If They Build It, Will Investors Come?

Transcription

1 Fourth Quarter 2017 INVESTMENT STRATEGY QUARTERLY If They Build It, Will Ivestors Come? Itroductio Baseball Hall of Famers Mike Schmidt built a career o power hittig while Ty Cobb operated as a deadball era cotact hitter, yet both are cosidered amog the best hitters of all time. Usig baseball as a aalogy, ivestig does t always mea swigig for the feces; cosistetly hittig sigles ad doubles over a storied career ca still geerate a trip to Cooperstow. Whe discussig asset allocatio with cliets, our goal is to costruct portfolios with log-term durability ot attemptig to be the hero hittig a game-wiig homeru. As actor Art LaFleur said as The Babe (Babe Ruth) i the 1990s film The Sadlot, Remember kid, there s heroes ad there s legeds. Heroes get remembered, but legeds ever die. We prefer our portfolios be of the leged variety. This philosophy meas costructig a portfolio that ackowledges the cyclical ature of markets, as well as beig clear about the loger-term retur potetial of the asset classes i which oe is ivested. Today, based o the valuatio eviromet ad what we believe to be the later iigs of the busiess cycle, our view is that it is advisable to move forward, but with cautio. 1 What does that look like? We thik it meas havig portfolios that are i lie with allocatio targets, perhaps lookig abroad where more attractive valuatios pait a better log-term retur picture, ad also lookig for asset classes with qualities that are more coducive to the curret eviromet. As it relates to the latter, we thik exposure to ifrastructure will cotiue to be additive to portfolio allocatios. We begi by offerig some iterestig statistics: The Uited States has a D+ ratig for ifrastructure from the America Society of Civil Egieers (ASCE). 2 Sice 2015 there are more electric vehicle (EV) chargig statios tha traditioal petrol statios i Japa. 3 Over the last five years, U.S. water/sewer service aualized Cosumer Price Idex (CPI) has bee 4.1% while headlie CPI is just 1.3%. 4 Chia is the world s largest solar pael istaller, more so tha the ext two coutries, the Uited States ad Japa, combied. 5 Geeral Motors is targetig 500,000 ew eergy vehicle sales i Chia o a aual basis by I Swede, droes equipped with automated exteral defibrillators have cosistetly reduced dispatch times compared to traditioal emergecy medical service respose teams. 7 Where ca you fid crumblig bridges, electrical browouts, ad multiyear water shortages? Believe it or ot, we are ot describig North Korea but 1 Howard Marks Memo to Oaktree Cliets, There They Go Agai Agai, July America Society of Civil Egieers, Failure to Act: Closig the Ifrastructure Ivestmet Gap for America s Ecoomic Future, May IEA Sapshot of Global PV, Adreas Claesso, Aders Bäckma, Mattias Righ, et al., Time to Delivery of a Automated Exteral Defibrillator Usig a Droe for Simulated Out-of-Hospital Cardiac Arrests vs. Emergecy Medical Services, Joural of the America Medical Associatio, Jue 13, 2017.

2 rather the Uited States! The largest ecoomy i the world has a glarig ifrastructure ivestmet gap estimated by the ASCE at $2 trillio over the ext 10 years. The quality of existig public works will likely cotiue to deteriorate uless sigificat capital ivestmets are made. For U.S. ivestors, it is commo to associate ifrastructure with shovel-ready jobs, traditioally fuded by various taxig authorities at the state ad local level. From a iteratioal perspective, however, the dyamic betwee private eterprise ad govermet-fuded ifrastructure operatios is quite the opposite. For example, just 15% of water projects are supported by the private sector i the Uited States, whereas that umber jumps to 75% i the Uited Kigdom ad 33% i Chia. 8 Withi the Uited States, efforts are beig made to shift the fudig ladscape toward the iteratioal model. For example, the Trump admiistratio has suggested payig state ad local govermets a bous for privatizig a project, with the size of the bous tied to the size of the project. The proceeds of that privatizatio could the be used for other ifrastructure projects, i what is referred to as asset recyclig. 9 As more ifrastructure projects worldwide are fuded by private capital (or existig ifrastructure is privatized), the opportuity set for ivestors will likely cotiue to expad. As may yield-seekig ivestors look for ivestmets that ca help achieve their log-term retur objectives, we thik ifrastructure may be a optio. While a relatively ew ivestmet solutio to a broad base of U.S. ivestors, asset flows ito ifrastructure ivestmets suggest demad is far from outpacig the supply of global projects. Furthermore, projects dedicated to clea eergy ad water provide a uique opportuity to act as both a log-term icome-geeratig asset as well as a impact ivestmet to help potetially fulfill the eeds of resposible ivestig (RI) ivestors a wi-wi, i our view. I this editio of Ivestmet Strategy Quarterly, we explore the world of global ifrastructure, outliig the key defiig characteristics of the asset class, what role we expect ifrastructure to play i portfolios, ad why ow might be a attractive time to add to existig positios or iitiate ew oes. Defiig Global Ifrastructure Defiig ifrastructure ca be a challegig exercise ad may lead to more questios tha aswers because the asset class is quite broad ad heterogeeous. Is the defiitio iteded to be specific to publicly traded securities such as utilities? Or is it tryig to access ifrastructure ivestmet via illiquid, private vehicles? Does the defiitio iclude miscellaeous social programs such as missio-orieted istitutioal ifrastructure for schools or hospitals? CFA Istitute defies ifrastructure ivestig as the private sector desigig, fiacig, ad operatig physical assets eeded for the fuctioig of a society. 10 I this variatio of the defiitio, a ivestor literally maitais the asset o behalf of the public sector (that is, the govermet), which pays leasig fees for use of that asset. Whe operators wat to exit their ivestmet, they typically sell their iterest to other ivestors, which allows the goverig body to avoid raisig taxes or issuig ew debt to fiace the cotiuatio of that project. We believe i thikig about global ifrastructure from multiple agles, where portfolio exposures ca be accessed through more direct private vehicles or through publicly traded exchage-traded fuds (ETFs) ad actively maaged mutual fuds. We will discuss these varyig exposure optios later i the report. Curretly, there are four primary categories of ivestable themes across the global ifrastructure spectrum: eergy, telecommuicatios, trasportatio, ad water. I Table 1 (page 3), we have highlighted both the challeges ad opportuities associated with each category, as well as the commo sectors/ idustries affected by each. 8 RobecoSAM, Water: The Market of the Future (2015). 9 Strategas Research Parters, Trump Pla Provides New Model for Ivestmet, Jue 6, Yves Courtois, Ifrastructure: A Emergig Global Asset Class, CFA Istitute, November

