upended
The economy’s lagging performance so far this year highlights
the huge gap between reality and expectations. Simply put,
the elevated level of optimism among households, businesses,
and investors is not yet reflected in the hard data. While the
economy is eight years into the recovery, long by historical
standards, it remains the weakest upturn in the postwar era.
The question is, how long can optimism be sustained without
confirmation from the hard data?
To be sure, it has been only a few months since the election,
which stoked confidence that the Trump administration would
jump-start growth through its tax and spending initiatives and
regulatory reform. It takes time for Congress to agree on the
details of the administration’s policy proposals and for these
policies to have an actual impact on the economy. But the
and under. She also enjoys traveling with her husband
to his Ironman competitions in places like Lake Placid,
New York, Hawaii, and Canada.
An extra special day begins when we spot a plate of
Mary’s Rice Krispies treats in the break room. If a diet
Coke has been placed in the freezer for a quick cooling,
we know that it is Mary’s. Mostly we look forward to
sharing a laugh with her during lighter moments
in the office.
Mary maintains a strong devotion to her work and is
committed to serving her clients in a multitude of ways;
no request is too big or too small for her to find a way to
get it accomplished. She takes great pride in the strong
personal relationships she develops with her clients
and their families, instilling complete confidence in her
attention to their wealth management needs.
timeline is being stretched out by an unfortunate sequence of
policy announcements. Instead of starting out with the progrowth agenda trumpeted during the campaign, Congress and
the administration used valuable time grappling with healthcare
reform, a highly complicated and divisive political issue that
confused the public and found resistance from legislators.
While the healthcare reform was being debated, uncertainty
over the fiscal package was growing. A key component of the
tax reform measure being considered in Congress, the border
adjustment tax, is already under attack in many quarters, and
even the president gives it a lukewarm acceptance. Odds are,
a package of tax cuts and infrastructure spending will wind
its way through Capitol Hill some time later this year, but its
growth-boosting effects will probably not be felt until 2018.
Splitting the Difference
Not surprisingly, the Fed did not take into account the
possible boost from fiscal policy when it hiked interest rates
on March 15. As Chair Yellen noted in her press conference
following the policy meeting, uncertainty regarding the
composition and timing of what might come out of Capitol Hill
makes it impossible to gauge the impact fiscal measures might
have on the economy. In fact, the central bank’s forecast of
growth, inflation, and unemployment remained the same as it
was in December.
Continued on back
Continued from inside
This brings us back to the question of how to reconcile the
high expectations for the economy, which are largely derived
from the pro-growth agenda of the Trump election, with the
reality of the economy’s mediocre performance. Most likely,
something will have to give on both sides of the ledger.
The post-election euphoria is fading a bit as investors and the
public recognize that any tax cuts and spending increases on
infrastructure are being pushed back to the fall at the earliest.
It also remains to be seen how much of a potential fiscal
boost will be accepted by an austerity-minded Republicancontrolled Congress.
That said, the growth slowdown in the first quarter
overstates the weakness in the economy. Consumers are
probably taking a temporary breather, as most suppressed
demand has been satisfied and about $20 billion in tax refunds
that should have arrived in February were pushed back due
a quirky change in IRS regulations. Those refunds were sent
out in March, which should give spending a belated boost.
With household optimism still elevated and job growth lifting
Expectations Exceed Reality
Index
100
95
90
85
80
75
70
65
60
55
50
Percent
6.0
U of M Consumer Sentiment Index
4.0
2.0
Real Personal Spending
(12-month % Change)
0.0
-2.0
-4.0
07
08
09
10
11
12
13
14
15
16
17
incomes, consumer spending should pick up in the spring,
underpinning a growth rebound that will also be nurtured
by firmer residential construction and capital spending.
The economy will probably not live up to the high growth
expectations on Wall Street and Main Street but it will deliver
a better performance than last year. While the Fed never
bought into the post-election euphoria, it should have enough
justification to stay on its gradual rate-hiking course.
Featured Legacy Investment Portfolios
Core Equity Portfolio
Global Tactical Growth Portfolio
The Core Equity Portfolio is designed to ensure broad participation
in the equity market, with less than average market volatility, while
effectively achieving investment goals for our clients. Our active
valuation strategy and analysis focuses on individual stock selection
in conjunction with economic sector discipline that looks beyond
mainstream consensus to construct customized client portfolios.
The Global Tactical Growth (GTG) Portfolio is a disciplined, proprietary
investment solution designed to maximize long-term investment
returns with moderate risk. Legacy’s goal is to position the GTG
portfolio in the best performing asset classes (domestic equity, fixed
income, foreign equity, foreign and domestic real estate, commodities
and currencies) using all Exchange Traded Products.
The chart below shows the sector weightings in the Core Portfolio as
of March 31, 2017.
The chart below shows the GTG asset allocation mix across four
major asset classes over the past six months.
Core Equity Portfolio Composition
Industrials – 13%
Global Tactical Growth Portfolio Composition
100%
Real Estate – 3%
80%
Financials – 17.5%
Health Care – 12%
60%
Consumer Staples – 8.5%
Energy – 4%
40%
Utilities – 3%
20%
0%
Consumer Discretionary – 11.5%
Oct ’16
Information Technology – 24%
Materials – 3.5%
Nov ’16
Dec ’16
Jan ’17
Feb ’17
Mar ’17
Domestic Equity
Foreign Equity
Fixed Income
Alternatives (Real Estate, Commodities, Foreign Currency)
Past performance does not predict future results. Current and future results may be lower or higher than those referenced in this newsletter. Investments are not FDICinsured, nor are they deposits of or guaranteed by a bank or any other entity. Investment return and principal value will fluctuate and investments may lose value.
To learn more, call us or visit www.lptrust.com.
Two Neenah Center
|
Suite 501
|
Neenah, WI 54956
|
920-967-5020 | www.lptrust.com
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