Stocks Fall on Worries about Global Slowdown, Fed Uncertainty. Could this be the end of the bull market? September Fed Decision Dominates the Quarter

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1 INVESTMENT MANAGEMENT UPDATE A QUARTERLY NEWSLETTER FROM BREMER ASSET MANAGEMENT 4th 2015 Stocks Fall on Worries about Global Slowdown, Fed Uncertainty Could this be the end of the bull market? September Fed Decision Dominates the Quarter The timing of a rate hike remains unclear.

2 JOEL REIMERS, CFA CHIEF INVESTMENT OFFICER MIKE ADKINS SENIOR PORTFOLIO MANAGER ANNE SORENSEN 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 VOLATILITY RETURNS IN Q It was a painful third quarter for global equity markets, primarily due to concerns about a global economic slowdown and uncertainty about the Fed s policy path for potential rate hikes. The third quarter marked a tumultuous period, with markets ending in negative territory. U.S. markets as measured by the S&P 500 declined 6.4% for the quarter. International stocks also were hit hard, with the MSCI All Cap World Index down 12.7% during the period. U.S. Treasuries were not immune from the volatility, with the yield on the 10 - year also declining, ending the quarter at 2.04%. What s Next? Does the worst quarterly decline in four years mean the equity bull market is over? Not necessarily, says Mike Adkins, Page 2. Why ignoring short-term noise is still your best investment strategy. No Hurry Rates will rise, the question is when? With ongoing market volatility and slow growth overseas, the Fed remains patient. On Page 8, Anne Sorensen recaps the bond market in Q3 and explores strategies to buffer against pending increases. 1

4 STOCKS FALL ON WORRIES ABOUT GLOBAL SLOWDOWN, FED UNCERTAINTY Could this be the end of the bull market? By Michael H. Adkins 2 Stocks fell in the third quarter on worries that a slowing global economy will hurt profits for U.S. companies, especially those companies with a lot of customers abroad. The Federal Reserve s decision to hold off on raising interest rates at its September meeting also shook markets. Third quarter losses on U.S. stocks were the largest in four years, with the S&P 500 Index down 6.4%. Foreign stocks also were down, especially in emerging markets. Foreign stocks in developed markets declined 10.2%, while emerging market stocks plunged 17.8%. A sharp slowdown in China s economy resulted in a 20% drop in Chinese stocks during the quarter. The government s attempts to prop up stock prices and its unexpected decision to devalue its currency led to a further loss of confidence in Chinese markets. While the Chinese government reports economic growth of approximately 7% in 2015, there is much doubt about the reliability of its numbers. It is quite likely that the Chinese economy is growing more slowly than 7%, with recent monthly reports showing big declines in Chinese imports and exports. Investors are rightly worried about the ripple effects of a slowdown in the world s second largest economy. A sharp slowdown in China s economy resulted in a 20% drop in Chinese stocks during the quarter. Federal Reserve punts on interest rates The Federal Reserve surprised investors by keeping interest rates unchanged at its September meeting. Fed policymakers decided that it was prudent to wait for evidence that a global economic slowdown was not knocking the American economy off course. Although it didn t think it had materially altered the economic outlook, the committee decided to wait for additional information due to risks to the outlook for economic activity and inflation.

5 The economy is close to reaching the Fed s goals of maximum employment and 2% inflation, but recent global developments have increased the downside risks to U.S. economic activity. The unemployment rate is down to 5.1%, but recent inflation measures have been well below 2%, triggering Fed worries about a stalling economy. The decision not to raise rates was a close call, with most Fed members still thinking it would be appropriate to raise rates by the end of the year according to minutes of the September meeting. Constant media speculation about what the Fed would do and how it would affect stock prices added volatility to the equity markets. There is growing speculation that the Fed s zero interest rate policy (ZIRP) may actually be hindering economic growth rather than stimulating it. 3

6 Stocks fall on worries Cont. 4 U.S. vs. foreign, growth vs. value Large-cap U.S. growth stocks continued to outperform value stocks due to weak earnings in the financial and energy sectors. Large-cap growth stocks fell the least in the 3rd quarter, down 5.3% versus a drop of 8.4% in large-cap value stocks. In the small-cap sector the trend was reversed, with growth stocks falling a whopping 13.1% compared with a drop of 10.7% in small-cap value. This was mainly due to a plunge in biotech stocks, which have had huge gains in recent years. For years, stocks in the health care sector have been the best performers. These gains were due to the strong growth prospects of biotech and other health care companies in a global economy Much attention has been given to above-average stock valuations in recent quarters. With the drop in the 3rd quarter, price-to-earnings (P/E) valuations have declined and are now more attractive, especially when compared to current bond yields. with few other areas of growth. That run ended last quarter, starting with a single tweet by Hillary Clinton. Clinton criticized price gouging by drug makers, which raised worries that increased regulation could lower profits for the industry. Health care stocks lost almost 11% in the third quarter after annualized gains of more than 20% over the past five years. Much attention has been given to above-average stock valuations in recent quarters. With the drop in the 3rd quarter, price-to-earnings (P/E) valuations have declined and are now more attractive, especially when compared to current bond yields. The dividend yield of 2% on the S&P 500 index is now virtually the same as the yield on the 10-year U.S. Treasury note. Despite the pullback in the 3rd quarter, stock returns have been very strong since the global financial crisis of Returns in the U.S. have far exceeded returns on foreign stocks, with the S&P 500 Index up 226% from the low reached on March 9, Over the same time period, European stocks are up 139% and emerging market stocks are up just 96%.

