2018 Midyear Market Outlook

2018

Midyear Market Outlook

Wealth | Investments | Planning Commerce Trust Company

2018 MIDYEAR MARKET OUTLOOK

MARKET SUMMARY  The current expansion should last well into 2019 and beyond.  The U.S. labor market is at nearly full employment with payrolls rising.  Tariff measures by the United States are provoking retaliations by trading partners.  The Federal Reserve has raised the Fed funds rate twice in the first six months, with two more hikes anticipated by year’s end.  Equity valuation levels are approaching lofty levels, but still below the all-time highs set in the 1990s.

MIDYEAR NUMBERS 3.0% 2018 U.S. GDP GROWTH

FORECAST 4.9% S&P 500 Y TD 3.8% 2018 MAY UNEMPLOYMENT 2.92% 10-YEAR U.S. TREASURY YIELD * -1.94% BLOOMBERG BARCLAYS AGGREGATE BOND INDEX Y TD RETURN * -0.49% BLOOMBERG BARCLAYS MUNICIPAL BOND INDEX Y TD RETURN *

*AS OF 6/15/18

2018 MIDYEAR MARKET OUTLOOK

U.S. ECONOMY OPERATING AT NEARLY FULL EMPLOYMENT COMBINED WITH FAVORABLE BUSINESS CLIMATE WILL DRIVE EXPANSION INTO 2019 Over the past year, the world’s major economies have been enjoying a rare period of synchronized global growth. The recent uptick in the U.S. economy, now in year 10 of the current expansion, has been the strongest we have witnessed over the past several years. Global growth momentum outside the United States remains solid, but appears to be leveling off modestly as growing concerns of trade friction, geopolitical risk, domestic political struggles, and debt-related risks begin to surface. In total, world economic growth is forecast to approach 4% in 2018.

2018 MIDYEAR MARKET OUTLOOK

ECONOMIC OUTLOOK On the global stage, after years of central banks’ aggressive monetary policy intervention in response to the last decade’s financial crisis, a different economic landscape may be emerging. Until recently, “quantitative easing” has forced interest rates downward, thereby lowering financing costs for all borrowers. That liquidity support is now being gradually removed. The Federal Reserve (Fed) has been in the process of shrinking its balance sheet while raising short-term interest rates. Meanwhile, the European Central Bank (ECB) has moved closer to exiting its asset purchase program, the Bank of Japan has reduced

U.S. GDP IN SECOND QUARTER OF 2018

EMPLOYMENT GAINS

MODESTLY RISING INFLATION 

2018 MIDYEAR MARKET OUTLOOK

its bond purchases, and various other central banks have hiked rates. Offsetting some of this shift in monetary policy, the United States has begun to implement a major fiscal expansion via tax cuts and higher federal spending over the next several years. The multiple moving parts have led us to remain cautious in our investment positioning for now. The U.S. economy, now in late cycle, is growing at the

EMPLOYMENT

600

Total average job growth at 187k/month since January 2010, 188k/month private only

400

200

0

-200

-400

Currently up 10.2 million jobs since January 2008

-600

-800

-1000

1999

2001

2004

2007

2010

2013

2016

Monthly Increase (Left Axis)

Source: Bureau of Labor Statistics, Bloomberg

2018 MIDYEAR MARKET OUTLOOK

quickest pace in the past four years. Second-quarter GDP growth is forecast to approach 4% for the first time since 2014. For the year 2018, the economy should register a 3% advance, supported by a large fiscal boost, including tax cuts and the recently passed fiscal spending package mentioned above. An economy running at nearly full employment combined with continued business expansion has pushed the core Consumer Price Index (core CPI excludes energy and food prices) past the Fed’s 2% inflation target (currently 2.2%), which will likely lead to another two rounds of Fed funds rate hikes in the second half of 2018. ONE OF THE BRIGHTEST SPOTS IN THE U.S. ECONOMY HAS BEEN THE LABOR MARKET. NO MATTER HOW YOU SLICE IT, THE ECONOMY LOOKS GOOD. PAYROLLS ARE RISING AND LAYOFFS ARE LOW. INITIAL JOBLESS CLAIMS AS A PERCENTAGE OF TOTAL EMPLOYMENT ARE AT THEIR LOWEST LEVEL EVER.

