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Posted on JUL 6, 2017

Johnson Bank Wealth Weekly Investment Commentary | Thursday, July 6

This is part of an ongoing series of Weekly Commentary articles published by Johnson Financial Group.
This week's issue is written by Brian Andrew, SVP, Chief Investment Officer.


I hope you enjoyed the holiday. As we were leaving the fireworks show, someone described the finale as “epic.” Really? It was good, much like last year's and the year before, but was it epic? Declaring your independence from another country, that's epic. Ending a fireworks show with a big bang? Maybe not so much. What's epic anymore? This word has become so overused that it may have lost its meaning.

Let's take a look at some epic events that have shaped markets over the last several years and some not so epic events from the last six months that will impact markets going forward.

Central Bankers

The financial crisis of 2008‐2009 could be described as an epic liquidity crisis. One way to think about what caused the crisis is this: A lot of people filled a stadium through many entrances. They borrowed their ticket money, used their house as collateral, and all wanted to leave at the same time. They needed to exit through one door and asked for their ticket money back to pay off their loan. There were very few who could provide liquidity during the crisis. (Warren Buffet's Berkshire Hathaway provided Bank of America liquidity after the crisis and announced last week that it would exercise the warrants it received for its liquidity injection in 2011 – the profit is about $12 billion.)

Stepping into the fray, then, were the world's central bankers, known as the Federal Reserve (Fed), European Central Bank (ECB), Bank of England (BoE), Bank of Japan (BoJ) and some others. As the after‐effects of the crisis continued to hamper economic activity, these bankers reduced the level of interest rates to never before seen levels at or even below 0%. They then grew their balance sheets to epic proportions (approximately $19 trillion from less than $4 trillion) in an effort to provide liquidity to the financial systems of the world. They went on a bond (and in the case of BoJ, stock) buying spree that continues today for the ECB and BoJ. Imagine: It has been a decade since the crisis, and central bankers are still providing the world's developed economies stimulus in the form of low rates and asset purchases. Now that is epic.

For their efforts, the global economy has slowed over the last five years. Developed economies like that of the U.S. and Europe are stuck with low growth rates of 2% and 1%, respectively, and very low inflation. The developed world's aging population has reduced spending at a time when emerging markets slowed. Add to this the deflationary forces of technology and you have the conundrum of the last five years.

Last week, bond markets were roiled because some of these bankers began to discuss a departure from their current policies. This means raising interest rates and eliminating those liquidity‐providing bond purchases. As a result, headlines described the epic reversal in bond yields as though bond investors had begun to run for the hills, raising yields and lowering prices. Yields did rise. Last week the 10‐year U.S. Treasury yield rose by 0.16% from 2.14% to 2.30%. The German 10‐year Bund rose 0.20% from 0.25% to 0.45% after bankers commented on this change in policy. Was this an epic reversal of their easy policies? No.

Of course the bankers are beginning to talk about a change in policy for two reasons. In a normal environment, when the economy slows, central banks lower their interest rate, markets follow and capital gets cheaper to help encourage more economic activity. It is hard to do that when the rate is negative or 0%. Because economic activity in the U.S. is marginally better (i.e., maybe 2.5% growth instead of 2% growth this year), and it is improving in Europe and Japan, these bankers are taking the opportunity to begin raising interest rates so they have the ability to lower them when another recession hits. They are doing that faster in the U.S. than overseas, as the Fed has already hiked rates four times since December of 2015 (from 0% to 1%).

The pace at which they raise these low interest rates and reduce the enormous liquidity pool they've provided will be slow. It will be slow because the economies of the developed world are growing at less than 2% in real terms, and inflation is still stubbornly below 2%. Earlier it was mentioned that they lower interest rates to stimulate the economy. Normally, they raise them to stave off inflation and to slow growth. We don't have either an inflation or growth problem, and hiking rates actually tightens financial conditions. Central bankers have no choice but to move slowly and carefully as they reverse course. This means that interest rates will move higher, albeit at a slow pace over years, not weeks or months. We may see fits, like last week, but the general pace will be very slow.

Pass the Baton

After last year's U.S. election, we had one of those fits, and bond yields moved higher by almost 1%. The 10‐year Treasury yield got as high as 2.6%, after seeing less than 1.5% mid‐2016. Stocks rallied, especially cyclical and small company stocks. The election proved to be a boon for Republicans, giving them control of the White House and Congress. Business owners and consumers hoped for a reduction in taxes and new spending that while not epic would provide stimulus. Investors believed that lower taxes for businesses and individuals were just around the corner and would produce faster economic growth. Republicans had talked about massive infrastructure spending as well, which would also be good for economic growth. The monetary policy makers at the Fed hoped they could pass the baton to the fiscal policy makers in government. We believe progress will be made, just not at the rate anticipated by those hoping for a tax cut in 2017.

However, it is six months into the new year and we haven't seen progress on a tax reform or an infrastructure bill, which could add a few tenths of a percent growth to the economy. The Republicans focused on the repeal and replacement plan for the Affordable Care Act in order to get some fiscal savings to pay for part of the tax reform. Unfortunately, both the House and Senate had to postpone a vote on the legislation suggesting that a coalition in the Republican party is hard to come by. If they get past the health care buzz saw, the fiscal conservatives will push back on any tax plan that raises the federal deficit. Because the portions of the tax plan that raise revenue are mostly unpopular, the tax debate may take until 2018 to get resolved. It is likely too late for any benefit in 2017. This may give the Fed pause in its plan to normalize the interest rate environment and reduce the size of its balance sheet.

