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Investment Outlook

& Issues —

2017

the next page’s chart that the driving factor

in the Fed’s decisions to increase or decrease

interest rates (the orange line) has been the

growth occurring in the domestic economy

(the green line). Inflation has been fairly

consistent (the blue line) domestically across

all interest rate cycles. Economic growth has

traditionally provided the impetus for the

Fed’s decision to change the target rate, but

they have still moved together over time.

Since the Great Recession officially ended in

June 2009, domestic economic data has not

forced the hand of the Fed to rapidly raise

rates, but it has provided a backdrop that

would allow for gradual increases. Our belief

is that the primary factor keeping U.S. rates

low and causing the Fed to maintain its

“lower for longer” stance regarding interest

rates has been the fragile global economy and

an overwhelming amount of close-to-zero

and negative yields on government debt.

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FIXED INCOME BACKDROP AND 2017 OUTLOOK

THE FEDERAL RESERVE (FED)Investors around the world have spent the past

few years fixated on what the Fed’s next move

might be or what the next statement might

say. Despite all the attention, not much has

changed. We are hardly above where we started

back in December 2008 when the Fed dropped

the federal-funds target rate to a range of 0% to

0.25%. The Fed continues to be pressured from

all angles as the rest of the world’s central banks

and global economic data continue to weigh

on its decisions. The European Central Bank,

the Bank of Japan, and the Swiss National

Bank have continued to drive yields well into

negative territory.

The chart on the next page shows the Fed’s

actions prior to the unprecedented monetary

easing that occurred worldwide. We expect

very gradual increases in the Fed’s target rate

to be the trend over the next two years.

Despite the Fed’s continual concern with

inflation reaching a target rate of 2%, one can

interpret from historical data presented on

i

STAYING THE COURSE

PAUL GIFFORD, Jr., CFA Chief Investment Officer

Investors move the financial markets

daily in a variety of directions, usually for reasons based on future expectations. Events such as the release of a single

economic number or an investment theme like dividend paying stocks can move the market. It seems that every year, investors are surprised and their expectations are altered by events outside their control. In the short-term these surprises can create quite a bit of chaos. In 2016 we had two such events: First was Brexit and second was the election of Donald Trump as president. Our cover page this year depicts railroad tracks with several paths further down the tracks. The tracks are a way for us to think about changing market conditions.

Brexit is the term coined for the June 23rd referendum in the United Kingdom (U.K.) whereby British citizens voted to leave the European Union (EU). It had seemed a foregone conclusion that the U.K. would stay in the EU, a belief that held up until the votes were counted. Global equity markets reacted

negatively with many markets losing 3% to 10% that day and the next. What will change in the coming years is the way in which theytransact with the rest of Europe. The global equity markets quickly moved past their initial reaction, with most recovering their initial losses and some even moving to new highs.

The U.S. Presidential election, like Brexit, came with a less than expected outcome. During the early hours after election day, as it became apparent Trump would win, the equity markets sold off 5%, which was a very similar response by the markets after Brexit. However, by the opening of U.S. equity markets, the decline was reversed. We have since experienced new highs in the Dow and S&P 500.

In this 2017 investment outlook we will discuss expectations that are likely to impact the markets and investors’ decisions in the coming year. After eight years of a bull market in U.S. equities, moderation seems to be emerging as a theme and, when it comes to interest rates and inflation, uncertainty has taken hold. The year 2017 will likely provide a few unexpected surprises. We believe that one of the best ways investors can “expect the unexpected” is to diversify their assets, determine what is an appropriate amount of risk given their situation, and stay invested through the market’s inevitable ups and downs. We expect to see more market volatility in 2017 like we saw in 2016. The following commentary discusses the investment backdrop and some issues that we believe could affect the financial markets in the year ahead.

2 32018 20192016

THE GLOBAL DEBT PICTURE Global debt continues to increase at an exorbitant pace and is expected to continue increasing in 2017.

Since the end of the global financial crisis in early 2009, the United States government has increased

its debt by over 100%, corporations have increased their debt by approximately 25%, and consumers

have increased their non-mortgage debt by 40%. All this has taken place on the back of historically

low to negative interest rates across most economies, whether of advanced or developing nations.

While the U.S. government and consumers have had sizable increases in debt over the past seven years,

China, the world’s second largest economy, has more than doubled the percentage increase that the

U.S. has experienced. The most alarming change within China has been the almost 400% increase in

corporate debt over the past seven years and the burden it will become on China’s economy. Low rates

in developed markets have allowed China to issue debt at extraordinarily low rates and have made their

bonds overly sensitive to interest rate increases, especially in the United States.

