2018 outlook illustrated, u.s. and international stocks have the highest expected return and risk,...

2 0 1 8 O U T L O O K

F I R S T N A T I O N A L B A N K W E A L T H M A N A G E M E N T 2 0 1 8 O u t l O O k | C r e a t i n g O p t i m a l p O r t f O l i O s

i t ’ s i r O n i C t H a t t i m e , i n a l l i t s C O n s i s t e n C Y , i s k e p t B Y a p e n D u l u m t H a t p e r p e t u a l l Y s W i n g s B a C k a n D f O r t H .

The global economy is a combination of countless intertwined

and continuously-shifting factors. These factors tend to swing (like a pendulum)

in patterns that coincide with economic cycles.

The 2018 edition of the First National Bank Outlook is intended to help explain our views

of the global economy and how we use those views to create better investment portfolios.

This year we chose to open with a discussion of our long-term expected return and risk

assumptions. As illustrated, U.S. and international stocks have the highest expected return

and risk, whereas cash, bonds and alternatives have the lowest.

Relative to historical returns, we have tempered our expectations for most asset classes,

as seen in the table. This is due to the expensive valuations currently seen in the stock and

bond market.

Asset Class Returns

INVESTMENT HISTORICAL EXPECTED

U.S. Stock 9.7% 7.3%

International Stock 7.8% 7.3%

Global Real Estate 10.1% 6.0%

Alternatives 3.7% 4.3%

Bonds 4.1% 3.0%

Cash 1.2% 2.3%

4

Historical: Last 15-year annualized return Expected: Next 10-year annualized return U.S. Stock: S&P 1500; International Stock: MSCI EAFE Global Real Estate: S&P Global REIT; Alternatives: HFRI Comp. Bonds: Barclays U.S. Aggregate; Cash: Citi 3 month T-Bill

Long-Term Expected Return/Risk

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

0% 10% 20% 30%

Retu

rn

U.S. Large-Cap Equity

U.S. Small/Mid-Cap Equity

International DevelopedEquityEmerging Markets Equity

Global Real Estate

Core Fixed Income

Bank Loans

Alternatives

RiskReturn: FNB capital market assumptions Risk: 10 year standard deviation

I N T R O D U C T I O NLong-term Return Expectations

The single most important factor driving long-term returns is the strategic, long-term asset allocation. Staying disciplined with your investment strategy is crucial to meeting return goals.

We have a spectrum of options available to accommodate a client’s risk tolerance and investment objective. As shown, they range from conservative to aggressive.

In an effort to optimize performance, we make tactical decisions to take advantage of opportunities created by market swings. Our experienced investment professionals are continuously monitoring and researching these movements and their implications. At this point in time, we have identified five major themes and have characterized them as pendulums.

The theme with the most impact to portfolios is PENDULUM ONE where we describe why we favor stocks over bonds.

The rest of the pendulums listed explain our best ideas for investing in each asset class and how we manage portfolios.

PENDULUM ONE: Global Economic Backdrop and Earnings Growth Favor Stocks Over Bonds Pages 6–9

PENDULUM TWO: Leverage to Global Growth Favors International Stocks Over Global Real Estate Page 10

PENDULUM THREE: Better U.S. Growth Favors Small & Mid-Cap Stocks Over Global Real Estate Page 11

PENDULUM FOUR: Low Defaults and Rising Interest Rates Favor Credit and Floating Rate Over Government Bonds Page 12

PENDULUM FIVE: Risks Require Disciplined Portfolio Management Page 13

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I N C O M E O R I E N T E DL O W R I S K

G R O W T H O R I E N T E DH I G H R I S K

CONSERVATIVE BALANCED MODERATE AGGRESSIVEMODERATECONSERVATIVE

MODERATEAGGRESSIVE

I N T R O D U C T I O NInvestment Objectives & Opportunistic Investing

Synchronized global growth expected to continue

• Global economic growth accelerated from 3.2% to an estimated

3.6% last year. Economists currently forecast growth of 3.7% in 2018.¹

• As seen in the Citi Economic Surprise Indices, global economic data

has been stronger than expected.

