Global Investment Committee Allocation Views

Transcription

1 Investment Team Update 1 June 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 June 2017 On a main asset class level, we held a favorable view of global equities and hedge funds. We have a negative view of developedmarket (DM) government bonds and cash. We lowered our favorable view of commodities in May but the asset class remains attractive to us. Our preference is for assets we believe should benefit from inflationary pressures picking up, such as global value equities 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 maintained favorable views of European and Japanese equities, 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 and low recession risk (especially in the United States) 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 June 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 MAIN ASSET CLASSES EQUITY REGIONS FIXED INCOME SECTORS Asset Class 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 (-) N (+) Represents month-over-month change Our Viewpoint Macro indicators have remained supportive of risk assets, based on our analysis. Despite some deceleration, 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. First-quarter earnings are off to a strong start. 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 EM debt relative to high yield, given stronger relative valuations. High interest-rate coverage ratios and low recession risk are supportive of investment grade (IG) but corporate fundamentals are 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, an uptick in global manufacturing and an increase in world trade growth depict advantageous conditions for commodities. However, technical indicators weakened in May. We also consider 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 corporate earnings 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) is weak. Valuations are elevated, with most metrics over one standard deviation rich relative to 10-year history. Economic indicators improved and are attractive relative to history, driven by corporate earnings surprises, some attractive OECD leading indicators and higher retail sales. 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 are favorable relative to history due to strong corporate earnings surprises, retail sales, industrial production and GDP forecasts. European Central Bank (ECB) policy is 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 still less so compared to DM peers. Geopolitical risks. Economic indicators are 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 are strong relative to history and improved, including revenue growth, earnings revisions, attractive ROE. Profit margins are strongest relative to DM peers. Revenue growth improved. Relative valuations are attractive compared to DM peers. Positive economic surprises, leading indicators, industrial production 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 but improving. Valuations stretched across trailing and forward price-to-earnings (P/E) ratios. Economic fundamentals are mediocre due to weak retail sales, industrial production and GDP forecasts, which are unattractive relative to history. However, economic indicators have improved over last four months. Corporate earnings surprises have been attractive and improved noticeably. Poor money growth is a large tailwind. ROE, profit margins extremely unattractive. But earnings and revenue data improved and now attractive. Valuations are high, but more attractive than DMs. Equities are overbought, in our view. Path of 2017 rate increases, tightening labor market, low term premium may cause yields to rise. Less certainty now on fiscal easing through potential tax cuts, infrastructure spending to 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. Wage growth supports Treasury Inflation-Protected Securities. 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 are weak and have deteriorated for several years. Rising rates are bearish for IG duration and total return potential. Spreads are 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 is 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 improved global growth, stronger income statement corporate fundamentals and potential inflows into global equities. Although the potential for robust US fiscal policy grew somewhat obscured in May, the implementation of these policies would support risk assets. We also see potential gains in US productivity, should proposed tax changes take effect. Global purchasing managers indexes (PMIs) have remained in expansion territory, despite a recent decline in US manufacturing PMI. The trend for a positive and rising (PORI) regime for composite, manufacturing and services PMIs suggests to us favorable global equity performance potential in the near term. Although the US Federal Reserve (Fed) is widely expected to increase its key short-term interest rate in June, the Fed has expressed continued confidence in the improving economy, and financial conditions generally remained accommodative. A measure of sentiment, the IFO Economic Climate Survey, found in May that optimism among national and global organizations improved considerably from earlier in 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 (see Chart 2). 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 (see Chart 3). 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 still remain, as has uncertainty regarding proposed fiscal policy. Although the markets reacted favorably following the results of France s presidential election, investors have tempered optimism surrounding proposed US tax reductions as the timing and certainty regarding these cuts came into question. Additionally, tensions remained elevated between the United States, along with its allies, and North Korea, Syria and Russia, among others. 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-may. 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 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 + 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. The combination of high P/E ratios and low volatility suggests to us a level of investor complacency. 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. However, we note ECB President Mario Draghi and fellow ECB members have kept a dovish tone on policy, despite positive economic reports and low unemployment in Europe. 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. Elsewhere, several fundamental and technical indicators for commodities weakened over the past month, including a shipping and trade index, seasonality factors, and 50- and 200-day moving averages. The breadth of some of these indicators has fallen to what we view as negative levels. Global Investment Committee Allocation Views 3

