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Securian Financial

The Economy and the Markets | Second quarter 2016

Leading up to the Brexit vote in the U.K., the U.S. economy was improving and markets were stabilizing. But second quarter improvement was overwhelmed by the U.K.’s surprise decision to leave the European Union.

This is a significant market and economic event that opens up major new pathways for political change, market reactions and central bank actions. Determining actual economic impacts for companies, labor, trade, etc. may be impossible for quite some time. It seems politics, rather than the economy, could have a more important impact on the markets in the near term. The possibility of other countries exploring exit from the E.U. could further anti-establishment/nationalist campaigns both in Europe and the U.S.

While the economic linkage is important, including how much trade the U.K. does with the E.U. and with the U.S., there is a broader risk. After decades of expanding the E.U. membership, the union has had one of its four most important members decide to leave. The E.U. can’t afford another of the remaining three key members to leave and expect to keep the union or the currency intact.

The vote could easily set off a market correction. However, we don’t think this is equivalent to a “Lehman Moment” that ushered in the Great Recession. We believe the impact on the financial sector will be most severe, as falling interest rates could hit financial institution operating revenue. Bank stocks in the U.K. and E.U. reflected this, ending down 1.06% and 17.75%, respectively, for the quarter. U.S. bank stocks fared better up 1.02% for the quarter.

We expect central banks will have a coordinated response, which could soften market outcomes. The U.K. is likely to cut its rate, the E.U. and Japan may add to their quantitative easing programs, and the U.S. will likely back off its rate rising rhetoric for this year and maybe longer. While the central bank actions can help, politics will likely trump central banks for attention and impact on the markets and global economy.

Fixed Income

Bonds performed very well in the quarter with the Barclays U.S. Aggregate Bond Index rising 2.21%. Interest rates in the U.S. were falling before the Brexit vote, which drove U.S. fixed income yields even lower and briefly approached the all-time low for 10-year U.S. Treasury yields of 1.4%. Even prior to the vote, yields on European government bonds fell further below zero, responding to the European Central Bank (ECB) policy of buying corporate investment grade and high yield bonds. U.S. yields followed Europe’s as many E.U. and Asian investors increased holdings of U.S. corporate bonds.

We think that U.S. bond yields could go even lower. While long term U.S. yields are already near all-time lows, the U.S. market looks attractive compared to negative yields in Europe and Asia. Corporate bond spreads, while immediately rising in reaction to the Brexit vote, are likely to narrow in the medium term. European and Japanese investors are likely to return to the safety and yield of the U.S. bond market over the coming quarters as their markets offer little if any positive-yielding bonds.

Yield Curve - Global Interest Rates

Source: FactSet as of 6/30/2016

Equities initially extended gains won in the first quarter rebound. But all that changed after the Brexit vote. U.S. and international stocks sold off sharply to send major international indices into negative territory for the quarter. U.K. and European stocks ended down the most, with FTSE All-Share Index and EURO STOXX Index down 3.48% and 5.06%, respectively. After initially trading down with the U.K. and European stocks, the S&P 500® Index staged a late quarter rally into positive territory up 2.46%.

Stocks went into the vote with valuations that were higher than long term averages but not at historical extremes. Earnings growth in the S&P 500® is forecast to turn positive in the second quarter, hopefully ending the negative earnings results experienced for the last five quarters. In the current environment stocks likely remain more risky as valuations will need to be supported by increasing earnings growth.

Expect volatility in stocks to remain very high into the U.S. election and the remainder of the year. Fear of Brexit fallout and hope for political reform and central bank involvement will likely keep stock movements unpredictable.

Real Estate

The U.S. real estate market is one of the least exposed equity sectors to U.K., Europe and global growth. While the Brexit vote and market reaction certainly impacted all risk assets, the impact on U.S. REITs was much lower. While broad stock indices were down following the vote, U.S. REITs were up. The Wilshire Real Estate Securities Index ended the quarter up 5.99%, more than double the return of the S&P 500® Index, and 11.60% year-to-date.

U.S. REITs have had a strong run since the recovery started in 2009, outperforming the broader stock market. Fundamentals in U.S. REITS have been solid throughout the recovery, supported by strong property demand and operating cash flow in the apartment, industrial, retail and office sectors. The demand in these sectors has made real estate one of the few industries able to demonstrate pricing power. While real estate demand is still relatively high, earnings growth rates are starting to come down. Returns in U.S. real estate remain a relative value bright spot in the equity markets due to continuing fundamental strength and lower risk due to global impacts from Brexit.

Outlook

The U.S. economy is not significantly linked with the U.K. for trade, but direct trade linkages tend not to be the driver for market action. Changes in general financial conditions drive markets more, and whenever global banks and the financial sectors are impacted significantly, the ripple effects are larger for the markets and the economy.

While the U.S. was showing signs of improvement in the second quarter, the data certainly wasn’t all positive. U.S. job growth in May had the lowest monthly increase in the last five years. Additionally, industrial production and leading indicators in the service sector were disappointing. The coming jobs reports will take on extra-special importance. The biggest issue for the outlook post Brexit vote is what happens with politics and monetary policy.

The immediate market outcomes of Brexit are potentially lower rates for even longer and higher volatility in stocks and bonds. We expect the weakening in financial conditions alone (volatile stock prices and wider bond spreads) to make growth in the U.S. tougher to come by. The Federal Reserve likely won’t raise rates again this year and markets have already priced that into expectations. Look for the ECB, Bank of England and Bank of Japan to all talk aggressively about the things they can and will do.

Despite the anticipated market reactions, we don’t believe this is a catastrophic event for markets. It’s likely more akin to concerns over China devaluing or the European Sovereign Debt Crisis in 2012 which caused corrections, but not recessions. We consider that the biggest risk is whether this vote reignites broader concerns over a potential breakup of the union and the end of the euro.

Bloomberg is the source for statistical data unless otherwise noted.

The Barclays U.S. Aggregate Bond Index is a broad-based benchmark that measures the investment grade, U.S. dollar-denominated, fixed rate taxable bond market.

The EURO STOXX Index is a broad yet liquid subset of the STOXX Europe 600 Index, representing large, mid and small capitalization companies of 12 Eurozone countries.

The S&P 500® Index consists of 500 large cap common stocks which together represent approximately 80% of the total U.S. stock market. The Financial Times Stock Exchange (FTSE) All-Share Index is a capitalization-weighted index, comprising around 1000 of more than 2,000 companies traded on the London Stock Exchange.

The Wilshire U.S. Real Estate Securities Index is a float-adjusted market capitalization weighted index of publicly traded real estate securities.

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 is a subsidiary of Securian Financial Group.

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