Q MAKENA STRATEGY INSIGHTS NOTE ARE WE THERE YET?

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1 ARE WE THERE YET? Q As the calendar year draws to a close, it is worth reflecting on the events that transpired over the past twelve months. In the capital markets, equities around the globe witnessed a rally of proportions typically only seen in a post-recession recovery. What makes these returns even more impressive is that they have occurred on historically low volatility. In equities, earnings per share growth and profit margins remain robust in the U.S. and are improving in Europe and in Emerging Markets. In bond markets, yields are off their lows with the U.S. yield curve flattening, reflecting less optimism about longer term expectations of growth and inflation. This isn t the first time in history that the equity and bond markets haven t agreed with each other completely. Market pundits continue to pontificate on the source of the low volatility and high returns and typically attribute it to various exogenous variables, with the principal theme usually being central bank manipulation of markets. To us, things aren t necessarily that simplistic, and the extraordinary globally synchronized growth spurt we are witnessing certainly has played a big part in the market environment we are witnessing. In any case, our philosophy isn t to bet on any one single outcome, but rather focus on a balanced portfolio that can survive multiple economic environments. We also keep a reasonably flexible stance so that we may take advantage of market dislocations when (not if) they occur. In our experience, rigid dogmatism is not a long term successful strategy. Portfolio Strategy By now, anyone with even a passing interest in financial markets is aware that asset valuations, and equity valuations in particular, are high. The problem with most of the commentary is that these comparisons are made relative to history. In our Q letter we detailed how valuations in today s low growth world should be higher than historic valuations, due to the fact that lower long-term discount rates imply higher stock price multiples. Furthermore, high valuations alone are rarely the cause for market corrections market corrections historically have been caused by external catalysts such as excessive rate hikes by central banks or excess leverage causing a slump in economic activity. Therefore, rather than lament valuations in the stock markets, we have decided to focus this letter on what could drive stock prices higher from here. Our analysis will focus on the U.S. since the U.S. is the region with the highest valuations however, we will also compare and contrast the U.S. situation relative to European and Emerging Markets along the way. Figure 2 below is the guiding framework for analyzing the environment. Asset price returns result from one of two things: 1) improving fundamentals and/or 2) higher valuations. Improving fundamentals, i.e. higher earnings, can be driven by either selling more goods and services to drive revenues (top branch of the decision tree) or selling goods and services at a higher margin (middle branch of the decision tree). Improving valuations simply reflect how much the market is willing to pay for an income stream, represented in shorthand by P/E multiples (bottom branch of the decision tree in Figure 2). We will review each return driver in order, assessing whether that driver will act as a headwind or tailwind to higher asset prices in the future. Figure 1: Possible Paths to Higher Prices

