Global Investment Committee Allocation Views

Transcription

1 Investment Team Update 1 May 2017 Global Investment Committee Allocation Views PERSPECTIVE FROM FRANKLIN TEMPLETON SOLUTIONS This investment team update describes the views of the Franklin Templeton Solutions (FT Solutions) Global Investment Committee (GIC) an experienced team of investment professionals who specialize in equities, fixed income, cross asset and absolute return investments. The committee meets regularly to share multiple viewpoints, debate implications and assess risks. This process generates key investment themes, which can be expressed in a variety of portfolios that FT Solutions offers to clients. The text below describes the views of the FT Solutions GIC as at the date of this publication. These views are for general information only, are subject to change, apply solely to FT Solutions strategies and are not representative of the views or strategies of other Franklin Templeton investment groups. Executive Summary as at 1 May 2017 On a main asset class level, we held a favorable view of global equities, commodities and hedge funds. We have a negative view of developed-market (DM) government bonds and cash. Our preference is for assets we believe should benefit from inflationary pressures picking up, such as global value equities, US Treasury Inflation-Protected Securities (TIPS) and bank loans. We also favor assets likely to benefit from a strong US dollar and proposed US tax reform, as well as those we view as having attractive relative valuations, such as US small-cap equities over US large-cap equities. We adopted favorable views of European and Japanese equities in March, due in part to valuations we regarded as attractive relative to peer DM equities. We remain bearish on assets that we find the most overvalued, such as DM government bonds outside the United States. Asset Class Preference* Major Themes That Frame Our Tactical Asset Allocation 1. Synchronized Global Growth: Many macro indicators suggest a positive growth outlook. Expectations for fiscal stimulus in DMs have raised global growth forecasts for 2017 across these markets. We see prospects for economic rebalancing in emerging markets (EMs), but would like to see more evidence of long-term structural reform. 2. Inflationary Pressures: We see the overwhelming deflationary pressures in DMs during the past few years subsiding. DM central banks are departing from unconventional operational tools and, in some cases, have reduced support. However, financial conditions remain easy across DM central banks, in our view. *Based on our analysis of market factors. 3. Business Cycle Remains Positive: The output gap, the US Treasury yield curve, negative real short interest rates, low recession risk (especially in the United States), and low debt-service costs for corporations and households suggest to us that the business cycle should remain positive in the medium term. All information presented herein represents solely the general views of the FT Solutions GIC as at the date of this publication and is for illustrative purposes only. Any statements about strategy positioning are as at 1 May 2017 and are subject to change without notice. The positioning of a specific portfolio may differ from the information presented herein due to various factors, including, but not limited to, allocations from the core portfolio and specific investment objectives, guidelines, strategy and restrictions of a portfolio. Not intended as investment advice or an investment recommendation. There is no assurance any forecast, projection or estimate will be realized.