2018 MIDYEAR MARKET OUTLOOK

One of the brightest spots in the U.S. economy has been the labor market. No matter how you slice it, the economy looks good. Payrolls are rising and layoffs are low. Initial jobless claims as a percentage of total employment are at their lowest level ever. The growing number of job openings and the lower number of available workers per opening suggests wage gains may finally accelerate. On balance, the macroeconomic data continue to point

INFLATION – BENIGN BUT TURNING UP FROM BOTTOM INFLATION BENIGN BUT TURNING UP FROM THE BOTTOM

6%

CPI (YOY)

5%

Core CPI (YOY)

4%

3%

2%

1%

0%

1991-2018 Averages CPI (YOY): 2.3% Core CPI (YOY): 2.3%

-1%

-2%

-3%

1991

1994

1996

1999

2002

2004

2007

2010

2012

2015

2018

Source: Bloomberg

Source: Bloomberg

2

2018 MIDYEAR MARKET OUTLOOK

toward growth, suggesting there is no recession on the near- term horizon. The current condition of the U.S. Treasury yield curve appears to support this contention. Over the years, the yield curve has been a consistently reliable recession indicator. Looking back, the yield curve has inverted (e.g., 10-year yields below 2-year yields) ahead of every recession in the past 40 years. Currently, the 10-year is 2.92% while the 2-year is 2.55%, so there is still 37 basis points of positive slope. An inversion would not be expected until later this year, at the earliest. Once the yield curve has inverted, historically, the lag period before a recession starts has been as short as 10 months and as long as 2-3 years. With this in mind, the current economic expansion should last well into 2019 and beyond. However, global economies and markets are highly sensitive to any talk of tariffs or trade wars. Markets don’t like change or uncertainty. When the world’s largest economy (United States) talks about protectionism, the markets become anxious

2018 MIDYEAR MARKET OUTLOOK

and volatile. So far, the initial tariffs do not appear to be the beginning of a major trade war. However, if the United States moves toward an aggressive protectionist stance against China, that would significantly alter our outlook, and we would become much more defensive in our investment positioning. In summary, the underlying economic trends remain well supported. Employment growth, rising wages, solid

REAL GROSS DOMESTIC PRODUCT

0% 1% 2% 3% 4% 5% 6% 7% 8% 9%

"Sustainable" Trend Growth

(Estimate*)

-5% -4% -3% -2% -1%

1973

1978

1984

1989

1995

2000

2006

2011

2017

*Commerce Estimate: 3.0% for 2018

Y-O-Y 10-Year Average

Source: Bloomberg, Bureau of Economic Analysis

2018 MIDYEAR MARKET OUTLOOK

corporate and consumer balance sheets, strong corporate sales and earnings, and elevated levels of consumer and business confidence are positive factors. While an unexpected global financial shock is always a possibility, current conditions should otherwise provide a healthy backdrop for continued growth in an increasingly complex global environment. EQUIT Y OUTLOOK Stock prices surged in January with the S&P 500 Index gaining 7%, fueled by strong corporate earnings prospects and an additional kicker of a 6% to 8% earnings boost from the corporate tax cut. In February, however, the markets incurred a swift 10% correction over

GROWTH VS. VALUE

CONSUMER & BUSINESS CONFIDENCE

POSSIBLE 5% OR 10% DECLINE IN SECOND HALF

2018 MIDYEAR MARKET OUTLOOK

rising interest rates and concerns that the economy may be a little too good. As we approach summer, the S&P 500 has not been able to surpass the highs reached in January, but is still posting mid-single-digit returns. Why is the market struggling in the face of earnings that are projected to increase in the range of 21% to 25% this year? As we reached all-time highs in January, valuation measures for the market were also approaching historically lofty levels, but still below the all-time highs set in the late

YTD EQUITY RETURNS AS OF 6/15/18 Y TD EQUIT Y RETURNS (AS OF 6/15/18)