3 Table 1 Ifrastructure Ivestable Themes Challeges Opportuities Sectors/Idustries Affected Eergy Telecommuicatios Trasportatio Water Source: PNC Drillig efficiecies Fiite resources Reewable eergy iitiatives Fiite mobile demad Limited fiber optic cables Federal Aviatio Admi. Suboptimal traffic flow Fiite resource Irrigatio demads Ucovetioal oil projects Pipelies Reewable eergy projects EV chargig statios 5G techology Dark fiber etworks Data ceters Toll roads Droes High-speed rail Oe Belt, Oe Road Waste water treatmet Desaliatio Smart waterig Oil & gas exploratio Pipelies Utilities Reewable eergy equipmet Telecommuicatio services Telecommuicatio carriers Semicoductors Costructio Egieerig services Rails & airports Utilities Measuremet istrumets Distiguishig Betwee Public Versus Private As with most asset classes, there are a umber of differet ways to gai exposure. Whe thikig about ifrastructure, alog with the ubiquitous active/passive choice, oe must uderstad the differece betwee public ad private ivestmet optios. Curretly, we gai our ifrastructure exposure through publicly traded ETFs ad mutual fuds, but private ivestmets also exist. We have ot itroduced private ivestmet vehicles to our platform, but we will cotiue to explore optios i the private uiverse as the private fudig of ifrastructure projects expads the opportuity set of available ivestmets. Private ifrastructure ivestmet vehicles will likely provide ivestors with more pure exposure to the asset class; however, there are other cosideratios such as accessibility, liquidity, ad fees to cosider. Public/Listed Global Ifrastructure Equity Ivestig i public equity ifrastructure typically meas ivestig i the publicly traded equity of compaies ivolved i a wide rage of sectors ad idustries, from eergy productio to telecommuicatio carriers ad beyod. Usig the MSCI World Ifrastructure Idex (MSCI Ifra) as a represetative sample or bechmark for global ifrastructure, oe ca see the sector weightigs vary sigificatly from a commo proxy used for large cap core equities, such as the MSCI World Idex (MSCI World) (Table 2, page 4). The red blocks highlight the sectors where the idex has o sector exposure, ad the gree blocks highlight the top three sectors for both idexes. Notice the high degree of cocetratio i both the Utilities ad Telecommuicatio Services sectors i the MSCI Ifra, whereas the MSCI World has the most exposure to Fiacials, Iformatio Techology, ad Health Care. Thus, the compositio of these two idexes is markedly differet, which meas their iheret factor exposures ad behavior across market cycles are likely to be materially differet as well. Eve whe takig ito accout the higher beta securities withi the Eergy ad Idustrials sectors (3-year beta of 1.07 ad 1.01, respectively), MSCI Ifra has a lower overall beta of 0.62 relative to the MSCI World with the sigificat overweights to Telecommuicatio Services ad Utilities (3-year beta of 0.76 ad 0.42, respectively) Beta is a measure of the volatility, or systematic risk, of a security or a portfolio i compariso to the market as a whole. 3

4 Table 2 Sector Weightigs As of 8/31/17 Sector MSCI World Ifrastructure MSCI World Cosumer Discretioary 0% 12.1% Cosumer Staples 0% 8.9% Eergy 9.5% 6.2% Fiacials 0% 18.1% Health Care 2.1% 12.4% Idustrials 5.1% 11.6% Iformatio Techology 0% 16.2% Materials 0% 5.1% Real Estate 0% 3.1% Telecommuicatio Services 39.1% 2.9% Utilities 44.2% 3.1% Source: Bloomberg L.P. Chart 1 Ivestable Mutual Fuds Categorized as Ifrastructure Fuds As of 8/31/17 Source: Bloomberg L.P. 54 Ifrastructure Fuds ad ETFs 16 Fuds >$500 millio assets uder maagemet 7 Fuds excludig MLPs ($14.3 billio total assets uder maagemet) There are may publicly traded vehicles that techically fall uder the Ifrastructure umbrella, for example, Utilities ad Idustrials sector-specific portfolios; atural gas master limited parterships (MLPs); muicipal reveue bods; ad techology, media, ad telecommuicatios (TMT) securities. But most of these do ot precisely fit our preferred defiitio of global ifrastructure. Compared to private ivestmets, the uiverse of ivestable mutual fuds categorized as ifrastructure fuds is quite limited (Chart 1). Per Bloomberg L.P., there are oly 54 such ifrastructure fuds domiciled i the Uited States, icludig ETFs. The uiverse with a scalable asset base to support large istitutioal ad ultra-high-et-worth ivestors shriks to just 16 fuds, ad whe excludig fuds specifically dedicated to MLPs (which i our view, have separate, distict ivestmet characteristics), leaves 7 ifrastructure fuds. Private Ifrastructure Ivestig i private ifrastructure typically requires the use of limited parterships or direct coivestmets as the operator of a asset, which ca make ivestor access a bit more limited. Private ifrastructure ivestig ca take o two geeral forms Greefield ad Browfield projects depedig o the poit i time of the life cycle of the ivestmet fud. Greefield projects (a term origially coied to describe projects built o virgi lad) occur before the fud is operatioal, which icludes the iitial plaig ad desig stage as well as the costructio stage. The costructio stage of a ifrastructure project is geerally cosidered the highest risk stage due to the level of capital outlays required, potetial budget overrus, the possibility of the project beig cacelled, ad little to o cash flows distributed to the ivestor. Take a step further, Greefield projects are closer from a risk-reward perspective to commoditybased real assets or private equity, ad whe lumped i with public/listed ifrastructure they ca have a tedecy to skew the potetial rewardrisk expectatios for the etire asset class of ifrastructure. Browfield ivestmets iclude projects already i operatio or i eed of additioal fiacig for ogoig maiteace ad other capital expeditures. Ofte the operator is lookig to create ew, greater efficiecies i order to reduce expeses. With a lower risk profile tha Greefield projects, fuds i Browfield projects ted to geerate steady cash flows ad maitai a quasi-moopolistic structure due to log-dated govermet cotracts (Chart 2, page 5). O the surface, private ifrastructure ivestig has some characteristics that resemble private 4

