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Market Outlook 4th Quarter 2015 Two intoxicated FED officials were walking upgrade between the railroad tracks. One of them said, “this is the longest stairway I have ever been on.” To this, the other replied, “It’s not the stairs that bother me, it’s the low banister.” We are inclined to compare the U.S. economy to that of a freight train hauling a long line of rail cars through various terrains including hills, curves, and valleys. The various segments of the economy are rail cars. At times, one or several of these rail cars come off the track, which stops or impedes the momentum of the train. The engineer at the train’s throttle is none other than the Federal Reserve Bank (FED), led by its Chair, Janet Yellen. She, along with her FED linemen, have been directing the train cautiously through various domestic and global problems. A few years back, the housing industry slipped off the tracks to start the last recession. That derailment caused problems for the labor market, consumer spending, and the banking industry. With proper fiscal and monetary tools, the rail cars were reset on the track and the economic train continued its journey. To get the economic train rolling after the last recession, the FED added the two extra powerful engines of easy monetary policy and quantitative easing (QE). As the economy chugged along, it at times gained or lost momentum. The FED was quick to unlink or linkup the QE engine as needed. The QE extra engine was finally put on a sidetrack last year. The FED keeps the additional easy monetary policy engine to safeguard against any moderation of growth. Since the start of 2010, GDP growth has averaged just 2.1% per year and has not grown greater than 2.9% for any rolling 12 month period. This rate of growth is less than the 3.3% average growth rate sustained between 1984 and 2007. Some analysts may be fooled into believing that the second quarter’s 3.9% growth showed the economy back on the fast track to accelerating growth. Instead, the strong growth seen in the second quarter was simply a rebound after the economy almost derailed with a 0.6% growth rate during the first quarter, as weather and geo-political problems disrupted the recovery schedule. Last year, the FED signaled that the remaining extra engine should be gradually taken off-line. This eventual shift in monetary policy strengthened the U.S. dollar last year, derailing commodity prices, which slowed emerging market economies and increased the price of U.S. goods sold on the global market. On top of that, falling global oil prices derailed both domestic oil patch jobs and new energy capital expenditures. The U.S. equity market suffered through a near third quarter wreck as the strong U.S. dollar put the brakes on multi-national corporate earnings and weakened emerging markets. Economic Forecasts Year Ahead Forecast Economic Indicator GDP Growth for 2015 to range between 2.00 - 2.50% Unemployment 2015 to average between 5.20 - 5.70% Interest Rates Long-term rates will remain volatile but stay range bound due to a strong dollar and low foreign interest rates Fed Funds Rate Stable most of the year with maybe an increase at year-end Inflation Less than 2% through 2015 Retail Sales Modest growth through 2015 financed by increasing consumer credit and lower energy costs Housing Prices Moderate growth in housing and new construction with tempered home price increases Oil Prices Volatility likely to continue. Anticipate next year's prices in the $55 - $70 per barrel range Neutral Outlook Upward Outlook Downward Outlook midlandsb.com 1-888-637-2120 1 Concerns are now growing that U.S. growth might have lost steam during the third quarter, and investors are wondering whether the FED should wait to sidetrack that extra engine of easy monetary policy. Worldwide, the economy is a mixed bag as results from China, Europe, Latin America, and elsewhere vary. U.S. job growth, while still positive, has slowed during the recent quarter. Whereas we might think that our economic train is different from the other global trains, we are affected because our tracks cross each other due to global trade. With global problems blocking the tracks, our economic train must reroute accordingly. Fortunately, the positive effects of a strong dollar and cheap energy prices are putting businesses and consumers on an express train to restrained inflation and greater cash flow. Consumers, according to a recent study by JP Morgan, are finally spending more of their gas savings. The third quarter’s economic growth rate of 1.5% is more like a train on the morning milk run than a bullet train with 3% plus growth. After lackluster third quarter growth, we see a light at the end of the tunnel as we feel the economy