US SMALL CAP GROWTH

13.6%

US LARGE CAP GROWTH

10.3%

US MID CAP GROWTH

9.5%

US SMALL CAP VALUE

6.7%

S&P 500

4.9%

US MID CAP VALUE

0.8%

US LARGE CAP VALUE

-0.1%

MSCI EAFE

-0.8%

MSCI EMERGING MARKETS

-3.0%

-4.0% -2.0% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%

Source: Bloomberg

2018 MIDYEAR MARKET OUTLOOK

1990s. We use valuation measures to gauge the amount of negative news the market could absorb. When valuations are high, negative news events can send the market tumbling. We are concerned that the acceleration of rising interest rates, escalating trade war threats, political turmoil in several emerging markets and the poor action of European bank stocks could cause another 10% correction this year, but we are not expecting a bear market (20% decline) in 2018. The presidential cycle also leads us to conclude that the upside is limited over the summer and into the fall. In the WE ARE CONCERNED THAT THE ACCELERATION OF RISING INTEREST RATES, ESCALATING TRADE WAR THREATS, POLITICAL TURMOIL IN SEVERAL EMERGING MARKETS AND THE POOR ACTION OF EUROPEAN BANK STOCKS COULD CAUSE ANOTHER 10% CORRECTION THIS YEAR, BUT WE ARE NOT EXPECTING A BEAR MARKET (20% DECLINE) IN 2018.

2018 MIDYEAR MARKET OUTLOOK

average mid-term election year of the presidential cycle since 1900, the equity market peaks in the spring and heads lower into the November election as investors become concerned over the results. This year we could have another late election night before we can determine which party will control the House and Senate. The good news is the equity market usually rebounds in the final two months of the year, regardless of who wins. If you feel like your equity portfolio isn’t keeping up with the stock indexes lately, the reason probably is you haven’t owned enough technology stocks. Apple, Alphabet (Google), Microsoft, Netflix and Amazon have accounted for a majority of the market gains this year. Technology stocks make up 40% of the Russell 1000 Growth Index and only 9% of the Russell 1000 Value Index. Since the beginning of 2017 through mid-June 2018, growth stocks are up 37.5% versus the value stock gains of 15.2%.

2018 MIDYEAR MARKET OUTLOOK

International stocks started the year strong, but have faded more than domestic stocks. Fears of slowing European economic growth and instability in Brazil along with the strengthening of the U.S. dollar have caused international equity returns to lag for another year compared to domestic returns. We continue to believe that, based on valuations and yields, international equities look inexpensive relative to domestic investments.

ALTERNATIVE INVESTMENTS OUTLOOK

Alternative investments include strategies such as hedge funds, real estate, energy master limited partnerships (MLPs) and commodities. We include them in many client portfolios to either reduce volatility or provide diversification. These investments have expected returns and risks that may be higher or lower than those of stocks and bonds, and they

2018 MIDYEAR MARKET OUTLOOK

often do not move in sync with traditional markets. This means they may provide some protection from a sharp decline in stocks or a significant rise in interest rates. Hedge funds are an area where we emphasize strategies that may provide protection in a declining market or behave differently than those of stocks and bonds. We have already experienced greater market volatility in 2018, so these strategies, which have lagged stock and bond markets since the 2009 recovery, may have their day as investors seek preservation of the wealth they have built over that time. While the conditions that drive their prices may differ, real estate investments

COMMODITIES

RISING INTEREST RATES

COULD BE A HEADWIND

HEDGE FUNDS MAY PROVIDE PROTECTION IN A DECLINING MARKET 

2018 MIDYEAR MARKET OUTLOOK

trusts (REITs) and master limited partnerships (MLPs) are a subset of the stock market. MLPs, along with commodities, have been among the worst-performing sectors over the past five years. However, there has been an improvement in MLP investor sentiment and price action in recent months. MLPs have been reporting improved fundamentals and earnings as industry participants have strengthened their balance sheets and companies are focusing on growing distributions at a slower, but more sustainable rate. Energy exploration and production companies have been revising their production expectations higher. A higher volume of oil and gas through BALANCE SHEETS AND COMPANIES ARE FOCUSING ON GROWING DISTRIBUTIONS AT A SLOWER, BUT MORE SUSTAINABLE RATE. MLPS HAVE BEEN REPORTING IMPROVED FUNDAMENTALS AND EARNINGS AS INDUSTRY PARTICIPANTS HAVE STRENGTHENED THEIR

2018 MIDYEAR MARKET OUTLOOK

pipelines is positive for MLPs. REITs and MLPs are likely to lag in a rising interest rate environment. Commodities typically perform well during later stages of economic expansions and into early stages of recessions. FIXED INCOME OUTLOOK The last time the bond market was dealing with a significant rise in interest rates was in 2013. That year also happens to be the last year that the bond market (as measured by the Bloomberg Barclays Aggregate Bond Index) had a negative year. Rising interest rates along with spread-widening generally lead to negative returns. The U.S. bond market has faced both year-to-date. Spreads have been widening due to concern about possible accelerating trade conflicts and questions about sustainability of corporate earnings momentum. As we approach the midpoint of 2018, Treasury yields continue their upward move that began in the fall of 2017.