• A primary source of strength is the improved outlook for growth in

the U.S. and Europe. Although emerging market positive surprises

have recently slowed, 5.0% GDP growth is expected in 2018.1

Manufacturing contributing to global growth

• When the Global Purchasing Managers Index (PMI) is

above 50, it signals growth. The latest reading of 54 is the

highest since 2011, which is consistent with strong industrial

production growth.1

• As illustrated in the chart, developed and emerging markets

have accelerated over the last two years.

• The strength in the readings provides confidence that

manufacturing will be a primary contributor to growth in 2018.

P E N D U L U M O N E :Economic Backdrop and Earnings Growth Favor Stocks Over Bonds

Citi Economic Surprise Indices

-100

-80

-60

-40

-20

0

20

40

60

80

100

-100

-80

-60

-40

-20

0

20

40

60

80

100

U.S. Citi Surprise Index (CSI) Eurozone CSI Emerging Market CSI

Jan ‘15Apr ‘1

5Jul ‘1

5Oct ‘

15Oct ‘

16Jul ‘1

6Apr ‘1

6Jan ‘16

Jan ‘17Apr ‘1

7Jul ‘1

7Oct ‘

17Jan ‘18

4

Source: ISI, Bloomberg data as of 12/31/2017

Global Manufacturing PMI

47.0

49.0

51.0

53.0

55.0

57.0

59.0

61.0

Dec ‘15 Mar ‘16 Jun ‘16 Oct ‘16 Jan ‘17 Apr ‘17 Aug ‘17 Nov ‘17

GlobalDeveloped MarketsEmerging MarketsU.S.JapanEuro AreaChina

5

Source: Bloomberg Data as of 12/31/2017

P E N D U L U M O N EEconomic Backdrop and Earnings Growth Favor Stocks over Bonds

6

U.S. consumer and business outlook supports growth

• As shown in the chart, domestic consumer confidence is

at high levels, reflecting gains in private employment and

personal income.

• Elevated confidence indicates a willingness to spend and

should lead to continued U.S. consumption growth.

• Small business confidence has also increased, which may

positively impact private employment.

Economic Confidence

20172003

20042005

20062007

20082009

20102011

20122013

20142015

201680

85

90

95

100

105

110

115

20

40

60

80

100

120

140

160Consumer Confidence Index (Left Axis)Small Business Optimism Index (Right Axis)

Source: Bloomberg data as of 12/31/2017

US Capital Goods(Non-defense, ex Aircraft & Parts)

-10

-5

0

5

10

15

20

25

% C

hang

e

7

20122013

20142015

20162017

Source: U.S. Census Bureau (Bloomberg, YoY%) as of 12/31/2017

Business investment contribution accelerating

• Heightened business optimism has led to a rebound in capital

goods expenditures as seen in the chart. This increased

business investment is attributed to better economic growth,

improved profitability, and prior years of underinvestment.

• Increased business investment is beneficial because it helps

improve productivity and the economy’s capacity to expand.

7


Treasury Yield & Projection

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

0 2 4 6 8 10

Yiel

d

Years

12/31/2018 (P) 12/31/2017

Source: Bloomberg bond yield forecasts

Different Fed Chairperson, same expectations

• In 2018, Jerome Powell will become the Chairperson for the

Federal Reserve (Fed).

• Monetary policy, which is accommodative, is anticipated to be

consistent under new leadership. The Fed forecasts three rate

hikes again this year.

Structural:

Technological advancements have led to a number of deflationary pressures in certain industries. Specifically,competition from cellular companies and online retailers,like Amazon and Walmart, has led to lower prices forcertain goods and services.

Cyclical:

We believe that inflation pressures are present as GDP is running close to 3% and unemployment has fallen to 4.1%.¹ Increased business activity at this stage in the cycle could provide a nudge towards higher inflation, given the upward trend of labor force participation and wage growth.

Yield curve moves higher

• Slightly higher inflation and a reduction in the Fed’s balance

sheet should exert upward pressure on long-term interest rates.

• As depicted in the chart, short-term rates, driven by monetary

policy, are expected to increase twice as much as the 10 year

Treasury yield. This would further flatten the yield curve.

