1st INVESTMENT MANAGEMENT UPDATE. Investment Outlook Cautious optimism follows extraordinary year
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1 INVESTMENT MANAGEMENT UPDATE A QUARTERLY NEWSLETTER FROM BREMER ASSET MANAGEMENT 1st 2018 Investment Outlook Cautious optimism follows extraordinary year Beyond Stocks and Bonds How alternative assets can enhance your portfolio
2 JOEL REIMERS, CFA CHIEF INVESTMENT OFFICER MICHAEL ADKINS SENIOR PORTFOLIO MANAGER MARK GIERACH SENIOR PORTFOLIO MANAGER If you or someone you know could benefit from our services, please contact a Wealth Management Advisor at BANK (2265). Ask about Wealth Management, or visit the Wealth Management tab on Bremer.com.
3 MARKETS REWARD INVESTORS IN 2017 Over the last 12 months we have seen the best period of coordinated, above-trend global growth in almost a decade. Investors around the world were rewarded in 2017 with sizable gains on equities and smaller but still positive returns on real estate and fixed income. U.S. data on jobs, housing, consumer confidence, and business activity remain strong as we move into The synchronized global economic expansion should continue to support equity markets. However, the Federal Reserve is on a path toward higher interest rates and stock valuations are above long-term averages. We are cautiously optimistic that global economic gains will drive markets higher in Winning Streak It was a remarkable year for global markets, with regional economies accelerating in unison and most asset prices continuing to rise. What s next? On page 2, Joel Reimers looks ahead and ponders the question on everyone s mind: Is it too good to last? Evaluating Alternatives The beauty of a diversified portfolio is that when one area fails, another has your back. Mark Gierach looks at the benefits and risks of alternative investments and their ability to hedge against market volatility, page 8. 1
4 INVESTMENT OUTLOOK Cautious optimism follows extraordinary year By Joel Reimers 2 The year in review It was a remarkable year for global markets, with most asset prices including equities, fixed income and real estate all moving higher in Although geo-politics dominated the headlines, improving global growth and an environment of relatively accommodative monetary policy provided the primary support for the continual rise in asset prices. Global growth solidified in 2017, with all major regional economies accelerating in unison for the first time in almost a decade. International investments did particularly well with both developed market equities and emerging markets outperforming the U.S. Global growth solidified in 2017, with all major regional economies accelerating in unison for the first time in almost a decade. In the U.S., the S&P 500 rose 21.83%, building on the double-digit gains from the previous year. Large company stocks did better than small company stocks, primarily due to stronger global growth and a weaker dollar. Perhaps two of the more remarkable things about the markets in 2017 were the absence of normal market volatility and the consistent monthly rise in equity prices. The largest intra-year decline during the course of 2017 was only 3%, which is extraordinary when considering the average declines over the past 37 years have been 14%. International stocks outperformed the U.S. for the first time since Developed market equities, as measured by the Morgan Stanley Capital International Europe, Australasia Far East index (EAFE), rose 25.62%, largely due to improving economic and earnings growth in Europe and Japan. Emerging market equities did even better, rising 37.75% for the year as measured by the MSCI Emerging Market Index. We saw the most impressive pick-up in growth coming from commodity-exporting countries such as Brazil, Russia and Mexico as global trade accelerated during the year.
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6 Cautious optimism follows extraordinary year 4 Our outlook The global economy has entered a phase of synchronized expansion, which should continue to provide support for the equity markets. Accelerating growth, ample liquidity and low inflation have all combined to create a period of exceptionally low market volatility. It remains to be seen whether this calm will persist in 2018, and it doesn t necessarily mean a correction is to come. But with markets reaching all-time highs, and valuations elevated, risks of a disappointment are higher. The current low interest rates should also provide support for the markets. However, the Federal Reserve is now on a path to normalize rates and is preparing to raise rates at least three more times in Rising rates aren t necessarily a negative for the markets as long as the path is not abrupt and corporate earnings are growing. However, just as low rates have supported market multiples in recent years, the shift toward global monetary policy normalization will likely reduce support for global asset prices over time. But that will likely play out in the next few years. For now, stocks gains will likely come more from earnings growth and less from price-to-earnings multiple expansion.