We have been attentively following China’s

economy as it transitions from one that

is manufacturing-based to one that is

service-driven. We have found that it’s often

challenging to understand what is going

on in China due to the lack of information

provided by its government and political

leaders. Approximately 20% of the world’s

population is in China and its economy is

expected to be 20% of the world’s gross

domestic product (GDP) by 2020. Thus,

we believe China plays a very important

role in global growth and in the world’s

equity and fixed income markets.

Chart: Federal Funds Target Rate, Domestic Growth, & Inflation (1986-2008)

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U.S. EQUITY MARKET

international markets. Borrowers’ ability

to pay off or refinance debt in the current

economic environment has been easy. Many

companies have plenty of cash or can easily

refinance their debt through new borrowings

and typically at a lower rate. Corporations

continue to experience strong cash flows and

profit margins and we expect that to continue

throughout the next few years.

Interest rates have historically increased when

economies have experienced growth and/or

inflation. Although the Federal Reserve

is currently in a rate-change conundrum,

from our perspective we still see a good

environment to be overweight in corporate

bonds relative to U.S. Treasuries. We believe

the U.S. economy will continue to march

along whether interest rates stay flat or slowly

rise. The core of our taxable fixed-income

portfolios will continue to be investment-

grade corporate bonds.

MANAGING CREDIT RISK IN A LOW INTEREST RATE ENVIRONMENT

The U.S. equity market started 2016 in a

tumultuous manner with the worst 10-day start

to a year on record. The market stabilized near

month end, but recorded the worst January

performance since 2009. The S&P 500® Index,

which includes 500 of the United States’

largest stocks from a broad variety of industries,

declined 5.1% and the technology-heavy

NASDAQ Composite Index declined 8% in

January. Historically, negative performance

in the first month of a calendar year does not

bode well for the market. There have been

26 instances when January was negative and the

average annual return was a decline of -3.29%.

Since January, the S&P 500 has recovered nicely

and was up almost 10% as of this writing.

During 2016’s market declines, like those in

other time periods, investor pessimism spiked,

anxiety increased, and investors became reluctant

to commit additional funds to the equity markets.

This was especially evident after the Brexit vote

and less so in response to the U.S. Presidential

election results. Investors rushed for the exits after

Brexit, sending the Dow Jones Industrial Average

down nearly 900 points in a two-day period in

late June. (The Dow Jones Industrial Average is a

price-weighted average of 30 blue chip, primarily

industrial stocks, traded on the New York Stock

Exchange.) While the implications of Brexit are

In a world of low to negative interest rates,

credit analysis and understanding credit spread

has never been more important as investors scour

the world for more yield. Credit spread is the

difference between the yield on a U.S. Treasury

security (deemed to be the highest quality and

carry the least risk) and a non-Treasury security,

such as a corporate bond, and are very similar

in all respects except for credit quality.

While it remains challenging for fixed income

investors to determine the appropriate amount

of risk to take for the right amount of yield,

we continue to believe that spread-based fixed

income investments offer the most relative value

over the short- and long-term.

The pillars of credit analysis — cash flow,

assessment of management, capital structure

and credit profile, and the business and

competitive environment — continue to be

strong domestically and throughout most

difficult to determine at this early stage,

we at 1st Source believe that the U.S.

economy is much more insulated from the

uncertainty surrounding the first country

to leave the European Union in its near

six decade existence. Even though the

U.S. economy may face the headwind of

a stronger dollar, one major tailwind is that

increased global uncertainty will likely keep

the Federal Reserve on a slow trajectory for

raising interest rates. Therefore, we believe

that in 2017 the U.S. equity market will

continue its uptrend, but at a pace well

below the earlier gains of this long-running

bull market.

For 2016, the S&P 500 is on pace to post its

eighth consecutive year of positive returns

making it one the longest stretches in market

history. Other periods of similar performance

would be the mid-1980s and mid- to late-

1990s when the U.S. equity market increased

for several years in a row. More traditional

measures of the value of a company’s stock

such as the price-to-earnings (P/E) ratio

(the price of a stock divided by its earnings

per share) or the price-to-sales (P/S) ratio

(a stock’s market capitalization divided by the

company’s sales over the trailing 12 months)

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less negative. The earnings estimate for S&P 500 companies is slightly positive for the third

quarter of 2016, which would make it the first quarter with year-over-year earnings growth in

over a year. Much of the improvement in earnings will come from the energy sector and the

fact that the earnings will be less bad when compared to the prior year. Of greater concern

for S&P 500 companies is the absence of sales growth due to sluggish global economic growth

and a stronger U.S. dollar. Sales growth for the second quarter of 2016 was negative at -0.5%.

Excluding energy sector revenue, sales growth was modestly positive at 1.5%.

In 2017, the U.S. economy will be in its eighth year of business cycle expansion and corporate

America will have to contend with the difficulty of growing sales and earnings in an expansion

that is the second longest of the postwar period.