8


Inflation Swinging Higher, but Anchored by Structural Factors

Stock Price and Earnings Outlook

150

250

350

450

550

650

10

15

20

25

30

35

S&P 1500 Forward Earnings Per Share (Left)S&P 1500 Price (Right)

20172003

20042005

20062007

20082009

20102011

20122013

20142015

2016

Source: FactSet Research Systems as of 1/1/2018

Higher valuations consistent with global outlook

• Global stock prices, as measured by the price-to-earnings

(P/E) ratio, are elevated as indicated in the table. We believe

valuation premiums of over 20% are due to the following factors:

– Broad-based global expansion

– Moderate inflation

– Low interest rates

– Lower volatility

Earnings growth drives long-term stock returns

• Synchronized economic activity is driving strong earnings

growth. Global earnings grew at 19.0% last year with 11.3%

growth expected in 2018.²

• We believe earnings growth is the primary determinant

of stock returns. As illustrated in the chart, forward earnings

per share and price move together.

2018 Earnings Growth & Valuations

Asset Class P/E P/E PremiumEPS

Growth

MSCI All Country World Index 16.1x 20.3% 11.3%

S&P 1500 U.S. Broad Market 18.2x 25.0% 12.1%

PENDULUM ONE INVESTMENT IMPLICATIONS: OVERWEIGHT STOCKS

We prefer stocks relative to bonds because of broad-based global expansion and earnings growth. However, current valuations limit the extent of our overweight.

9

P/E - Next Twelve Months Price-to-Earnings Ratio P/E Premium - P/E divided by 15-year average P/E EPS Growth: Next Twelve Months Earnings Per Share Growth Source: FactSet (calculation); as of 1/1/2018


Central Bank Rates and Forecasts

-1.00%

0.00%

1.00%

2.00%

3.00%

2015 2016 2017 2018 2019

Fed Fund Rate Target BOE Rate Target ECB Deposit RateSNB Rate Target Norges Bank Rate Target

11

Source: ISI, Bloomberg Data as of 12/28/17

International economies benefit from low interest rates

• International central banks have kept interest rates at record lows. These low rates are intended to stimulate economies and tend to be positive for stock market returns.

• International markets are early in their economic cycle which provides central bankers added flexibility to keep rates low. As seen in the chart, limited increases are expected in the next two years.

International stocks attractively valued

• As depicted in the table, developed and emerging market equities offer solid earnings growth.

• International market P/E ratios are reasonable given these earnings expectations.

Weak U.S. dollar benefits international stock returns

• Currencies can be a major factor for international stock returns and historically trend in the same direction for multiple years.

• U.S. dollar weakness contributed +0.9% to international stock returns in 2016 and +12.5% last year.¹ Most economists expect a positive contribution from the dollar in 2018.



Growth

International Developed 14.9x 13.2% 8.9%International Emerging 12.4x 9.2% 13.4%International Indices: MSCI EAFE, MSCI Emerging Markets Source: FactSet (calculation); as of 1/1/2018

P E N D U L U M T W OLeverage to Global Growth Favors International Stocks over Global Real Estate

PENDULUM TWO INVESTMENT IMPLICATIONS: OVERWEIGHT INTERNATIONAL STOCKS

We are overweight international stocks to take advantage of the higher sensitivity to global economic activity, accommodative monetary policies, and the potential for U.S. dollar weakness.

10

Tax reform positive for U.S. economy

• Analysts estimate a +0.3% contribution to GDP growth in 2018 and 2019 as a result of tax reform.³ Survey data shows 39% of businesses expect to increase hiring and 51% expect to increase capital investment as a result of lower taxes.4

• As seen in the chart, small and mid-sized companies have a higher tax rate and stand to benefit more from a reduction in corporate tax rates.

Return potential favors small and mid-cap (SMID) stocks

• SMID companies benefit more from U.S. economic expansion due to their higher exposure to cyclical industries.

• The table shows double digit earnings growth across all U.S. cap sizes. SMID stocks are trading at a premium, but present a tactical opportunity based on their higher earnings growth.

• U.S. large-cap companies benefit from the same economic trends, but currently trade at the highest valuation.