will continue to grow modestly into 2016. We just hope that light is not, in fact, an oncoming train. FED Policy and Interest Rates Remember the children’s story “The Little Engine That Could” by Watty Piper? The story is about how a little train engine took on the job of pulling a string of railway cars over a hill. The FED is like the little engine in the story. When confronted with raising rates, the FED is uttering the phrase, “I think I can, I think I can” in showing its determination. Many investors also thought the FED could, but 2 Market Outlook 4th Quarter 2015 global volatility and growth worries held it back. However, not every member at the FED is on the same time schedule for the first tightening move. Low inflation and global instability has given the FED a chance to wait a bit longer before acting. If the economy expands, inflation increases, and wages improve, the FED could begin a measured pace of interest rate increases since the economy would likely be strong enough to withstand the tightening without choking off growth. The end of the year is fast approaching. We stated in previous newsletters that the FED could begin tightening monetary policy near the end of the year. We feel it is irrelevant whether the hike occurs in December or next year. However, the markets may initially react negatively when that time comes. We believe the FED has most of the evidence it needs to remove the last powerful monetary policy engine. Stable inflation should give businesses, households, investors, and the FED more confidence about the economy. The FED will raise rates sooner or later, but it wants to make sure the timing of the increase is appropriate. We hope that when the FED finally crosses that bridge, the markets will realize it intends to take a slow and easy route to raising rates over the next few years. Treasury yields have been in a tight trading range since the beginning of the year. Volatility in yields has occurred in the credit spreads for non-U.S. Treasury instruments. This volatility is a product of the indecision of the FED to tighten rates and the fixed income markets’ reaction to the decrease in market liquidity. The latter is a by-product of postrecession bank capital requirements as large dealers are coerced into reducing their inventories of securities. This illiquidity will not go away soon and could be evidence for further credit spread decompression. What will it take for the FED to raise rates in December? If the following seven points occur, we would put a very high probability of a rate increase this year. 1. Reduced equity market volatility 2. Two healthy U.S. payroll/jobs reports 3. Continued consumer spending 4. Further progress in the housing market 5. No further worsening in exports 6. No long, drawn-out government shutdown 7. More signaling from FED officials via forward guidance Equity Outlook – The correction came, but is it over? The third quarter of 2015 woke investors up to the fact that markets can, and indeed do, go down more than 4-5% at a stretch. The S&P 500 fell -6.44% over the quarter with a total drawdown of -12% from the market high that we saw in May. The picture got worse across the globe as the rest of the global markets, as measured by the All Country World Index ex US (ACWI ex US) index declined by -12.17%, with emerging markets leading the bulk of that decline with a fall of -10.23%. The reasons for the weak performance in the third quarter have been attributed to three main factors. First, the FED was talking up the expectation for a rate hike, which would have been the first increase in nearly 10 years. Investors who had long known this day would come still decided to get a little antsy and sell stocks. Secondly, and probably more critical, was news out of China indicating that the Chinese economy continued to slow in the third quarter. While the direct exposure to China for the U.S. stock market is still relatively modest, it was enough to worry investors about the state of the global economy, particularly since China accounts for about 10% of global GDP. Again, worry led to selling. Lastly, the economic data here at home also began to weaken, confirming that we are truly a global economy. Now, the same investors who worried that the FED would raise rates have started to worry that it may not. Interestingly, the reaction was the same: sell stocks. Many investors have indicated that they felt the markets were long overdue for a correction, and when that correction came, they would be buyers on that weakness. However, theory and practice can differ greatly. Now that we have had a -12% correction from the high, investors find it difficult to go in and buy when everyone else is selling. Often the uncertainty will win out as investors wonder how long and