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Economic and Capital Markets Review
Periods ended June 30, 2018
1 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
Global Economic Update The Big Picture
● Globally, interest rate policies may start to converge – The Fed hiked interest rates a quarter point at the March and June meetings, and expects two more hikes in 2018, and three in
2019. The target range for the Fed Funds rate is now 1.75% to 2.0%. – The Fed began to reduce the size of its balance sheet last October; other central banks are expected to taper purchases and stop
expanding balance sheets entirely by the end of 2019.
● Labor market continues to tighten. – In the U.S., unemployment fell to 3.8% in May 2018, a generational low. The U.S. is showing clear signs it is reaching the limits of
full employment. – Initial claims for unemployment insurance have fallen to the lowest level since 1969. – Employment cost index rose 2.7% year-over-year in the first quarter <Q2 not release yet>, the highest rate of growth since 2007. – Euro zone unemployment dropped to 8.8%, below 9% for the first time since 2009, although economic growth began to sputter in the
second quarter. The U.S. and euro zone economies appear to be diverging again.
● Inflation may finally be perking up, after years of a perplexing absence. Headline CPI rose 2.9% during the quarter, continuing a gradual rise, and core CPI (ex-food and energy) rose 2.3%, slightly above the Fed’s 2% target.
● The U.S. dollar rose 5% in the second quarter against a broad basket of developed market currencies. The dollar had been hurt in the first quarter by growing worries over a trade war with China, as well as signs that other countries may join the U.S. in raising interest rates. As growth appeared to diverge between the U.S. and developed non-U.S. markets, and the U.S. alone raised rates, the dollar rallied.
● Crude oil prices rebounded in the second half of 2017, and continued to trend higher during the first and second quarters of 2018, cresting $70 by the end of June.
2 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
Global Economic Update The Big Picture (continued)
● The U.S. economy continues to thrive, in contrast to headlines full of concerns about trade wars, the revival of inflation, an inverted yield curve and what it means for the coming recession.
● GDP was revised down slightly to 2.0% in the first quarter, but second quarter GDP clocked a very solid 4.1%, though this pace is expected to slow in Q3. The U.S. economy continued to thrive:
– The unemployment rate dropped to 3.8% in May, the lowest reading since 2000
– Wages are inching up; consumer spending remains robust, as does consumer confidence
– Housing starts surged to an 11-year high in May
– Inflation is gradually trending up but remains contained. Much of the recent rise is attributable to a rebound in oil prices; if prices remain steady, the increase in
inflation will abate.
– However, the length of the current expansion and richly priced capital markets spur concerns about an “inevitable” market correction
● Against this backdrop, the Fed raised rates for the second time in 2018, bringing the Fed Funds rate to 1.75%-2.0%. The Fed expects two more rate hikes this year and three more in 2019
● Driving 2Q U.S. growth was robust growth on international trade in goods for May and June
– U.S. and China enacted tariffs on $34 billion of each other’s imports on July 6. The trade wars could prove to be inflationary, recessionary, or both.
– Growth over the next 18 months will be tempered by depletion of inventories and expectations of slowing consumption spending; consensus forecasts suggest a slowdown is coming, regardless of a trade war
– In contrast, euro zone is showing slower growth in 2018, after notching the strongest year in a decade in 2017. Unemployment remains high, geopolitical
turmoil across the zone, from Italy to Brexit, and the uncertainty from trade wars are dampening sentiment along with reported slower gains in GDP.
– China also showed signs of slowing, with industrial output and retail sales reporting growth at rates lower than expected in May and June. Japan (the world’s third-largest economy) shrank by 0.2% in the first quarter (latest data), and the decline is expected to continue in the second quarter
3 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
1 Quarter 1 Year 5 Years 10 Years 25 YearsU.S. EquityRussell 3000 3.89 14.78 13.29 10.23 9.65S&P 500 3.43 14.37 13.42 10.17 9.60Russell 2000 7.75 17.57 12.46 10.60 9.59Non-U.S. EquityMSCI World ex USA -0.75 7.04 6.23 2.63 5.59MSCI Emerging Markets -7.96 8.20 5.01 2.26 --MSCI ACWI ex USA Small Cap -2.60 10.57 8.98 5.77 --Fixed IncomeBloomberg Barclays Aggregate -0.16 -0.40 2.27 3.72 5.133-Month T-Bill 0.45 1.36 0.42 0.35 2.57Bloomberg Barclays Long Gov/Credit -1.45 -0.78 5.10 6.79 6.99Bloomberg Barclays Global Agg ex-US -4.76 2.78 0.88 1.76 4.64Real EstateNCREIF Property 1.70 7.07 9.75 6.21 9.24FTSE NAREIT Equity 10.04 3.50 8.31 7.94 10.06AlternativesCS Hedge Fund 0.10 4.74 3.60 3.24 --Cambridge Private Equity* 3.03 18.27 13.81 9.51 15.62Bloomberg Commodity 0.40 7.35 -6.40 -9.04 2.38Gold Spot Price -5.48 0.98 0.50 3.06 4.90Inflation - CPI-U 0.98 2.87 1.54 1.42 2.25
Returns for Periods ended June 30, 2018
Volatility Spikes in First Quarter 2018, U.S. Market Rebound in Second Quarter
● Surge in volatility in February subsided through May, modest ramp back up in June, but still below “average” market volatility measures, both realized and forward-looking.
● Correction (10% decline) achieved at one point in mid-February for the S&P 500, but stocks rebounded within the following weeks. S&P returned 3.4% in second quarter, and is up 2.7% year to date.
● Outside the U.S., both developed and emerging markets saw losses in the second quarter, and are down year to date.
● Dollar rose more than 5% during the second quarter, contributing to losses for U.S. investors overseas.
● 10-year U.S. Treasury yields rose from 2.74% in March to 2.85% in June; yields are up 55 bps from June 2017.
● The Fed raised rates in March and June and signaled two more hikes this year, and three in 2019. CPI rose to 2.9% year-over-year, continuing the gradual rise begun in 2016. Wage pressures may finally be building as the unemployment rate falls below 4%.
Cambridge PE data are available through March 31, 2018.
Which quarter represents the return to normal?
4 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
What Are We Talking About with Investors?
● Current expansion is growing long in the tooth; a downturn seems inevitable, should something be done about it? – Increased conversation around the merits of risk mitigation strategies.
● Corporate plans are suddenly moving to de-risk—large contributions before tax deadline, moving down de-risking glidepaths, exploring and pursuing termination
● Capital market concerns: – Inflation remains benign, but trade wars and rising oil prices raise concern. Should inflation-hedging strategies be considered?
–Trade wars—could be inflationary, or recessionary, or perhaps both –Crude oil prices are back at $70 due to supply constraints, and potential impact of trade conflict –Yield curve is very flat; does an inverted curve mean the same thing as it once did? –EAFE and emerging markets are underperforming for U.S. investors once again. Will the rough ride be a concern for staying the
course in asset allocation?
Common themes in the first half of 2018
5 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
Trade War: Could Be Inflationary, or Recessionary, or Both
● World trade has held up well through Q2, driving growth in the U.S. in particular
● However, surveys by CPB and Markit show a sharp slowdown in trade growth coming, reflecting fears of protectionism (top chart)
● Current tariffs represent less than 2% of world GDP (bottom chart); at current levels, impact of tariffs expected to cause limited damage
● Worse case scenario = 25% of all goods traded affected by tariffs; global economy may avoid downturn but GDP growth may be reduced by as much as 2% to 3% (global GDP growth, which includes emerging markets, is typically several percentage points higher than developed markets only)
Sources: Capital Economics; CPB, Markit, Thomson Reuters, UNCTAD
Export Order Surveys & World Trade Volumes
Traded goods covered by tariffs (% World GDP, 2017)
6 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
Will Inflation Catch Fire? The Job Market Squeeze on Policy
● Discouraged worker effect has been pervasive since the Global Financial Crisis.
● Gradual, persistent growth has finally coaxed workers back from the sidelines, shrinking the slack in the job market.
10 years of persistent monetary and fiscal stimulus has caught up to global growth
Source: Federal Reserve
● The U.S. unemployment rate is reaching a generational low, and dropped to 3.8% in May before bouncing back to 4% in June.
7 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
Broad-Based Inflation Measures Still Relatively Benign in the U.S.
U.S. inflation expectations as expressed by the break-even rate (TIPS vs nominal Treasury yields) moved higher in 2017 and cracked 2% as the year began, but the rate has since hovered around 2.1% through the first two quarters.
Expectations are higher, but still low relative to long-term history
Source: Federal Reserve, U.S. Department of Labor
● Wages have been very sticky in a narrow range around 2% growth until 2016.
● January 2018 report of 2.8% growth triggered the February market sell-off. Wage growth has not taken off since January.
● Tight labor markets might finally be pushing up wages. Good for workers and consumer spending.
● Tax cut may also flow to owners and wage earners, fueling further inflationary pressures.
● Such pressure may be starting to show as headline inflation inches up.
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
U.S. Average Hourly Earnings, %Year over Year
8 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
Oil Prices Have Pushed Recent Inflation Rise, but Impact Is Expected to Abate
● Global inflation and impact of oil prices depicted in the chart at left, including short-term forecasts by Capital Economics
● While core inflation will continue to trend upwards in Japan, in the euro zone and particularly in the U.S., lower oil prices should bring down headline inflation. Even if oil prices did not fall as expected, and instead stayed at their current level, the contribution of energy prices to inflation in OECD economies would still drop by about a percentage point, on average, by early next year.
Sources: Capital Economics; Markit, Thomson Reuters
Oil prices & energy contribution to CPI inflation in OECD economies
9 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
0%
1%
2%
3%
4%
0 5 10 15 20 25 30Maturity (Years)
June 30, 2018March 31, 2018June 30, 2017
U.S. Economy
-10%-8%-6%-4%-2%0%2%4%6%8%
97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18
Quarterly Real GDP Growth (20 Years)
For periods ended June 30, 2018
9899 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 1718-15%
-10%
-5%
0%
5%
10%
15%
20%
Inflation Year-Over-Year
2.9% - CPI-U5.5% - PPI
Sources: Bureau of Labor Statistics, Bloomberg
U.S. Treasury Yield Curves
-1%
0%
1%
2%
3%
4%
5%
6%
2Q08 2Q09 2Q10 2Q11 2Q12 2Q13 2Q14 2Q15 2Q16 2Q17 2Q18
10-Year Global Government Bond Yields U.S. Treasury Germany U.K.