2018 MIDYEAR MARKET OUTLOOK

Well-telegraphed hikes of the Fed funds rate helped fuel some of the rise. The 10-year U.S. Treasury note yield began the year at 2.41% and has risen to 2.92% (as of 6/15/2018). Except for the 30- year Treasury yield’s 0.35% increase, yields are up over 0.50% across the yield curve. During the past five months, the yield curve has flattened as a result of the decreasing difference between yields of short-term bonds and long-term bonds. The last time the yield curve was this flat was in 2007. Historically, the curve’s flatness has been a sign of slowing economic growth. This time around it appears that factors related to geopolitical concerns and Eurozone rumblings are slowing the increase in

FED FUNDS RATE HIKES

10-YEAR U.S. TREASURY YIELD

RISING YIELDS LEAD TO LOWER BOND PRICES

2018 MIDYEAR MARKET OUTLOOK

long yields relative to the remaining (shorter) part of the yield curve. Despite the flattest yield curve in a decade, data seem to support the idea that the economic outlook remains healthy, as discussed above…rather than on the brink of a recession. Bond market returns year-to-date are negative for most fixed income sectors, with asset-backed securities and high yield nearly flat as of the end of May. Spread-widening triggered by Italy/Eurozone concerns and rising tariffs contributed to the fall in returns. With the need for companies to refinance an estimated $4 trillion in bonds over the next five years looming over the market, it is not surprising that the corporate bond sector has been the laggard year-to- IN ADDITION, TWO MORE RATE HIKES BY THE FED ARE ANTICIPATED BEFORE YEAR-END, TRIGGERING HIGHER TREASURY YIELDS IN THE SHORT TO INTERMEDIATE PORTION OF THE CURVE.

2018 MIDYEAR MARKET OUTLOOK

date. The Bloomberg Barclays Aggregate Bond Index has generated a -1.94% year-to-date return (as of 6/15/18). The Bloomberg Barclays Municipal Bond Index is down -0.49% year-to-date (as of 6/15/18), performing better than most of the taxable bond market. The municipal bond yield curve has not flattened to the same degree as the Treasury yield curve. Much of this can be attributed to a positive technical backdrop created by U.S. tax reform. One TREASURY YIELD CURVE CHANGES - LAST FED TIGHTENING CYCLE VS. TODAY’S CYCLE TREASURY YIELD CURVE CHANGES FURTHER FLATTENING OF THE YIELD CURVE

4%

06/15/2018

3%

3%

12/31/2017

2%

2%

1%

1%

0%

3M 1Y 2Y 3Y

5Y

7Y

10Y

30Y

MATURITY/TERM

Source: Bloomberg

Source: Bloomberg

4

2018 MIDYEAR MARKET OUTLOOK

key provision essentially eliminated municipal issuers from advance refunding of existing, higher-cost debt. This has reduced new issue supply by over 20% year-to-date. While the U.S. corporate tax rate was reduced from 35% to 21%, individual tax rates were only slightly altered, particularly for those in the highest marginal brackets. This has kept individual investor demand for tax-exempt munis strong.

ED INCOME – RETURNS

YTD Returns (As of 06/15/2018) FIXED INCOME SECTOR RETURNS (AS OF 6/15/18)

Municipal High Yield Corporate High Yield Mortgages Intermed TIPS Municipal Index Intermed Cred Intermed Tsy Intermed Gov/Cred Aggregate