Politics have been on investors' minds a lot during the last six months. And not just in the U.S. The wave of populism that swept the world last year hit a wall in France when the center‐left Emmanuel Macron won the national election for president over the populist Marine La Pen in May. One year after Brexit, the U.K.'s new prime minister's party lost ground in the spring, and last week, Japan's Prime Minister Shinzo Abe lost the majority of his party's seats in parliament. It seems that populism has given way to voters wanting change faster than policy makers can deliver it. Central bankers may find that they can't pass the baton as quickly as they'd like.

Commodities Are the Economy's Tell

When thinking about the global economic growth picture, one of the best indicators of whether things are getting better or worse is the price of commodities. This includes energy commodities like oil and natural gas, as well as industrial metals like copper and iron. Last year, oil prices declined to $25 and then recovered to near $55. This recovery made sense because low oil prices led to a decline in U.S. production and a pick‐up in economic activity around the world. However, higher prices made it easier for U.S. shale producers to re‐enter the market in 2017, and once again supply is outstripping demand. As a result, oil prices have declined by over 20% from this year's peak. Some of this weakness results from a weaker dollar, which is also down nearly 6%.

The commodity price cycle is long. While maybe not epic, commodity prices rose in the early and mid‐2000s due to China's unprecedented urban expansion. The urbanization of several hundred million people was perhaps epic, resulting in China becoming the number two global economy in size. As a result its economic growth has a large impact on commodity prices as well. Its stimulus policy in 2015 and 2016 led to an increase in economic growth that pushed some commodity prices higher in 2016. As it has reduced its efforts, the economy has slowed. This has reduced demand for energy and industrial metals, leading to a price decline this year.

The change in commodity prices, specifically energy, has had a big impact on stock prices as well.

New Highs

The rally in oil prices led to a recovery in energy earnings in the first quarter of 2017. This contributed to a quarterly earnings growth rate of over 14% for S&P 500 companies–a number not seen in over two years. The combination of the 2016 recovery in economic activity, higher oil prices pushing up energy sector earnings, a weaker dollar helping international companies and the promise of lower corporate taxes all combined to push stock prices in the U.S. to new highs during the second quarter of 2017. The U.S. S&P 500 Index was up over 9% YTD. Better improvement in economic growth in Europe and Japan helped to lift markets there as well. The MSCI EAFE index (includes Europe and Asia) was up almost 14% YTD.

World markets all benefitted from better economic growth, leading to improved corporate earnings and the promise of new fiscal policies. They also benefit from the continuation of those low interest rates and liquidity programs promulgated by the world's central bankers.

What's Next?

The question on stock investors' minds is: Will this continue? At this point, it seems somewhat likely for two reasons. First, the global economy is showing signs of strength, benefitting from last year's lower energy prices, interest rates and inflation. In some parts of the world, economic data is mixed because those three things rose in the second half of 2016. However, the changes are modest and the absolute level of inflation and interest rates remains stimulative for corporate earnings growth. We're likely to end up with an economic growth and inflation rate this year that looks much like it did last year. The pick‐up in European and Asian economic activity is helping European companies' earnings that benefit from trade in particular.

Second, those stimulative central bank policies, while likely having reached their peak, will continue to make stocks an attractive asset for investors, so their demand will also support prices.

While we started the year hoping that lower taxes would also improve corporate earnings, the market has discounted the likelihood that this will happen in 2017, although there is still some earnings benefit priced into future earnings estimates. At this point, we don't believe that fiscal policy changes will be epic. More likely, changes will be mildly helpful, and then not until next year.

While the financial crisis could be considered epic, so too could the U.S. stock rally from the low point in March 2009 to this last quarter. The S&P 500 Index is up over 260% during that period. From here, markets can continue higher, but it gets tougher to generate earnings growth that supports these stock values. For the same period, international markets are up only 155%. The economic improvement in Europe and Japan may continue to offer better corporate earnings growth than what we see here in the U.S., potentially offering a better opportunity.

Markets will always provide mixed messages and occasionally make epic moves. In fact, you could consider a successful financial journey through adulthood to retirement, epic. Our job however, is to make it seem more uneventful.

Brian Andrew
As Chief Investment Officer, Brian Andrew leads Johnson Financial Group's investment strategy
to provide consistent, actionable investment solutions for our clients.

This information is for educational and illustrative purposes only and should not be used or construed as financial advice, an offer to sell, a solicitation, an offer to buy or a recommendation for any security. Opinions expressed herein are as of the date of this report and do not necessarily represent the views of Johnson Financial Group and/or its affiliates. Johnson Financial Group and/or its affiliates may issue reports or have opinions that are inconsistent with this report. Johnson Financial Group and/or its affiliates do not warrant the accuracy or completeness of information contained herein. Such information is subject to change without notice and is not intended to influence your investment decisions. Johnson Financial Group and/or its affiliates do not provide legal or tax advice to clients. You should review your particular circumstances with your independent legal and tax advisors. Whether any planned tax result is realized by you depends on the specific facts of your own situation at the time your taxes are prepared. Past performance is no guarantee of future results. All performance data, while deemed obtained from reliable sources, are not guaranteed for accuracy. Not for use as a primary basis of investment decisions. Not to be construed to meet the needs of any particular investor. Asset allocation and diversification do not assure or guarantee better performance and cannot eliminate the risk of investment losses. Certain investments, like real estate, equity investments and fixed income securities, carry a certain degree of risk and may not be suitable for all investors. An investor could lose all or a substantial amount of his or her investment. Johnson Financial Group is the parent company of Johnson Bank, Cleary Gull Advisors Inc. and Johnson Insurance Services LLC. NOT FDIC INSURED * NO BANK GUARANTEE * MAY LOSE VALUE

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