how far a correction can last. The talk of “buying the dips” turns into “sell the rally” to limit losses. We are reminded of the often quoted one-liner from boxer Mike Tyson, “Everyone has a plan until they get punched in the face.” For some investors, the speed and severity of the late August decline may have felt like a punch in the face. So where do we go from here? The fourth quarter has started strong with the S&P 500 gaining back most of its losses, with the S&P 500 only down -1.3% as of October 20. We feel that our 2015 forecast of 4-6% gains for the S&P 500 may still come to fruition. However, many nervous midlandsb.com 1-888-637-2120 3 investors have some legitimate concerns that could hold the market back. Specifically, we are looking at economic data coming out of China and the United States, corporate earnings reports, and valuations. The bad news is that a slowing China will have a negative impact on commodity producers across the world. The companies in the U.S. that have exposure to these markets and to commodities will continue to struggle to generate growth. The good news, however, is that the non-manufacturing sectors of China are still doing very well. In fact, most Chinese citizens do not even realize that their growth rate is slowing. One of our colleagues went to China in August. She said the people she spoke with had no inkling of any slowdown. She also told us there were still plenty of cranes dotting the skyline, lots of name brand shopping bags to be seen, and many Mercedes, Lexus, and Audis on the streets. For corporate earnings and fourth quarter expectations, the story is also mixed. Companies like Nike and Pepsi have announced very good earnings and are optimistic going forward, but others like Alcoa and YUM Brands (owner of KFC and Taco Bell) have reported poor results. The financial sector appears to be doing well, which is a good sign of the economy overall (more loans and more credit lead to more consumption). Within the sector, results have been mixed. Wells Fargo, Citigroup, and Bank of America reported good earnings while JP Morgan was slightly negative. The market as a whole has also seen its valuation drop from previously high levels. The ratio of price compared to the next 12 month expected earnings (forward PE or FPE) for the S&P 500 has gone from over 17x to 15.1x. At current levels, the U.S. stock market does not appear to be overly expensive. Over the intermediate and longerterm we still believe the uptrend in this market is intact. As for the shortterm, we are a little more cautious due to the change in sentiment outlined above and a few of the risk cases that we have discussed. We believe the equity market returns could still hit our mid-single digit target by year end. Corporate earnings may surprise to the upside this quarter. Energy companies have dealt with low oil prices for almost a year and they should be getting the worst news behind them. In addition, while we do not rely solely Analysts say the S&P 500 has Double Bottomed. On its Way Back Up? 2,150 2,100 2,050 2,000 1,950 1,900 1,850 7/1/15 4 Market Outlook 4th Quarter 2015 8/1/15 9/1/15 10/1/15 on technical analysis (the examination of stock and index price charts) we do find it instructive. What the quarterly chart of the S&P suggests is that we may have formed what is known as a “double-bottom.” Many investors want to see a stock or a market index “retest” a recent low before having the conviction to buy into any subsequent rally. Many analysts are forecasting that the S&P 500 is clear to continue its rebound due to this successful re-test and “double bottom.” We feel the developed equity markets are still in a long-term uptrend, though they will most likely remain volatile for the rest of this year and into next year. We believe it is likely that markets will finish the year higher. In fact, our target from the beginning of the year may still be in play, but the change in investor sentiment and the continued presence of risk factors compel us to remain cautious. Internationally, we feel that developed markets are a better risk/return trade-off than emerging markets, which are still feeling the double pinch from sinking commodity demand and a strong dollar. All told, we think returns from equities across the globe will remain modest for some time. Tactical Asset Allocation The third quarter proved to be a challenge for financial markets as several global concerns seemed to have temporarily derailed economic growth. Investors were already nervous about a possible Greek exit from the Euro, which was again resolved at the last minute. However, that resolution prompted investors to turn their attention to China and the questions surrounding its economy. Given that China represents over 10% of the global