Canada Japan
10 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
Ironies Abound in the Current Capital Market Environment
● Consensus lowering of expectations for all segments of the capital markets, particularly for equity
● Continued pursuit of diversification deep into every corner of the capital market
● Public equity is the primary source of diversification
● While the epic run in equity just seems to keep going
● Going forward: – Callan maintains expectations for subdued capital market returns:
–equity below 7%, fixed income at 3%, no magic to be found in other asset classes without substantial (and perhaps different) risk – Illiquidity, concentration, leverage, manager enterprise risk
– Many investors feel compelled to take on substantial market risk –Lower return expectations = even greater allocations to “growth” to reach targeted goals
– Turning diversification on its head? What other asset classes can be considered growth? –Strategies with equity factor exposure but at least some diversification benefit to long-only equity –High yield, low vol equity, hedge funds, MACs, option-based strategies, private credit
– Broader asset allocation concepts: growth, income, real assets, opportunities – Explicit liquidity budget
–Ongoing spending/distribution/benefit payments –Ability to withstand another large capital market drawdown without forced selling of distressed assets
11 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
'97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17 '18600
900
1,200
1,500
1,800
2,100
2,400
2,700
3,000
Oct. 9, 2002 P/E (fwd.) = 14.1x
777
S&P 500 Price Index
yield
-yr. Treasury
Source: Compustat, FactSet, Federal Reserve, Standard & Poor’s, Thomson Reuters, J.P. Morgan Asset Management.Dividend yield is calculated as consensus estimates of dividends for the next 12 months, divided by most recent price, as provided by Compustat. Forward price to earnings ratio is a bottom-up calculation based on the most recent S&P 500 Index price, divided by consensus estimates for earnings in the next 12 months (NTM), and is provided by FactSet Market Aggregates. Returns are cumulative and based on S&P 500 Index price movement only, and do not include the reinvestment of dividends. Past performance is not indicative of future returns.Guide to the Markets – U.S. Data are as of June 30, 2018.
-49%
Mar. 24, 2000 P/E (fwd.) = 27.2x
1,527
Dec. 31, 1996 P/E (fwd.) = 16.0x
741
Jun. 30, 2018P/E (fwd.) = 16.1x
2,718
+101%
Oct. 9, 2007 P/E (fwd.) = 15.7x
1,565
-57%
Mar. 9, 2009 P/E (fwd.) = 10.3x
677
+302%
+106%
U.S. Stock Market Pulls Back Modestly from the Incredible Run in 2017
● Relentless climb in S&P 500 Price Index since the trough of the market in Q1 2009.
● Forward valuation dropped in the first and second quarter of 2018; now at 16.1, it’s near the 25-year average, and nowhere near the peak set in 2000
● Dividend yield on stocks has been comparable to that of a 10-year Treasury for an extended period, and the gap is just widening now; vastly different relationship between stock and bond yields in 2000 and 2007
Source: J.P. Morgan Asset Management.
12 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
Market Watches the Fed, But Doesn’t Always Believe It
● Median of 2018 projections (2.4%) still lies in the range between 2.0% and 2.5%, but is up from 2.1% in March, suggesting a total of four rate hikes this year.
● Median for 2019 is 3.1%, up from 2.9% in March, and 3.4% in 2020, which is unchanged
● Longer term, median expectation is settled around 3%
Futures market discounts FOMC projections of future Fed funds target
Source: Federal Reserve
Federal Reserve Dot Plot—June 2018
FOMC participants’ assessments of appropriate monetary policy: Midpoint of target range or target level for the federal funds rate
13 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
Unprecedented Policy Response Is Finally Over Fed moves toward normalization with four rate hikes expected in 2018
Source: J.P. Morgan Asset Management.
Federal funds rate expectations FOMC and market expectations for the fed funds rate
Extremely Unusual 2.38%
3.13% 3.38%
2.88 %
1.88% 2.19%
2.70% 2.76%
0%
1%
2%
3%
4%
5%
6%
7%
'99 '01 '03 '05 '07 '09 '11 '13 '15 '17 '19 '21
Source: Bloomberg, FactSet , Federal Reserve , J.P . Morgan Asset Management. Market expectations are the federal funds rates priced into the fed futures market as of the date of the June 2018 FOMC meeting. Guide to the Markets – U.S. Data are as of June 30, 2018.
Federal funds rate
FOMC long - run projection
FOMC year - end estimates
Market expectations on 6/13/18
Long r un
Fixed income
FOMC June 2018 forecasts (percent)
2018 2019 2020 Long run
Change in real GDP, 4Q to 4Q 2.8 2.4 2.0 1.8
Unemployment rate, 4Q 3.6 3.5 3.5 4.5
PCE inflation, 4Q to 4Q 2.1 2.1 2.1 2.0
14 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
Length of Zero Interest Rate Policy Truly Unprecedented
Futures market and virtually all forecasters have been predicting higher interest rates since January 2009. No one predicted the will of central banks to hold rates low for this long, nor for inflation to remain at bay in the face of such unprecedented easing.
Sources: FRB, Bloomberg Finance LP, DB Global Markets Research
Rates markets have been pricing in Fed liftoff since 2009
15 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
Long Period of Zero Interest Rate Policy Skews Memories of ‘Normal Markets’
Long-term historical relationship between bond yields and dividends has been distorted by 10 years of extreme policy intervention.
Yields on 2-Year Treasury notes are higher than the S&P dividend for the first time in 10 years
Source: Callan LLC
0.0
2.0
4.0
6.0
8.0
10.0
12.0
14.0
1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017
Yiel
d %
10-Year Treasury 2-Year Treasury S&P 500 Dividend Yield
16 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
New Term Has Entered the Lexicon—Quantitative Tightening (QT)
● U.S. Federal Reserve ceased balance sheet expansion gradually through tapering. Other central banks are tapering debt purchases and will cease balance sheet expansion by the end of 2019.
● U.S. Federal Reserve will be reducing its balance sheet, suggesting potential debt sales starting in 2018 and upward pressure on rates. Simply allowing bonds to mature without repurchasing will reduce the balance sheet.
Global monetary policy shifts from expansion to contraction of Central Bank balance sheets
Source: J.P. Morgan Asset Management, Bank of England, Bank of Japan, European Central Bank, FactSet, Federal Reserve, Morgan Global Economic Research Guide to the Markets – U.S. Data are as of June 30, 2018
Global central bank balance sheet expansion* USD billions, 12 - month rolling flow
Fixed income
Fed
BoJ
ECB
BoE
Total
-$1,000
-$500
$0
$500
$1,000
$1,500
$2,000
'16 '17 '18 '19
17 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
Expansion Continues, But Not Without Raising Concerns
● The slow burn in the current expansion may enable it to continue, at the risk of building up asset price bubbles even further.
● Current recovery is one of the longest, but also one of the slowest, averaging GDP growth in the U.S. of just 2.2%.
● Inverted yield curves typically suggest the onset of recession. The yield curve has flattened but is not yet inverted. Long rates have not budged as short rates have been elevated.
● The explanatory power of an inverted yield curve has lessened in the wake of the GFC and QE. Demand on the long end and limited supply are driving the slope, holding down the long end.
Expansions do not die of old age, but this one is close to becoming the longest
Source: J.P. Morgan Asset Management.
0
25
50
75
100
125
1900 1912 1921 1933 1949 1961 1980 2001
-6%
4%
14%
24%
34%
44%
54%
0 8 16 24 32 40
Source: BEA, NBER, J.P. Morgan Asset Management. *Chart assumes current expansion started in July 2009 and continued through June 2018, lasting 108 months so far. Data for length of economic expansions and recessions obtained from the National Bureau of Economic Research (NBER). These data can be found at www.nber.org/cycles/ and reflect information through June 2018.Guide to the Markets – U.S. Data are as of June 30, 2018.
Length of economic expansions and recessions Strength of economic expansionsCumulative real GDP growth since prior peak, percent
Prior expansion peak
— 4Q48 — 1Q80
— 2Q53 — 3Q81
— 3Q57 — 3Q90
— 2Q60 — 1Q01
— 4Q69 — 4Q07
— 4Q73
Expansions: 47 months
Recessions: 15 months
Average length (months): 108 months*
Number of quarters
Current Expansion
18 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
Consumers Sensitive to Interest Rate Hikes, but Disaster May Not Be Looming
● The U.S. savings rate has fallen to its lowest level in a decade.
● From Capital Economics: “The savings rate is at a decade low because the household net wealth is at a record high. This situation is sustainable IF housing and equity valuations don’t fall.”
● That remains a big IF…
● Debt servicing cost looks very reasonable relative to history.
● However, rise in credit card debt is potential cause for concern.
Consumption is two-thirds of GDP, and the sector typically leads growth (and contractions)
Source: Capital Economics; Thomson Reuters
Consumer Interest Rates (%)
Household Debt Servicing Costs (% of disposable income)
19 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
Consumer Borrowing Reaching New Heights
● Consumer credit (ex-mortgages) as a percentage of disposable income keeps climbing, well above the pre-GFC peak.
Leverage clearly fueled consumption growth through 2017, suggests vulnerability to deleveraging
Source: Federal Reserve
● The increase stems from non-revolving debt, mostly student and auto loans.
● The ratio of non-revolving debt to disposable income peaked in November 2017, has held flat through the first two quarters of 2018.
20 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
Global Equity Valuations
● U.S. valuations slipped in the second quarter, but remain high relative to other regions of the world
● Non-U.S. regions, while above their 10-year averages, appear more reasonably valued versus the U.S
● Despite reasonable relative valuations, both political and economic risks remain in international markets
Source: FactSet as of 6/30/18. NTM P/E is market price per share divided by expected earnings per share over the next tw elve months. Data provided is for informational use only. Past performance is no guarantee of future results.