-1.94%

-1.26%

-1.05%

-1.63%

-0.49%

-0.35%

-1.39%

0.73%

3.01%

Emerging Market Preferred

0.89%

-5.36%

-8.0%

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

Source: Bloomberg

erg

2018 MIDYEAR MARKET OUTLOOK

Despite the negative returns, municipal bond funds have experienced over $6 billion in positive inflows so far this year. In the coming quarters, the bond market faces several challenges. The end of the bond-buying program by the European Central Bank is targeted to begin in the second half of this year. Such a move is expected to lead to higher interest rates abroad. This would likely result in lessening the attractiveness of U.S. bonds to foreign investors. Higher bond yields (lower prices) in the United States could be the negative outcome. In addition, two more rate hikes by the Fed are anticipated before year’s end, triggering higher Treasury yields in the short to intermediate portion of the curve. The benefits of the tax reform bill passed at the end of 2017 are expected to help spur additional economic growth and provide cover for the Fed to raise rates. Eurozone issues related to government changes in Italy and an escalation in trade wars could be

2018 MIDYEAR MARKET OUTLOOK

a headwind to the Fed’s expected move of two more rate hikes by the end of the year. Risk premiums, as reflected in spreads, appear to be on the rise due to uncertainty related to new tariffs and political developments related to the European Union. Also, the rewards of improving corporate cash flows are increasingly going to shareholders rather than bondholders via share buybacks and mergers and acquisitions activity. We plan to reduce allocations for some of the more risk-sensitive corporate bond holdings in our clients’ portfolios, while gradually improving quality by adding more mortgage- backed securities. The strong technical backdrop in the municipal bond sector should continue through the balance of the year and provide opportunities in tax-exempt bonds. Portfolio durations should be maintained slightly short to neutral relative to their corresponding benchmarks.

2018 MIDYEAR MARKET OUTLOOK

CONCLUSION Is there an expiration date on the current economic recovery? Many will try to handicap the timing of the next recession, but we believe its demise is not on the immediate horizon. Economic expansions don’t really die of old age, but economic stresses tend to grow over time as a recovery unfolds. The current economic expansion is now the second-longest U.S. economic expansion ever, surpassing the period of growth that occurred from 1961 through 1969. If the current expansion holds through the summer of 2019, it will earn the top spot in the history books, exceeding the 10-year span between 1991 and 2001, which currently holds the No. 1 position. What will happen as this recovery continues to progress? The stock market volatility in the first half of the year will likely continue to be part of the mix in the remainder of 2018. What may be important now for portfolios is disciplined re-balancing and continued diversification in the

2018 MIDYEAR MARKET OUTLOOK

later stages of this expansion. As a result of the long market run, it is possible that some investors may now have highly appreciated equity values disproportionate to their asset allocation targets. Consulting with your investment advisor is generally a good practice to keep portfolios matched up with your personal investment strategy.

INVESTMENT POLICY COMMITTEE - June 22, 2018

Disclosures: Past performance is no guarantee of future results, and the opinions and other information in the Market Outlook are as of June 22, 2018. The Midyear Update is a special report designed to provide investment information on economic markets for Commerce Trust Company’s clients. It is intended to provide general information only and reflects the opinions of the Commerce Trust Company Investment Policy Committee. This material is not a recommendation of any particular security, is not based on any particular financial situation or need, and is not intended to replace the advice of a qualified attorney, tax advisor, or investment professional. Diversification does not guarantee a profit or protect against all risk. Commerce Trust does not provide tax advice or legal advice to clients. Consult a tax specialist regarding tax implications related to any product and specific financial situations.

2018 MIDYEAR OUTLOOK COMMERCE TRUST COMPANY AUTHORS

SCOTT M. COLBERT, CFA ® EXECUTIVE VICE PRESIDENT, CHIEF ECONOMIST AND DIRECTOR OF FIXED INCOME MANAGEMENT

JOSEPH C. WILLIAMS III, CFA ® EXECUTIVE VICE PRESIDENT, DIRECTOR OF INVESTMENT STRATEGY

BARBARA TURLEY, CFA ® SENIOR VICE PRESIDENT, DIRECTOR OF INVESTMENT RESEARCH

WM. MICHAEL CODY, CFA ® SENIOR VICE PRESIDENT, DIRECTOR OF FIXED INCOME TRADING

CYNTHIA RAPPONOTTI, CFA ® , CAIA ® SENIOR VICE PRESIDENT, SENIOR PORTFOLIO MANAGER

DOUGLAS R. KOESTER, CFA ® SENIOR VICE PRESIDENT, SENIOR PORTFOLIO MANAGER

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