2 Returns Driver #1: Revenue Growth Aggregate revenue growth can be traced back to the simplest of metrics: GDP growth. This makes sense intuitively, as GDP essentially measures the sum total of expenditures in the economy. Said differently, strong GDP growth should reflect positively on corporate revenues, not necessarily on an instantaneous basis, but over longer time horizons. This is what we show in Figure 3 below using data from the St. Louis Federal Reserve. Note how a simple single factor regression between corporate revenues and GDP growth generates a significant result with a correlation north of 80%. Therefore one can argue that it is not unreasonable to assume that if we are in a strong GDP growth environment, corporate revenues should eventually follow suit. Business Sales Highly Dependent On Economic Growth Growth Rate QoQ, Trailing 4 Qtr Avg 6% GDP Growth Totl. Business Sales Growth 4% 2% 0% -2% -4% y = 2.52x R² = 0.65 ρ = % Mar-93 Nov-93 Jul-94 Mar-95 Nov-95 Jul-96 Mar-97 Nov-97 Source: Federal Reserve Bank of St. Louis, Bloomberg, Makena Analysis Jul-98 Mar-99 Nov-99 Jul-00 Mar-01 Nov-01 Jul-02 Mar-03 Nov-03 Jul-04 Mar-05 Figure 2: GDP and Corporate Revenue Closely Tied Figure 4 below highlights recent growth trends in the Euro Zone, the U.S., and Japan, which represents the lion s share of the developed world economy. As a reference point, the horizontal line shows trend GDP growth for each of those economies, i.e. what one would expect the GDP growth rate to be on average over the long term. Note how all three of these regions are not only significantly above trend but have been moving upwards in an accelerating fashion. Indeed, we have not witnessed such a synchronized global growth spurt since However, that comparison undermines the importance of the current growth spurt: we are in the third if not fourth quarter of this economic expansion and having such robust global growth at this point in the cycle is unusual. As far as we can tell, one would have to go back to the 1980s to see a similar phenomenon. By contrast, 2011 was a classic recovery out of a recession, a much more expected phenomenon. Looking ahead, various forward-looking indices, ranging from purchasing manager indices to consumer confidence indices to economic surprise indices, are all indicating a continuation of this growth spurt into the immediate future. In other words, we can expect the environment to remain supportive of corporate revenue growth and help support asset prices for the time being. Nov-05 Jul-06 Mar-07 Nov-07 Jul-08 Mar-09 Nov-09 Jul-10 Mar-11 Nov-11 Jul-12 Mar-13 Nov-13 Jul-14 Mar-15 Nov-15 Jul-16 Mar-17 2

3 Euro Zone Real GDP Growth US Real GDP Growth Japan Real GDP Growth Growth, YoY Growth, YoY Growth, YoY Growth YoY 2017 Potential Growth: 1.3% 4.0% 3.5% Growth YoY 2017 Potential Growth: 1.8% 3.5% Growth YoY 2017 Potential Growth:.6% 1.5% 2.3% 1.5% 1.6% 1.0% 1.0% 0.5% 1.5% 0.5% 0.0% 1.0% 0.0% -0.5% -0.5% 0.5% -1.0% -1.0% Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Jun-14 Dec-14 Jun-15 Source: IMF, CEIC, Makena Analysis Dec-15 Jun-16 Dec-16 Jun % Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Jun-14 Figure 3: Synchronized Global Growth Spurt Figure 5 below shows the recent revenue growth for the S&P 500. Note how revenue growth has recently accelerated and now stands at the highest level since the end of the post recovery growth period. Since most of the companies in the S&P 500 have significant international activities, Figure 5 captures the improvement not just in U.S. growth but in global growth. Total S&P 500 Sales Growth Growth, YoY 12% Dec-14 Jun-15 Dec-15 Jun-16 Dec-16 Jun % Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Jun-14 Dec-14 Jun-15 Dec-15 Jun-16 Dec-16 Jun-17 10% 8% 6% 5.6% 4% Average Growth: 2.8% 2% 0% -2% -4% Source: Bloomberg, Makena Analysis Figure 4: Impressive Revenue Growth Recently Finally, with the recent passage by the Senate of the tax reform bill, the U.S. federal government is going to initiate a fiscal stimulus over the next few years. According to the latest CBO analysis, from 2019 through 2022 inclusive, the U.S. federal deficit is slated to increase annually by more than $220 billion, with the total increased deficit over that period totaling $930 billion. To put that number into context, the troubled asset relief program (TARP) that was enacted at the height of the global financial crisis cost $421 billion. In other words, we are preparing to spend twice as much during a globally synchronized 3