5 Chart 2 Browfield versus Greefield Ivestmets Chart 3 Ifrastructure Categorizatio As of Jauary 2017 Desig Stage Higher Risk Costructio Stage Higher Cash Flows Operatio Stage 7% 10% 4% Time Source: PNC Greefield Projects Browfield Projects 10% 69% equity i that both are typically illiquid, with logterm ivestmet horizos. Compared to other commodity-based real assets, a commoality is that both ivest i icome-geeratig physical assets. Aside from those characteristics, that is where the similarities betwee private equity, real assets, ad ifrastructure ed. Private equity ivestmets typically follow a J-curve 12 ivestmet trajectory compared to Browfield ifrastructure projects, which geerate a highly predictable, stable icome stream. Commodity-based real assets, icludig the project s iitial costructio ad desig, cotai sigificatly higher risk profiles tha do ifrastructure operators already i productio/operatioal stages. I a Asset Class of its Ow Give these reasos, we believe ifrastructure retais a distict asset class categorizatio. I a recet survey by Preqi, early 70% of ivestors surveyed cout ifrastructure as a stadaloe asset class, ad this estimate icreases to early 80% whe icludig respoders that codify it i the real asset category (Chart 3). Reviewig the Ivestor Ladscape Give the still relatively limited but growig supply of global ifrastructure projects, the size ad opportuity set for ifrastructure ivestmets remai vast, makig these projects more available for a wider istitutioal ivestor audiece i recet years. Excludig public equity exposure such as utilities, costructio compaies withi the Idustrials sector, ad atural gas pipelie MLPs, the average asset allocatio is 5% for ifrastructure Separate Ifrastructure Allocatio Icluded i Private Equity Other Source: Preqi Geeral Alteratives Allocatio Icluded i Real Assets ivestmets (Chart 4). The other colum i the chart icludes a wide variety of ivestors icludig sovereig wealth fuds, supraatioal fuds, ad quasi-govermet agecies that have a wide rage of allocatio targets. The growig ivestmet demad ad overwhelmig eed for ifrastructure capital ivestmets has allowed ew etrats to participate i the asset class just withi the last few years (Chart 5, page 6). For example, just four years ago, ifrastructure was predomiatly ivested i by major pesio plas Chart 4 Ifrastructure Allocatio by Ivestor As of Jauary 2017 Percet E&Fs Source: Preqi Private Sector Pesio Fud Average Ifrastructure Allocatio Public Pesio Fud Isurace Compay Other Weighted Average 12 See the PNC white paper Goig Private: A Guide to Private Ivestmets, December

6 Chart 5 Ifrastructure Ivestors by Type As of Jauary 2017 Other Asset Maager Ivestmet Bak Isurace Compay High Net Worth/Family Office Public Pesio Fud Private Sector Pesio Fud Edowmets & Foudatios Source: Preqi Percetage ad sovereig wealth fuds with the size, scope, ad scale to become the actual ifrastructure operator, rather tha ivest through a traditioal limited partership or private placemet. 13 As global ifrastructure demad becomes more prevalet amog ivestors of all sizes ad types, ew private fuds are comig to market allowig access to ifrastructure fuds for first-time ivestors. Ideed, as see i Chart 5, ivestor iterest from edowmets ad foudatios, as well as ultra-highet-worth idividuals, has experieced the fastest adoptio rates of all ivestor types from 2013 to This is ot to suggest ivestor demad is decreasig withi certai ivestor types depicted i the chart, but rather depictig a shrikig share of the overall pie of sorts, as the total allocatios i the chart equal 100%. Global Ifrastructure Ivestmet Thesis I Table 3, we compare a few select asset classes ad our 10-year capital market retur/volatility assumptios ad calculate their Sharpe ratios. Over log horizos, we believe global ifrastructure has the potetial to outperform most other asset classes o a risk-adjusted retur basis. Aother way to view ifrastructure s positioig withi a asset allocatio framework is to plot the Table 3 10-Year Capital Market Assumptios for Select Asset Classes As of 9/30/17 Asset Class Total Retur Volatility Sharpe Ratio Private Debt 9.70% 17.85% 0.43 Private Equity 12.80% 27.20% 0.40 Private Real Estate 9.05% 17.60% 0.40 Global Ifrastructure 6.75% 11.75% 0.40 Developed Iteratioal 8.80% 18.75% 0.36 Equities Domestic Equities 7.35% 15.25% 0.35 Emergig Market Equities 10.95% 26.25% 0.34 Hedge Fuds 5.25% 10.78% 0.30 High Yield Bods 5.55% 12.20% 0.29 Ivestmet Grade Bods 3.00% 3.95% 0.25 Real Estate Ivestmet Trusts 7.05% 24.80% 0.20 Source: PNC reward-risk characteristics of various asset classes o a cotiuum (Chart 6, page 7). With fixed icome ad private equity at the extremes, ifrastructure falls somewhere i betwee. With moopolistic features ad cotracts embedded with iflatioadjusters, ifrastructure has attributes that provide relatively lower risk expectatios tha both private equity ad traditioal large cap core public equities. Relative to fixed icome securities, ifrastructure is uique i that the asset provides stable cash flows like traditioal fixed-coupo bods, with the potetial for capital appreciatio. I Table 4 (page 7), we have highlighted what we believe are the key merits ad risks of ivestig i global ifrastructure as a asset class. Ifrastructure has historically exhibited defesive ad high icome qualities. Ivestig mostly i publicly traded compaies that ow assets such as airports, seaports, toll roads, ad utilities, the bull thesis for these assets is relatively