Energy companies areequities. Going forward, as a result of

recent equity market performance and

higher than average valuations, we would

expect equity market returns to be below

historical averages. Corporate earnings

have been negative on a year-over-year

basis for over a year, mainly due to the

significant decline in earnings at energy

companies. The energy sector reported

that earnings declined 75% versus

the prior year. Energy companies are

focused on restructuring their businesses

and repairing their balance sheets

to adjust to the new reality of lower

energy prices. The earnings drag from

the energy sector lessened during the

second half of 2016 and the year-over-

year contribution from energy will be

indicate that the equity market is fully valued

after the significant move from the lows in

March 2009. One favorite valuation metric of

Warren Buffet is the relationship between the

S&P 500’s market capitalization and the gross

domestic product of the U.S. The S&P 500’s

market cap has historically averaged about

55% of annual GDP in the U.S. However, at

the end of May 2016 it stood at 90% of GDP.

The ratio was as low as 38% in 1981 and as

high as 131% in 2000. On the other hand,

relative valuation metrics, which compare

equity prices to other asset classes such as

fixed income, suggest the equity market is

fairly valued. We currently have neutral

equity allocation at our mid-point based

on the significant run up in equity prices

since 2009 and the extended valuation of

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8

THE EFFECTS

OF AN ELECTION

YEAR

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HOME BIASInvestment theory suggests that investors can reduce risk in their investment portfolios by investing

across different asset classes, such as equities and fixed income, and by diversifying their equity

allocation between domestic and international companies. Nevertheless, many investors exhibit

“home bias” or the preference to allocate the vast majority of their investment portfolio to

domestic securities. The U.S. makes up roughly 40% of the world’s equity market capitalization,

but U.S. investors, on average, allocate roughly 85% of their equity investments to domestic

securities. Home bias is even more evident in Europe and Asia. For example, French investors

allocate 90% of their investment portfolios to domestic securities. In China, investors allocate

over 95% of their equity investments to home grown companies. Home bias may be partly

explained by market restrictions in certain countries regarding the flow of funds, liquidity

concerns, currency risk, or governance. However, it is more likely due to investors’ greater

willingness to invest in what they know and in what is close to home.

The poor performance of international equity markets since the Great Recession has many

investors questioning the benefits of investing abroad. At 1st Source, we believe it is important

to remember that markets move in cycles. From 2002 through 2008, international markets

outperformed the U.S. market by over five percentage points per year. Our asset allocation

committee currently recommends an equity allocation of 80% to U.S. companies with the

remaining 20% invested in international companies. Please note that we change our allocation

recommendations based on opportunities we see in the markets. We believe in diversification

through international equity investments. Most election years bring a sense of renewed energy and higher expectations

for many voters. Expectations rise based on the promises made by those running

for office. The challenge for investors is that election promises matter less when

it comes to investment returns. What seems to matter more is how, over time,

investors see the outlook for the economy, interest rates and corporate earnings.

Studies by our research partner the Leuthold Group have shown that investment

returns vary little whether voters elect a Democrat or a Republican president,

the median return for their terms is 27.7% and 27.3%, respectively.

Another notable point is that the first year of a newly-elected president’s term

tends to be the lowest for market performance. The good news is that the

historical average is still a positive 3.5% and that does not include dividend income.

THE U.S. AND GLOBAL ECONOMIES

“Slow and steady” best describes our

expectations for the U.S. and the global

economy. In the last seven years the U.S.

economy has grown at an average rate of

2.1%, well below the historical average growth

rate after a recession. The global economy

is only growing modestly better. The largest

drop in growth will continue to come from

China as the country struggles with a large

amount of debt and the transition from a

manufacturing-led economy to a service-based

economy.

We expect to see continued improvement in

the service-based labor market in the U.S.

Unemployment has fallen by all measures.

Even the U6 measurement of unemployment

(those underemployed or working part time for

economic reasons) is at the lowest level since

April of 2008. The headline unemployment rate

stood at 4.6% in November, well below its peak

of 10% following the recession. We have started

to see wages increase as well, which bodes well

for the economy.

Housing continues to be a strong area

of the economy. The persistence of low

interest rates, demand exceeding supply,

and a tight labor market has helped the

housing market maintain its strength.

In some markets, including Seattle and

the Bay Area, net new jobs have well

exceeded the increase in new housing.

We have also seen an improvement in

consumers’ balance sheets. Today, only 10%

of consumers’ disposable income is going

toward paying non-mortgage debt. The

challenge for Millennials (the generation

born starting in the early 1980s through

the early 2000s) is student debt, which has

ballooned to $1 trillion. There has also

been an increase in debt owed by seniors

who are suffering from the low interest rate

environment.

