HAPPY 8TH BIRTHDAY BULL MARKET WHAT DEFINED THE RALLY, AND HOW IS THE THESIS MATURING?

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1 HAPPY 8TH BIRTHDAY BULL MARKET WHAT DEFINED THE RALLY, AND HOW IS THE THESIS MATURING? MAY 217 Laurence Taylor Portfolio Specialist, Global Equities We all come to approach our birthdays with a healthy dose of cynicism as we age, but has any been viewed with such mixed feelings as that of the global equity bull market's 8th birthday? Over the course of what seems like an eternity since this bull was born in March 29 (taking the S&P s low point), we have certainly climbed a mighty wall of worry. THINGS THAT DIDN T EXIST IN MARCH 29 Half of China s GDP (in current prices) The Game of Thrones television series WhatsApp, Instagram, and Uber The term Brexit Justin Bieber s tattoos Abenomics The ipad Fitness trackers The Tesla Model S Selfie sticks Naturally, the scars incurred during the financial crisis have been slow to heal, but confusion has also reigned for much of this equity cycle. This is no surprise given policymakers have been forced to employ radical measures to deal with both an absence of growth and the perpetual threat of crisis 2.. With economic conditions impacting and changing society outside of equity markets, the net result has been an ongoing lack of comfort and few warm hearts toward the Aging Bull. An unusual perspective considering the magnitude of positive returns delivered. Today, anxiety remains even despite renewed equity market strength. While understandable, we remain constructive that enough drivers are in place to maintain and elevate market levels, albeit over a new and, hence, uncertain phase of the equity cycle. It is also important to recognize that change, innovation, and improvement have occurred in spite of fears that a new normal environment signaled a peak for global economies. A BIG BULL Since market lows were touched in March 29, the S&P 5 has come roaring back with a total return of over 31% (Figure 1), making it the second-longest, and one of the strongest, bull markets of all time. Global markets have performed less well but have still delivered significant returns to investors. Given the strength in markets, it is perhaps surprising that we have yet to witness the kind of broad-based bubbles forming that often mark the end of an equity cycle. This is where pessimism demonstrates a measure of value, in that dampened sentiment has prolonged this particular equity cycle by warding off many of the excesses and extremes that form as a result of overexuberance. FOR INVESTMENT PROFESSIONALS ONLY. NOT FOR FURTHER DISTRIBUTION.

2 Figure 1: The unloved global equity rally Regional Returns, as of March 31, 217 Rebased to S&P 5 MSCI Emerging Markets MSCI Japan MSCI Europe THE DEATH OF EQUITIES? Sources: MSCI and FactSet. Note: MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI. Past performance cannot guarantee future results. IT WAS ALL ABOUT VALUATION (AT FIRST) While now becoming a history lesson, it was on the November 25, 28, that the U.S. Federal Reserve announced the beginning of its quantitative easing (QE) program to support asset prices. The Federal Funds target rate was subsequently cut to near zero in January 29, with the S&P 5 breaching a trough a few weeks later with a valuation of around 1-times forward earnings. Since the start of this global equity rally, it seems like we have been through endless mini-crises and recovery cycles, with one familiar friend in the background inexpensive valuations paying investors to take a chance on recovery. The power of extremely cheap valuations with respect to potential future returns has therefore rewarded the faithful and been the principal foundation of this bull market (Figure 2). Figure 2: Valuations Allowing investors to take a chance Developed Versus Emerging Markets, 12-Months Forward Price-to-Earnings (P/E) Ratio January 1996 March 217 P/E Ratio MSCI EM Long- Term Average: 11.8x MSCI World Long-Term Average: 16.2x MSCI Emerging Markets MSCI World Emerging Markets Long-Term Average World Long-Term Average Sources: MSCI and FactSet. As of March 31, 217.