2 Current Convictions from the FT Solutions GIC Asset Class (-) N (+) Our Viewpoint MAIN ASSET CLASSES EQUITY REGIONS FIXED INCOME SECTORS Equities Corporate Bonds Government Bonds Commodities Hedge Funds Cash Developed (DM) United States Europe Japan Canada Emerging (EM) US Treasuries Ex-US Govt. Bonds High Yield Investment Grade (IG) EM Debt Represents month-over-month change Macro indicators have remained supportive of risk assets, based on our analysis, and we have observed a number of indicators that suggest to us a potential inflection point in improved global growth, stronger corporate fundamentals and encouraging investor sentiment. Valuations relative to history present risks to our favorable view. High-yield bonds are extremely overvalued, in our view. We favor bank loans due to their highest yield with least amount of duration and emerging-market debt relative to high yield, given stronger relative valuations. High interest-rate coverage ratios and low recession risk supportive of investment grade (IG) but corporate fundamentals weak and spreads rich relative to history. Given low term premiums for Treasuries and other DM government bonds, inflation pressures in the United States, potential for less demand for Treasuries, and improved growth and inflation data in Europe, we have an unfavorable view of DM government bonds broadly, especially those outside the United States, and most notably German Bunds. Expected increases in capital expenditures and an uptick in global manufacturing [as exhibited in a rising trend for purchasing managers indexes (PMIs)] depict advantageous conditions for oil. We balance these favorable indicators with a negative roll return. 1 Sector-level dispersion among US equities has continued to widen. For example, the performance spread between the best and worst S&P 500 sectors increased in 2016 after remaining relatively narrow for the previous several years. Historically, hedge funds have demonstrated generally healthy performance when the spread has widened. Macro indicators increasingly supportive of risk assets such as equities, commodities and hedge funds. Recovery in earnings, profit margins, productivity and manufacturing all strengthened, leading us to favor risk assets over cash. Elevated DM government bond valuations outside the US with low yields; cash more attractive defensive asset class. Economic indicators improved, attractive relative to history, driven by upside corporate earning surprises, improved gross domestic product (GDP) forecasts and strong retail sales. Monetary policy supportive. Corporate fundamentals improved and strong relative to history due to revenue data, earnings data, profit margins. But return on equity (ROE) weak. Valuations elevated, with most metrics over one standard deviation rich relative to 10-year history. Economic indicators improved and attractive relative to history, driven by corporate earning surprises, attractive OECD leading indicators and higher retail sales. Momentum strong. Revenue, profit margins, earnings momentum strong, but poor ROE presents risk. Valuations elevated, with most metrics over one standard deviation rich relative to 10-year history. Economic indicators favorable relative to history due to strong corporate earning surprises, retail sales, industrial production and GDP forecasts. European Central Bank (ECB) policy supportive. Corporate fundamentals improving and attractive relative to history due to revenue growth, earnings growth, earnings revisions and earnings momentum. ROE extremely weak but improving. Valuations increasingly expensive but less so compared to DM peers. Geopolitical risks. Economic indicators attractive relative to history, driven by OECD leading indicators, industrial production. Central bank policy supportive and money growth improving and attractive relative to history. Corporate fundamentals strong relative to history and improved, including revenue growth, earnings revisions, earnings momentum, attractive ROE. Profit margins strongest relative to DM peers. Revenue growth improved. Relative valuations attractive compared to DM peers. Positive economic surprises, leading indicators, industrial production and retail sales all improved. Money growth weak, but monetary policy supportive. Revenue growth, earnings growth, earnings revisions and earnings momentum strong. ROE and profit margins extremely weak. Valuations stretched across trailing and forward price-to-earnings (P/E) ratios. Economic fundamentals mediocre due to weak retail sales, industrial production and GDP forecasts, which are unattractive relative to history. However, economic indicators improving over last three months. Corporate earnings surprises attractive and improved noticeably. Poor money growth a large tailwind. ROE, profit margins extremely unattractive. But earnings and revenue data improved and now attractive. Valuations high, but more attractive than DMs. Equities overbought, in our view. Path of 2017 rate increases, tightening labor market, low term premium