4 economic expansion as was spent attempting to stave off the greatest recession since the Great Depression of the 1930s. Importantly, fiscal stimulus implemented during tight labor markets can plausibly lead to inflation, a topic we cover in Multiple Expansion, further below. Returns Driver #2: Margin Improvement We now turn to the question of whether companies can improve their margins from here. Unlike in our discussion around revenue growth where the picture was positive globally, the margin situation is more nuanced. Figure 6 below shows the evolution of corporate margins over time. Regional Profit Margins Proportion of July 2007 Peak 120% 100% Reference = 100% US EU EM Euro Debt Crisis 96% 80% 77% 60% 64% Change: 48% 40% 20% Recession-like margins 0% Source: Bloomberg, Makena Analysis Figure 5: EU and EM Margins Still Have Room to Improve Note how European corporate margins have historically tracked closely with U.S. margins but with a slight lag perhaps due to the more rigid labor markets in Europe. That behavior changed dramatically during the European debt crisis, when European margins fell back down to near recessionary levels, as indicated by red arrow, while margins of U.S. companies had returned to 90% of their pre-crisis peak. European margins have since started recovering, albeit slowly, and are now at approximately 64% of their pre-crisis peak. While that represents a nearly 50% improvement in margin over the recent past, European companies still have a long way to go to bring their margins back to near pre-crisis levels. Therefore, improving margins can still be a driver of European asset prices. Meanwhile it is difficult to see margin improvement being a significant driver of equity returns in the U.S. where margins are hovering near all-time highs. EM corporate margins are somewhere in between European and U.S. margins, with room to grow. For the U.S., the question becomes whether margins will start falling from current levels. Given that the U.S. economy is overwhelmingly a services-oriented economy, the main input cost for U.S. companies are wages. Figure 7 below shows this relationship with a pronounced (lagged) anti-correlation between average hourly earnings and corporate margins. 4

5 Profit Margin and AHE Growth In Services Margin Percent, YoY Growth 9.8% S&P500 Profit Margin 6m lag (lhs) Services AHE Growth 9m Trlg. Avg. (rhs) 9.6% 2.8% 9.4% 9.2% 2.6% 9.0% 2.4% 8.8% 8.6% 2.2% 8.4% 8.2% 8.0% Source: Bureau Of Labor Statistics, Bloomberg, Makena Analysis Figure 6: A Matter of Time Before Margins Turn 1.8% The typical acceleration seen in wages at this stage of an economic expansion have been conspicuously absent, with average hourly earnings increasing around annually since late This compares to an average rate of approximately 3.2% following the last two recessions. With the economy at full employment and growth solidly above trend, the last pressure relief valve for the labor market has been the participation rate a substantial proportion of working age people had left the workforce during the crisis, and many have now returned, with the participation rate increasing steadily as a result. Traditionally, an increase in the participation rate is followed by an increase in wages with about a 12-month lag, as labor supply slack is absorbed, as indicated in Figure 8 below. The current employment and participation dynamics therefore imply headwinds for U.S. corporate margins in the future. Hourly Wage Growth Lagged and Participation Growth Rate Percent Change (YoY), 6M Trailing Avg 5.0% Hourly Wage Growth YoY, lagged 12m (lhs) Participation Rate, 6m Avg, Both Gender (rhs) 0.8% 4.5% 0.6% 4.0% 3.5% 0.4% 0.2% 0.0% -0.2% -0.4% -0.6% 1.5% -0.8% 1.0% -1.0% Source: Bureau of Labor Statistics, Bloomberg, Makena Analysis Figure 7: Hourly Wage Growth Primed Returns Driver #3: Multiple Expansion 5

