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Posted on JUL 26, 2017

Johnson Bank Wealth Weekly Investment Commentary | Wednesday, July 26

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.

Canoeing and Diversification

Last week I had the opportunity to spend some time canoeing and was reminded of the importance of working with a partner to navigate a waterway and the challenges it may bring. A successful trip requires coordination and communication between the stern paddler and the bow paddler (who is hopefully au courant about river conditions). Any lack of communication could result in wet paddlers, gear or, worse, the loss of the canoe. Fortunately, I was with a bow paddler who excelled at both and our trip was successful. (In fact, I believe we returned with everyone who started the trip!) Likewise, the component parts of a portfolio must work together to create a successful financial outcome.

Rapids Ahead

The current investment environment has many investors feeling like the bow paddler who hears a rush of water ahead on an unfamiliar river. Not knowing what to expect, they gird themselves for anything. We are at a point where both stocks and bonds seem to have extended their market values beyond reason, leaving investors feeling that the usual benefit of owning both may not help them make it through the fast water that may lie ahead.

The stock market is making new highs again. There are regular headlines about how extended the valuation is. While we would agree with that notion, we also recognize that corporate earnings growth looks better than last year. It may look quite a bit better, in part due to energy earnings, and there are other sectors such as financial services also showing signs of accelerating growth. We believe that the modest uptick in economic growth should enable companies to show real revenue and earnings growth. However, it may be more modest than anticipated at the beginning of the year.

More importantly, one of the main factors supporting higher stock prices has been the low level of interest rates, which make it easier for companies to borrow to buy back their shares or buy other companies to improve their growth rate. In the last several weeks the monetary policy makers at the Federal Reserve have talked about their plans to continue raising interest rates and reduce the size of their bond portfolio. They've done so believing that the economy is on more solid footing and inflation is moving toward their target level. If markets believed the rhetoric, it would seem likely that stock prices may decline and bond yields would move higher. However, the opposite is true. Stocks, as mentioned earlier are reaching new highs and yields have actually declined. Once again, markets aren't buying the Fed's view and instead believe rates will remain low. Rapids may be further down river than some investors think.

If you spend time canoeing or kayaking, you know that it is more exciting earlier in the summer when the water is usually higher, rapids are faster and rocks are harder to see. Later in the season, the water is low, obstacles are more easily observed and the pace of progress can be downright relaxing.

We believe we are in a late summer environment. Economic growth remains positive but slow, and inflation remains tame and below the Fed's target. Corporate earnings growth is improving at a modest pace. This backdrop could actually lead to higher stock prices because it may result in the Fed moving more slowly than previously discussed (more on that to come as the Fed begins meeting this week). Still, as any good bow paddler knows, it is important that we keep our eye on the risks ahead and think about how to protect against them.

Stern Paddling

While the person in front is responsible mainly for power and providing an early warning, the person in back (stern) is mainly responsible for steering. In a balanced portfolio, stocks provide power and generate the majority of return, while bonds should provide income and a counter‐balance when stock risk rises.

Because yields are so low (prices high), many are worried about bonds' ability to offer the principal protection sought in a balanced portfolio. Like the seasoned stern paddler with any number of strokes in their arsenal, to avoid problems on the river, we can take a number of steps to allow them to do their job, despite the low level of interest rates.

First, we can reduce our portfolios' average maturity. This implies that a greater amount of the portfolio will mature each year, providing the opportunity to reinvest more of the portfolio at higher interest rates. Secondly, we can invest in securities or funds that produce more income, which also provides more cash flow to invest as interest rates move higher. Finally, while we've benefitted from the higher yields available from taking corporate credit risk, we can reduce that risk in favor of leaving it with the stock portion of the portfolio.

These changes will create a more defensive bond portfolio which should be less price sensitive as rates rise.

We believe we are in a late summer paddling environment for the near future, where the benefits of low interest rates and central bank stimulus will continue because growth and inflation will move like an August river. The benefits of a balanced portfolio remain in place as long as we are thoughtful about how we manage each component and, like the bow paddler, keep an eye out for trouble.

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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