may cause yields to rise. Increased fiscal easing through potential tax cuts, infrastructure spending may increase growth and inflation, but also fiscal deficits and national debt. Higher relative yields, risk-off sentiment, stalled wage growth, geopolitics are upside risks to our unfavorable view. Improved inflation expectations and wage growth support TIPS. High valuations, low term premiums, improved economic data led to unfavorable view. Small rise in yields could quickly wipe out any carry. Improved inflation and inflation expectations in Europe. Fiscal policy either expansionary or less contractionary in Europe. Global headwinds, fears of secular stagnation, geopolitics, ECB/Bank of Japan quantitative easing all technical supports. Bank loans preferred, with highest yield for least amount of duration. Potential for deregulation, favorable tax reform, increased fiscal spending supportive of sector due to high expectations for corporate earnings to improve. Our fair value model indicates high-yield valuations rich, fundamentals weak. Isolationism could negatively impact supply chains. High interest-rate coverage ratios and low recession risk supportive, in addition to ECB buying of European IG. Corporate fundamentals weak and have deteriorated for several years. Rising rates bearish for IG duration and total return potential. Spreads rich relative to history. Positive carry supports excess returns. Yields are noticeably attractive relative to high yield. Challenges include pro-growth policies, which could lead to higher US rates and USD, and realignment of global geopolitics. However, US implementation of trade restriction policies uncertain, which supports EMs. Individual economies' fortunes are likely to differ widely. EM USD aggregate slightly expensive relative to history, but EM USD Latin America option-adjusted spread slightly cheap. No arrow = No change from the previous month The graphic reflects the views of the GIC regarding each asset class relative to a neutral portfolio allocation. All viewpoints reflect solely the views and opinions of the GIC. Equity regions and fixed income sector totals roll up to the main asset classes. Global Investment Committee Allocation Views 2

3 Cross Asset Macro indicators have remained supportive of risk assets, based on our analysis, and we have continued to observe a number of indicators that suggest to us a potential inflection point in improved global growth, stronger income statement corporate fundamentals and potential inflows into global equities. The potential for robust US fiscal policy also supports risk assets. We also see potential gains in US productivity, should proposed tax changes take effect. Global PMIs have reached levels well above the narrow range that persisted for much of calendar year 2016, despite a recent decline in US PMIs. The trend for a positive and rising (PORI) regime for composite, manufacturing and services PMIs suggests favorable global equity performance potential in the near term. Although the US Federal Reserve (Fed) increased its key short-term interest rate in mid-march, the move signaled its continued confidence in the improving economy, and financial conditions generally remained accommodative. In April, sentiment among market traders moved from what we viewed as overly optimistic to a more neutral sentiment, which we regarded as another potential tailwind for risk assets. Another measure of sentiment, the IFO Economic Climate Survey, found optimism among national and global organizations improved recently. Corporate performance also supported risk assets, in our assessment. Measures of corporate profit margins and earnings momentum have trended upward recently, while business confidence readings have also shown substantial improvement. A significant improvement in the breadth of earnings revisions over the past six months represented to us another tailwind for risk assets such as equities. Historically, when earnings revisions have trended up, global equity performance generally has been robust. However, the precipitous climb is a risk to our view and led us to temper expectations going forward, as we believe this measure may be approaching an extended level. Our analysis and evaluation of these supportive factors led to a favorable view on global equities. Although most indicators were supportive of risk assets, geopolitical risks have grown, as has uncertainty regarding proposed fiscal policy. Although the markets reacted favorably following the results of the first round of France s presidential election, another round and more uncertainty await investors. In the United States, investors tempered optimism surrounding proposed tax reductions as the timing and certainty regarding these cuts came into question. Additionally, tensions have risen over the past month between the United States, along with its allies, and North Korea, Syria and Russia, among others. GIC Asset Class Views Equities Corporate Bonds Government Bonds Commodities Hedge Funds Cash The graphic