Source: Eaton Vance
21 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
Equity Valuations—Historical Data
● U.S. equity valuations have slipped in each quarter since the start of the year but remain high relative to the 15-year average
● Current valuations are well below the tech-bubble era and have recuperated steadily after the Global Financial Crisis
● U.S. equity valuations are higher relative to non-U.S. equity; ACWI ex-US valuations are at their 15-year average
03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 185.0
10.0
15.0
20.0
25.0
30.0
for 15 Years ended June 30, 2018Price/Earnings Ratio (exc neg)
S&P 500 S&P 500 Average
03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 185.0
10.0
15.0
20.0
25.0
30.0
for 15 Years ended June 30, 2018Price/Earnings Ratio (exc neg)
MSCI ACWI ex USA MSCI ACWI ex USA Average
22 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
Equity Valuations—Historical Data
● U.S. equity valuations have slipped in each quarter since the start of the year, but remain higher than non-U.S. developed and emerging market equity valuations relative to the 15-year average for each index
● Current valuations are well below the tech-bubble era and have recuperated steadily after the Global Financial Crisis
● U.S. equity valuations are higher relative to non-U.S. developed and emerging market equity
● Forward valuations have dropped in each of the first two quarters of 2018, and the 16.1 June reading is at the 25-year average
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 20185.0
10.0
15.0
20.0
25.0
30.0
35.0
Price/Earnings Ratio (exc neg) for 15 Years ended June 30, 2018
22.2 - S&P 500
15.7 - MSCI EAFE
13.5 - MSCI Emerging Markets
17.8 - S&P 500 Average16.0 - MSCI EAFE Average
12.9 - MSCI Emerging Markets Average
23 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
Fixed Income Valuations
● Overall, spread sectors continue to trade at rich levels relative to Treasuries on a 15-year basis due to demand for yield the last several years.
● Below-investment grade sectors such as high yield and bank loans maintain a yield advantage over other spread sectors.
Source: Factset as of 6/30/18. Spread history measures past 15 years. Data provided is for informational use only. Past performance is no guarantee of future results. All f ixed-income spreads are in basis points and measure option-adjusted yield spread relative to comparable maturity U.S. Treasuries using daily data. Loan Index spread represents the three-year discounted spread over LIBOR. Aggregate represented by Bloomberg Barclays US Aggregate Index. Agency represented by Bloomberg Barclays U.S. Agency Index. MBS represented by Bloomberg Barclays U.S. Mortgage Backed Securities (MBS) Index. ABS represented by Bloomberg Barclays U.S. Asset Backed Securities (ABS) Index. CMBS represented by Bloomberg Barclays U.S. CMBS Investment Grade Index. Corporate represented by Bloomberg Barclays U.S. Corporate Investment Grade Index. Preferred represented by ICE BofAML Fixed Rate Preferred Securities Index. Floating-Rate Loans represented by S&P/LSTA Leveraged Loan Index. Emerging Markets(USD) represented by JPMorgan Emerging Markets Bond Index (EMBI) Global Diversif ied. High Yield represented by ICE BofAML US High Yield Index.
Source: Eaton Vance
24 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
Market Volatility—Realized and Implied
● The VIX, measuring the implied volatility of S&P 500 Index options, spiked 116% on Feb 5 when the market sank 4%, marking the biggest jump ever recorded—albeit from historically low levels.
● Volatility remained elevated through March and April, then fell back to the low teens in May, before climbing slowly through June, ending the second quarter at 16, still below the long-term average of 19.3
● First quarter 2018 volatility was exacerbated by anxiety about overly optimistic sentiment to start the year, expectations for determined action on the part of the Fed to raise rates, de-risking on the part of systematic investors, and accelerating wage growth.
● Valuations as measured by traditional metrics like P/E remain high.
S&P 500 Index
0%
5%
10%
15%
20%
25%
30%
Standard Deviation for S&P 500
S&P 500 S&P 500 Average
0
10
20
30
40
50
60
70
80
90
CBOE VIXTM
CBOE S&P 500 VIX™ Average (19.3)
72 80 90 00 10 18 90 95 00 05 10 15 18
25 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
Diversification Remains Key Risk Control Periodic Table of Investment Returns 2001–2018 Q2
S&P 500
-11.89%
S&P 500
-22.10%
S&P 500
28.68%
S&P 500
10.88%
S&P 500
4.91%
S&P 500
15.79%
S&P 500
5.49%
S&P 500
-37.00%S&P 500
26.47%
S&P 500
15.06%
S&P 500
2.11%
S&P 500
16.00%
S&P 500
32.39%
S&P 500
13.69%
S&P 500
1.38%
S&P 500
11.96%
S&P 500
21.83%
S&P 500
2.65%
GrowthS&P 500
-12.73%
GrowthS&P 500
-23.59%
GrowthS&P 500
25.66%
GrowthS&P 500
6.13%
GrowthS&P 500
4.00%
GrowthS&P 500
11.01%
GrowthS&P 500
9.13%
GrowthS&P 500
-34.92%
GrowthS&P 500
31.57%
GrowthS&P 500
15.05%
GrowthS&P 500
4.65%
GrowthS&P 500
14.61%
GrowthS&P 500
32.75%
GrowthS&P 500
14.89%
GrowthS&P 500
5.52%
GrowthS&P 500
6.89%
GrowthS&P 500
27.44%
GrowthS&P 500
7.28%
ValueS&P 500
-11.71%
ValueS&P 500
-20.85%
ValueS&P 500
31.79%
ValueS&P 500
15.71%
ValueS&P 500
5.82%
ValueS&P 500
20.81%
ValueS&P 500
1.99%
ValueS&P 500
-39.22%
ValueS&P 500
21.17%
ValueS&P 500
15.10%
ValueS&P 500
-0.48%
ValueS&P 500
17.68%
ValueS&P 500
31.99%
ValueS&P 500
12.36%
ValueS&P 500
-3.13%
ValueS&P 500
17.40%
ValueS&P 500
15.36%
ValueS&P 500
-2.22%
Russell 2000
2.49%
Russell 2000
-20.48%
Russell 2000
47.25%Russell 2000
18.33%
Russell 2000
4.55%
Russell 2000
18.37%
Russell 2000
-1.57%
Russell 2000
-33.79%
Russell 2000
27.17%
Russell 2000
26.85%
Russell 2000
-4.18%
Russell 2000
16.35%
Russell 2000
38.82%
Russell 2000
4.89%Russell 2000
-4.41%
Russell 2000
21.31%
Russell 2000
14.65%
Russell 2000
7.66%
GrowthRussell 2000
-9.23%
GrowthRussell 2000
-30.26%
GrowthRussell 2000
48.54%
GrowthRussell 2000
14.31%
GrowthRussell 2000
4.15%
GrowthRussell 2000
13.35%
GrowthRussell 2000
7.05%
GrowthRussell 2000
-38.54%
GrowthRussell 2000
34.47%
GrowthRussell 2000
29.09%
GrowthRussell 2000
-2.91%
GrowthRussell 2000
14.59%
GrowthRussell 2000
43.30%
GrowthRussell 2000
5.60%
GrowthRussell 2000
-1.38%
GrowthRussell 2000
11.32%
GrowthRussell 2000
22.17%
GrowthRussell 2000
9.70%
ValueRussell 2000
14.02%
ValueRussell 2000
-11.43%
ValueRussell 2000
46.03%
ValueRussell 2000
22.25%
ValueRussell 2000
4.71%
ValueRussell 2000
23.48%
ValueRussell 2000
-9.78%
ValueRussell 2000
-28.92%
ValueRussell 2000
20.58%
ValueRussell 2000
24.50%
ValueRussell 2000
-5.50%
ValueRussell 2000
18.05%
ValueRussell 2000
34.52%
ValueRussell 2000
4.22%
ValueRussell 2000
-7.47%
ValueRussell 2000
31.74%
ValueRussell 2000
7.84%
ValueRussell 2000
5.44%
ex USAMSCI World
-21.40%
ex USAMSCI World
-15.80%
ex USAMSCI World
39.42%
ex USAMSCI World
20.38%
ex USAMSCI World
14.47%
ex USAMSCI World
25.71%
ex USAMSCI World
12.44%
ex USAMSCI World
-43.56%
ex USAMSCI World
33.67%
ex USAMSCI World
8.95%
ex USAMSCI World
-12.21%
ex USAMSCI World
16.41%
ex USAMSCI World
21.02%
ex USAMSCI World
-4.32%
ex USAMSCI World
-3.04%
ex USAMSCI World
2.75%
ex USAMSCI World
24.21%
ex USAMSCI World
-2.77%
Barclays AggBloomberg
8.43%
Barclays AggBloomberg
10.26%
Barclays AggBloomberg
4.10%
Barclays AggBloomberg
4.34%
Barclays AggBloomberg
2.43%
Barclays AggBloomberg
4.33%
Barclays AggBloomberg
6.97%
Barclays AggBloomberg
5.24%
Barclays AggBloomberg
5.93%
Barclays AggBloomberg
6.54%
Barclays AggBloomberg
7.84%
Barclays AggBloomberg
4.21%
Barclays AggBloomberg
-2.02%
Barclays AggBloomberg
5.97%
Barclays AggBloomberg
0.55%
Barclays AggBloomberg
2.65%
Barclays AggBloomberg
3.54%
Barclays AggBloomberg
-1.62%
MarketsEmerging
MSCI
-2.61%
MarketsEmerging
MSCI
-6.16%
MarketsEmerging
MSCI
55.82%Markets
EmergingMSCI
25.55%Markets
EmergingMSCI
34.00%Markets
EmergingMSCI
32.17%Markets
EmergingMSCI
39.38%
MarketsEmerging
MSCI
-53.33%
MarketsEmerging
MSCI
78.51%
MarketsEmerging
MSCI
18.88%
MarketsEmerging
MSCI
-18.42%
MarketsEmerging
MSCI
18.23%
MarketsEmerging
MSCI
-2.60%
MarketsEmerging
MSCI
-2.19%
MarketsEmerging
MSCI
-14.92%
MarketsEmerging
MSCI
11.19%
MarketsEmerging
MSCI
37.28%
MarketsEmerging
MSCI
-6.66%
High YieldBarclays
Bloomberg
5.28%
High YieldBarclays
Bloomberg
-1.37%
High YieldBarclays
Bloomberg
28.97%High YieldBarclays
Bloomberg
11.13%
High YieldBarclays
Bloomberg
2.74%
High YieldBarclays
Bloomberg
11.85%High YieldBarclays
Bloomberg
1.87%
High YieldBarclays
Bloomberg
-26.16%High YieldBarclays
Bloomberg
58.21%
High YieldBarclays
Bloomberg
15.12%
High YieldBarclays
Bloomberg
4.98%
High YieldBarclays
Bloomberg
15.81%
High YieldBarclays
Bloomberg
7.44%High YieldBarclays
Bloomberg
2.45%High YieldBarclays
Bloomberg
-4.47%
High YieldBarclays
Bloomberg
17.13%
High YieldBarclays
Bloomberg
7.50%
High YieldBarclays
Bloomberg
0.16%
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 20172018
2 Qtrs.
26 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
2Q18 Asset Class Observations
Global Equity – Factor-based defensive, minimum variance, low volatility,
ESG, and concentrated strategies are areas of interest within U.S. equity.
