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Securian Financial

The Economy and the Markets | Third quarter 2017

Markets are behaving as if we’ve entered a Goldilocks economic environment that is neither too hot nor too cold. The third quarter delivered promising results for the economy and the markets, with stocks yet again reaching new highs.

Neither the Federal Reserve’s plan to reverse quantitative easing nor saber rattling between President Trump and North Korea have derailed markets. U.S. stocks were propelled by strong corporate earnings, lower inflation, a weaker dollar and positive economic signs. While stocks are now seen by many as overvalued, fundamentals continue to improve in support of valuations. Adjusted for today’s low interest rates and inflation, stocks aren’t considered in dangerous territory, in our opinion. Interest rates barely moved in the U.S. and in most other developed markets, reflecting diminishing concerns about inflation and expectations that central banks will only slowly raise rates.

Second quarter growth bounced back from a weak first quarter, despite the lack of fiscal boost from Washington policymakers. The hurricanes in Houston, Florida and the Caribbean in September were disasters but are likely to have only a modest impact on U.S. growth. Any negative impact on growth in the current or coming quarter likely will be met with a rebound from rebuilding efforts in 2018. Growth in developed and developing economies outside of the U.S. is also showing signs of renewed strength.

At its September Federal Open Market Committee meeting, the Federal Reserve (Fed) announced it would begin to taper its bond purchases, slowly reversing the quantitative easing program it began in 2008, and which grew its balance sheet from $858 billion to $4.5 trillion. Based on the Fed’s plan, its balance sheet will decline slowly over the next three years, with a remaining projected terminal balance approaching $3 trillion in assets. While the Fed’s reversal of its bond purchases could be considered “Quantitative Tightening,” we don’t expect a significant rise in longer-term interest rates as a result of the program’s reversal. Inflation has continued to disappoint policymakers and appears to have had a bigger impact on long-term yields than have any moves in the Fed’s policy this year. The Fed reaffirmed its expectations of another Fed Funds rate hike in December and three more hikes in 2018.

2015 Issuance by sector

Source: Bank of America/Merrill Lynch 2015

The markets finished the quarter with momentum as President Trump finally introduced a tax reform plan that many had been waiting to see since early in the year. It proposes to cut corporate tax rates substantially, and reduce income tax rates and complexity for individuals.

Fixed income

The fixed income market keeps chugging along with stable long-term interest rates and strong demand for corporate and other nongovernment bonds. Institutional and retail investors continue to put more investment dollars into bonds. Strong inflows into retail mutual funds have been one of the big surprises of the year. Demand has been propelled by developed country age demographics and a global reach for yield. We expect the continued rise in the number of retirees to support investment in safe, income-bearing investments for some time to come.

Spreads relative to Treasuries on corporates, mortgage-backed, asset-backed and commercial mortgage-backed securities narrowed again in the quarter after a brief spike in August. Spreads on high-yield corporate bonds are at or near their tightest levels all year.

Demand for nongovernment bonds remains supported by the same strong fundamentals that are supporting equities: steady growth, low inflation and strong earnings. The high demand has been met with another year of strong supply. We are expecting this to be the fifth year in a row of over $1 trillion in investment grade corporate bond issuance. While valuations appear rich, spreads are nowhere near their tightest levels reached during the 1990s. Should current conditions persist as they did then, spreads could tighten.

Equity

All major U.S. equity indices hit new highs and ended the quarter at or near those highs. Equity prices were supported by strong fundamentals as well as by a declining dollar, which makes U.S. exporters more competitive and can generate an earnings boost through currency translation. The U.S. dollar fell 3 percent during the quarter against major trading partners as reflected in the decline of the trade weighted dollar, and is down 8 percent since the beginning of the year. Growth and cyclical stocks outperformed defensive stocks. Large cap companies continued to exploit their scale advantage and overall, the U.S. large cap market has maintained record high profit margins for over two years.

Valuations in the stock market are high by many measures but remain substantially below the peak reached in 2000. While technology stocks have made up a substantial share of the market’s performance, as they did in the late 1990s, valuations in the technology sector appear to be supported by real earnings and profit growth this time around.