reflects the views of the GIC regarding each asset class relative to a neutral portfolio allocation. Represents month-over-month change No arrow = No change from the previous month N + Sentiment and certain valuations also appeared less favorable to us. The global equity risk premium was below its rolling five-year average and falling as at mid-april. Given the continued uncertainty surrounding political and legislative events, the risk premium did not sufficiently compensate investors for these risks, in our opinion. A pullback in corporate earnings surprises also suggested a potential headwind. Another cautious indicator for global equities was an environment of high P/E ratios and low volatility. Historically, this regime has been associated with muted performance for the forward three-month period. We see the potential for more hawkish central bank policy during the remainder of 2017 as DM economies continue to expand. With broad expectations for higher interest rates moving forward, investor cash flows have started to tilt more toward equities as opposed to bonds. This trend may signal a pivotal investor shift away from government bonds following a 30-year period of inflows. For example, while the ECB left interest rates unchanged in April and kept a lid on German Bund yields, pressure for the ECB to taper its accommodative monetary policy is emerging, especially from northern Europe, as core inflation picks up. We held a slightly unfavorable view of global corporate bonds. Valuations for high-yield bonds have been extremely overvalued, according to our proprietary high-yield fair value model. However, we do favor bank loans within the corporate sector, since they currently offer the highest yield in this sector for the least amount of duration, or sensitivity to interest rates, and we found their relative valuations more attractive as at April-end. As a result of these factors, we have a preference for bank loans relative to DM government bonds and investment-grade bonds. Global Investment Committee Allocation Views 3

4 Financial Conditions Remained Accommodative Even Following the Fed Interest-Rate Hike Chart 1: Global Financial Conditions Index June 2012 April Financial conditions above zero = supportive -1 6/12 3/13 11/13 7/14 4/15 12/15 8/16 4/17 Statistics PORI POFA NERI Regime NEFA Agnostic Avg. 3M Fwd. Return 2.7% 2.9% -0.8% 1.0% 1.4% Median 3M Fwd. Return 3.4% 3.2% 1.7% 1.1% 3.1% Max. Return 8.9% 11.3% 17.6% 25.9% 25.9% Min. Return -11.8% -14.7% -30.3% -20.7% -30.3% Std. of Return 4.6% 5.3% 9.8% 9.2% 7.7% % of Time 30.0% 21.0% 26.0% 22.0% 100.0% Source: Bloomberg. Data as at 1/5/17. PORI = positive and rising. POFA = positive and falling. NERI = negative and rising. NEFA = negative and falling. Past performance does not guarantee future results. Global Output Gap Suggests Further Expansion Chart 2: Global Output Gap, or Difference between Actual and Potential Output of Economies March 1970 February % 4% 3% 2% 1% 0% -1% -2% -3% -4% -5% -6% 3/70 1/78 11/85 9/93 7/01 4/09 2/17 MSCI Barclays US GSCI NERI Statistics World Aggregate Treasuries Commodities Average Quarterly Return 4.0% 1.6% 1.6% 0.2% Median Quarterly Return 4.1% 1.6% 1.4% 1.0% Std. of Return 6.3% 2.5% 2.7% 9.3% % of Time in NERI Regime 31.0% 32.0% 31.0% 31.0% Med. Return vs. Risk Ratio Source: Thomson Reuters Datastream. Data as at 15/4/17. All statistics reflect quarterly returns. Past performance does not guarantee future results. Looking at commodities, we note that global capital expenditure spending has risen in recent months from low levels. Furthermore, several fundamental indicators remained supportive of commodities. For example, global manufacturing has trended up over the past year (see Chart 3). Historically, when global manufacturing was in a PORI regime, global commodities have enjoyed healthy performance (see table for Chart 3). Relative and long-term valuations, worldwide trade levels, and both global and China composite leading indicators all appeared to be tailwinds for commodities, according to our analysis. Combining these attractive macro growth fundamentals with an upward trend for oil prices led us to a favorable view of commodities. We balance these favorable indicators with a negative roll return. 1 Climbing Global PMI Suggests Upside Potential for Commodities Chart 3: Global Manufacturing, One-Month and Three-Month Moving Average April 2014 March % 53.0% 52.5% 52.0% 51.5% 51.0% 50.5% 50.0% 49.5% 49.0% 4/14 11/14 6/15 1/16 8/16 3/17 Bloomberg Commodity Index Total Return Performance Statistics PORI POFA NERI NEFA Regime Agnostic Average Fwd. Return 2.8% 0.2% 3.3% -5.1% 0.5% Median Fwd. Return 2.5% 0.3% 2.2% -2.9% 1.3% Std. Dev. of Return 7.4% 7.2% 8.9% 13.9% 11.3% Count % of Time 41% 35% 10% 13% 100% Market PMI: Global Manufacturing One-Month Average Three-Month Moving Average Source: Thomson Reuters Datastream. Data as at 17/3/17. PORI = positive and rising. POFA = positive and falling. NERI = negative and rising. NEFA = negative and falling. Past performance does not guarantee future results. Global Investment Committee Allocation Views 4