– New ESG products continue to trickle in. – Clients interested in defensive strategies in anticipation of a
market downturn, while small and micro cap searches have increased as clients also seek alpha in less efficient markets.
– Appetite for non-U.S. equity searches continues, particularly non-U.S. small cap and ACWI ex-US value as firms are experiencing portfolio manager or organizational changes.
– Currency and China A-shares continue to be topics of discussion. Callan posted a research brief and blog post on China A, which we don’t see as a market mover at this point but worth monitoring.
– We have seen a mergers and acquisitions trend in the asset management industry. Managers with a clear plan for team integration and investment strategies will fare better.
Fixed Income – Fixed income managers expressing concern over policy
uncertainty in the U.S., particularly regarding trade, geopolitics, and monetary policy.
– Long duration fixed income remains an area of interest. Recent tax law changes create potential for significant contributions, which support additional long duration allocations. With average fund status reaching the low 90s, plan sponsors should be vigilant about protecting their contributions.
– Non-core segments with less interest rate sensitivity and potential for yield pick-up also of interest, particularly high yield, bank loans, multi-sector credit, and direct lending.
– Multi-sector credit products continue to be introduced although we have not seen search activity among our clients.
– Structured product strategies have begun to make more headway in the market. This area of the market may gain interest as a high quality diversifier amidst a credit cycle that shows signs of being closer to its end than its beginning.
– Stable value innovations have paved the way for entry into the 403(b) market. These developments will offer more transparency and diversification to a market with limited options.
Public Markets
27 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
-6.00%
-3.00%
0.00%
3.00%
6.00%
9.00%
12.00%
Dec-17 Jan-18 Feb-18 Mar-18 Apr-18 May-18 Jun-18
Russell 2000 Russell 1000
Trump Tariff Trauma
● Retaliatory tariffs impacting U.S. agriculture, auto, and industrial metals sectors, among others. Ongoing decline of U.S. export market share exacerbating impact on large caps, which may continue to face macro headwinds in the coming quarters.
● Large cap (+2.9% YTD) significantly trailing small cap (+7.7% YTD) as investors view small companies as more insulated against potential trade wars/looming tariffs. S&P 500 companies generate 38% of revenue overseas versus 20% for S&P SmallCap 600.
● Rising dollar and concerns over divergence between strong U.S. economy and slower global growth also driving investors to relative safety of smaller companies.
Large Cap Trailing Small Cap in Wake of Potential Trade Wars
28 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
Concentration Risk within U.S. Equities
Concentration Risk ● FAANG stocks (Facebook, Apple, Amazon, Netflix,
Google/Alphabet and to some extent Microsoft) continue to drive outsized proportion of returns within equity indices.
● Concentrated portfolio holders should be mindful of attribution coming from a small handful of names and potential for downside exposure should a correction ensue.
● Biotech represents half the Health Care weight of RUS2G (12% vs. 25%) and many small growth managers have struggled in selecting biotech names given the binary outcomes and depth of resources needed to do it well.
Amazon Effect Continues ● Amazon (+17% 2Q18) increased in size by over
69% since last year’s Russell reconstitution with continued market share expansion in the retailing space (including food) and now into Health Care.
● Active large cap managers with underweight positions to Amazon will likely continue to lag their benchmarks given Amazon’s looming presence in large cap indices.
3.38
-0.73
2.65
-1.00
0.00
1.00
2.00
3.00
4.00
FAANG Rest of Index
Contribution to S&P 500 total return (ppt)S&P 500 total return (%)
0%
1%
2%
3%
4%
5%
S&P 500 Year to Date Sector* Attribution
Tech(4.8%)
S&P 500non-tech(0.1%)
*w eights as of 03/31/2018; performance as of 06/14/2018 Source: Syntax LLC
S&P 500 (YTD 4.9%)
Excluding FAANG stocks, index returns would have been negative
Note: FAANG = FB, AAPL, AMZN, NFLX, GOOG/GOOGL Source: S&P, BofA Merrill Lynch US Equity & US Quant Strategy
FAANG stocks’ contribution to the S&P 500 1H18 total return
29 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
-6%
-3%
0%
3%
6%
9%
12%
Dec-17 Jan-18 Feb-18 Mar-18 Apr-18 May-18 Jun-18
Russell 1000 Value Russell 1000 Growth
Time to Rebalance into Value Equity?
● Large value trailed large growth by nearly 900 bps in the first half of 2018 (-1.7% vs. +7.3%) driven by ongoing outperformance of the Tech sector and Tech-exposed Consumer Discretionary companies.
● Performance gap further impacted by the type of value manager employed as statistical value (reliant upon traditional measures of low P/B, low P/E) lagging relative value (companies trading at a discount to intrinsic value).
● Be mindful of value manager rotation into Apple, Microsoft, and Alphabet—the very drivers of growth outperformance—which we have seen with several large value managers.
30 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
Large Cap Equity QuarterLast
Last Year YearsLast 3
YearsLast 5
YearsLast 10
YearsLast 15
Russell 1000 Growth 5.76 22.51 14.98 16.36 11.83 10.30Russell 1000 Value 1.18 6.77 8.26 10.34 8.49 8.63Mid Cap EquityRussell Midcap Growth 3.16 18.52 10.73 13.37 10.45 11.07Russell Midcap Value 2.41 7.60 8.80 11.27 10.06 11.04Small Cap EquityRussell 2000 Growth 7.23 21.86 10.60 13.65 11.24 10.95Russell 2000 Value 8.30 13.10 11.22 11.18 9.88 9.93
For Periods ended June 30, 2018
U.S. Equity Market
● U.S. equities (S&P 500 +3.4%) rose on a strong earnings season and positive economic data. – Energy was the best-performing sector
(+13.5%) as oil prices trended higher after U.S. withdrew from Iran nuclear accord.
● Small cap (+7.8%) outperformed large cap (+3.6%) on trade war fears. Large cap companies derive big portion of revenues from foreign markets (S&P 500 aggregate is ~40%) and are more negatively impacted compared to their domestically focused small cap peers.
● Growth (+5.8%) continued to outperform Value (+1.2%) due to strong results in Tech (+7.1%) and Consumer Discretionary (+8.2%).
● Concentration of returns within broad indexes remains a concern. Excluding FAANG stock performance, S&P 500 performance was negative.
13.9%
7.2% 6.4% 3.8% 2.1% 1.8%
0.4%
-1.9% -2.1%
20.4%
14.2% 10.1%
9.8% 8.5%
6.8% 6.6% 3.9%
2.7%
-4.0%
-3.0%
-2.0%
-1.0%
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
7.0%
8.0%
9.0%
10.0%
11.0%
12.0%
13.0%
14.0%
15.0%
16.0%
17.0%
18.0%
19.0%
20.0%
21.0%
Energy Con Disc Tech HealthCare
Utilities Materials&
Processing
Financials ProducerDurables
ConsStaples
Russell 1000 Russell 2000
Source: Callan, Russell Investment Group FAANG: Facebook, Apple, Amazon, Netf lix, Google/Alphabet
Economic Sector Quarter Performance as of June 30, 2018
31 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
Second Quarter 2018 Search Rationale (by count)*
Replacement 36%
Structural 64%
Year to Date 2018 Search Rationale (by count)*
Replacement 45%
Structural 55%
Large Core 24% Large Growth 7% Large Value 7% Mid Cap 7%
Smid Core 7% Smid Growth 4%
Smid Value 7%
Small Core 3%
Small Growth 17%
Small Value 7%
Other* 10%
Percent of Searches (29 searches)*
Large Core 28%
Large Growth 8%
Large Value 8% Mid Cap 8% Smid Core 8%
Smid Growth 4%
Smid Value 8%
Small Growth 12%
Small Value 4%
Other 12%
Percent of Searches (25 searches)*
Insights from Callan's Global Manager Research Group
Large Core 9% Mid Cap 0% Smid Core 3%
Smid Value 1% Small Core 16% Small Growth 22%
Small Value 22%
Other* 27%
Year to Date 2018 Percent of Assets Allocated ($2.7 billion total assets)*
Large Core 18% Mid Cap 0% Smid Core 6% Smid Value 2% Small Growth 12% Small Value 11%
Other 51%
Second Quarter 2018 Percent of Assets Allocated ($1.4 billion total assets)*
Second Quarter 2018 Year to Date 2018
U.S. Equity
*Preliminary **Other includes micro cap equity
32 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
Currency Volatility: Central Bank Divergence Leads to U.S. Dollar Rally
● Diverging interest rates around the world are causing currencies to diverge. With the U.S. Federal Reserve raising rates, and other central banks remaining more accommodative, the U.S. dollar is rallying, thereby hurting returns for non-U.S. equity exposure (unhedged).
● As long as this divergence continues, U.S. dollar investors face a currency-effect headwind with non-U.S. exposures.
● Several banks (Sweden, Japan, and Switzerland) maintain negative interest rates. Financials were among the worst-performing sectors for those countries.
* Source: www.global-rates.com
33 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
Non-U.S. Equity QuarterLast
Last Year YearsLast 3
YearsLast 5
YearsLast 10
YearsLast 15
MSCI ACWI ex USA -2.61 7.28 5.07 5.99 2.54 7.74MSCI ACWI ex USA Growth -1.42 9.90 6.56 7.18 3.01 7.91MSCI ACWI ex USA Value -3.84 4.64 3.51 4.75 2.03 7.50MSCI EAFE -1.24 6.84 4.90 6.44 2.84 7.26MSCI EAFE (local) 3.47 6.12 5.18 8.93 4.98 7.01Regional EquityMSCI Europe -1.27 5.28 4.22 6.21 2.36 7.07MSCI Europe (local) 4.08 4.30 5.69 8.71 5.42 7.23MSCI Japan -2.84 10.51 6.25 7.37 3.54 6.62MSCI Japan (local) 1.20 8.94 2.78 9.73 4.00 6.05MSCI Pacific ex Japan 1.77 8.68 6.57 6.04 4.64 10.42MSCI Pacific ex Japan (loc) 4.50 11.15 7.51 9.05 6.30 9.59
For Periods ended June 30, 2018
Non-U.S. Equity Market
● Non-U.S. markets ended in the red as trade war talk moved into action. Although initial tariffs levied by the U.S. were targeted, retaliatory actions and supply chain disruptions broadened their effects. – Growth outpaced value—although no factor
category showed significant strength. – Cyclical sectors were hurt later in the
quarter as the prospect of slower growth led to reduced expectations.