7 Chart 6 Ifrastructure Risk-Retur Expectatios Compared to Other Asset Classes ad withi Ifrastructure Subsectors Private Equity Expected Retur Public Ifrastructure Greefield Global Public Equities Commodity Real Assets Nocyclical Browfield Bods Risk Source: PNC straightforward ivestig i compaies that ted to have stable, predictable, iflatio-liked cash flows is attractive whe iterest rates are low ad growth is slow. Referrig to our 2017 outlook, as published i the first-quarter 2017 Ivestmet Strategy Quarterly, Great Expectatios, we ackowledged the likelihood of a flatteig yield curve. We poited out that i all ie of the Federal Reserve s (Fed s) previous tighteig cycles, the yield curve has flatteed i respose. Aalyzig the five periods of curve flatteig sice the early 1990s fids ifrastructure-heavy sectors such as Utilities ad Idustrials outperformig the broad S&P 500. Although we believe iterest rates may rise as we move ito 2018, we cotiue to thik rates will remai historically low ad the yield curve will have a flatteig bias as the Fed tightes policy. Therefore, from a sector exposure perspective, ifrastructure fuds may cotiue to be well positioed. I a eviromet i which rates are likely to remai low by historic stadards, ifrastructure fuds ofte exhibit greater cash flow Table 4 Key Merits ad Risks of Ivestig i Global Ifrastructure as a Asset Class Merits Global diversificatio/exposure Stable, recurrig reveue base Geerally high operatig margis Cosistet icome/cash flow geeratio Iflatio-liked ivestmet returs Low correlatio to traditioal asset classes Less cyclical/more defesive behavior across market cycles Risks Currecy traslatio for U.S.-based ivestors Techological obsolescece Regulatory/political climate Slower log-ru growth profile tha other equity asset classes Less upside capture i rapidly risig public equity markets Heterogeeous reward/risk potetial May be vulerable to risig costs of capital/iterest rates Source: PNC 7

8 Table 5 Risk ad Retur Metrics As of 8/31/17 Risk/Retur Metrics (5 year uless oted) MSCI World Ifrastructure Idex MSCI World Idex MSCI World REIT Idex Aleria MLP Idex Bloomberg Barclays Aggregate Bod Aualized Retur 7.7% % -0.3% 2.2% Stadard Deviatio 10.1% % 17.5% 2.8% Sharpe Ratio Year Beta (to S&P 500) Year Average Operatig Margi 12.2% 10.7% 26.0% 9.0% /a Forward price/earigs (P/E) 16.6x 17.6x 23.9x 21.5x /a 3-Year Average Forward P/E 16.8x 16.9x 24.5x 23.2x /a 3-Year Average Retur o Equity 10.0% 10.6% 9.9% 4.6% /a Taper Tatrum Performace (5/22/13 9/5/13) -3.0% -0.3% -14.5% -5.9% -3.9% Postelectio Bump 11/14/16-2/28/ % 9.3% 7.8% 11.3% 0.6% Maximum Drawdow -9.8% -20.9% -14.2% -48.5% -3.7% Correlatio Source: Morigstar stability relative to other equity sectors, meaig higher divided yields ad less volatile price fluctuatios (Table 5). Give there have bee few prologed periods sice the 2008 recessio with risig iterest rates, we did look at two distict episodes where yields did spike i a relatively short timeframe i order to assess the behavior of the asset class: the taper tatrum of 2013 ad the postelectio reactio i late 2016-early I both istaces, yields rose quickly, albeit for differet reasos. For example, whe markets were caught off-guard durig the taper tatrum, ifrastructure ivestmets outperformed early all asset classes o a relative basis. Although likely iflueced by ivestor expectatios regardig the Trump admiistratio s policy plas, whe iterest rates spiked ad risk assets rallied after the electio i 2016, ifrastructure slightly outperformed the broader equity market. 14 Busiess Cycle Framework The first ad perhaps most importat compoet of our overarchig ivestmet process is the aalysis we perform o the busiess cycle. It is ideed the first leg of the proverbial three-legged stool. Based o examiig what stage of the busiess cycle we are i, the attractiveess of differet parts of the ivestable uiverse become more apparet. Accordig to our proprietary busiess cycle aalysis, we remai i the slowig expasio phase of the curret cycle, characterized by a ecoomy that cotiues to grow, albeit sluggishly, ad at a deceleratig pace. Historically, ifrastructure ivestmets have outperformed the broader equity markets durig this phase, capturig less of the dowside whe markets correct (Charts 7 ad 8 o page 9). Volatility curretly remais achored at the extreme lower ed of historical experiece, reflectig the market s cofidece that the global ecoomy will 14 From November 14, 2016 through February 28, 2017 the S&P 500 had a total retur of 9.9% versus MSCI World Ifrastructure retur of 10.3%. 8