However, long-term market valuation measures, such as the Shiller CAPE Ratio, are raising warning signs that today’s valuation levels portend substantially lower returns for stocks in the coming decade.

At the sector level, brick and mortar retailer stocks continue to be hit hard for any miss on earnings projections.

Real Estate

Real Estate Investment Trusts (REITs), as measured by the Wilshire Real Estate Securities Index, were up marginally in the quarter, rising 1 percent. REITs, which are most sensitive to the success of President Trump’s policy agendas, such as health care and office, underperformed. Similarly, hotel REITs were lagging the index until the aftereffects of Hurricanes Harvey and Irma resulted in tens of thousands of displaced residents in Houston and across Florida. This short-term, transitory business caused the group to rally sharply in September.

Property sectors associated with e-commerce continue to shine, most notably data centers and industrial warehouse. As more retailers look to enhance their web presence, the shipping fulfillment necessary to accommodate online shopping has resulted in record leasing of warehouse space. In addition, grocery-anchored shopping centers made a recovery from last quarter.

REIT earnings continue to decelerate on a sequential basis, with forward year-over-year earnings growth expectations hovering around 6 percent. With occupancy levels at or near record highs across most property sectors, REITs will be more reliant on rental rate escalations than occupancy gains to deliver accelerating earnings growth.

Outlook

We expect growth to remain at trend or above for the remainder of 2017 and surpass the meager 1.6 percent real Gross Domestic Product (GDP) growth posted in 2016. Third quarter GDP growth was trending in the mid-2 percent range before storm damage curtailed consumer and business activity in Texas and Florida. Consumer confidence and business confidence remain strong, as they have been for most of the year, and we expect that this sentiment will continue to support spending, investment and growth. Despite the horrible disasters from hurricanes in terms of both human life and property destruction, the impact on GDP is expected to be modest.

Falling inflation has been one of the big surprises this year, and while we could see a reversal of this trend, we no longer expect inflation to reach or exceed the Fed’s target in the near future. Wage inflation is the most important driver, and it is not substantively picking up. Where wages are rising, the costs are not being passed through to the consumer as firms are able to maintain their margins by cutting other costs to offset any rise in labor costs.

The outlook is surprisingly stable in the economy and the markets, except for the geopolitical market risk due to continued saber rattling between President Trump and North Korea’s leader, Kim Jong-un. The uncertainty of the situation dented stock gains and pressured interest rates lower from time to time over the quarter. We remain more concerned about these type of endogenous factors negatively impacting the markets than we do about a natural end to the current conditions.

After eight years of a slow recovery and expansion, we continue to see good sailing ahead for the market as the economy and markets put up steady gains into a gradual Fed tightening. We expect more of the same like we experienced in the third quarter as we move through the end of the year and into 2018.

Source is Bloomberg for all information unless noted otherwise.

Major U.S. equity indices include the S&P 500® Index, Dow Jones Industrial Average, NASDAQ Composite Index, and the Russell 2000 Index.

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 floatadjusted market-weighted index (stock price times float-adjusted shares outstanding), with each stock affecting the index in proportion to its market value.

The Dow Jones Industrial Average is a stock market index that shows the price-weighted average of 30 large and well-known U.S. companies.

The NASDAQ Composite Index measures all NASDAQ domestic and international based common type stocks listed on The Nasdaq Stock Market. The NASDAQ Composite is calculated under a market capitalization weighted methodology index.

The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership.

The Shiller CAPE ratio is also called the Shiller price-to-earnings ratio. It is calculated by normalizing irrational valuations generated during times of economic booms and busts, thus smoothing fluctuations in market price-to-earnings ratios that are really a result of boom and bust economic cycles.

The Wilshire U.S. Real Estate Securities Index is a float-adjusted market capitalization weighted index of publicly traded real estate securities, such as: Real Estate Investment Trusts (REITs), Real Estate Operating Companies (REOCs) and partnerships. The index is comprised of companies whose charter is the equity ownership and operation of commercial real estate.

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

Basis points represents the percentage change in the value or rate of a financial instrument. One basis point is equivalent to 0.01% (1/100th of a percent).

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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