7 U.S. maintains a wide performance advantage since global financial crisis REGIONAL RETURNS March 2009* September 2015 *Begins on March 9, 2009 which was the low point for the S&P 500 during the financial crisis. Past performance cannot guarantee future results. Chart is shown for illustrative purposes only and does not represent the performance of any specific security. Source: Factset, Standard & Poor's, MSCI. Returns in USD. Looking at these figures, it may appear tempting to want to avoid foreign stocks altogether. However, when measured over long periods of time, emerging markets have provided the best stock returns. Valuations on emerging markets have dropped sharply in recent years, providing the potential for strong future returns. If you have been invested in emerging markets, we believe it is a good time to harvest tax losses while maintaining your exposure to this depressed sector. If you have been fortunate enough to avoid recent losses, this is a good time for long-term investors to consider adding some exposure to this volatile sector. Is this the end of the bull market? The 3rd quarter drop in the stock market leads one to wonder if the bull market may be over. After all, this bull market is into its seventh year since stocks bottomed in March of However, the simple passage of time doesn t usually bring bull markets to an end, nor do lofty valuations. The end typically comes when a recession sets in, often coinciding with geopolitical conflicts, rising interest rates, or a spike in oil prices. The only exception in eight bull markets in the last 50 years was the bull market of , which was followed by a bear market that lasted just three months. 5

8 Stocks fall on worries Cont. How long can the U.S. equity bull market last? the past four quarters, and there have only been two negative quarters since March While a recession does not appear imminent, we do seem to be in the mid-to-late stages of the current economic expansion. Corporate balance sheets remain strong with high cash levels, but debt loads have started to rise as companies take advantage of low financing costs. Corporate profits have declined in 2015 due in large part to the strengthening dollar and low oil prices. We could see an earnings rebound in the near future if either or both of these trends reverse course. Past performance cannot guarantee future results. Chart is shown for illustrative purposes only and does not represent the performance of any specific security. Source: RBC Capital Markets, Standard & Poor's, Haver Analytics A recession is generally identified by an economic decline in two successive quarters, as measured by the gross domestic product (GDP). The average growth rate for U.S. GDP has been 2.7% for Bear markets typically begin before a recession occurs, but stock performance often remains strong even in the latter stages of a bull market, making it very difficult to time the market. The thought of getting out of stocks when the market is dropping is very tempting. We tend to think the market will continue to go in whatever direction it is currently going, when in fact reversals occur regularly with no advance warning. Ignoring the short-term noise and staying focused on long-term investment goals and asset allocation targets will usually produce the best results.

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10 SEPTEMBER FED DECISION DOMINATES THE QUARTER The timing of a rate hike remains unclear. By Anne Sorensen 8 The yield curve flattened during the quarter with short-term yields virtually unchanged and longer-term yields falling. The 2-year Treasury yield dropped only.01%, ending the quarter at.63%, while the 10-year Treasury yield fell to 2.04% from 2.35% at the quarter s onset. The Outlook for Fed Rate Increases Differences in yield of U.S. 10- and 2-year Treasurys (percentage point) Sources: FactSet, WSJ.com Speculation about the timing of the Federal Open Market Committee s rate hike continued to dominate the bond markets, as it has all year. The Federal Reserve s zero interest rate policy has been in place for seven years, providing plenty of liquidity for the markets. Just before the recent September meeting, many market participants expected the Fed to raise rates by 25 basis points based on the improving U.S. economy. Instead, the Fed stood pat, acknowledging that a troubled global economy and market turmoil could potentially crimp U.S. economic growth. In addition, inflation continues to be well below the Fed s 2% target. Many market strategists expect the Fed to raise short-term rates before year-end based on continued slow improvements in the U.S. economy, especially the labor market. However, some economists are concerned the Fed may wait too long, and then will have to raise rates aggressively in the near future. These economists note that at 5.1%, the jobless rate is near levels where pressures could start to build that cause inflation or asset-price bubbles.