9 Chart 7 Multi-Statistic Performace versus S&P 500 September 2012-August 2017 Chart 9 Recessio Probability As of 9/30/ S&P Total Retur Lazard:GI Lstd Ifr;Ist Recessio Probability - Aggregate - Mothly Percet Upside Capture % Dowside Capture % Source: FactSet Research Systems Ic. Best Retur Worst Retur Recessio Aggregated Probability Source: PNC Chart 8 Cumulative Retur versus S&P 500 September 2012-August S&P 500 (%) Lazard Global Listed Ifrastructure (%) -20 9/12 3/13 9/13 3/14 9/14 3/15 9/15 3/16 9/16 3/17 Source: FactSet Research Systems Ic. cotiue to expad. Still, we believe drawdow maagemet remais importat markets remai vulerable to exogeous shocks; the short-term combiatio of heighteed geopolitical risk ad U.S. policy ucertaity cocers are likely to remai; the emergig risks appear to be more political tha ecoomic, which makes them especially challegig to price i; ad, perhaps most importatly, high valuatios may icrease the potetial magitude of drawdows. Over the past moth, the Dow Joes Idustrial Average has traded i a rage (from high to low) of 1.4%. Goig back to 1970, that s the least volatile period i history. At 2.2%, the same rage for the S&P 500 is ot the lowest ever, but it s close. I fact, if the year eded today, the largest drawdow we have see i 2017 (3%) would be the lowest aual drawdow ever. Lookig throughout history, low volatility aloe is ot a reliable harbiger of poor forward returs. However, what we ca say with a reasoable degree of certaity is that periods of extremely low volatility ted to be followed by periods of higher volatility. I other words, volatility teds to be mea revertig. Timig the ievitable rise i volatility is extraordiarily difficult, but give its extremely low level today, ivestors should expect a icrease. This is part of the reaso we believe global ifrastructure is a good complemet to our overall equity exposure that may be more exposed to market fluctuatios. Agai, this may mea we do ot capture all of the upside i a low volatility bull market, but it will likely provide for some stability withi portfolios whe volatility rises. Lastly, from a macro perspective, the ifrastructure asset class is certaily ot immue to ecoomic cotractios ad performs best whe the ecoomy is expadig. Therefore, it is critical to ote that we do ot believe the ecoomy is i immiet dager of cotractig based o our proprietary recessio probability idicator, which employs a combiatio of ecoomic ad fiacial market variables. The aggregated idicator is depicted i Chart 9. 9

10 Datig back to the 1970s, our aalysis idicates that oce the probability of recessio crosses defiitively above 50%, as measured by the red horizotal lie i Chart 9, we ca typically expect a recessio to occur about eight quarters hece. This is substatial lead time ad allows us to cofirm this sigal with other leadig ad coicidet ecoomic data/idicators we track. The aggregated recessio probability as of August 31, 2017, was 49.0%. For perspective, the average probability at the start of a recessio is typically 75.2%. The lowest the probability has ever bee at the start of a recessio is 65%, while the highest is 88%. The logest false positive (idicator above 50% the movig back below 50%) is 12 moths, but durig that period the idicator ever rose above 54%. I short, we believe the curret expasio ca cotiue, eve if growth remais well below what might be cosidered average or ormal from a historical perspective. Therefore, eve if volatility icreases, we should remai i a busiess cycle phase that teds to be supportive of the global ifrastructure asset class. Valuatio Methodology The secod compoet of our ivestmet process (that is, the secod leg of the stool) is a i-depth examiatio of global valuatios. Oce we have idetified where we thik we are i the cycle, our valuatio work tells us about the log-term retur Chart Year Average Forward Price/Earigs Ratio Compariso As of 8/31/ S&P GLOBAL INFRASTRUCTURE 10-year Average Curret S&P 500 Source: FactSet Research Systems Ic MSCI WORLD EX US potetial of a asset class versus its ow historical retur profile, as well as compared to other competig asset classes. The questio here is whether there is still opportuity i a asset class that has ejoyed such strog performace over the past few years. Geerally, i light of the recet stregth i the broad asset class, the curret opportuity set of attractively priced ivestmets for ifrastructure maagers is smaller today tha it has bee i the past several years. Therefore, as reflected i our aual Capital Market Assumptios, it is likely that the retur o public ifrastructure ivestmets will be lower tha the average aual retur of almost 9.0% ivestors have gotte used to postfiacial crisis. 15 However, that ca also be said for almost all equity sectors, ad the relatively stable returs ad higher yields offered i the ifrastructure uiverse are attractive, i our view. We do prefer ivestmets i actively maaged fuds that ca idetify pockets of value, but geerally speakig the ifrastructure asset class does ot appear meaigfully more exteded tha the broader equity markets (Chart 10). Techical Aalysis The third leg of the stool of our ivestmet process focuses o techical aalysis, which helps forecast the directio of security prices through the study of past market data ad primarily focuses o treds related to prices ad volumes. This is ot market timig so much as it is tellig us whe the appropriate time to move ito or out of a ivestmet might be (that is, whe is the right time to ot fight the market o etry). A ivestmet opportuity could look attractive based o the busiess cycle ad valuatio metrics for a log time but be dead moey if the market is directioally workig agaist it. The techicals help us idetify what those forces might be. Global ifrastructure, just like most other equity idexes, has delivered solid performace sice the start of the year with the passive implemetatio or proxy for global ifrastructure, as measured by the S&P Global Ifrastructure, up about 9% year to date. The 200- ad 400-day movig averages are both i risig treds (with decet mometum ad uderlyig support), so the asset class looks 15 Average aual retur is the arithmetic average of aual returs of the MSCI World Ifrastructure Idex from 2009 to