We expect the U.S. economy to grow

between 2% and 3% in 2017, unless there is

a significant economic or geopolitical event.

10 11

The chart above shows that over longer periods of time it does not matter to the stock market who is president. We know it’s the economy that matters.

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Today’s savers and investors face challenges in what they might expect to earn from

the pool of assets they have accumulated. What investors are facing in the coming

years will be influenced by expected returns from different asset classes. Forecasts

for future returns have been greatly influenced by the eight-year bull market in

U.S. stocks and historically low interest rates here and abroad. In determining the

allocation of your investment portfolio, which you have entrusted to us, where and

how you will earn money for a given level of risk is an important consideration.

Savers are facing a continued period of low interest rates domestically and in many

parts of the world interest rates are negative. The Wall Street Journal recently

published an article on the concept of earning interest when you take the risk

of lending money, a practice that was established approximately 5,000 years ago.

Today, there are countries, and some companies, paid to borrow money as opposed

to paying interest for the right to borrow. This is creating unique and difficult times

for families, pensions, endowments and other investors. Many of these investors

need high returns to meet their retirement needs, benefit payments, and other

required distributions.

The charts on the next page show how the investment market, particularly the

fixed income market, has changed over the past 20 years. Twenty years ago,

the return on a fixed income portfolio would meet the needs of many investors

without the need for them to invest much or any of their assets in the stock market.

To obtain similar returns today, an investor needs a portfolio that is invested in

both fixed income securities and equities. Chart A shows that in 2015 significant

exposure to stocks and other assets classes was needed to earn the same return

as a fixed income portfolio earned in 1995. Chart B shows associated volatility.

Chart A

CHALLENGES FOR SAVERS AND INVESTORS

Chart B

This chart shows how volatility in the price of a portfolio of securities from different asset classes in 2005 and 2015 is much greater than a bond-only portfolio in 1995. To obtain the same return in 2015 as in 1995 as shown in Chart A, the portfolio’s volatility increased by nearly four times.

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NAVIGATING THE LANDSCAPE

At left, our last chart shows how today’s savers and investors

have greater responsibility for their future. The chart shows

the decline in the number of pension plans and the rise

of defined contribution plans such as 401(k) and 403(b) plans.

As a result of these changes, budgeting, understanding

cash flow and financial planning have become more

important today than they may have been 20 years ago.

We are here to help you navigate the current financial landscape.

At 1st Source, we want to work with you to determine the asset allocation that is appropriate for your

unique situation and to help you realistically set your expectations regarding potential investment returns.

We will follow up with more conversations to understand the sources of income available for your

retirement and lifestyle needs. We have expanded our wealth management offerings to better meet your

needs and we are able to assist you with financial and social security optimization. We feel confident that

by working with us you will have the tools that will help meet your needs today and in the future.

1st Source Corporation Investment Advisors, Inc. (Left to Right) Jon Cisna; Randy Thornton, MBA; Paul Gifford, Jr., CFA; Tamara Simon, MBA, IACCP®;

Chris Davis, MBA; Erik Clapsaddle, CFA, CFP®; Anthony Gaipa, Marie Alvarez; Jackie Kronewitter;

Noreen Kazi, MBA; Rob Romano, CFA; Jason Cooper, MBA 1716

1st Source Bank Wealth Advisory Services is a closely-knit team of over 100 caring, knowledgeable

professionals who are fiercely committed to providing unbiased and balanced advice, and who work

to fully understand our clients’ professional and personal aspirations.

Wealth Advisory Services has twelve (12) staff members on the 1st Source Corporation Investment

Advisors, Inc. team. Together, they offer more than 210 years of combined professional experience,

and an average of 17 years of experience per team member. Three (3) of our investment staff

members have the CFA (Chartered Financial Analyst) designation, one (1) staff member has

the CFP® (CERTIFIED FINANCIAL PLANNER) designation, and one (1) staff member

has the IACCP® (Investment Advisor Certified Compliance Professional) designation.

1ST SOURCE CORPORATION INVESTMENT ADVISORS, INC.

Understanding that each person and family have different financial goals, 1st Source

Corporation Investment Advisors design customized plans to suit each situation

and with the long-view in mind. As independent, unbiased advisors, we select from

a wide variety of investments, adding flexibility, using an open investment structure,

and offering hands-on investment advice and education if desired.

Some members of our investment team hold the investment industry’s highest

professional designation of Chartered Financial Analyst (CFA); some hold advanced

business degrees; all are fiercely dedicated to their clients. By focusing exclusively

to keep each client’s best interest in mind, the 1st Source Investment Advisors

provide clients with deep peace of mind.

Not FDIC Insured Not Bank Guaranteed May Lose Value Not Insured by any Federal Government Agency Not a Bank Deposit

We aspire to be your first call.(800) 882-6935