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Securian Financial

The Economy and the Markets | Second quarter 2017

Optimism about the new administration’s growth proposals have certainly faded from early in the year.

The 10-year Treasury yield fell along with growth expectations as legislative progress has been slow to arrive. Actions on reduced regulation or tax cuts may provide the main boost for growth from the White House this year.

Despite reduced optimism, the economy continues to perform smoothly, with Gross Domestic Product (GDP) likely bouncing back in second quarter from a weak first quarter. Steady results in employment, housing and continued strong lift in consumer confidence led to strong business sentiment.

Stocks hit new highs again, despite lower growth optimism and decidedly weaker inflation. All asset classes have done pretty well in an environment that doesn’t require the Federal Reserve (Fed) to act too hastily in raising interest rates – continuing the balance that’s persisted for quite some time of slow growth, low inflation and accommodative monetary policy.

One of the biggest surprises this year has been the record low stock volatility – both realized and implied. The market’s risk measure, CBOE VIX® (VIX), has recorded some of its lowest readings ever. Against the more unconventional political backdrop in Washington, and what could be a season of substantially more policy uncertainty, this appears to be at odds with investor expectations. Another surprise is that oil entered a bear market, down $11.36 from $57.40 at its high this year, which put pressure on oil stocks, bonds and peripheral energy exposures.

The Fed raised rates 25 basis points in June, following a similar rise in March and last December. The changes were largely expected and had little impact on the markets.

The administration’s growth agenda should get a test soon with a key vote on healthcare reform. This could set the stage for whether tax reform has the potential to pass later this year or next, and consequently should impact investors’ views of growth expectations.

Fixed Income

Bond returns were positive for the second quarter. The big story in bonds this year has been that long-term rates have fallen as growth expectations and inflation have disappointed. This along with the Fed raising the Fed Funds Rate has contributed to a significant flattening in the bond yield curve (the difference between long and short yields). The difference between 30-year and 2-year bonds was 145 basis points at the end of the quarter, the flattest yield curve spread between these two rates since September 1, 2016.

Slow and steady economic growth and low inflation are good ingredients for non-government (corporate and other) bond performance versus Treasuries. Investment grade and high yield corporate bonds outperformed Treasuries in the quarter as did all other fixed income sectors except for agency mortgage backed securities.

However, spreads now are pretty narrow when considering historical experience. Despite the favorable mix of economic growth and inflation, the value in non-Treasuries is low. The economy and credit cycle are now entering the ninth year of recovery and expansion. Corporate credit growth has risen faster than GDP growth for some time. As a result, we believe it’s prudent to be cautious about risk positions.

Corporate Debt* as % of GDP over credit cycles

*Non-financial corporate business debt. Gray bars represent recessionary periods
Source: Board of Governors of the Federal Reserve System/FRED, 12/31/2016

Equities

We reached a new all-time high in the stock market five out of the first six months of this year. Solid earnings growth has been the primary driver of higher stocks with the S&P 500® up 9.3 percent. Technology stocks had big gains, with the FAANG stocks (Facebook, Amazon, Apple, NetFlix and Google) all up 17.7 percent to 31.2 percent. Businesses were able to maintain strong margins much longer than expected. Low inflation and low wage pressure kept business expense growth moderate, and businesses offset that expense growth with other cuts.

The current conditions have been good to U.S. and non-U.S. stocks alike, which led to low volatility across most asset classes. But stock volatility has been extraordinarily low. The VIX has recorded four of the top 10 lowest ever daily values so far this year. The low volatility is in part supported by an upturn in global growth, especially when compared to growth concerns in the first half of last year, which were overshadowed by a China slowdown, tumbling commodity markets and Brexit.

Real Estate

Investors in retail real estate were surprised by the Amazon acquisition of Whole Foods. The dramatic announcement ended up driving down the stocks of many retail Real Estate Investment Trusts (REITs). The concern was that Amazon could impact grocery stores – and hence grocery-anchored real estate centers – similar to how it has impacted other retail business models, disrupting their distribution and ultimately their brick and mortar locations. We think the initial response by these stocks was likely overblown and we did see a quick recovery in several that sold off. Retailing has changed dramatically over the last couple of decades, due in part to the Amazon phenomenon and changing shopper preferences. We believe good retailers are adjusting their focus as consumers are more interested in experiences and are changing their shopping habits.

REIT returns have been low to date, up 2.4 percent for the year, as measured by the Wilshire U.S. Real Estate Securities Index. As with the last few quarters, the fundamentals broadly in real estate reflect continued strength but slowing growth. Most property segments and markets are in good balance. The best performing sectors are industrial/warehouse driven by demand for e-commerce fulfilment centers, as well as data centers and the multifamily sector.

Outlook

We remain optimistic about the prospect for economic growth above 2 percent for the second half of the year. The likelihood of continued business investments remains high as reflected by the elevated readings in small and large business optimism. While the Fed has been raising short term rates, overall interest rates remain very low and the Fed is still accommodative with continued purchases of long term bonds that keep bond yields lower than they otherwise might be. We expect the Fed to raise interest rates again this year and to begin scaling back its bond buying program by reinvesting less of the portfolio that matures. This should put some upward pressure on bond yields.

We believe that policy changes will come from the administration and Congress to boost growth. But those changes are likely to be later than originally anticipated, moving any substantive growth to 2018. Coupled with a more robust global growth outlook, this could be a good combination for next year.

The U.S. just completed the eighth year of this recovery and expansion, and we believe there are likely two or more years remaining. Financial crises are usually succeeded by long, slow expansions and we think this expansion could rival the longest in history, which was in the 1990s. Both expansions were preceded by housing and banking crises. This current expansion with slow and shallow growth along with very low inflation has resulted in few sectors of the economy becoming over-heated and over-invested. While many risks remain in the later stages of the business cycle (e.g., the Fed in tightening mode and high corporate debt issuance), we believe there is a better chance for growth to rise in the coming quarters. Ultimately, risk markets could benefit from the better economic tone.

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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