11 Chart 11 S&P Global Ifrastructure Movig Averages As of September ishares S&P Global Ifrastructure ETF MA-200D MA-400D Support Level 20 12/07 12/08 12/09 12/10 12/11 12/12 12/13 12/14 12/15 12/16 Source: FactSet Research Systems Ic., PNC attractive based o these techical measures. This particular idex has recetly broke out ad is earig its highs achieved post the 2008 fiacial crisis. If the former resistace levels aroud the rage hold, it would become the ew support level, suggestig a cotiuatio of curret treds is possible (Chart 11). Am I Just a Bill Stuck o Capitol Hill? The oe topic we have ot yet discussed is fiscal policy support for ifrastructure projects. I other words, is ifrastructure ivestig just ridig the coattails of fiscal stimulus expectatios from the ew admiistratio? Presidet Doald Trump campaiged o a platform callig for, amog may other policy adjustmets, reewed ifrastructure spedig leadig up to the November 2016 presidetial electio, but this is much easier said tha doe, i our view, ad is imperative to recogize ad uderstad the complexities associated with raisig taxes, which is how a ifrastructure package would ultimately be fuded via strictly the public sector. Headlies cotiue to make referece to a pedig $1 trillio ifrastructure pla uder the Trump admiistratio; however, it was origially proposed by Commerce Secretary Wilbur Ross durig the campaig as a reveue-eutral package. 16 Durig the campaig, Presidet Trump was oly seekig $550 billio over 10 years to support trasportatio ifrastructure. As recetly as August 17, 2017, he aouced he was dissolvig the Natioal Ifrastructure Advisory Coucil, leavig a potetial ifrastructure stimulus package i ucertai territory, i our view. Of course, public-private parterships for ifrastructure ivestmet are still a possibility, but give the log list of to-dos o the policy frot i Washigto, D.C., we do ot expect this item to take ceter stage i the short ru. For perspective, it took Presidet Barack Obama two attempts over the course of four years (that is, durig his secod term i office) for Cogress to approve a ifrastructure bill, the first dedicated ifrastructure program sposored at the federal level i more tha 10 years. I 2009, the America Recovery ad Reivestmet Act did iclude $105 billio out of the total $831 billio specifically allocated for ifrastructure projects. The iitial 2015 pla was for $478 billio; however, the fial package was reduced to $305 billio ad was desigated solely for highway ad bridge repairs. Ifrastructure support withi Cogress is ot typically cosidered to be a partisa issue (for example, the GOP-cotrolled House passed the 2015 Ifrastructure bill by a vote); however, based o comparable success rates for Presidet Obama, the fial amout of a ifrastructure package could wid up beig far less tha Presidet Trump s iitial campaig expectatios, i our view. Despite these difficulties to pass ifrastructure legislatio, the ASCE estimates the ext 10 years will require approximately $4.6 trillio i aual spedig costs just to maitai curret coditios, which geerally are quite poor. With a estimated fudig gap of $2 trillio, regardless of a stimulus program from the federal govermet i the ear to medium term, the eed for ifrastructure ivestmet has bee ad cotiues to appear quite dire (Chart 12, page 12). So, clearly the eed is there, but will the dollars ever come? That is literally the two trillio dollar questio, i our view. To belabor the poit, our 10-year capital market projectios were established well before the outcome of the 2016 presidetial electio was kow, ad our thesis for global ifrastructure is 16 Wilbur Ross ad Peter Navarro, Trump Versus Clito o Ifrastructure, October 27,

12 Chart 12 A Ifrastructure Misadveture Trillios of Dollars Fuded Source: ASCE, PNC Ufuded irrespective of ew legislatio-related stimulus, which we believe has a low probability of success i the ear term. I our opiio, should a ifrastructure program come to fruitio, it would provide additioal support to our already strog, base-case, fudametal ivestmet thesis. A Few Thoughts o Bechmarkig Selectig a bechmark ca sometimes be a fairly simple/straightforward task ad, at other times, ca become a more challegig exercise. Give the high degree of heterogeeity across the global ifrastructure asset class, i terms of passive, active, ad private ivestmet optios, as well as their differet reward-risk profiles, choosig a appropriate bechmark is critically importat but may fall closer to the more challegig ed of the spectrum. A umber of global ifrastructure idexes exist i the marketplace today, with some of the most commoly refereced icludig MSCI World Ifrastructure, S&P Global Ifrastructure, Dow Ifrastructure Composite, ad FTSE Global Ifrastructure. Each has differet geographic, sector, ad idustry exposures that will geerally cause them to behave/perform differetly across a market cycle. For example, we did a quick geographic compariso betwee a well-kow actively maaged global ifrastructure fud ad the MSCI World Ifrastructure idex. The mutual fud had just 16% exposure to the Uited States while MSCI World had approximately 49% Table 6 Pesio Plas ad Bechmarks Used Pla Ifrastructure Bechmark Used CalPERS CPI + 4% CalSTRS CPI + 4% Otario Teachers CPI + 4% CPPIB CPP Referece Portfolio N. Dakota PERS CPI-W (social security) Source: Compay Reports, PNC exposure. O this basis aloe, we would expect markedly differet performace characteristics over time. I our view, there is o bechmark idex that is perfectly represetative of all actively maaged strategies. The bottom lie is kow your bechmark. It is essetial to help set appropriate expectatios, as well as defie ad measure success over time. A typical ifrastructure cotract is log term (10+ years), i which the ivestor provides fiacig for the project ad receives cash flows for the life of the project. Ulike traditioal fixed icome securities, ifrastructure cotracts are geerally liked to iflatio measures through various adjusters, either o a aual or multiyear adjustmet basis, helpig to preserve asset values over time. Ifrastructure assets themselves also ted to be liked to various measures of iflatio (utilities or toll roads, for example), further protectig ivestors from uexpected iterest rate volatility. Therefore, it should come as o surprise to most ivestors that private ifrastructure ivestmets, as disclosed by various public pesio plas, employ absolute retur bechmarks to measure ad evaluate performace (Table 6). A absolute retur bechmark is a hurdle rate that the ivestmet should strive to meet or exceed over loger horizos. This hurdle rate ca be simply the required retur objective outlied i a cliet s ivestmet policy statemet. Over a period less tha oe year, however, holdig a ivestmet or asset class to this level of retur could be iappropriate or ureasoable. However, whe measured over 3-, 5-, ad 10-year periods, a retur cosistet with or i excess of that retur objective seems more feasible/reasoable. 12