5 Equities Much of the financial headlines surrounding Europe have focused on uncertainty regarding upcoming and recent elections, as well as the impact of the United Kingdom s exit from the European Union. Perhaps unsurprisingly, European equities significantly trailed their DM peers in 2016 amid sizable investor outflows. However, investor concerns have overshadowed many positive attributes and developments for European bourses. European PMI and IFO Survey data have signaled, respectively, economic expansion and optimism among businesses. In core European markets such as Germany, France, the Netherlands and Spain, earnings growth, momentum and revisions (see Chart 4) have shown improvement in recent months. French stocks, for example, appear undervalued to us amid pessimism and fear from many investors. We believe the perceived populist threat in Europe will largely fade over calendar year 2017, allowing investors to turn their attention to the eurozone s economic growth and emergent inflation as the economic backdrop continues to improve. We remain fully cognizant of potential headwinds for European stocks. France s presidential run-off in May and parliamentary elections in June remain ahead, and a victory by populist candidate Marine Le Pen (which is not our base case) would weigh on markets. Greece s fight to avoid default could be tested, or lead to new conditions for a bailout. From an economic standpoint, while we see European demand as the primary driver of the region s economy, deceleration in EM economies, particularly China, could weigh on eurozone growth. Finally, while inflation has started to firm in Europe, it appeared somewhat tenuous as at April-end. Ultimately, however, we hold high conviction that the business cycle will trump politics, which led us to upgrade our view of European stocks to favorable. Japan s economy has shown improvement in recent months, as reflected in leading economic indicators. A tight labor market has been supporting wage growth. From a corporate performance standpoint, earnings-per-share (EPS) revisions and ROE momentum have both been robust in recent months. Japanese ROE momentum, in particular, was higher than in most DMs. Central bank support in Japan has remained as another tailwind. Despite the strengths, our analysis indicated to us that analyst expectations and guidance from Japanese corporations have continued to underestimate EPS growth. Valuations also seemed to us to underestimate improved corporate profitability in Japan. Japanese equities offered lower valuations compared to other DM equities across most measures as at mid-april, including P/E, despite less political risk in Japan. Money growth was also robust in Japan, GIC Views of Equity Regions N + Developed United States Europe Japan Canada Emerging The graphic reflects the views of the GIC regarding each asset class relative to a neutral portfolio allocation. Represents month-over-month change No arrow = No change from the previous month providing what we see as further support for Japanese equity performance potential (see Chart 5). We adopted a favorable view of Japanese equities in March. Turning to DM equities as a whole, corporate fundamentals appear strong to us across several measures, particularly earnings growth and earnings momentum. However, valuations for DM equities as at April were well above their historical averages, including trailing and forward 12-month P/E and price-to-cash earnings ratios. Inflationary pressures remained high in recent months, representing an equity headwind, particularly for growth-oriented global stocks. On a sector level, value equities provide much more exposure to the financials sector than growth equities, both in the United States and across global DMs. Based on our analysis, the financials sector offered improving earnings revisions and strong earnings momentum. Relative to history, profit margins for financials were also attractive to us and improving. As one would expect for a sector with greater representation in the value space than in the growth space, valuation measures for global financial stocks were less expensive than their peer sectors. In contrast, valuations for consumer staples across trailing and forward P/E, price-to-sales (P/S) and price-to-book (P/B) ratios were all over one standard deviation rich relative to their 10-year history as at April. We also have a preference for global value equities given the greater representation of consumer staples in the global growth space. The combination of strong fundamentals for DM stocks, high valuations relative to history, our preference for financials sector equities, and our aversion to consumer staples stocks led us to a favorable view of value stocks in DMs relative to growth stocks in these markets. Looking at other spaces within the equity universe, US economic sentiment has improved in recent months, which should support domestically focused companies. Small-cap stocks have historically performed better than their large-cap Global Investment Committee Allocation Views 5