6 P/E ratios have been rising steadily over the last several years, a phenomenon often referred to as multiple expansion. As we have argued in prior quarterly letters (see Q for instance), a higher multiple on U.S. and European stock earnings is justified given the reduction in the trend growth rate of both those economies, ultimately implying low interest rates on a goforward basis. Lower rates drive stock prices by increasing the discounted present value of future earnings, effectively increasing the P/E ratios of stocks. Even though we continue to argue that current and future multiples should be higher than historical multiples (thereby casting doubts on analyses that rely on mean reversion to calculate future returns), U.S. stock multiples are now between one and two standard deviations above long run levels, depending on the metric used. In the face of rising rates and high multiples, one would expect a re-rating of U.S. multiples downwards. The picture is very different for European equities as the ECB is not envisaging hiking rates anytime soon at this juncture, apparently not until mid Likewise in EM, inflation pressures seem generally under control and high levels of earnings growth serve to dampen the influence of P/E ratios in those markets. Furthermore, for Europe and EM, it is interesting that multiples have not expanded to the same degree as U.S. equities, especially on a cyclically-adjusted P/E ratio basis. In other words, worries around multiples re-rating downwards are mainly U.S.-centric. Let us therefore analyze the situation for the U.S. in more depth. Using the Atlanta Federal Reserve s Taylor rule calculator, we created the table below, in Figure 9. The figure is a sensitivity analysis that shows what the ultimate Federal Funds rate could be at the end of this hiking cycle, depending on what inflation and unemployment metrics we observe. The green boxes represent a reasonable range for the Fed Funds rate at the end of this cycle somewhere in the mid 2% area, implying 3-4 rate hikes from current levels. President Trump s fiscal stimulus, however, would likely lead to a new scenario as highlighted by the red box an outcome with slightly more inflation and slightly stronger employment relative to the green scenario. In that red scenario, the ultimate Fed funds rate would likely be in the mid 3% area, representing an additional 2-3 rate hikes above the base case outcome. With much of the detail still very uncertain around the tax reform stimulus, the red scenario is little more than an educated guess, but it implies a U.S. stock market with lower P/E multiples. Figure 8: Upper Bound of Fed Funds Rate Mid-2 s Without Stimulus Importantly, short end rates such as the Fed Funds most likely do not drive stock multiples as much as longer term rates do. Corporations are long-lived entities, so a more appropriate discount rate is longer dated, say in the 10-year area of the yield curve. Traditionally, as illustrated in Figure 10 below, the yield curve flattens during a rate hiking cycle: front end rates go up with the Fed s actions, while longer term rates represent a tradeoff of higher short term interest rates versus lower inflation expectations. Indeed, one can see in Figure 10 that during the last two expansions the yield curve went completely flat and was inverted for a short period of time. Based on our current flatness, this implies that the next bps of Fed rate hikes may not influence 10 year rates. In this scenario, a re-rating of multiples is most likely an issue to worry about in late

7 Yield Curve Flatness Yield, Yield Spread (bps) 10 Yr Yield (lhs) 2 Yr Yield (lhs) 2-10 Steepness (rhs) 12% % % 200 6% % 50 2% % -100 Source: Bloomberg, Makena Analysis Figure 9: Yield Curve Typically Significantly Flattens Late in the Cycle Summary of Investment Strategy In our Q letter, we outlined a series of investment recommendations. Many of those themes remain unchanged, though we introduce some new themes based on an expectation of higher inflation going forward. i. Caution over growth companies during the run-up to and immediate aftermath of Fed rate hikes Growth companies will likely exhibit sensitivity to the effects of a rate hike via the P/E multiple. However, in a world of scarce growth, they may be able to attract and sustain higher valuation multiples than they have attracted historically, suggesting that re-rating risk is perhaps somewhat muted. ii. Similar to (i) above, buy into long term growth via EM equities Growth countries will also likely exhibit heightened sensitivity to the effects of a rate hike. Indeed, many EM markets seem to have already priced-in the effect of rate rises. Moreover, in a world of scarce growth, they should be able to attract and sustain higher valuation multiples than they have historically. Said differently, some EM countries currently represent growth at a reasonable price. iii. Buy real assets and commodities Many real assets and commodities respond with positive beta to inflation and to surprise inflation, making them helpful investments to protect the buying power of a portfolio. The implicit assumption is that real rates do not rise significantly from here, which given the growth outlook, seems reasonable. iv. Longer duration vs. shorter duration in Fixed Income portfolios Uncertainty over the timing and pace of the Fed hiking cycle is likely to continue to generate substantial volatility in the short end of the curve and potentially less volatility in the longer end. Additionally, should market expectations price a lower growth rate and a lower inflation outlook following a rate hike, we could actually see a rally in the long end. v. Neutral positioning for U.S. dollar in currency portfolios Real rate rises would push a currency upward due to improved carry dynamics. However, the current outlook appears more inflationary, which has a mixed impact on currency: carry improves but the buying power for the currency is reduced. 7

