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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
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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
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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
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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
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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
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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.
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Market Outlook 4th Quarter 2015