3 Given where we are today, valuations are unlikely to be the major driver of future returns, unless we find a catalyst for extreme exuberance. While some would argue that markets are already pricing in extremely optimistic assumptions, we disagree. Valuations are certainly not cheap, and this impacts the magnitude of the upside versus the past, but it is extreme valuations or a crisis that will likely end this bull market. Between valuation extremes, markets are more likely to be data dependent with respect to whether economic activity is accelerating or decelerating and how corporates are being impacted by these trends at an earnings and cash flow growth level. On these measurements, the data is implying a reasonably good setup for fundamental improvement over the medium term. History suggests that this phase of the equity cycle should help to drive further returns and should not be overlooked, despite the greater complexity. CORPORATE PROFITS THE EARLY YEARS While extreme (cheap) valuations have been central to the magnitude and length of this equity market rally, improving economic data and strengthening corporate fundamentals (Figure 3) have also lent a hand, albeit not with the consistency and strength to ever make life comfortable for investors. Figure 3: Earnings in most regions have bounced back (Europe being the exception) Regional Profits Earnings per Share Last Cycle Peak (October 27), as of March 31, 217 Rebased to Sources: MSCI and FactSet. Emerging Markets Europe ex UK Japan United Kingdom United States When looking for evidence of fundamental recovery in corporate earnings, the U.S. market remains on top with dramatic cost control by companies and an earlier exit from recession speeding the process of improvement. While the U.S. backdrop has weakened in recent quarters, we have seen an Abenomics-inspired Japan join the profits growth party since 212. Elsewhere, the picture has given investors little to be optimistic about since the initial rebound in This is a factor that has legitimately weighed on sentiment in segments of Europe and the emerging world especially. So what have we learned from the earnings recovery, or lack thereof, amid this bull market so far? First, we have learned that U.S. companies continue to be at the forefront of squeezing out profits growth, doing whatever it takes (to quote a European central banker). While cost management and topline growth have helped, growth in profits has also come from changing capital allocation policy trends, in part reflecting a recognition of giving your audience what it wants more capital return in times of scarce income. With borrowing costs low, the use of leverage to boost dividends and buy back stock became a popular method of generating returns for shareholders in U.S. companies. Management teams were quick to respond to investor demand, especially as the rewards were observed via higher stock prices. However, in the absence of excess leverage becoming a feature of the corporate backdrop, this theme has now likely peaked, placing more emphasis on topline sales growth in

4 the coming quarters. Regardless, the U.S. equity market s outperformance is an important lesson with respect to investors willingness to pay for companies that seek and deliver profit maximization and apply adaptable capital allocation over the long run. Quality does matter over time, especially at the corporate management team level. Second, we have learned that, while history never repeats itself, it does often rhyme. On this point, Japan has risen from the depths of despair to deliver on its cyclical corporate profits promise (Figure 4), even in spite of anemic domestic and global economic growth trends. This bottom-up, later-cycle earnings improvement has shown itself more materially than the macroeconomic policy arrows targeting inflation in wages or prices and has been instrumental in Japan outperforming most major markets since 212. In a macro-obsessed world, Japan has acted as an important reminder of the differences between economic and equity fundamentals. Figure 4: Japan delivers on its promises Leverage to Recovery and Recession. Beta of Corporate Earnings (Regional EPS) to Global Industrial Production. As of March 31, Inflation or no inflation, this corporate earnings improvement should be viewed as a success for Japan, especially when considering that Europe has failed to deliver on its own, more modest later-cycle earnings profile. In truth, emerging markets have also disappointed in this regard, although looking at emerging markets as a single entity disguises much of what needs to be understood about the opportunity set today. Looking forward, despite the weakness in global profits since the peak in 213, corporate earnings have now stabilized and, importantly, are beginning to move upward in many major markets. This can be described as just in the nick of time given the reality that earnings improvement is now crucial to the future prospects of this bull market. The key question now is: Where will improvement evolve, and by how much? We personally doubt it is everywhere and a lot as the postelection Trump Trade has implied at times, potentially setting up big macro and stock-specific fundamentals for a clash as we move through 217. While an imperfect message for many, selectivity really will be key in the next stage of the cycle. POOR OLD EUROPE Beta of EPS to Global IP Japan Emerging Markets Continental Europe Source: Empirical Research Partners Analysis. Data exclude financials and utilities. World U.S. UK While the full consequences of the global financial crisis have evolved differently within regions and have been tackled with diverse policy response, a striking dichotomy has been apparent when comparing the pattern of recovery in the U.S. and Europe. Both regions faced their own brand of credit crisis and both utilized QE as a means to spur economic growth. However, while the U.S. tackled its financial system issues as a point of priority and urgency, the vested interests of European governments led to an inability to deal with banking system frailties. Deferral over action has been the net result, adding to the gridlock of policy action as diverse and conflicted governments have struggled to agree on a balance of fiscal austerity and stimulus. Extreme and very easy