11 Bond yields most likely will remain in a trading range until the timing of the first interest rate increase becomes apparent. The Fed has indicated it may increase rates in late 2015, or in 2016, because of the U.S. economy s continued growth trajectory. While the rate hike has been delayed in the short term, the longer term direction of rates is up. The yield on high-yield bonds increased one third since June Currently, the index has an average yield of slightly more than 7%, up sharply from 6% in early June. During that same period, Treasury yields remained steady. High-yield bonds experiencing headwinds High-yield bonds have been under pressure since last year when commodity prices plunged, causing bonds from energy companies, a big chunk of the high-yield market, to sell off. Today energy companies make up approximately 14% of the high-yield bond market, up from less than 5% a decade ago. Energy company bonds represent an even greater share of the low quality distressed market, accounting for 36% of the BofA Merrill Lynch U.S. Distressed High Yield Index in The yield on high-yield bonds increased one third since June Currently, the index has an average yield of slightly more than 7%, up sharply from 6% in early June. During that same period, Treasury yields remained steady. In other words, at the start of the summer, U.S. investors demanded inflation plus 4% to lend money to riskier companies. Now they demand inflation plus 6%. To put this in perspective, research shows that since the late 1960s, high-yield bonds have tended to produce annualized returns of about 4% a year over inflation. Investors now apparently are so nervous they are requiring a real interest rate that is about 50% greater than average. 2 9

12 September Fed decision Cont. 10 High-yield bond spreads relative to treasuries are close to While we made a minor trim to our clients high-yield holdings, we 2001 recession levels believe that high-yield bond funds have a place in many portfolios. Investors are concerned about the credit quality of high-yield bonds High-yield bonds provide diversification because their price movements are not correlated with those of other fixed income asset classes. Additionally, they provide a stream of income unmatched by most other asset classes. Yield (bp) over Treasuries Source: Morgan Stanley Research, the Yield Book Current conditions can be considered an economic warning by an efficient market or a buying opportunity in an inefficient one. Thomson Reuters data shows that U.S. investors have been withdrawing about half a billion dollars per week from high-yield bond mutual funds recently. 2 Emerging economy debt in the spotlight Borrowing costs in emerging markets are ticking up, a further blow to developing economies already hit by slowing growth, weak exports and high debt. Emerging market currencies also are tumbling, with the MSCI Emerging Market Currency Index, a broad gauge of emerging-market currencies, falling to its lowest level in six years. 3 According to BofA Merrill Lynch, investors pulled money out of emerging market debt funds for 11 straight weeks through early October, taking net outflows to $16 billion, almost 6% of total assets this year. 4 Weak growth in China has stemmed fears that emerging market economies will suffer because of reduced demand for their goods.

13 China s growth pace has slowed substantially from the double-digit rates of only a few years ago and its consumption of materials has accordingly declined. This lower demand for commodities has severely crimped emerging markets, which were exporting goods to China. We believe that emerging market debt continues to hold a place in investor portfolios. Many analysts are becoming more positive on emerging market debt as the downdraft makes valuations attractive. 11 Fiscal deficits, (when government spending exceeds revenues), as a percentage of gross domestic product, are becoming larger and are forecast to be at their widest since Weakening government finances have led to more debt, producing an overall increase in the supply of emerging markets debt worldwide. Emerging markets also have been harmed by continued expectations that the Fed will raise interest rates. Higher interest rates will make safer U.S. debt relatively more attractive, causing capital to move back to less riskier assets in the U.S.

14 September Fed decision Cont. We believe that emerging market debt continues to hold a place in investor portfolios. Many analysts are becoming more positive on emerging market debt as the downdraft makes valuations attractive. Emerging market debt also provides good diversification. According to JP Morgan it has a low correlation with U.S. bonds Tax exempt bonds continue to be a safe haven Historically, tax exempt bonds perform well when the Fed normalizes rates. As the central bank tightened monetary policy in 2004, the $3.6 trillion market returned 5.5%, about two percentage points more than Treasuries. Municipal bonds continued to outperform other bond classes over the next two years. 6 The main reason municipal bonds perform well in a challenging interest rate environment is that they are largely owned by buy-and-hold investors looking for steady tax-exempt income. Their buy-and-hold ownership buffers the bonds from volatility in other areas of the markets. When rates rise, higher yields make municipal bonds even more attractive by providing a higher stream of income.

15 Municipal bond debt also is attractive on a valuation basis with the average 10-year municipal bond yielding slightly more than 10-year Treasury bonds at the end of the quarter. Typically municipal bonds yield less than Treasuries because the income they generate is exempt from federal, and often state, income tax. As the central bank tightened monetary policy in 2004, the $3.6 trillion market returned 5.5%, about two percentage points more than Treasuries. Municipal bonds continued to outperform other bond classes over the next two years. The quarter ahead Ongoing market volatility and continued slow growth overseas are adding uncertainty to the timing of the Fed s first interest rate hike. To buffer against rising rates, we recommend that clients hold laddered bond portfolios with bonds maturing at regular intervals. Some sectors of the market, such as high-yield, tax-exempt bonds and emerging markets, are trading at attractive values right now. High-yield and emerging markets bonds provide good diversification, and high-yield bonds in particular provide a significant stream of income. These two bond categories also are volatile and higher risk than other bond classes, so they should be held in more moderate position sizes. Sources: 1. How Has the Rise in Distressed Debt Affected the High-Yield Bond Market? Charles Schwab Client Center, August 11, The Wall Street Journal, Marketwatch, September 8, Emerging Markets go From Bad to Worse, The Wall Street Journal, September 25, Commodities Rebound but Investors Remain Wary, The Wall Street Journal, October 9, J.P. Morgan Guide to the Markets, June 30, Muni Debt Seen Offering a Bond Market Haven as Fed Normalizes, Bloomberg News, September 16,

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