Real estate investment trusts (REITs) offer limited upside

• Commercial real estate is exhibiting strong cash flows given a growing global economy and acts as an inflation hedge over long-term time periods.

• We are underweight REITs due to their elevated valuations and leverage to interest rates, which are likely to trend higher in the U.S.

Median Corporate Tax Rate by Market Capitalization14

23.8%

28.0%

31.9%

20.0%

22.0%

24.0%

26.0%

28.0%

30.0%

32.0%

Mega-Cap Large-Cap Small-CapMega-Cap: Dow Jones Industrial Average; Large-Cap: S&P 500; Small-Cap: Russell 2000 Source: Reuters



Growth

S&P 500 Large-Cap 18.2x 25.9% 11.5%S&P 400 Mid-Cap 18.3x 16.4% 14.8%S&P 600 Small-Cap 19.7x 20.0% 17.8%Source: FactSet (calculation); as of 1/1/2018

P E N D U L U M T H R E EBetter U.S. Growth Favors Small & Mid-Cap Stocks over Global Real Estate

PENDULUM THREE INVESTMENT IMPLICATIONS: OVERWEIGHT SMALL & MID-CAP STOCKS

We are overweight SMID stocks due to a better earnings outlook stemming from improving U.S. economic fundamentals.

11

Delinquency Rates vs Corporate Spreads16

0%

1%

2%

3%

4%

5%

6%

7%

Delinquency Rate on Commercial and Industrial LoansIntermediate Corporate Average Spread (OAS)Average Spread (OAS)

20022003

20042005

20062007

20082009

20102011

20122013

20142015

20162017

Source: FRED Database & Bloomberg Data As of 12/31/2017

Low delinquencies provide support for credit

• Credit spreads are less than their historical average,

consistent with low delinquency rates, as seen in the chart.

• The yield advantage for credit over government bonds is

appropriate to compensate for the additional default risk.

• Sectors through which we gain credit exposure include

investment grade corporate bonds, asset and mortgage

backed securities, high yield, and floating rate.

Interest rate risk poses threat in rising rate environment

• Rising yields put pricing pressure on bonds with fixed

interest rates.

• We reduce interest risk in portfolios by emphasizing short

and intermediate maturity bonds, and have added a modest

allocation to floating rate investments.

• Floating rate bonds have a variable interest rate,

which is a benefit in a rising interest rate environment.

PENDULUM FOUR INVESTMENT IMPLICATIONS: OVERWEIGHT CREDIT AND FLOATING RATE

We are overweight credit given low delinquencies and have a floating rate allocation to protect portfolios from rising interest rates.

12

Yield Contribution by Factor17

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

IntermediateGovernment

Asset Backed IntermediateCredit

CommercialMortgage Backed

HighYield

FloatingRate

Fed Funds Rate Term Premium Credit PremiumTerm Premium: Yield of U.S. Treasury with similar duration; Credit Premium: Additional compensation for assuming credit and liquidity risk. Source: Barclays Intermediate Government/Credit Indices, Barclays ABS and CMBS Indices, Lord Abbott Floating Rate, Federated High Yield. Source: Bloomberg Data

P E N D U L U M F O U RLow Defaults and Rising Interest Rates Favor Credit and Floating Rate over Government Bonds

PENDULUM FIVE INVESTMENT IMPLICATIONS: DISCIPLINED PORTFOLIO MANAGEMENT CRUCIAL

Disciplined portfolio management is crucial due to potential risks and the lower long-term return outlook.

1. Policy Error:

If global growth leads to an inflationary environment, central banks would likely increase interest rates faster than expected and could potentially cause a recession.

2. Economic Slowdown:

The recent pickup in European and Japanese growth and stabilization in the Chinese economy could be temporary. This would result in a deceleration in global earnings growth.

1. Diversify:

Combining different asset classes optimizes portfolio return and risk. We further diversify portfolios within each asset class:

– U.S. stocks: Large-cap, mid-cap, small-cap – International stocks: Large-cap developed, small-cap developed, emerging markets

– REITs: Global real estate – Alternatives (alts): Multi-manager mutual fund with six distinct investment strategies

– Bonds: Credit, government bonds, high yield, floating rate

3. Geopolitical Risk:

International turmoil such as a military conflict with North Korea would cause volatility. This would likely be temporary if the global economic outlook did not change.