4 Financial Conditions Remained Accommodative Chart 1: Global Financial Conditions Index June 2012 April Financial conditions above zero = supportive /12 5/13 5/14 4/15 4/16 4/17 Global Threshold Global Equity Regime Statistics PORI POFA NERI 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. Manufacturing and Consumer Confidence Strong and Trending Higher Chart 2: OECD Global Confidence Aggregate May 2012 April /12 7/13 10/14 1/16 4/17 Global Confidence Aggregate Three-Month Moving Average Global Equity Statistics Above 3 MMA Below 3 MMA Regime Agnostic Average Fwd. Return 15% 8% 11% Median Fwd. Return 13% 13% 13% Std. Dev. of Return 14% 17% 15% Count % of Time 51% 49% 100% Source: Thomson Reuters, MSCI, Organisation for Economic Co-operation and Development (OECD). Data as at 8/5/17. All data is annualized using three-month forward returns (MSCI World Index). Past performance does not guarantee future results. However, we still observe several areas of support for commodities. Investor sentiment for the asset class has continued to decline over the past few years, which we find a bullish sign. Global capital expenditure spending has risen in recent months from low levels. Furthermore, several fundamental indicators remained supportive of commodities. Relative and long-term valuations, worldwide trade levels, and China composite leading indicators all appeared to be tailwinds for commodities, according to our analysis. With regard to oil, the supply/demand outlook reflects more normalized conditions, in our opinion. Combining these attractive macro growth fundamentals against the recent downturn for certain indicators led us to lower the conviction of our favorable view of commodities. We balance the favorable factors with a negative roll return. 1 The Breadth of Global Corporate Earnings Revisions Was Strong Chart 3: Global Corporate Earnings Breadth 24 May May % 10% 0% -10% -20% -30% -40% -50% 5/12 2/13 10/13 7/14 3/15 12/15 8/16 5/17 MSCI All Country World Index Earnings Revisions Breadth Three-Month Moving Average Global Equity Statistics Above 3 MMA Below 3 MMA Average Fwd. Return 13% -1% Regime Agnostic Return 6% 5% Std. Dev. of Return 14% 20% Regime Agnostic Std. Dev. 17% 17% Count Source: Thomson Reuters, MSCI. Data as at 18/5/17. 3 MMA = Three-month moving average. Past performance does not guarantee future results. Global Investment Committee Allocation Views 4

5 Equities Following an extended period of political uncertainty weighing on European stocks, investor concerns surrounding populist politics in the region have largely faded. Following the French election results in May, along with encouraging economic data, European equities enjoyed a healthy rally. Continued reversal of the significant investor outflows from European equities in 2016 could further support performance potential for European stocks. We believe the receding political headwinds should allow for more investors to focus on the eurozone s economic growth and emergent inflation as the economic backdrop continues to improve. Higher GDP forecasts for European Monetary Union (EMU) countries reflect improving macro conditions, and IFO Survey data signaled optimism among businesses. Consumer confidence also recently climbed in several countries. In core European markets such as Germany, France, the Netherlands and Spain, earnings growth, momentum and revisions have shown improvement in recent months. We are also encouraged by significant potential for EMU profit margins to converge with their US peers (see Chart 4). Historically, a positive and rising trend for profit margins in Europe has been followed by positive stock performance. We remain fully cognizant of potential headwinds for European stocks. Greece s fight to avoid default could be tested, or lead to new conditions for a bailout, and the country fell back into a recession in the first quarter. 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 May-end. Ultimately, however, we hold high conviction that the business cycle will trump politics, which led us to maintain a favorable view of European stocks. In Japan, corporate earnings-per-share (EPS) revisions and ROE and profit margin momentum have all been robust in recent months. Japanese ROE momentum, in particular, was higher than in most DMs. A tight labor market has been supporting wage growth and lowered deflation concerns. 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-may, 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 held a favorable view of Japanese equities. 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 May 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. 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 and price-to-book ratios were all over one standard deviation rich relative to their 10-year history as at May. 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 Global Investment Committee Allocation Views 5