economy and over 25% of global growth, continued concerns over a “hard landing” in China spurred a sell off in global equities in late August. All of this occurred just as the FED was hoping to raise interest rates for the first time in 10 years. With increased stock market volatility, accompanied by slower global growth and weaker economic data, the FED could very well be on hold for the remainder of the year. Tactical Asset Allocation Underweight Target Overweight Fixed Income Short Term Bonds Intermediate Term Bonds Long Term Bonds High Yield Bonds Intl Developed Bonds Bank Loans Emerging Market Fixed TIPs Our outlook for the market has been cautious for much of the year. We began reducing our equity exposure in the first quarter by moving from over-weight to neutral, as well as continuing to “de-risk” the portfolio by reducing and eliminating positions that were sensitive to commodity prices and foreign currency fluctuations. We did this because we viewed the stock market as slightly over-valued and felt that 2015 earnings could be at risk due to a strengthening dollar and falling commodity prices. Fortunately for our clients, these changes were made prior to the third quarter correction. Although not cheap, we feel stocks are closer to fair value after the recent sell-off. As commodity prices and the dollar begin to stabilize, we are hopeful for improved corporate earnings as companies report third quarter results and give fourth quarter guidance. With the recent contraction in P/E ratios and global interest rates at historically low levels, we are still constructive on stocks and continue to maintain a neutral weight in equities. Equity U.S. Large Cap Equity U.S. Mid Cap Equity U.S. Small Cap Equity Intl Developed Equity Emerging Market Equity Real Estate Alternatives Commodities Absolute Return Cash Indicates current position Indicates position as of last report if position has changed The bond market has been handcuffed for much of the year with a “maybe we will, maybe we won’t” FED as it pertains to interest rate policy. In its effort to be “transparent,” the FED’s credibility has now come into question, especially after the September FOMC meeting when midlandsb.com 1-888-637-2120 5 Wealth Management Contacts Investment Team Effingham, IL Eric Chojnicki........... 217-342-7302 Jackie Gray............... 877-616-3371 Dixon, IL Connie Bontz...........815-285-5186 Ken Boone................815-285-5189 Bloomington, IL Ron Drane............... 309-532-8145 Vanessa Spenard.... 315-778-8920 Milwaukee, WI Benjamin Malsch..... 414-258-3175 Deanna Haught.......414-258-3279 Centralia, IL Jackie Gray............... 877-616-3371 Sterling, IL Linda Perry...............815-622-1302 Bon Keomany........... 815-622-1313 Champaign, IL Becky Von Holten.... 217-974-7144 Decatur, IL Ron Drane............... 309-532-8145 Carol Craig.............. 217-358-8222 Danielle Diskey........ 217-412-8586 the FED elected to not raise interest rates. With the possibility of an interest rate increase still on the table, we are maintaining a slightly shorter duration within our bond portfolios and continue to find credit spreads attractive. While we did reduce our exposure to high yield bonds last year as credit spreads narrowed to historically low levels, our current exposure to high yield did hinder Joliet, IL Dan Stevenson........ 815-230-4301 Jeri Madison........... 815-230-4304 Debra Targonski..... 708-308-1492 Rockford, IL Pat Fong...................815-312-5500 Heath Sorenson.......815-312-5504 Rockford, IL........... 815-316-0222 John P. Culhane, CFA Chief Investment Officer Tracey L. Garst, CFP Senior Portfolio Manager Keith J. Akre, CFA Portfolio Manager Elizabeth Gipson, CFP Portfolio Manager Steve Lukasik Associate Portfolio Manager Denise Melton Investment Analyst www.midlandsb.com/wealth our fixed income returns in the third quarter. The sell off in the global stock markets has spilled over to the high yield bond market, which has a significant exposure to the distressed energy industry. Now that high yield credit spreads are back to their historical averages, we feel these securities offer good value and could outperform going forward. Past performance is no guarantee of future results. This newsletter is provided for informational purposes only and does not constitute an offer or solicitation to purchase or sell any security or commodity. Any opinions expressed herein are subject to change at any time without notice. Information has been obtained from sources believed to be reliable, but its accuracy, interpretation and timeliness are not guaranteed. Copyright © 2015 Midland States Bancorp, Inc. All rights reserved. Midland States Bank® is a registered trademark of Midland States Bancorp, Inc. 6 Market Outlook 4th Quarter 2015