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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 © 2017 Legacy Private Trust Company. All rights reserved.