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Securian Financial

The Economy and the Markets | First quarter 2017

Investors remain focused on the Trump administration for signals that government or fiscal policy will indeed propel the U.S. economy and markets to higher levels.

So far though, clear signals are the last thing that investors are getting from the new president. The economy, in the meantime, is doing well – probably better than during much of the last four years. Investor and business optimism remain at very high levels due to strong interest in and hope for Trump’s promises to cut taxes and reduce regulation.

All eyes now are on the administration’s agenda following its failure to make changes in the Affordable Care Act (ACA). Tax cuts or tax reform are next on the list for the administration to address, but partisan politics are running high and the Republicans are not anywhere near aligned, calling into question the potential for progress on many fronts.

Despite all the political wrangling, the economy is chugging along and positive economic surprises continue to stack up, so much so that the Bloomberg Economic Surprise Index is at its highest level since 2011. The rise can be attributed to improved sentiment, as well as better results in the labor markets and housing. Unemployment claims are at the same level as they were in 1973. All indications are that this quarter’s corporate earnings will bring double-digit growth over the previous year.

With the earnings and energy recessions over, there is a bit of a synchronized tailwind with better results in the U.S. economic data, strong U.S. and EU sentiment, and improved earnings trajectory. This coupled with the “hope” that the Trump administration can deliver on lower taxes and less regulation has taken the stock market to new all-time highs, raised short to intermediate-term interest rates and driven stock volatility to near 30-year lows.

Earnings recovery

Source: FactSet estimates

The Federal Reserve (Fed) is now clearly in a tightening cycle. The Fed raised interest rates during the quarter by 25 basis points. Not long ago that would have been the headline for our quarterly commentary. This quarter, however, the Fed has clearly taken a backseat. The markets – both stock and bond – barely budged on the rate news, even though early in the quarter investors hadn’t discounted the change.

The Trump administration looks erratic and we expect it to stay that way. With the ACA reform stalled, Trump is turning to tax reform, which could prove positive. On the other hand, the defeat could mean that Trump fiscal policy is less likely to be effective, resulting in a potentially watered down version of tax reform. Political outcomes are hard to gauge from any administration. With the new President we think it will remain difficult to distinguish the true progress from the noise.

Fixed Income

The U.S. yield curve flattened and long-term U.S. Treasury yields were lower at the end of the quarter while short-term rates rose with the Fed rate rise. Corporate bond spreads were narrower in the quarter, but had sold off (widened) from their tightest levels in March as prospects for a fast start from Trump and the Republicans began to fade. The Fed raised rates in March and investors now believe there is at least one more rate rise this year, coming as early as June.

Corporate and other non-government bond issuance remained strong in the quarter. However, the Republican proposal for corporate tax reform could have significant impacts on debt and fixed income markets in the future. In particular, the proposal to eliminate the deductibility for corporate interest would significantly raise the cost of capital for high yield bond issuers and could reduce the attractiveness of debt to investment grade companies, enough so that issuance could fall. We continue to track closely the developments with the Trump and Republican proposals as they could have significant impacts on business models for the companies in which we invest.

While investors expect interest rates to rise, induced mainly by better economic results and the Fed in a tightening cycle, overall yields still look relatively attractive, particularly for international investors whose home country yields in Europe are very low. Also, bond yields now rival dividends. The 10-year U.S. Treasury is now yielding more than the S&P 500® Index.

U.S. stock indexes hit new all-time highs and earnings multiples expanded to where price/earnings (P/E) ratios far exceed the historical average. The S&P 500 Index is up about 10 percent since the election and trading is at one of the highest forward P/E ratios since the internet bubble.

Year-over-year earnings growth has been positive. The upcoming earnings reporting cycle is key to whether the positive momentum continues. While the market was strong for the quarter, it faded in March as the Trump and Republican agenda stumbled. As market direction has shifted from the Fed to fiscal and tax policy, the key to further improvements lies with the administration and legislature. Despite the missteps by the administration and the high degree of political noise, stock volatility as measured by the VIX has remained historically low.

Utility stocks were another surprise. Traditionally a defensive sector, utility stocks were one of the best performing sectors in the quarter despite the expected rise in interest rates. Low or negative rates overseas may have brought foreign investors to U.S. bond-like substitutes in the stock markets such as utility stocks.

Real Estate

Real estate stocks barely budged in the quarter due to rising interest rate expectations. Real estate fundamentals are slowing but still positive. Demand for private real estate continues to be healthy and there hasn’t been a change in private valuations with the rise in interest rates since the election.

The Real Estate Investment Trust (REIT) market is exhibiting a typical late cycle pattern with a slow-down in supply and tightening lending conditions. The retail real estate segment has been hit with recent store closures and bankruptcies. As consumers shift more of their purchasing online, retail storefronts are being replaced by warehouse fulfillment centers at much lower costs, boosting demand in the industrial real estate sector.

Multifamily properties could pose potential issues, particularly on both the east and west coasts, where rents are expensive. Thus far, strong job growth in high paying sectors hasn’t accompanied the supply of upscale apartments in these areas.

Outlook

Our optimism about the economy and markets remains, but it has been dented somewhat by the slowed political agenda. We believe growth will surpass that of 2016, but it is unlikely to be the 3-4 percent that Trump promised. Lower taxes, looser regulation and generally more business friendly policies have the potential to lead to growth. If enacted, the pro-growth policies should extend this already long business cycle. However, the realism of what it takes to run Washington is settling in on the markets.

While our outlook for growth remains positive, there is strong potential for trade and immigration proposals to lead to more inflation. Inflation measures have already turned up in the U.S. as well as in Europe, surprisingly. Immigration may crimp labor supply and trade policies could turn protectionist, raising both labor and import costs.

Corporate tax reform has the potential to substantially impact companies’ business models. Challenges include the complex border adjustment tax that favors exporters and hinders companies that import the goods for sale in the U.S. Apparel retailers have already been impacted by these prospects.

For much of the last eight years, Fed policy has overshadowed the economy and fiscal policy in propelling the markets. Now it looks as though the economy and the government’s policies could supplant the Fed for market leadership. For investors to truly take this to heart though, the government will have to show it can really get something done.

Source is Bloomberg for all information unless noted otherwise.

The S&P 500® Index consists of 500 large cap common stocks, which together represent approximately 80% of the total U.S. stock market. It is a float-adjusted market-weighted index (stock price times float-adjusted shares outstanding), with each stock affecting the index in proportion to its market value.

FactSet is a leading provider of financial information and analytics. See FactSet.com for more information.

Please note one cannot invest directly in an index. Past performance is not guarantee of future results.

Investment risks associated with real estate investing, in addition to other risks, include rental income fluctuation, depreciation, property tax value changes, and differences in real estate market values. Investment risks associated with international investing, in addition to other risks, generally will include currency fluctuations, political, social and economic instability and differences in accounting standards when investing in foreign markets.

Fixed income securities are subject to credit and interest rate risk and, as such, values generally will fall as interest rates rise.

Investments will fluctuate and when redeemed may be worth more or less than originally invested. Past performance is not indicative of future results.

Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. This commentary should not be viewed as a current or past recommendation or a solicitation of an offer to buy or sell any securities or to adopt any investment strategy. Opinions expressed herein are those of Advantus only. Investors should keep in mind that markets are volatile and unpredictable.

This article contains forward-looking statements based on expectations and assumptions. Actual results could differ materially because of changes to these expectations and assumptions. The Economy and the Markets has been prepared for informational purposes only and is the opinion of Advantus Capital Management, Inc., a registered investment advisor.

Advantus Capital Management, Inc. is a subsidiary of Securian Financial Group, Inc.

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