7 Expectations for a reduction in the corporate tax rates helped drive U.S. markets higher in 2017 and should be a positive for equity markets this year with the cuts now in place. However, the longer-term impact from tax cuts on the U.S. economy will likely be modest given that the jobs market is already tight and capital expenditures have recovered from the 2016 downturn. Ironically, if tax cuts do the trick and drive growth and inflation higher, we could see the Fed take steps to curtail the cycle. In the U.S., equity valuations are at the high end of the historical ranges. However, this doesn t necessarily mean equities are overvalued when we consider the current low inflation and interest rate environment. Yet while market valuations are not a good predictor of short-term returns, when viewed from a longer-term perspective, history shows that elevated valuations are typically followed by muted returns in subsequent years. Vanguard points out the high valuations near the peak of the tech bubble in the year 2000 were subsequently followed by depressed returns over the following lost decade. This is not to say that a dramatic correction is imminent, only that it is reasonable to expect more muted equity returns on average in the coming years. Expectations for a reduction in the corporate tax rates helped drive U.S. markets higher in 2017 and should be a positive for equity markets this year with the cuts now in place. We believe international equities currently offer slightly better opportunities than what can be found in the U.S. markets. Although not necessarily cheap from an absolute basis, developed and emerging market equities are more attractive from a relative standpoint. For example, economic and earnings growth have been improving in Europe, but that is yet to be reflected in increased price-to-earnings multiples. The emerging markets are also attractive, but they come with more risks than stocks of the developed markets, so some caution is in order.
8 Cautious optimism follows extraordinary year Although U.S. equity valuations are high from a historical perspective, stocks are still cheaper when compared to bonds. Putting it all together 6 As we examine the current opportunities and risks, we remain cautiously optimistic on the markets. Although U.S. equity valuations are high from a historical perspective, stocks are still cheaper when compared to bonds. Although our expectations for bonds are modest, we still believe that bonds play an important role as a risk diversifier in portfolios. We are aware of the possibility of rising interest rates, and are managing accordingly. For growth, we are looking to the international markets to provide added return and diversification opportunities.
9 MSCI All Country World ex-u.s. and S&P 500 Index Dec = 100, U.S. dollar, price return P/E 20 yr. avg. Div. Yield 20 yr. avg. S&P x 16.0x 2.0% 2.0% ACWI ex-u.s. 14.3x 14.5x 3.1% 3.0% Dec. 31, 2017 P/E (fwd. ) = 18.2x % -49% +101% -57% +295% Dec. 31, 2017 P/E (fwd. ) = 14.3x % +127% % -52% +216% Sources: MSCI, Standard & Poor's, FactSet, J.P. Morgan Asset Management.
10 BEYOND STOCKS AND BONDS How alternative assets can enhance your portfolio By Mark Gierach 8 One question that frequently comes up in meetings with clients is, What do you consider an alternative investment and how does it fit into my portfolio? This is a great question because there are many investments that fall under the alternative category. Some are more straightforward than others, but understanding why certain funds are included in a portfolio is every client s right. This article should shed some light on the benefits that alternatives can provide to an investment portfolio. While we do not believe alternatives should be an overwhelming part of your investment portfolio, ignoring the category altogether would be a mistake. The main goal of including alternatives is to reduce overall volatility while still providing a reasonable return. To achieve this goal, the Bremer investment committee chooses alternative investments that have a low correlation to the equity and bond markets. Currently, these categories include real estate, global infrastructure, and a multi-strategy hedge fund. All of the current investment vehicles that Bremer uses are operated under a standard mutual fund structure. This is important because some alternative investments can be very illiquid. The funds in the Bremer strategic portfolios are all bought and sold in the same manner as an S&P 500 Index fund, at daily closing prices. All of the current investment vehicles that Bremer uses are operated under a standard mutual fund structure. This is important because some alternative investments can be very illiquid. The chart on the next page provides index performance information for the three alternative categories where Bremer currently allocates client money, along with the S&P 500 Index and the Bloomberg Barclays US Aggregate Bond Index. The return information looks at three periods of extreme market moves and then at the last 17 years, which includes most of all three of the extreme periods.