– The U.S. dollar was up, hurting non-U.S. returns. The euro and British pound were hit especially hard with the rise of populism and Brexit turmoil.
● Emerging markets sold off significantly led by China and Latin America. – Fears of increasing debt burdens and trade
war effects impacted China. – Brazil affected by slower global growth, and
falling sentiment hit energy and financials hard.
● Frontier markets impacted by Argentina (-42%) on continuing political unrest, severe drought, and a devaluing currency.
Emerging/Frontier Markets QuarterLast
Last Year YearsLast 3
YearsLast 5
YearsLast 10
YearsLast 15
MSCI Emerging Markets -7.96 8.20 5.60 5.01 2.26 10.70MSCI Emerging Markets (loc) -3.51 10.47 7.48 8.45 5.23 11.57MSCI Frontier Markets -15.19 1.69 2.15 4.55 -2.52 6.70Non-U.S. Small Cap EquityMSCI EAFE Small Cap -1.57 12.45 10.09 11.32 6.81 10.69MSCI Em Mkts Small Cap -8.60 5.64 2.55 4.32 4.44 11.30
Sources: Callan, MSCI
34 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
Non-U.S. Equity Market
● Emerging markets were among the hardest hit with Latin America taking the brunt of the sell-off. In May, Brazil’s central bank unexpectedly left rates unchanged, while a trucking strike and growing concern about October elections weighed on markets. The Brazilian real fell 14% in the quarter versus the U.S. dollar.
● China reversed a five-quarter rally on concerns surrounding growing debt burdens, slower growth, and trade uncertainty.
as of June 30, 2018Non-U.S. Quarterly Performance (U.S. Dollar)
World ex USA
ACWI ex USA
China
Europe ex UK
Japan
Pacific
Pacific ex Japan
United Kingdom
Emerging Markets
-0.75%
-2.61%
-3.50%
-2.86%
-2.84%
-1.35%
1.77%
2.95%
-7.96%
Australia
AustriaBelgiumCanada
DenmarkFinlandFrance
GermanyHong Kong
Ireland
IsraelItaly
JapanNetherlands
New Zealand
NorwayPortugal
Singapore
SpainSweden
Switzerland
United Kingdom
Quarter ended 6/30/18
5.2
-10.6
-6.0
4.7
-7.0
1.3
-0.5
-4.0
-1.2
2.0
10.9
-7.3
-2.8
-1.8
5.7
2.3
1.2
-7.5
-4.4
-3.7
-2.7
2.9
1 Year ended 6/30/18
8.7
8.9
1.7
9.1
0.9
10.4
9.9
2.5
9.2
5.3
-4.6
8.4
10.5
9.2
1.7
27.1
15.7
7.9
-3.6
-4.6
-3.4
10.0
Sources: Callan, MSCI
Developed Country Returns
35 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
Second Quarter 2018 Search Rationale (by count)*
Replacement 67%
Structural 33%
Year to Date 2018 Search Rationale (by count)*
Replacement 73%
Structural 27%
Non-U.S. Developed 18%
Non-U.S. All Country 27%
Non-U.S. Growth 9%
Non-U.S. Value 18%
Non-U.S. Small Cap 14%
Emerging Markets 14%
Percent of Searches (22 searches)*
Non-U.S. All Country 25%
Non-U.S. Growth 17%
Non-U.S. Value 33%
Non-U.S. Small Cap 17%
Non-U.S. Developed 8%
Percent of Searches (12 searches)*
Insights from Callan's Global Manager Research Group
Non-U.S. Developed 1% Non-U.S. All Country 8%
Non-U.S. Growth 2% Non-U.S. Value 4%
Non-U.S. Small Cap 11%
Emerging Markets 75%
Year to Date 2018 Percent of Assets Allocated ($4.0 billion total assets)*
Non-U.S. Developed 5%
Non-U.S. All Country 10%
Non-U.S. Value 12%
Non-U.S. Small Cap 74%
Second Quarter 2018 Percent of Assets Allocated ($0.6 billion total assets)*
Second Quarter 2018 Year to Date 2018
* Preliminary
Non-U.S./Global Equity
36 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
Answers May Be Blowin’ In the (Trade) Wind
● Announced tariffs aren’t expected to have a meaningful impact on growth; however, the extent of the costs ultimately depends on the degree to which other countries counter.
● An OECD study that looks at the far larger shock of a 10% across-the-board increase in tariffs by the U.S., euro zone, and China finds that global GDP would fall by 1.4%.
● The more impactful result may be an increase in uncertainty, which tends to precede weaker economic activity.
● These effects will take time to ultimately play out and are even more difficult to cap and quantify.
Global GDP impact of 10%-pts tariff increase
Economic Policy Uncertainty Index
37 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
U.S. Temps Not the Only Thing Heating Up—Inflation and Rates
● The Fed’s preferred measure of inflation (PCE) is on the precipice of its 2% target. – Impact of increased tariffs and fiscal policy
may lead to even higher future prints. – Only the recent strength of the USD and a
drop in energy prices have curtailed the dramatic rise over the past year.
● The spread between the 2- and 10-year U.S. Treasury yields has reached its lowest point since 2007 (33 bps). – With two more hikes forecasted for this year
and three more next year, the curve is inching closer to inversion.
– While not an immediate cause of recession, an inverted curve has been a reliable signal of recession in the past.
Sources: JPMorgan, BEA, PIMCO
Core PCE inflation, including June forecast
U.S. Treasury Yield Curve Forwards 3.5%
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
0.0% 1M 10Y 30Y
Current 1Y Forward 3Y Forward
38 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
Broad Fixed Income QuarterLast
Last Year YearsLast 3
YearsLast 5
YearsLast 10
YearsLast 15
BB Barclays Aggregate -0.16 -0.40 1.72 2.27 3.72 3.77BB Barclays Gov/Credit -0.33 -0.63 1.83 2.29 3.78 3.71BB Barclays Government 0.10 -0.63 1.02 1.48 2.91 3.20BB Barclays Credit -0.88 -0.65 2.86 3.37 5.15 4.52BB Barclays Corporate High Yld 1.03 2.62 5.53 5.51 8.19 7.77Long-TermBB Barclays Long Gov/Credit -1.45 -0.78 4.34 5.10 6.79 5.84BB Barclays Long Government 0.26 -0.13 3.40 4.56 6.02 5.57BB Barclays Long Credit -2.65 -1.30 4.95 5.48 7.30 5.99Intermediate-TermBB Barclays Interm Aggregate 0.09 -0.32 1.27 1.83 3.29 3.47BB Barclays Interm Gov/Credit 0.01 -0.58 1.16 1.60 3.08 3.21Short-TermMoney Market Funds (net) 0.38 1.06 0.44 0.27 0.23 1.11ML Treasury 1-3 Year 0.22 0.08 0.42 0.58 1.24 1.9290-Day Treasury Bills 0.45 1.36 0.68 0.42 0.35 1.29
For Periods ended June 30, 2018● Fixed Income markets grappled with multiple
issues. resulting in continued volatility. – Trade conflicts due to imposition of tariffs, EM
elections, and rising U.S. dollar contributed to the unstable environment.
● U.S. rates rose in the second quarter and the yield curve continued its flattening trend. – The spread between the 2-year and 10-year
ended at its lowest level (33 bps) in more than 10 years.
● Investment grade corporates faced increased headwinds during the quarter, dragging returns lower. – Concerns over potential trade wars and rising
rates increasingly weighed on IG credit despite rising earnings and revenues.
● High yield corporates rebounded in Q2 pushing year-to-date returns into positive territory. – CCC-rated credits continued to outperform
higher-rated credits within high yield. – Earnings growth remains strong and defaults
remain benign amid positive economic outlook.
Source: Callan, Bloomberg
Fixed Income Market
39 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
Second Quarter 2018 Search Rationale (by count)*
Replacement 0%
Structural 100%
Year to Date 2018 Search Rationale (by count)*
Replacement 33%
Structural 67%
Core 13%
Core Plus 13%
Defensive 13%
Extended Maturity 27%
Mortgages 6%
TIPS 7%
Non-U.S/ Global Fixed 7%
Stable Value 7%
Other 7%
Percent of Searches (15 searches)*
Core 29%
Core Plus 14% Defensive 29%
Extended Maturity 14%
Non-U.S/ Global Fixed 14%
Percent of Searches (7 searches)*
Insights from Callan's Global Manager Research Group
Core 1%
Defensive 0%
Extended Maturity 70% Mortgages
25%
TIPS 0%
Non-U.S/ Global Fixed 1%
Stable Value 3%
Other 0%
Year to Date 2018 Percent of Assets Allocated ($7.0 billion total assets)*
Core 12%
Core Plus 0%
Defensive 4% Extended Maturity 78%
Non-U.S./ Global Fixed 6%
Second Quarter 2018 Percent of Assets Allocated ($0.8 billion total assets)*
Second Quarter 2018 Year to Date 2018
Fixed Income
*Preliminary**Other includes tax exempt municipal f ixed income
40 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
Explosion in Growth of Private Credit
● 1H2018 middle market sponsored loan volume totaled $40 billion, on pace to exceed 2017’s total of $78 billion
● Lending standards are loosening and leverage increasing
● Leverage limit for BDCs recently increased to 2:1 (from 1:1), which may result in increased competition for deals
Private Credit Industry Assets Under Management
Sources: Preqin, ACC research
Committed Capital by Type
41 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
2Q 2018 Asset Class Observations
Real Assets
● U.S. core real estate returns continue to moderate and shift toward income with limited appreciation, with any appreciation that does deliver coming from NOI growth rather than further cap rate compression.