6 peers during periods when consumer confidence improved from negative levels. Historically, periods of optimism for small business owners have tended to accompany healthy performance for small-cap stocks relative to large-cap stocks. One reason for higher optimism among small business owners may result from currently higher effective tax rates for companies in the Russell 2000 Index compared to the Russell 1000 Index. With US President Donald Trump s administration proposing tax reductions for corporations overall and proposing the reduction of loopholes that favor large multinational companies (despite some uncertainty on the timing and extent of these changes), these small-cap stocks have a greater potential to benefit from tax reform. We have also observed attractive corporate fundamentals for small-cap stocks evident in stronger earnings revisions and ROE relative to large-cap stocks. From a valuation standpoint, US large-cap stocks have appeared expensive to us on both a trailing and forward earnings basis. Although US small-cap stock valuations stood above their historical averages as at April, these valuations were lower than their large-cap peers. As a result of our comparative analyses, we hold a favorable view of US small-cap stocks relative to US large-cap stocks. A Positive and Rising Regime for Earnings Revisions Has Historically Supported European Equities Chart 4: Europe EPS Revisions January 2005 March 2017 Europe EPS Revisions /05 2/11 3/17 Revisions Average +/- Standard Deviation European Equity Statistics PORI POFA NERI NEFA Regime Agnostic Average Fwd. Return 0.7% 1.5% 0.2% -0.3% 0.5% The Trend for Money Growth in Japan Has Historically Supported Japanese Equities Chart 5: Z-Scores for Money Growth in Japan January 2005 March 2017 Money Growth Z-Score /05 2/11 3/17 Japanese Equity Statistics PORI POFA NERI NEFA Regime Agnostic 6-Month Fwd. Return 4.0% 0.9% 2.0% 2.0% 3.0% Median Fwd. Return 0.7% 1.7% 0.0% 0.4% 0.7% Std. Dev. of Return 3.7% 5.1% 6.8% 6.0% 5.5% Count % of Time 28% 22% 26% 24% 100% Source: Thomson Reuters. Data as at 15/4/17. PORI = positive and rising. POFA = positive and falling. NERI = negative and rising. NEFA = negative and falling. Past performance does not guarantee future results. Source: Thomson Reuters. Data as at 15/4/17. PORI = positive and rising. POFA = positive and falling. NERI = negative and rising. NEFA = negative and falling. Past performance does not guarantee future results. Narrow money growth (M1) is a definition of the money supply which is based on money as a medium of exchange, rather than its broadest economic use. It includes currency, i.e., banknotes and coins, plus overnight deposits. Global Investment Committee Allocation Views 6

7 Fixed Income From our perspective, the US Treasury market has been excessively pricing in sluggish growth and a conservative path of interest-rate hikes, particularly past 2017, even with higher expectations for growth and future interest-rate increases. The latest Federal Open Market Committee projections for monetary policy in 2017 suggest a high probability of two more interest-rate increases in addition to the March increase, as economic data suggest to many investors that the case for rate tightening has strengthened. Employment in the United States has remained strong, as reflected in the March unemployment rate at a multi-year low, the rise in nonfarm payrolls and the US economy adding a healthy amount of jobs early in These improving US employment indicators should continue to bode well for wage gains, in our opinion. The tighter labor market in the United States supports our view of strengthening inflationary forces, and core inflation has trended higher over the past 12 months. In addition, the gap between the unemployment rate and the nonaccelerating inflation rate of unemployment appears to us to have closed (see Chart 6). Given the difference between strengthening inflationary factors and market pricing, we viewed term premiums in the US Treasury market as low and unattractive. Demand for US Treasuries from foreign governments also suggests to us upward pressure on yields. Many governments, particularly that of China, substantially reduced exposure to US Treasuries in late The decrease in foreign holdings in US Treasuries has contributed to the upward trend in Treasury yields over the past six months. In addition, the Fed may announce a change to its policy of reinvestment of payments of principal for US Treasuries and agency bonds. This potential action could add to upward pressure on US Treasury yields and spreads for mortgagebacked securities. Outside of the United States, ECB policy rates are likely to remain low (with a slightly negative deposit rate) for the next several years. The ECB has not been talking about a taper of its policy, but if we continue to see a cyclical bounce in eurozone growth, some pressure is likely to emerge from