4. Sentiment Risk:

The potential of a market decline from increased investor anxiety is present given high valuations. Sentiment change is difficult to predict.

2. Maintain Discipline:

We work closely with you to confirm the appropriate investment objective. We rebalance portfolios to your asset allocation target based on identified goals.

3. Monitor:

As markets create opportunities, we make tactical adjustments to improve risk-adjusted returns. Effectively, we strive to take advantage of volatility by buying low and selling high.

P R I M A R Y R I S K S I N 2 0 1 8

W H A T A R E W E D O I N G T O M I T I G A T E R I S K S ?

13

P E N D U L U M F I V ERisks Require Disciplined Portfolio Management

Core Fixed Income 45.0%

Global Real Estate2.7%

International Stock8.6%

U.S. SMID Stock9.7%

U.S. Large Cap-Stock24.0%

Alts7.0%

Cash3.0%

U.S. SMID Stock11.5%

International Stock9.8%

Global Real Estate1.5%

Core Fixed Income35.3%

High Yield & Floating Rate Bonds

5.7%

Alts7.0%

Cash3.0%

U.S. Large-Cap Stock 26.2%

Portfolio Construction:

The foundation of a professionally managed portfolio is a diversified set of investments with different characteristics. Intensive research has been completed to construct optimal portfolios for the long run. For the balanced objective, target weightings are stocks 45%, bonds 45%, alts 7% and cash 3%. The long-term allocations are illustrated in the chart.

Portfolio Management:

We make tactical allocation decisions to increase returns or reduce risk. As reviewed, we are currently tilting portfolios to enhance returns. Specifically, we have an overweight to stocks (international and small and mid-cap stocks), and an emphasis on credit and floating rate within bonds. The current allocations are shown in the chart.

For demonstration purposes, we selected one of our investment objectives to display how diversification and the pendulums fit in with portfolio management.

14

Long-Term Allocation Tactical Allocation

C L O S I N G T H O U G H T SPortfolio Management

Balanced Investment Objective

15

Since the inception of the stock exchange, many investors have built wealth while others have lost it. This begs the question, “Why do some investors achieve their goals and others do not?” First National Bank believes the following is vital for success:

Maintain a long-term, disciplined perspective and stay invested in a diversified portfolio consistent with your investment objectives.

As we enter 2018, challenges will inevitably arise that will test your investment resolve. Our wealth management team has stood the test of time and will be here for you as the pendulums swing.

Thank you for your interest in this year’s Outlook and the trust you place in us.

Kurt Spieler, CFA Chief Investment Officer

Investment Team Contributors:

Kurt Spieler, Erica Blake, Scott Summers, Jason Buol, Tim Laughlin, Dave Young, Rick Frevert, Geri Harris

Marketing Team Contributors:

Katie Flanagan, Christina Kahler, Jeff Burgher, Todd Boswell

Unless otherwise stated, all data are as of December 31, 2017 or most recently available.

This material is for information purposes only. The views expressed are those of the author as of the date noted and not necessarily of the Corporation and are subject to change based on market or other conditions without notice. The information should not be construed as investment advice or a recommendation to buy or sell any security or investment product. It does not take into account an investor’s particular objectives, risk tolerance, tax status, investment horizon, or other potential limitations. All material has been obtained from sources believe to be reliable, but the accuracy cannot be guaranteed.

PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS. Periods greater than one year are annualized except where indicated. Returns of the indexes also do not typically reflect the deduction of investment management fees, trading costs or other expenses. It is not possible to invest directly in an index. Indexes are the property of their respective owners, all rights reserved.

No bank guarantee | May lose value | NOT FDIC INSURED

Neither First National Bank nor any officer or employee of First National Bank accepts any liability whatsoever for any direct, indirect or consequential damages or losses arising from any use of this information.

Sources

¹Bloomberg ²FactSet Research Systems ³Business Insider 4Federal Reserve Bank of Atlanta

C L O S I N G T H O U G H T SKeys for Success

2018 outlook illustrated, u.s. and international stocks have the highest expected return and risk,...

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