8 vi. vii. viii. U.S. small and medium enterprises (including Private Equity) vs. large-caps With a strong dollar and weaker commodity prices, the U.S. consumer has more disposable income, thereby favoring smaller domestically-oriented services companies. Potential tax code changes will only accentuate our preference for smaller capitalization domestically-oriented companies. Long Europe exporters and periphery intra-europe exporters Thanks to internal deflation across most of Europe, European exporters should see margins continue to improve. The weak Euro will continue to bolster exports to outside the Eurozone and imports from peripheral Europe to the core as a substitute for imports from outside the Eurozone. Long EM reformers vs. laggards (across asset classes) Some countries have embraced reforms since the last few crises, implementing flexible exchange rates, minimizing interventions in their domestic economies, and in general fostering an environment where private industry can thrive. These countries should be able to navigate volatility driven by exchange rates and the Fed s moves more successfully than the laggards that have not reformed. As always, we are thankful for your continued trust and support. The Partners of Makena Capital Management Analysis by Michel Del Buono, Global Investment Strategist 8

9 IMPORTANT NOTES AND DISCLOSURES Makena Capital Management, LLC ( Makena ) prepared this document solely for the person to whom it has been given for informational and discussion purposes only. This document and the information contained herein are strictly confidential and may not be reproduced, distributed or communicated, in whole or in part, to any third party without the express approval of Makena. Makena reserves the right at any time to amend or change the contents of this presentation without notice to you. Under no circumstances should the information presented be considered an offer to sell, or a solicitation to buy, any security referred to in this document. Such offer or solicitation may only be made pursuant to the current offering documents for the Makena Fund (the Fund or Funds ) which may only be provided to accredited investors and qualified purchasers as defined under the Securities Act of 1933 and the Investment Company Act of This document should be read in conjunction with, and is qualified in its entirety by, information contained in the Funds offering documents. Makena believes that the research used in this presentation is based on accurate sources (including but not limited to economic and market data from various government and private sources and reputable external databases), but we have not independently verified those sources, and we therefore do not guarantee their accuracy. The opinions, projections, and estimates contained herein reflect the views of Makena only and should not be construed as absolute statements and are subject to change without notice to you. Certain statements in this presentation may constitute forward-looking statements that should not be relied upon as representations of the future performance of any Makena Fund. The past performance of any Makena Fund is not necessarily indicative of future results. The projected performance results presented in this document, if any, are hypothetical and for informational and illustrative purposes only and should not be construed as a guarantee of actual or future performance results of any Makena Fund. Actual performance results may vary significantly from projected performance results due to many factors, including, but not limited to, new issue eligibility, different liquidity terms, timing of investment and other factors. Certain performance numbers in this presentation may be unaudited, preliminary and based on estimates. Final reported and audited performance numbers may vary considerably from these estimates. Estimated gross and net performance numbers could change materially as final performance figures and underlying investment costs and fees are determined and allocated. Unless otherwise noted, performance is shown net of underlying manager fees and net of the standard Makena fees per the applicable limited partnership agreement, including any incentive fees earned or estimated that a day one investor would pay. Asset class performance is shown net of underlying manager fees but gross of Makena fees. Please refer to the offering documents of the Makena funds for complete information regarding fees and expenses. Past performance is not indicative of future results. Comparison of the performance of any Makena Fund to a benchmark or benchmarks is for illustrative purposes only and the performance of the Makena Funds may differ materially from the performance of the benchmarks due to diversification, asset allocation, volatility or other factors. If MSCI data is presented be aware that MSCI has not approved, reviewed or produced this report, makes no express or implied warranties or representations and is not liable whatsoever for any data in the report. You may not redistribute the MSCI data or use it as a basis for other indices or investment products. 9