Northern European hawks. The annual rate of inflation in the eurozone rose above the ECB s target for the first time in four years in February, although it dipped in March. Economic data in Europe has improved recently, and fiscal policy has been turning expansionary or at least less contractionary. The transmission mechanism of monetary policy is showing gradual improvement. Consequently, we view German Bunds as overvalued, resulting in asymmetrical risk and reward. For example, the term premium is currently quite negative for German Bunds, and a small rise in yields could wipe out years of carry. GIC Views of Fixed Income Sectors US Treasuries Ex-US Govt. Bonds High Yield Investment Grade EM Debt N + The graphic reflects the views of the GIC regarding each asset class relative to a neutral portfolio allocation. Represents month-over-month change No arrow = No change from the previous month Given our assessment of low term premiums for Treasuries and other DM government bonds, inflation pressures in the United States, the potential for less demand for Treasuries, and improved growth and inflation data in Europe, we have an unfavorable view of DM government bonds broadly, especially those outside the United States, and most notably German Bunds. Continued Tightening of US Labor Market Should Increase Wages and Consumption Chart 6: Average Hourly Earnings and Unemployment Gap June 1984 March 2017 Average Hourly Earnings 1.0% 1.5% 2.0% 2.5% 3.0% 3.5% 4.0% 4.5% 5.0% -2% Recession Unemployment Gap LABOR SURPLUS LABOR DEFICIT Average Hourly Earnings: Total Private Nonfarm (LHS, Inverted) Unemployment Gap: Unemployment Rate NAIRU (RHS, 2Q Lag) Source: Thomson Reuters Datastream, Congressional Budget Office, US Bureau of Labor Statistics. Data as at 15/3/17. NAIRU = non-accelerating inflation rate of unemployment. 5% 4% 3% 2% 1% 0% -1% Global Investment Committee Allocation Views 7

8 Delays and some uncertainty over President Trump s proposed trade restriction policies have resulted in less of a headwind for EM debt, in our opinion. This development has contributed to substantial investor inflows into the asset class year-to-date. Another reason for inflows into EM debt is the bond sector s yield, which we found attractive relative to US investment-grade and high-yield bonds (see Charts 7a and 7b). Our analysis also weighed considerations such as the absolute valuations and spreads for EM debt, which were elevated relative to history. However, we found the tailwinds for this bond sector convincing, and we adopted a favorable view of EM debt relative to US high-yield debt. FT Solutions Fair Value Model: Option-Adjusted Spread for EM Debt Was in Line with the Asset Class s Historical Average Chart 7a: Actual Minus Estimated Emerging-Market Debt Spread over Time March 2003 April 2017 Deviations from Model /03 3/05 3/07 3/09 3/11 3/13 3/15 4/17 Residuals 1 Sigma Limit Middle Source: Calculations by FT Solutions using data sourced from Bloomberg. The full index name is the JP Morgan Emerging Market Bond Index. Data as at 1/4/17. Indexes are unmanaged and one cannot invest directly in an index. They do not reflect any fees, expenses or sales charges. FT Solutions Fair Value Model: Option-Adjusted Spread for US High Yield Was More than One Standard Deviation Rich Compared to the Asset Class s Historical Average Chart 7b: Actual Minus Estimated US High-Yield Debt Spread over Time August 1999 April 2017 Deviations from Model /99 1/04 6/08 11/12 4/17 Residuals 1 Sigma Limit Middle Source: Calculations by FT Solutions using data sourced from Bloomberg. The full index name is the Credit Suisse High Yield Index. Data as at 1/4/17. Indexes are unmanaged and one cannot invest directly in an index. They do not reflect any fees, expenses or sales charges. Global Investment Committee Allocation Views 8

9 Alternatives Sector-level dispersion among US equities has continued to widen since the US election as investors continued to assess the new Trump administration s policy objectives and price in the timing and extent of tax cuts and increased infrastructure spending. For example, the performance spread between the best and worst S&P 500 sectors increased in 2016 after remaining relatively narrow for the last several years (see Chart 8). Historically, hedge funds have demonstrated generally healthy performance when the spread has widened. Furthermore, the correlation of S&P 500 component returns reached a record low in January. We also expect the quantitative easing-driven equity beta tailwind that has been evident over the past few years to have less impact on equity performance potential, and companyspecific developments could have more influence on equity performance potential going forward. We believe the combination of rising US interest rates and the uptrend in dispersion could provide a tailwind for long short equity managers in the hedge fund space. The inverse environment was characteristic of the past few years, and hedge fund performance has been modest over this period. However, when