● Spreads remain relatively tight between core and value-add due to large amounts of capital in both strategies chasing fewer available deals combined with many core investors seeking to create core assets by utilizing their non-core buckets to buy and stabilize non-core properties.
● Both U.S. and non-U.S. REITs are trading at discounts to net asset value, indicating relative value for public market securities compared to private real estate valuations.
● As private real estate valuations continue to test historical highs, investors are looking at other sectors such as real estate debt and REITs to access the best risk-adjusted returns from real estate. This is resulting in some products with very wide mandates that allow the investment manager to place capital across real estate debt and equity markets and up and down the capital stack based on relative value.
Hedge Funds and Private Equity
● Client demand for hedge funds remains limited, especially given lower-cost MAC solutions. However, rising rates and increasing volatility is creating fertile ground for hedge funds focused on idiosyncratic risks.
● The private equity fundraising environment remains “frothy.” Liquidity remains healthy. Strong plan sponsor appetite for private equity continues unabated.
● Buyouts are dominating the market. Distressed managers appear to be gaining interest despite headwinds.
● LPs are concerned with high and increasing company entry prices and more leverage.
● Private equity markets are increasing in complexity due to GPs raising ancillary products, aging GP restructurings, and early liquidity options.
● Many successful GPs selling stakes in their management companies to third parties as a means to reinvest in the business, create new products, and/or pay out management. This is an important diligence item that LPs must address prior to making an investment.
Private Markets
42 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
Real Estate Trends Led by Europe, Asia, and Infrastructure
European real estate markets (ex-U.K.) gaining momentum due to strong fundamentals in major European cities and despite continued political noise across region.
– Value-add and opportunistic real estate owners and operators continue to see significant opportunity to create and sell core product to a robust market of buyers. Paris, Berlin, Frankfurt, Amsterdam, Stockholm, and Madrid continue to see increased levels of investment activity.
Asian real estate products are seeing strong fundraising momentum, with existing managers reaching target fund sizes and an increase in Asia-focused open-end funds.
– Chinese government is implementing policies to increase domestic growth and consumption, including support for the development of multi-family rental property, a relatively new concept in China. Over the summer, the Chinese renminbi has weakened against the dollar, due to monetary easing in China and global trade tensions, and more stringent capital controls have increased the amount of capital looking to invest within the country; investment activity remains steady in China.
– Other major markets such as Japan, Australia, South Korea, and India continue to see investment activity across multiple sectors.
Infrastructure strategies are raising significant capital. – Open-end infrastructure managers have secured substantial new commitments this year. Infrastructure managers have reported
mixed impact to their portfolios following the implementation of the latest tax law changes. The variety of closed-end infrastructure products continues to increase with new offerings in debt and emerging markets-focused strategies.
43 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
Second Quarter 2018 Search Rationale (by count)*
Replacement 14.3%
Structural 85.7%
Year to Date 2018 Search Rationale (by count)*
Replacement 8.0%
Structural 92.0%
Core 20%
Value Added 28%
Opportunistic 4% Non-U.S. 4%
Real Estate Debt 16%
Farmland 4%
Infrastructure 24%
Percent of Searches (25 searches)*
Core 7%
Value Added 14%
Opportunistic 7%
Real Estate Debt 29%
Infrastructure 43%
Percent of Searches (14 searches)*
Insights from Callan's Global Manager Research Group
Core 19%
Value Added 21%
Opportunistic 6%
Non-U.S. 27%
Real Estate Debt 16%
Farmland 3%
Infrastructure 8%
Year to Date 2018 Percent of Assets Allocated ($3.3 billion total assets)*
Core 2%
Value Added 13%
Opportunistic 3%
Real Estate Debt 55%
Infrastructure 27%
Second Quarter 2018 Percent of Assets Allocated ($1.0 billion total assets)*
Second Quarter 2018 Year to Date 2018
Real Assets including Real Estate
*Preliminary
44 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
Home Field Advantage for Hedge Funds
Hedge funds are finally getting a home field advantage, after almost a decade of being disadvantaged by QE-suppressed short-term interest rates.
– Rising rates increase underlying returns from “short interest rebate” and any discretionary cash balances
– Though rising rates increase financing rates, typical hedge fund trade is short duration, so higher financing costs are rationalized in new trades pending
Head Start with Rising Short Rates
06 07 08 09 10 11 12 13 14 15 16 17 180%
1%
2%
3%
4%
5%
6%
Rolling 12 Month Returns
1.36% - 3 Month T-Bill
45 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
50%
55%
Jan-18 Mar-18 May-18 Jul-18 Sep-18 Nov-18 Jan-19 Mar-19 May-19 Jul-19 Sep-19 Nov-19
Expiration Dates
January 5, 2018 January 31, 2018 February 5, 2018 March 5, 2018
● Vol shows w/o warning: see adjacent chart
● Higher rates likely to translate into bigger market moves that create more profitable opportunities for hedged traders
● Hedge funds are not oversubscribed, so a greater supply of opportunities will likely reward discretionary capital in hedge funds.
● Realized alpha is still modest, but the potential is better with today’s tightening liquidity and less synchronized markets.
Source: LongTail Alpha, LLC, Callan LLC (estimated)
Ready to Rumble with Rising Volatility?
Term Structure of Implied Volatility—S&P 500 Index Options
46 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
Hedge Funds and Multi-Asset Class
● Given trade war threats and other geopolitical events, hedge funds across most strategies struggled for traction.
● Strong M&A activity provided support to event-driven strategies, but regulatory risk remains notably uncertain in deal approvals.
● Credit opportunities are limited in a still-durable economy, leaving FOFs and event-driven funds at low end of target allocations.
● Momentum, or trend, lost more ground last quarter with markets flip-flopping, adding to the prior quarter’s sting from February’s market reversal.
● As the FAANG stocks continued to gain popularity last quarter, the value risk premia was left more unappreciated. Flashback of memories from the late 90s?
● Both large and small hedge funds yielded similar middling results, on average. FOFs earned their fees last quarter with performance matching that of the underlying indexes.
Returns for Periods ended June 30, 2018
Hedge Fund Universe QuarterLast
Last Year YearsLast 3
YearsLast 5
YearsLast 10
YearsLast 15
HFRI Asset Wtd Composite 0.87 5.31 2.68 4.17 3.52 --HFRI Fund Weighted Index 0.84 5.67 3.63 4.44 3.45 5.57.HFRI Equity Hedge 0.85 8.22 4.85 5.84 3.69 5.66.HFRI Event-Driven 2.15 5.79 4.63 4.80 4.67 6.57.HFRI Macro -0.16 1.17 0.17 1.23 1.13 3.88.HFRI Relative Value 1.12 3.91 3.74 4.38 5.11 5.763 Month T-Bill 0.45 1.36 0.68 0.42 0.35 1.29Liquid Alternatives UniverseS&P 500 3.43 14.37 11.93 13.42 10.17 9.30Bloomberg Barclays Aggregate -0.16 -0.40 1.72 2.27 3.72 3.7760% S&P 500/40% BC Aggr 1.99 8.34 7.88 8.97 7.84 7.30CS NB MARP Index (5%v) -0.51 -1.03 2.79 2.99 6.31 --SG Trend Index -1.34 2.90 -2.27 2.11 1.16 3.34* Gross of fees
Equity Momentum Equity Carry Equity Value
Fixed Momentum Fixed Carry Fixed Value
Currency Momentum Currency Carry Currency Value
Comm Momentum Comm Carry MARP (5%v) Average
-2.2%-0.9%
-4.6%-2.6%
0.3% 0.1%
-4.1%
2.8%
-0.3%
9.5%
1.7%
18
-10%
-5%
0%
5%
10%
Ret
urns
Alternative Risk Factor Breakdown—Last Quarter ended June 30, 2018
Source: Credit Suisse Neuberger Berman Multi-Asset Risk Premia Index
47 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
363 361.1 396.8 459.7
603.1 646.6 631.4 649.8 677.7
333.2
2009 2010 2011 2012 2013 2014 2015 2016 2017 2018YTD
Capital Raised ($billions)
Private Equity Landscape
Speed and Magnitude of Fundraising ● Ever greater investor appetite for private
equity
● Funds are coming back to market very quickly (often 2–3 years) and raising large amounts (many GPs are doubling in fund size)
● Fundraising timelines are condensed, shortening the time frame for investor due diligence
Company Valuations and Leverage ● Due to the competitive private equity
environment, general partners are forced to pay up in order to outbid their peers
● As valuations have risen, so has the use of leverage, which has surpassed pre-GFC levels
● Borrowing standards continue to loosen under a less regulatory administration
2009 2010 2011 2012 2013 2014 2015 2016 2017
Purchase Price Multiples
Others Equity/ EBITDA Sub Debt/ EBITDA Senior Debt/ EBITDA
10.6x 10.0x 10.3x
9.7x 8.8x 8.8x 8.5x
7.7x 8.7x
Source: S&P LCD
Source: Pitchbook
48 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
0
5
10
15
20
25
30
35
40
45
0
200
400
600
800
1,000
1,200
1,400
1,600
1,800
2009 2010 2011 2012 2013 2014 2015 2016 2017 2018YTD
Cap
ital R
aise
d ($
billi
ons)
Med
ian
Fund
Siz
e ($
mill
ions
)
Fundraising—Distressed/Restructuring
Capital Raised Median Fund Size
● More distressed funds are fundraising in preparation for a possible market dislocation.
● Some funds will only be turned on once a disruption occurs; this creates a nice hedge for the overall private equity portfolio when the market dips.
Source: Pitchbook
Distressed Funds Poised for Market Dislocation
49 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
Private Equity Market
● With the public market zig-zagging sideways, private equity activity slowed modestly. Fundraising picked-up in 2Q but is slightly behind last year’s first half. Company investments and exits trended slightly down.