6 stocks have historically performed better than their large-cap 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 May, 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. The Potential for Profit Margin Convergence and Improvement Supports European Equities Chart 4: Profit Margins (Last-12-Month Net Income/Sales) 24 May May % The Trend for Money Growth in Japan Has Historically Supported Japanese Equities Chart 5: Z-Scores for Money Growth in Japan April 2005 April 2017 Money Growth Z-Score % % 0.5 8% 7% EMU has a lot of potential for selfimprovement and convergence with the United States % % 5/07 5/08 5/09 5/10 5/11 5/12 5/13 5/14 5/15 5/16 5/17 European Equity Statistics Agnostic POFA PORI NERI NEFA Signal EMU United States Every Time Regime Analysis: One-Month Post Regime EMU Profit Margins vs. MSCI Europe Index January 2005 April 2017 Bearish BullishBullishBearish Average 0.63% -0.59% 1.65% 1.56% -1.03% Percent in Regime 45% 53% 36% 64% Percent in Positive 54% 65% 65% 51% /05 4/06 4/07 4/08 4/09 4/10 4/11 4/12 4/13 4/14 4/15 4/16 4/17 Japanese Equity Statistics PORI POFA NERI NEFA Regime Agnostic 6-Month Fwd. Return 4.0% 0.9% 2.0% 2.0% 3.0% Source: Thomson Reuters. Data as at 8/5/17. PORI = positive MOM change and rising. POFA = positive MOM change and falling. NERI = negative MOM change and rising. NEFA = negative MOM change and falling. MOM = month-over-month. 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. Significant Yes Yes Yes Yes Source: Thomson Reuters. Data as at 24/5/17. PORI = positive and rising. POFA = positive and falling. NERI = negative and rising. NEFA = negative and falling. Past performance does not guarantee future results. Global 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 following the March increase, including likely action at the Fed s June meeting, 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 April unemployment rate at a 10-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 contributed to an upward trend in Treasury yields in the first quarter of 2017, a trend that we believe will resume. 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 mortgage-backed 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 has trended up over the past year and was close to the ECB s target. On a country level, inflation has strengthened in Germany over the past 12 months, including rising price expectations in areas such as construction, consumers and manufacturing. 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 Overall 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 (see Chart 7). For example, the term premium is currently quite negative for German Bunds, and a small rise in yields could wipe out years of carry. Continued Tightening of US Labor Market Should Increase Wages and Consumption Chart 6: Average Hourly Earnings and Unemployment Gap June 1984 April 2017 Average Hourly Earnings Unemployment Gap 1.0% 1.5% 2.0% 2.5% 3.0% 3.5% 4.0% 4.5% LABOR SURPLUS LABOR DEFICIT 5.0% Recession 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 8/5/17. NAIRU = non-accelerating inflation rate of unemployment. 5% 4% 3% 2% 1% 0% -1% -2% Global Investment Committee Allocation Views 7

8 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. Relative to US Treasuries, German Bunds Appear Expensive to Us Chart 7: German Bunds versus US Treasury Yields 24 May May % 0.5% 2% 1% Increasing uncertainty over President Trump s proposed trade restriction policies has resulted in less of a headwind for EM debt in recent months, 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. 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. 0.0% -0.5% -1.0% -1.5% -2.0% -2.5% -6% Year German Bunds 10-Year US Treasuries (LHS) Eurozone US Nominal GDP Growth YOY, One-Year Lag (RHS) Source: Thomson Reuters Datastream. Data as at 24/5/17. 0% -1% -2% -3% -4% -5% Alternatives 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 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 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 company-specific 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 Investor net inflows resumed in the first quarter of 2017, which we believe reflected recognition of the growing tailwinds for the asset class. Accordingly, we maintained a favorable view of hedge funds. Global Investment Committee Allocation Views 8

9 Within hedge funds, we continue to see generally favorable conditions in the discretionary global macro space amid an active political calendar, increased dispersion between stronger and weaker economies, and diverging central bank interest-rate policies. However, we held a neutral view of the systematic substrategy in global macro, as we see increased potential for volatile markets in the short term. The Dispersion of Equity Returns Has Been Increasing Chart 8: S&P 500 Correlation and Dispersion, Standard Deviation from the Mean March 1991 March 2017 Standard Deviations from the Mean Lower average correlation to the S&P 500: better for alpha generation Higher dispersion: better for alpha generation -3 3/91 3/93 3/95 3/97 3/99 3/01 3/03 3/05 3/07 3/09 3/11 3/13 3/15 3/17 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 31/3/17. Past performance does not guarantee future results. 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 9