13 It is imperative to uderstad ot oly the costructio methodology of the fuds or idexes i questio but also the bechmark chose. Usig a oe-size-fits-all approach to compare ay or all global ifrastructure strategies to the S&P 500 is aki to measurig all fixed icome strategies agaist the Barclays Aggregate Bod Idex, i our view. Results may differ quite materially at times because it is ot a proper apples-to-apples compariso. Additioally, i the case of global ifrastructure, there are certai idexes that hedge currecy exposure. I a iteratioal equity portfolio that has exposure to a basket of currecies, some will likely have positive returs i local currecy terms while others will be egative at times. I theory, this couterbalacig effect should result i currecy exposures ettig themselves out over time. I additio, currecy returs are largely ucorrelated (or at least, ot strogly positively correlated) ad, as such, they ted to help a equity portfolio o the diversificatio frot. Further, there is ample empirical evidece (cited by CFA Istitute ad others) suggestig that the stadard deviatio (that is, volatility) of currecy is oly about half the stadard deviatio of stock prices. This suggests uhedged currecy exposure may actually help to reduce a iteratioal equity portfolio s volatility over time. As currecies also ted to revert to a theoretical fair value /mea over time, currecyrelated volatility/risk teds to fall or wash out, so to speak, becomig a less critical compoet of equity risk. Thus, over the log term (that is, o a strategic basis) our preferece is to be uhedged. Cleaig Up with Resposible Ivestig Ifrastructure As techological chage creates ew ivestmet opportuities, a ew breed of ifrastructure projects is begiig to emerge that ca help bridge the global ecoomy ito the 21st cetury. Due to the history of how regulated idustries evolved over time ad oftetimes specific to coutry ad regio, most of the opportuities for RI ifrastructure projects are foud outside of the Uited States. For example, with Switzerlad beig surrouded by the Alps, their primary source of locally geerated eergy is actually hydropower a practical but strategic decisio made primarily as a fuctio of the low opportuity cost rather tha as a purposeful/itetioal sese of evirometalism. 17 Cotrast this particular case with the challeges facig rural Idia where more tha 50% of the populatio still does ot have access to electricity. The ifrastructure buildout there is primarily focused o developig off-grid reewable eergy solutios. 18 Other clea eergy solutios iclude reewable eergy storage ad the uderlyig ext geeratio techologies i eergy efficiecies themselves. Makid s eteral quest to capture, store, ad haress eergy has see sigificat breakthroughs i recet years, givig rise to compaies that specialize i battery power techology. These are just a few of the umerous, ad perhaps uexpected, clea techology-related solutios that overlap with RI ad ifrastructure ivestig, if oly oe takes a closer look. As regioal govermets cotiue to establish laws requirig icreasigly streuous vehicle emissios stadards ad/or some form of electric vehicles, we expect the shift toward reewable eergy ifrastructure projects to accelerate. As the efficiecy of photovoltaic cells ad related semicoductors cotiues to grow, ew clea eergy techology should geerate eve more demad for RI-ifrastructure opportuities. Turig to water projects, Chia has bee a leadig example of creatig successful private-public parterships for water ifrastructure ivestmet i what has bee traditioally domiated by muicipalities i the Uited States. Through Build-Operate-Ow ad Build-Operate-Trasfer cotractual arragemets, private compaies have bee workig closely with the Chiese govermet to develop water ifrastructure projects. Throughout the course of our research, we have discovered a umber of ivestable themes 17 Swiss Federal Office of Eergy

14 havig the uique distictio of servig dual purposes withi the realms of global ifrastructure ad RI/impact ivestmets. These elusive impact uicors, as we refer to them, have the potetial to achieve both a market rate of fiacial retur ad high levels of impact, whether it be social, evirometal, or other qualitative metrics. 19 Coclusio We believe ifrastructure ivestig may be well positioed for the later iigs of the busiess cycle, supported at least i part by risig global demad for the asset class. We believe there are secular forces at play (for example, low productivity growth ad global moetary policy cross currets) that may cotiue to weigh o iterest rates for some time. Therefore, ivestors may be compelled to cotiue to look for cosistet icome geeratio coupled with capital appreciatio potetial over the proverbial home ru ivestmet idea. This is ot just a play o lower-tha-average iterest rates, however, as we have described may of the other elemets that curretly make the asset class attractive i our opiio. Give the preset valuatio backdrop, we prefer ivestmets i actively maaged fuds that ca idetify pockets of value. The asset class offers attractive cash flows relative to most fixed icome asset classes, ad relatively less volatility tha broader equity markets, ad as such, we believe ifrastructure should be cosidered a viable portfolio optio i today s market. Amada E. Agati, CFA Maagig Director, Chief Istitutioal Ivestmet Strategist Daiel J. Brady Ivestmet & Portfolio Strategist 19 See our white paper Resposible Ivestig: A Ripple i Still Water, September