● 2Q private equity partnership commitments totaled $90.3 billion, with 329 new partnerships formed. The dollar volumes and number of funds both rose 36% from 1Q. (Source: Private Equity Analyst)
● Funds closed 443 investments with $36.0 billion in disclosed deal value, representing a 26% dip in count and a 47% decline in value from 1Q. (Source: Buyouts)
● New investments in venture capital companies totaled 1,895 rounds of financing with $27.3 billion of announced value. Investments were down 10% from 1Q, and value fell 13%. (Source: National Venture Capital Association)
● There were 132 private M&A exits of buyout-backed companies with disclosed values totaling $24.5 billion. Both the count and dollar volume were down from 1Q. Six buyout-backed IPOs raised an aggregate $2.5 billion, down from 11 totaling $3.9 billion previously. Venture-backed M&A exits totaled 173 transactions with disclosed value of $8.8 billion, compared to 203 sales with values of $13.6 billion in 1Q. There were 28 VC-backed IPOs in 2Q with a combined float of $1.9 billion. 1Q had 15 IPOs and total issuance of $2.2 billion. (Source: Buyouts)
Funds Closed January 1 through June 30, 2018
Strategy # of Funds $ Amt (mil) % Venture Capital 273 24,612 16% Acquisition/Buyouts 193 108,047 69% Private Debt 39 8,457 5% Secondary and Other 23 8,537 5% Fund-of-funds 43 7,140 5% Totals 571 156,793 100%
Source: Private Equity Analyst
Private Equity Performance Database—Pooled Horizon IRRs Through December 31, 2017 – Returns are net of fees
Strategy 3 Mos 1 Yr 3 Yrs 5 Yrs 10 Yrs 15 yrs 20 Yrs All Venture 3.7% 13.0% 9.2% 16.2% 9.5% 9.7% 17.9%
Growth Equity 5.8% 20.1% 12.2% 13.6% 10.0% 13.0% 13.5%
All Buyouts 5.4% 22.6% 13.7% 14.4% 8.8% 14.6% 12.4%
Mezzanine 3.2% 14.7% 9.7% 10.2% 8.8% 9.7% 8.7%
Distressed 2.5% 11.0% 6.7% 9.5% 9.5% 10.8% 10.3%
All Private Equity 3.6% 15.3% 10.1% 10.8% 9.3% 11.5% 11.2%
S&P 500 4.8% 19.1% 11.9% 14.0% 9.1% 13.0% 12.8%
Source: Thomson Reuters/Cambridge
50 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
High Demand for Private Markets
1,304
1,624 1,561 1,619
1,845 1,949
2,098 2,235
2,651
2,965
3,211
705 888
699 607
758 797 733 793 946 1,008
1,212
Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 Oct-17
As at Date
Private Capital Funds in Market over Time, January 2008 – October 2017
No. of Funds in Market Aggregate Capital Targeted ($bn)
2017 fundraising on course for record year
51 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
Rising interest rates, low return expectations and increased risk controls drive today’s strategic allocation decisions.
Active vs passive debates loom large
Managed account evaluations, target date fund implementation and recordkeeper fee reviews are driving fund sponsor projects. Target date funds continue to dominate asset flows.
Summary of Key Issues
Rising interest rates, continued low return expectations, and the desire for strong risk controls in anticipation of a late cycle market downturn are top line discussion points. Several schools of thought have emerged. Some fund sponsors are looking for down side protection while others are seeking higher yield in less efficient markets in order to reach return targets. Other sponsors want strong, transparent risk controls and lower performance volatility while examining lower fee structures.
Providing down market protection and maneuverability in volatile, low return environments are two strong reasons for investing in active management. However, during periods of underperformance and high fees, plan sponsors may be tempted to abandon actively managed equity. The debate continues about whether active management or passive management provides investors with the right balance between higher performance and lower costs.
Examination of managed account offerings on a standalone basis in order to improve participant outcomes and experiences is ongoing and will continue into the future. Defined contribution plans are evaluating different levels of service offered by recordkeepers and shifting away from off-the-shelf target date funds.
Target date funds’ (TDF) share of defined contributions assets grew to 31.3%, marking another all time high for the category according to the Callan DC Index™.
Fund Sponsor Strategy
52 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
Our clients’ strategic allocation discussions are based on their unique plan perspectives and market views.
Corporate DB funding status improved for some, so “balancing the tradeoffs of de-risking vs. remaining total return focused” is important while, …
For another corporate DB client, “EROA remains a sensitive subject with earnings implications that result from de-risking strategies.” Still another corporate DB client is “moving towards long duration now that the plan is fully funded.” Callan's survey data shows fixed income has benefited.
Public DB plans, with less ideal funding status, are concerned with “downside protection and asset allocation shifts” … “to diversify away from equity risk.” There is interest in private real estate, private equity and multi-asset classes (MACs).
Endowments and Foundations, also “concerned with downside protection in an equity downturn” are seeking “diversification from U.S. equity and fixed income” … and …
“the plan is looking for sources of income in other asset classes (e.g. private real estate)”
Consultant Survey: Second Quarter 2018
-20%-10%
0%10%20%30%40%
U. S.Equity
Non- U.S.Equity
GlobalEquity
FixedIncome
PrivateReal
Estate
PrivateEquity
HedgeFunds
Multi-AssetClass
-20%-10%
0%10%20%30%40%
U. S.Equity
Non- U.S.Equity
GlobalEquity
FixedIncome
PrivateReal
Estate
PrivateEquity
HedgeFunds
Multi-AssetClass
-20%-10%
0%10%20%30%40%
U. S.Equity
Non- U.S.Equity
GlobalEquity
FixedIncome
PrivateReal
Estate
PrivateEquity
HedgeFunds
Multi-AssetClass
Strategic Allocation Policy
Incr
ease
A
lloca
tion
Dec
reas
e A
lloca
tion
Percentage of Callan clients considering changes in strategic allocation policy Public DB Plans
Corporate DB Plans
Endowments & Foundations
Incr
ease
A
lloca
tion
Dec
reas
e A
lloca
tion
Incr
ease
A
lloca
tion
Dec
reas
e A
lloca
tion
53 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
Many public plans most concerned with return enhancement, are “realizing this is as good as it gets for equity market returns” and are “continuing to search for managers to fund increased allocations to private equity and real estate.”
One consultant reports that “two clients, a public DB and a corporate DB client, are doing micro-cap equity searches this quarter.” … “Probably an indication of more clients digging deeper to find pockets of potential alpha.”
Another public DB client is focusing priorities on … “overall plan liquidity” due to “the risk of a simultaneous equity market drawdown and a rising rate environment (positive stock and bond market correlations).” … when diversification benefits disappear.
Consultant Survey: Second Quarter 2018
9%
4%
6%
6%
6%
2%
2%
2%
Alternative beta
Private credit
Real asset(other than private real estate)
Short duration fixed income
Low volatility equity
ESG
Unconstrained fixed income
Opportunistichigh tracking error equity
3.1
2.5 2.4 2.0
0.00
0.50
1.00
1.50
2.00
2.50
3.00
3.50
Return enhancement
Risk control Funding status Liquidity
Public DB Plans: Strategic Priorities and Investment Structure
Ranking of issues in order of most importance for Public DB clients (4 = most important)
Percentage of public DB clients seriously considering adding or increasing exposure to the following
“Where are the ‘parking places’ for alternative investments given recent volatility in the public markets?”
54 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
3.0 2.8 2.6
1.7
0.00
0.50
1.00
1.50
2.00
2.50
3.00
3.50
Reduce return volatility
Control funded status volatility
Return enhancement
Liquidity
Consultant Survey: Second Quarter 2018
In 2018, many corporate DB plans are taking advantage of current tax incentives to address de-risking.
One consultant notes a “DB plan is pre-funding to take advantage of 2017 vs 2018 tax rates … to 100% funding status and, thus need to re-allocate from risky assets to interest hedged assets, e.g., bonds.”
Other corporate DB plans are “closing DB plans leading to further discussions about de-risking.”
Another consultant reports a DB plan is evaluating …
“Liability mitigation strategies, either through investments or other settlement strategies like lump sums and plan spin outs or terminations.”
At one DB plan, “the board just voted to terminate the pension plan entirely.”
53%
28%
12% 9% 0%
10%
20%
30%
40%
50%
60%
Make lump sum offers
No actions taken or planned in the near future
Small balance annuities
Sell the entire liability
Corporate DB Plans: Strategic Priorities and Liability Transfer
Ranking in order of most importance for corporate DB clients (4 = most important)
Corporate DB clients that have taken action or plan to take the following action within 3 years regarding liability
*Multiple responses allow ed.
55 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
21%
2% 2%
5% 56%
No pursuit of LDI
Adopted a de-risking strategy but have notbegun implementation
Started implementation of a de-riskingstrategy but currently on hold
Partially hedged to changes in nterest ratesbut not contemplating an increase
Continuing to implementde-risking process
While many sponsors have committed to an LDI glidepath and de-risking, one consultant reports, “a shift from total return to LDI.”
Implementation of an LDI glidepath is not always as clear. A consultant describes the situation for one client…
“Sponsors are trying to figure out how to actually move down the de-risking path.”
Another consultant reports, a DB plan “realizes there is no incentive to dampen total fund returns by going LDI until full funding is achieved.”
A corporate DB plan reports it is …
“Considering additional steps towards immunization, as plan continues to mature.”
While another plan is taking action by…. “hedging plan liabilities and freezing the plan.”
Corporate DB Plans: Liability-Driven Investing
Consultant Survey: Second Quarter 2018
Steps corporate DB clients have taken toward implementing an LDI strategy
2% At this time, few corporate DB plans report purchasing long-duration bonds before de-risking glidepath triggers are met and hedging exposure with various financial instruments
56 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
The focus on fee reduction is the most important issue for defined contribution plans this quarter.
One consultant reports “good conversations about evaluation of a TDFs' appropriateness for the fund’s populations and the risks of their target date fund providers' glidepath, implementation, fees, etc.”
A DC plan is looking at plan design and is “questioning partial distributions and mega roths as well as manager replacements.”
Plan sponsors are discussing whether they should … “increase adoption or consideration of a discretionary model?”
Consultant Survey: Second Quarter 2018
2.9
2.4
2.3
2.3
0.00 0.50 1.00 1.50 2.00 2.50 3.00 3.50
Fees
Compliance
Investment structure
Participant communication
15%
26% 22%
1%
Employ custom glidepath
Are entirely passive
Include private real estate or real asset
Include absolute return alternative
Defined Contribution Trends
Percentage of DC clients employing target date funds with these characteristics
Ranking of issues in order of most importance by Defined Contribution clients (4 = most important)
“Clients remain focused on fiduciary issues and avoiding any potential for litigation.”