5 monetary policy action has therefore had to do the vast majority of heavy lifting in Europe, but this hasn t driven improvement at the bottom-up level as expected. As a result, while there has been a clear correlation between GDP growth and earnings growth in the U.S., that union has been absent in Europe, with corporate profits falling consistently, even during periods of improving GDP growth. This perhaps encapsulates both the bull and bear case for European stocks now. Will improving global economic conditions finally drive profits away from depressed levels, or is the surpassing of Europe s return on equity (ROE) by Japan (Figure 5) for the first time in decades symptomatic of a structural decline in profitability, given unaddressed structural issues? Time will tell, but with unemployment now falling in Europe and with deflationary fears subsiding, now is the moment for Europe to show its improvement teeth. Figure 5: Japan plays catch-up with Europe Regional RoE (%) as of March 31, ROE (%) 1 5 S&P 5 MSCI Emerging Markets MSCI Europe TOPIX First Section Sources: MSCI and FactSet. EMERGING MARKET PAIN While emerging markets suffered intensely during the global economic crisis, equity prices in the emerging world also experienced the strongest rebound, posting stronger returns than either the S&P 5 or the MSCI Europe Index in the years immediately following. However, just as developed market investors breathed a temporary sigh of relief, emerging market optimism seemed to come to a sudden halt, first with the taper tantrum of 213 and then with the collapse of commodity prices shortly thereafter. The rearview mirror now shows emerging market equities underperforming developed equities over 1-, 3-, 5-, and 1-year periods. This is some change from the promised land of the BRIC growth story. We believe that the forward looking emerging market investment case is perhaps the most complex to summarize because emerging market fundamentals are about as dispersed as they have been for two decades. This is important because the point of maximum fundamental correlation has now passed, leaving dispersion and opportunity but no lack of confusion in its wake. The most notable driver of this change is China s maturing industrialization phase, ending the commodity supercycle that, as a byproduct, created high economic correlation between China and major emerging market commodity producers. Emerging market fundamentals have evolved and evolved for good in our view. We will save our detailed comments for a separate paper, but while taxing the nerves, and sometimes the conviction short term, the evolution of the emerging market thesis makes the most durable and most contrarian segments of emerging markets a promising long-term opportunity for investors. While we do not believe the case has ended, despite their long-term underperformance, we do believe the case for passive emerging market investing is a hard one to make today.

6 HAPPY BIRTHDAY, AND HERE S TO (MAYBE A COUPLE) MORE While equity investors will continue to face many complexities, we remain cautiously optimistic that the aging bull is not on its last legs. While slower economic growth has become the new normal, it is growth nonetheless, and indicators are that a backdrop of improvement is in place. Indeed, economic activity has been rising for nearly a year now, beginning before the Brexit vote and the U.S. elections, which somewhat disguised the turn in economic data. Most encouraging, employment data continues to be solid to strong on a global basis (Figure 6), creating potential echo effects in demand from what remains a relatively low base. While rising asset prices have created a wealth effect, employment growth was the ultimate goal of policymakers, and here we are seeing some success, albeit without the wage growth that history would have predicted. Figure 6: Positive backdrop building Employment Growth by Region, as of March 31, 217 4% 3% Year-Over-Year % Growth 2% 1% % -1% -2% -3% Japan -4% European Union U.S. -5% Source: FactSet. Ultimately, earnings delivery will be crucial to returns in the next stage of the equity cycle, given expectations have been rising alongside valuations. This may result in some near-term volatility, but if this does transpire, it should not be confused with the end of this bull market. One way or another, the unknowns of the cycle will mean that investors are offered the opportunity to refresh portfolios on weakness at some stage, before this bull market does eventually end. All else being equal, we will be doing just this.

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