hedge fund performance has improved from below-average levels, as both the economic environment and recent performance suggests, the asset class historically has exhibited strong performance potential. Additionally, less competition in the hedge fund space may support managers, as investor net outflows were substantial in 2016, representing the first year of net outflows since Accordingly, we maintained a favorable view of hedge funds. Within hedge funds, our highest strategy convictions were in long short equity Europe, relative value (fixed income) and event driven. Many of the supportive factors for our view on European equities, such as the region s GDP, confidence and inflation, also apply to this space in hedge funds. For relative value fixed income, the investor shift in duration risk, which accompanies rising interest rates, creates volatility and what we see as opportunity in credit markets. Elsewhere, event driven strategies could be supported by more business friendly policies from the Trump administration, which should help corporate activity remain robust. The Dispersion of Equity Returns Has Been Increasing Chart 8: S&P 500 Correlation and Dispersion, Standard Deviation from the Mean March 1991 December 2016 Standard Deviations from the Mean Lower average correlation to the S&P 500: better for alpha generation /91 2/94 12/96 10/99 9/02 7/05 5/08 4/11 2/14 12/16 Higher dispersion: better for alpha generation Dispersion Standard Deviation Correlation Standard Deviation 12-Month Moving Average (Dispersion Std. Dev.) 12-Month Moving Average (Correlation Std. Dev.) Source: Bloomberg and K2 Analysis. Data as at 31/12/16. Past performance does not guarantee future results. Global Investment Committee Allocation Views 9

10 WHAT ARE THE RISKS? All investments involve risks, including possible loss of principal. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Value securities may not increase in price as anticipated or may decline further in value. Smaller companies can be particularly sensitive to changes in economic conditions and have less certain growth prospects than larger, more established companies and can be volatile, especially over the short term. Investments in smaller-company securities that may have limited liquidity involves additional risks, such as relatively small revenues, limited product lines and small market share. Bond prices generally move in the opposite direction of interest rates. Thus, as the prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in emerging markets, of which frontier markets are a subset, involve heightened risks related to the same factors, in addition to those associated with these markets smaller size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets. Because these frameworks are typically even less developed in frontier markets, as well as various factors including the increased potential for extreme price volatility, illiquidity, trade barriers and exchange controls, the risks associated with emerging markets are magnified in frontier markets. Derivatives, including currency management strategies, involve costs and can create economic leverage in a portfolio which may result in significant volatility and cause the portfolio to participate in losses (as well as enable gains) on an amount that exceeds the portfolio s initial investment. A strategy may not achieve the anticipated benefits, and may realize losses, when a counterparty fails to perform as promised. Currency rates may fluctuate significantly over short periods of time and can reduce returns. Real estate securities involve special risks, such as declines in the value of real estate and increased susceptibility to adverse economic or regulatory developments affecting the sector. Investments in REITs involve additional risks; since REITs typically are invested in a limited number of projects or in a particular market segment, they are more susceptible to adverse developments affecting a single project or market segment than more broadly diversified investments. Investing in the natural resources sector involves special risks, including increased susceptibility to adverse economic and regulatory developments affecting the sector prices of such securities can be volatile, particularly over the short term. Investments in hedge funds are speculative investments, entail significant risk and are suitable only for persons who can afford to lose the entire amount of their investment. Global Investment Committee Allocation Views 10

11 IMPORTANT LEGAL INFORMATION This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as at publication date and may change without notice. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market. All investments involve risks, including possible loss of principal. Data from third party sources may have been used in the preparation of this material and Franklin Templeton Investments ( FTI ) has not independently verified, validated or audited such data. 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