57 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
2.8
2.6
2.4
2.1
0.00 0.50 1.00 1.50 2.00 2.50 3.00
Return enhancement
Spending policy
Risk management
Liquidity
Consultant Survey: Second Quarter 2018
Endowments and foundations are highly focused “on return enhancement to meet their spending objectives and growth of corpus.”
One Callan consultant describes conversations with clients this way …
“Endowments & foundations are looking for diversification away from U.S. equity and U.S. fixed income, especially given valuations and rising rates and credit cycle concerns.”
An endowment & foundation client reported the organization is …
“considering other asset classes to help with diversification and volatility reduction.”
Another client is looking at …
“how to increase private investment allocation in the current highly-valued market.”
5%
8%
20%
33%
Have adjusted spending rule to reducepayments
Plan to reduce spending rule in the near future
Have decided not to reduce spending rule atthis time
Have not discussed reduction in spending rule
Endowment & Foundation Trends
Ranking of issues in order of most importance by Endowment & Foundation clients (4 = most important)
Percentage of endowment & foundation clients that have made these decisions regarding their spending rule
58 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
Conclusion
Defined Contribution DC plans are increasingly reviewing recordkeepers, fees, and levels of service to better align with plan demographics and participants’ outcomes/experiences. According to the Callan DC Index™, target date funds now account for 31.3% of DC assets, the highest level to date. 70% of asset flows into DC funds originate from target date funds. Additionally, U.S. fixed income had net inflows of 13.13% while riskier assets saw significant outflows. Overall, equity allocation fell for the first time in 7 quarters, ending at 70%.
Broad Themes Concerns about low capital market return expectations; the spike in equity volatility; and anticipation of a late cycle market downturn are driving today’s discussions. Other topics that concern plan sponsors are rising interest rates and uncertain outcomes of tariffs with global trade partners. Despite these concerns, some plans will seek enhanced returns at the expense of increased risk. Not surprisingly, well constructed and transparent risk controls are becoming more important in strategic plans.
Corporate Funds Most corporate DB clients have embraced de-risking (increasing fixed income and extending duration). They are moving along their de-risking glidepath and working at different stages of the process. Callan expects plan sponsors to diversify existing long bond portfolios with a wider range of fixed income allocations. Implementation of de-risking plans depends largely on the movement of interest rates this year. Callan expects to see allocations to riskier assets, e.g. equities and alternative investments, decrease as rates rise and plans move forward with de-risking.
Public and Endowment & Foundation Funds Return enhancement, return enhancement, return enhancement….continues to be the focus of public plans and endowment & foundation funds. As endowments & foundations seek higher returns, asset classes such as global equity, non-U.S. equity and real estate benefit. Risk and funded status for public plans are definitely ongoing concerns, especially with the increased market volatility experienced thus far in 2018.
Fund Sponsor Outlook
59 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
U.S. Equity
Non-U.S. Equity
Fixed Income
Conclusion
New products are continuations of existing investment strategies (e.g. small cap team managing SMID; diversified large cap strategy introducing a concentrated version).
Callan believes small cap strategies will remain the most desired products. Large cap style product generation will decrease as negative flows continue.
Product demand for non-U.S. equity is strong particularly among DC plans. Search activity is in non-U.S. small cap and ACWI ex USA. value. Although Callan favors global equity, there has been little activity.
Emerging market product demand is down this half and expected to remain low in the near future.
Increase interest in currency is demonstrated by client requests for more education about hedging diversification.
The 403(b) market is encouraging stable value innovations due to requirements for more products with transparency and diversification abilities.
Structured product strategies are seen as good diversifiers in a late credit cycle.
Multi-sector credit products continue to be introduced, despite few allocations seen recently.
Product Demand Outlook
60 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
Real Estate
Conclusion
Real asset demand is strong. Unsurprisingly, products with income generation and downside protection are preferred. Callan clients are maintaining and, in some cases, increasing exposure to real assets. Core and value-added real estate strategies see the strongest market demand. The real estate and infrastructure sectors are experiencing increasing interest as clients continually look for the benefits of risk diversification.
Product Demand Outlook (continued)
Callan Update
62 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
Published Research Highlights from 2Q18
Your Plan Will Face a Cyberattack. Here’s How to Prepare. 2018 ESG Survey
Our Take on Crypto- currencies Mark Wood
Rebalance Your Portfolio, or Let It Ride? John Jackson
Risk Parity: Silver Bullet or a Bridge Too Far? Greg Allen
China A-Shares: Key Issues for Investors to Consider
Callan Monthly Periodic Table of Investment Returns
Incorporated ESG factors
into the investment
decision-making process
Additional Reading
Private Markets Trends quarterly newsletter
June Regional Workshop Summary: Governance Alpha
Active vs. Passive quarterly Charts
Capital Market Review quarterly newsletter
Popular Blog Posts
43%
63 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
Callan Institute Events
Live Events
October Regional Workshops October 16, 2018 – New York October 18, 2018 – Atlanta
2019 National Conference January 28–30, 2019 – Palace Hotel San Francisco, California
Webinars: On-Demand now available at https://www.callan.com/ondemandwebinar/
Our library of pre-recorded webinars on specific investment-related topics, such as:
– Beyond the Yale: Other Portfolio Options for Endowments and Foundations
– Auto Features & Financial Wellness: Can They Work Together in DC Plans?
– Infrastructure Considerations for Investors
“Callan College”—Ongoing fiduciary education Introduction to Investments sessions – October 2–3, 2018, in Chicago
Upcoming Conferences, Workshops, and Webinars
“Research is the foundation of all we do at Callan, and sharing our best thinking with the investment community is our way of helping to foster dialog to raise the bar across the industry.” — Greg Allen, CEO, CRO
64 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
Callan’s sixth annual 2018 ESG Survey presents trends on ESG adoption for U.S. institutional funds. The results reflect input from 89 unique institutional U.S. funds and trusts.
Callan 2018 ESG Survey Key Findings
Risk Matters Achieving an improved risk profile was the most frequently cited reason for incorporating ESG
13% of defined contribution plans feature an ESG option in the plan lineup
of large funds have incorporated ESG factors into investment decisions
55% of those who have incorporated ESG consider ESG factors with every investment / manager selection
15% of those who have not yet incorporated ESG factors are considering it
39% public funds
64% foundations
56% endowments
Incorporated ESG factors into the investment decision-making process—the highest in the history of our survey
ESG incorporation by region
Pacific 60% Northeast 54% Central 42% Mountain 38% Southeast 13%
20% corporate
41% of respondents who incorporated ESG plan to broaden the scope of incorporation in the future
43%
65 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
Foundations 35%
Endowments 34%
Foundations 39%
Endowments 53%
Foundations 56%
Foundations 64%
Endowments 22%
Foundations 31%
Endowments 37%
Foundations 48%
Endowments 39%
Endowments 56%
Public 15%
Public 22%
Public 27%
Corporate 30%
Public 35%
Public 39%
Corporate 14%
Corporate 16%
Corporate 15%
Public 25%
Corporate 25%
Corporate 20%
2013 2014 2015 2016 2017 2018
ESG Factor Adoption Rates by Fund Type
By fund type over last six years
64% of foundations have incorporated ESG factors into investment decisions, the 2018 survey found. Foundations have incorporated ESG factors at a higher rate than all other fund types in four out of the six years that Callan has fielded this survey. Endowments and foundations have consistently led other fund types in ESG implementation over time.
39%
20%
56% 64%
Public DB 43% Corp DB
33%
Public DC 20%
Corp DC 9%
Public Corporate Endowments Foundations Public Corporate
2018 funds that are incorporating ESG factors into investment decisions
defined benefit plans are more than 3x more likely to incorporate ESG factors into investment decisions than defined contribution plans.
Defined benefit plans, public and corporate combined, incorporated ESG at a rate of 40% while defined contribution plans only incorporated ESG at a rate of 13% (not pictured)
66 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
ESG Factor Adoption Rates by Fund Size
72% of the largest respondents (>$20 bn) have incorporated ESG factors into investment decisions. The largest funds have incorporated ESG factors at the highest rate since the inception of the survey in 2013.
47%
28% 33%
72%
< $500mm $500mm to $3bn $3bn to $20bn > $20bn 0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
50%
55%
60%
65%
70%
75%
80%
85% 2018 funds that are incorporating ESG factors into investment decisions
By fund size over last six years
135% Small funds are catching up, with a nearly 1.5x increase for the smallest funds (respondents <$500mm) that have incorporated ESG factors into investment decisions since 2013.
> $20bn 33%
> $20bn 31%
> $20bn 35%
> $20bn 71%
> $20bn 78%
> $20bn 72%
$3bn to $20bn 29%
$500mm to $3bn 24%
$3bn to $20bn 31%
<$500mm 39%
$500mm to $3bn 42%
<$500mm 47%
$500mm to $3bn 23%
<$500mm 22%
<$500mm 26%
$3bn to $20bn 33%
<$500mm 30%
$3bn to $20bn 33%
<$500mm 20%
$3bn to $20bn 18%
$500mm to $3bn 26%
$500mm to $3bn 29%
$3bn to $20bn 22%
$500mm to $3bn 28%
2013 2014 2015 2016 2017 2018
67 Market Environment – Second Quarter 2018 Knowledge. Experience. Integrity.
55%
55%
50%
45%
37%
37%
32%
26%
18%
13%
5%
Considered ESG factors with everyinvestment/investment manager
selectionCommunicated to investment
managers that ESG is important to thefund
Engaged with management, activelyvoted proxies, and/or submitted
shareholder resolutions
Added language to investment policystatement
Hired a manager/strategy thatincorporates ESG
Incorporated a screening process
Divested from a certain industry,sector, or other area
Added language to investment beliefs
Scored investment managers usingESG metrics
Hired a manager/strategy for impactinvesting
Added an ESG option to the DC planlineup
Words becoming action When Callan inquired about ESG implementation
approaches in 2016 and 2017, “added language to the
investment policy statement” was the most popular
method among survey respondents.
In 2018, the two most popular approaches suggest funds
are now taking action on ESG beliefs: considering them
in manager selection and communicating them to
investment managers.
As ESG research develops and investors become more
educated about the issues and implementation options,
we’re observing a shift to action, working with others in
the investment management community to implement
ESG beliefs.
*Multiple responses allow ed.
ESG Implementation
How funds are incorporating ESG*
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