15 Istitutioal Advisory Solutios Asset Allocatio Playbook (As of 8/31/17) Asset Class Equities U.S. Equity No-U.S. Equity Sub Asset Class Large Cap Mid Cap Small Cap Public Real Estate (REITs) Itl. Large/Mid Cap Itl. Small Cap Emergig Markets Taxable Fixed Icome U.S. Fixed Icome No-U.S. Fixed Icome Alteratives Real Assets Private Hedge Fuds Cash Short Fixed Icome Core Fixed Icome U.S. High Yield U.S. Leveraged Loas U.S. TIPS Global Bod Ucostraied Bod Emergig Market Bod Commodities Ifrastructure Private Real Estate Private Debt Private Equity Equity Log/Short Evet Drive Relative Value Directioal Favorability - Neutral + Poits of View Relative valuatios, our view o the curret phase of the busiess cycle, ad vulerability to overall market volatility cause us to favor mid- ad large-cap over small, eve as small has lagged thus far i That said, if we start to see tagible mometum o the policy frot, small-cap compaies may ejoy a outsized beefit from chages i tax rates ad regulatio. Supply/demad fudametals across the group remai fairly balaced ad, though valuatio has pulled back to more reasoable levels lately, we still see the group as fairly valued at best. Valuatios appear relatively more attractive versus domestic equities, potetially makig these markets the better log-term value. Near term we believe these markets are more vulerable to ay softeig of global growth. Pressures from tighteig i Chia ad less bad, but still egative, earigs per share revisios suggest the fudametals have discoected from price performace. Ay reversal higher i U.S. rates or the dollar would become headwids, especially after a 31% year-to-date gai. With the possibility of loger-term rates remaiig rage-boud, we favor itermediate duratio fixed icome. To date, core fixed icome has outperformed short, ad we believe this tred will persist for the balace of Overall credit coditios remai favorable, but credit spreads are tight, leavig high yield less room to outperform. Perhaps more attractive tha high yield give their place higher i the capital structure ad protectio from risig rates. A reasoable hedge if iflatio overshoots curret expectatios; however, that is ot our base case forecast. Sovereig debt looks about fairly valued curretly with the primary sources of retur likely to come from coutervailig global treds i currecies ad iterest rates, hece our eutral stace. Flexibility provides for diversificatio if rates should steadily rise (a primary risk to fixed icome i this market). Spreads look too tight curretly (that is, fudametals i the regio suggest wider spreads) ad we expect this to occur i Relative yield advatage makes EM debt margially more attractive tha EM equities. We do ot believe log positios i commodities ear persistetly positive ad sigificat risk premia. Depedig o the asset/ eviromet, the risk premium may actually accrue to the short positio. Still like the log-term theme, but valuatio is a headwid. With the pedulum swigig more recetly toward short-termism, we thik this creates a opportuity at the opposite ed of the spectrum for patiet, log-term ivestors. At a time whe the expected returs o traditioal asset classes are likely to be below historical orms, the illiquidity premium has become icreasigly valuable. Ca geerate outperformace i a market where the overall risk/ reward balace may be skewed toward risk. Equity market correlatios are fallig, ad the removal of extreme moetary policy accommodatio which compressed the cost of capital across the quality spectrum should help swig the performace pedulum back i favor of certai hedge fud strategies. However, should the market move steadily higher with little volatility, these allocatios will likely uderperform. 15

16 The PNC Fiacial Services Group, Ic. ( PNC ) uses the marketig ame PNC Istitutioal Advisory Solutios for discretioary ivestmet maagemet, trustee, ad other related activities coducted by PNC Bak, Natioal Associatio ( PNC Bak ), which is a Member FDIC. Stadaloe custody, escrow, ad directed trustee services; FDIC-isured bakig products ad services; ad ledig of fuds are also provided through PNC Bak. These materials are furished for the use of PNC ad its cliets ad does ot costitute the provisio of ivestmet advice to ay perso. It is ot prepared with respect to the specific ivestmet objectives, fiacial situatio, or particular eeds of ay specific perso. Use of these materials is depedet upo the judgmet ad aalysis applied by duly authorized ivestmet persoel who cosider a cliet s idividual accout circumstaces. Persos readig these materials should cosult with their PNC accout represetative regardig the appropriateess of ivestig i ay securities or adoptig ay ivestmet strategies discussed or recommeded i this report ad should uderstad that statemets regardig future prospects may ot be realized. The iformatio cotaied i these materials was obtaied from sources deemed reliable. Such iformatio is ot guarateed as to its accuracy, timeliess or completeess by PNC. The iformatio cotaied i these materials ad the opiios expressed herei are subject to chage without otice. Past performace is o guaratee of future results. Neither the iformatio i these materials or ay opiio expressed herei costitutes a offer to buy or sell, or a recommedatio to buy or sell, ay security or fiacial istrumet. Accouts maaged by PNC ad its affiliates may take positios from time to time i securities recommeded ad followed by PNC affiliates. PNC does ot provide legal, tax, or accoutig advice uless, with respect to tax advice, PNC Bak has etered ito a writte tax services agreemet. PNC does ot provide services i ay jurisdictio i which it is ot authorized to coduct busiess. PNC Bak is ot registered as a muicipal advisor uder the Dodd-Frak Wall Street Reform ad Cosumer Protectio Act ( Act ). Ivestmet maagemet ad related products ad services provided to a muicipal etity or obligated perso regardig proceeds of muicipal securities (as such terms are defied i the Act) will be provided by PNC Capital Advisors, LLC. Securities are ot bak deposits, or are they backed or guarateed by PNC or ay of its affiliates, ad are ot issued by, isured by, guarateed by, or obligatios of the FDIC, the Federal Reserve Board, or ay govermet agecy. Securities ivolve ivestmet risks, icludig possible loss of pricipal. PNC Istitutioal Advisory Solutios is a registered service mark of The PNC Fiacial Services Group, Ic The PNC Fiacial Services Group, Ic. All rights reserved. 16