11 Category Performance for Selected Time Periods (Average Annual Returns) 25% 20% 15% 10% 5% 9 0% -5% -10% Tech Bubble (6/30/ /31/2003) Financial Crisis (6/30/ /31/2010) Current Bull Market (3/31/2009-3/31/2017) Last 17 Years (12/29/ /29/2017) n Bloomberg Barclays US Aggregate Bond Index n S&P 500 Index n Macquarie Global Infrastructure Index 100 USD n Credit Suisse Multi-Strategy Index n FTSE EPRA/NAREIT United States Index
12 How alternative assets can enhance your portfolio 10 The first period to consider is the technology bubble of the early 2000s. Over the three-and-a-half-year period indicated on the graph, bonds and U.S. real estate performed the best. This is easily explained by the Federal Reserve s move to reduce interest rates from 6.5% down to 1%. An interest rate reduction of that magnitude will always help the general bond market and in most cases cause real estate prices to increase due to the availability of cheap financing. Stocks were led downward by investor overexuberance for technology companies. Global infrastructure and multi-strategy hedge funds ended in the middle of the group. The second period to examine is the most recent financial crisis. The category performance during this period has a similar tone to the tech bubble period, with a twist. Once again, the Federal The first period to consider is the technology bubble of the early 2000s. Over the three-and-a-half-year period indicated on the graph, bonds and U.S. real estate performed the best. Reserve drastically reduced interest rates from 5.25% to 0% and implemented quantitative easing to soak up the excess assets in the financial system. Bonds did well again, but real estate did not. The explanation is that this time, real estate replaced technology stocks as the asset subject to investor exuberance. Global infrastructure was hurt in a similar manner due to government money being used to bail out banks and keep the financial system afloat. On a global basis, investments in bridges, roads and airports declined dramatically during this time. Stocks ended up negative during the period, with multi-strategy hedge managing to create a small gain. The third period is the current bull market. One thing to point out is that the time period analyzed only runs through March This is due to limited data for the global infrastructure index. Most of the time period is captured and provides a reasonable comparison. Stocks and real estate have performed the best by a wide margin due to the Federal Reserve s cautiousness in raising interest rates. The Fed has had a dovish stance since the financial crisis with the intent of averting another recession. Multi-strategy hedge comes
13 Global infrastructure was hurt in a similar manner due to government money being used to bail out banks and keep the financial system afloat. in a respectable third, with bonds and global infrastructure plodding along. Looking at the final period from 2001 through 2017, you will see that real estate and multi-strategy hedge funds performed the best, followed by stocks, bonds and global infrastructure. Now that the history lesson is done, the question remains: Why would someone want to invest in alternative asset classes? As we walked through the different time periods, one thing to notice is only two categories were positive in every time frame bonds and multi-strategy hedge funds. Neither category obtained returns above 10% on an annual basis, but neither category went below about 1.5% annually. Real estate and stocks were rather volatile, with global infrastructure a little less so. 11
14 How alternative assets can enhance your portfolio 12 Currently, the unemployment rate is 4.1%. It has taken a long time to get to this point, but now millennials who have been graduating from college are finding employment, building wealth, buying homes and starting families. To completely answer the why question, consider the viewpoints of the Bremer investment committee. We include multi-strategy hedge in our strategic portfolios to provide a less volatile return over the long term. (One thing to note is that you cannot directly invest in the index used in the graph, so the fund that we have chosen will not behave exactly like Credit Suisse Index, but we believe it is a reasonable approximation.) Real estate is considered to be a better opportunity because of pent-up demand due to the lack of new housing coming out of the financial crisis. The unemployment rate was near 10% entering Currently, the unemployment rate is 4.1%. It has taken a long time to get to this point, but now millennials who have been graduating from college are finding employment, building wealth, buying homes and starting families. This dynamic can be a solid driver for real estate in the U.S. going forward. Global dynamics will eventually lead to huge infrastructure projects. For example, there are countries in the Middle East with the goal of moving their economies from being oil dependent to being driven by tourism. Traffic in India, a country of more than one billion people, is horrendous. Electric vehicles are replacing those that run on internal combustion engines, and they need a place to recharge. These are just a few of the global dynamics that will lead to huge infrastructure projects.
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16 PRESORTED STANDARD U.S. POSTAGE PAID PERMIT NO TWIN CITIES, MN Products offered through Bremer Trust, National Association are not FDIC insured, are not a deposit or other obligation of, or guaranteed by, the depositing institution, and are subject to investment risk including possible loss of principal amount invested. This report has been compiled using data and other statements of fact derived from sources which we believe to be accurate and reliable. However, such data and other statements of fact have not been verified by us, and we do not make any representations as to their accuracy or completeness. Any opinion expressed herein reflects our judgment at this date and is subject to change Bremer Financial Corporation. All rights reserved. Bremer is a registered service mark of Bremer Financial Corporation. 18DMWM101102
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