10 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. FTI accepts no liability whatsoever for any loss arising from use of this information and reliance upon the comments opinions and analyses in the material is at the sole discretion of the user. Products, services and information may not be available in all jurisdictions and are offered outside the U.S. by other FTI affiliates and/or their distributors as local laws and regulation permits. Please consult your own professional adviser for further information on availability of products and services in your jurisdiction. Issued in the U.S. by Franklin Templeton Distributors, Inc., One Franklin Parkway, San Mateo, California , (800) DIAL BEN/ , franklintempleton.com - Franklin Templeton Distributors, Inc. is the principal distributor of Franklin Templeton Investments U.S. registered products, which are available only in jurisdictions where an offer or solicitation of such products is permitted under applicable laws and regulation. Australia: Issued by Franklin Templeton Investments Australia Limited (ABN ) (Australian Financial Services License Holder No ), Level 19, 101 Collins Street, Melbourne, Victoria, Austria/Germany: Issued by Franklin Templeton Investment Services GmbH, Mainzer Landstraße 16, D Frankfurt am Main, Germany. Authorized in Germany by IHK Frankfurt M., Reg. no. D-F-125-TMX1-08. Canada: Issued by Franklin Templeton Investments Corp., 5000 Yonge Street, Suite 900 Toronto, ON, M2N 0A7, Fax: (416) , (800) , In Canada, FT Solutions is part of Fiduciary Trust Company of Canada, a wholly owned subsidiary of Franklin Templeton Investments Corp. Dubai: Issued by Franklin Templeton Investments (ME) Limited, authorized and regulated by the Dubai Financial Services Authority. Dubai office: Franklin Templeton Investments, The Gate, East Wing, Level 2, Dubai International Financial Centre, P.O. Box , Dubai, U.A.E., Tel.: Fax: France: Issued by Franklin Templeton France S.A., 20 rue de la Paix, Paris, France. Hong Kong: Issued by Franklin Templeton Investments (Asia) Limited, 17/F, Chater House, 8 Connaught Road Central, Hong Kong. Italy: Issued by Franklin Templeton International Services S.à.r.l. Italian Branch, Corso Italia, 1 Milan, 20122, Italy. Japan: Issued by Franklin Templeton Investments Japan Limited. Korea: Issued by Franklin Templeton Investment Trust Management Co., Ltd., 3rd fl., CCMM Building, 12 Youido-Dong, Youngdungpo-Gu, Seoul, Korea Luxembourg/Benelux: Issued by Franklin Templeton International Services S.à r.l. Supervised by the Commission de Surveillance du Secteur Financier - 8A, rue Albert Borschette, L-1246 Luxembourg - Tel: Fax: Malaysia: Issued by Franklin Templeton Asset Management (Malaysia) Sdn. Bhd. & Franklin Templeton GSC Asset Management Sdn. Bhd. Poland: Issued by Templeton Asset Management (Poland) TFI S.A., Rondo ONZ 1; Warsaw. Romania: Issued by the Bucharest branch of Franklin Templeton Investment Management Limited, Buzesti Street, Premium Point, 7th-8th Floor, Bucharest 1, Romania. Registered with Romania Financial Supervisory Authority under no. PJM01SFIM/400005/ , authorized and regulated in the UK by the Financial Conduct Authority. Singapore: Issued by Templeton Asset Management Ltd. Registration No. (UEN) E. 7 Temasek Boulevard, #38-03 Suntec Tower One, , Singapore. Spain: Issued by the branch of Franklin Templeton Investment Management, Professional of the Financial Sector under the Supervision of CNMV, José Ortega y Gasset 29, Madrid. South Africa: Issued by Franklin Templeton Investments SA (PTY) Ltd which is an authorised Financial Services Provider. Tel: +27 (21) Fax: +27 (21) Switzerland: Issued by Franklin Templeton Switzerland Ltd, Stockerstrasse 38, CH-8002 Zurich. UK: Issued by Franklin Templeton Investment Management Limited (FTIML), registered office: Cannon Place, 78 Cannon Street, London EC4N 6HL. Authorized and regulated in the United Kingdom by the Financial Conduct Authority. Nordic regions: Issued by Franklin Templeton Investment Management Limited (FTIML), Swedish Branch, Blasieholmsgatan 5, SE Stockholm, Sweden. Phone: +46 (0) , Fax: +46 (0) FTIML is authorised and regulated in the United Kingdom by the Financial Conduct Authority and is authorized to conduct certain investment services in Denmark, in Sweden, in Norway and in Finland. Offshore Americas: In the U.S., this publication is made available only to financial intermediaries by Templeton/Franklin Investment Services, 100 Fountain Parkway, St. Petersburg, Florida Tel: (800) (USA Toll-Free), (877) (Canada Toll-Free), and Fax: (727) Investments are not FDIC insured; may lose value; and are not bank guaranteed. Distribution outside the U.S. may be made by Templeton Global Advisors Limited or other sub-distributors, intermediaries, dealers or professional investors that have been engaged by Templeton Global Advisors Limited to distribute shares of Franklin Templeton funds in certain jurisdictions. This is not an offer to sell or a solicitation of an offer to purchase securities in any jurisdiction where it would be illegal to do so. 1. Roll return refers to the resulting return from rolling a short-term contract into a longer-term contract in a futures market. A negative roll return indicates an investor will lose money when rolling a contract. MSCI makes no warranties and shall have no liability with respect to any MSCI data reproduced herein. No further redistribution or use is permitted. This report is not prepared or endorsed by MSCI. 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