Is Growth the New Value?

Transcription

1 Secod Quarter 2018 STRATEGY INSIGHTS Is Growth the New Value? Itroductio Sometimes i life it s hard to walk away. People geerally become attached to thigs, be they objects, other idividuals, or eve ivestmets. Some might argue, however, it s eve harder to stay whe thigs get tough. As Key Rogers said i his sog The Gambler, You ve got to kow whe to hold em, kow whe to fold em, kow whe to walk away, ad kow whe to ru. As it relates to the market, we thik it s safe to say that times have bee tough for Value ivestors, with Growth stocks sigificatly outpacig Value stocks i recet years. For perspective, i 2017 aloe the total retur spread betwee the Russell 1000 Growth Idex ad the Russell 1000 Value idex was 16.6% i favor of Growth, oe of the widest spreads o record. These treds were mimicked i other Value ad Growth idexes, such as the S&P 500. Though the performace gap arrows i differet market capitalizatios, the Growth outperformace remais: The S&P SmallCap 600 Growth idex retured 15% last year, while the S&P SmallCap 600 Value idex retured 11%. Whe a particular ivestmet style uderperforms to this degree, we thik it s atural to ask: Fold em? Is it time to walk away from Value? Or, hold em? Should ivestors cotiue to expect Value stocks to geerate outperformace over the log term? I this editio of Strategy Isights, we help ivestors uderstad the curret Value versus Growth paradigm. We ot oly provide evidece for why we believe Value has struggled i recet years, but we also offer our outlook for Value exposure goig forward. I additio, we review our origial ratioale for icludig a Value tilt as part of our log-term strategic asset allocatios. Ultimately, our view is that Value ivestig works, just ot all the time. But we expect value will agai have its day, ad ivestors should ot abado their allocatios to this style. For that reaso, our view is a log-term tilt toward Value has the potetial to help geerate a performace premium over time. Aalyzig the Performace Drivers of Value Ivestig Value ivestig is a approach whereby stocks that trade below their itrisic values are purchased (thik: Berkshire Hathaway). Commo valuatio metrics for Value stocks iclude high divided yields ad relatively low price-to-book ad priceto-earigs (P/E) ratios. Growth ivestig, o the other had, is a stock selectio approach i which stocks are selected based o their projected above-average earigs growth rates relative to a particular idustry or the overall market, with valuatio beig a secodary cosideratio (thik: Amazo). The merits of Value ivestig are rooted i decades of academic research ad real-world observable, ot just backtested, outperformace over log horizos. Possible reasos for this persistet Value premium iclude: Behavioral biases: Some ivestors may ted to prefer the more excitig arratives associated with may Growth stocks, thus biddig up their valuatios. Certai stocks cosidered cheap, however, may still be high-quality busiesses with solid fiacials. These stocks, for whatever reaso, may be mispriced, providig ivestors with a opportuity to purchase shares at a discout to fair value. Efficiet market explaatios: Historically speakig, Value stocks, o average, have geerally compesated ivestors for takig o higher levels of risk associated with ivestig i compaies that, i theory, could become distressed, but ultimately get re-rated i terms of valuatio multiple expasio by the market.

2 Table 1 Value s Log-Term Domiace Q2018 Value Retur Value Volatility Growth Retur Growth Volatility Large Cap 12.1% 14.4% 11.5% 16.8% Mid Cap* 11.9% 15.6% 11.0% 19.9% Small Cap 13.0% 17.2% 9.9% 22.3% *Data history oly goes back to Source: FactSet Research Systems Ic., PNC We thik the true driver of the Value premium is likely some combiatio of behavior ad efficiet market factors, alog with other psychological biases that make markets less tha perfectly efficiet. Simply put, buyig Value stocks has worked out quite well, o average, for may ivestors over the log term (Table 1). Give Value s recet struggles, however, it s appropriate to aalyze some of the most ifluetial dyamics i equity style performace. Elemets such as relative valuatio, sector compositio, iterest rates, bod yields, iflatio expectatios, currecy movemets, ad a ecoomy s perceived positio i its busiess cycle all play a role i determiig which of the two major ivestmet styles are i favor at ay give time. Based o our research, outsized performace differetials betwee Value ad Growth stocks ca be traced to two predomiat pheomea: a otable story focused o a sigle sector or idustry group, ad the ecoomic growth backdrop associated with the busiess cycle. Sector ad Idustry Ifluece I the rollig three-year period edig March 31, 2018, Growth stocks outperformed Value stocks across market capitalizatios, both domestically ad iteratioally. The largest ad most otable performace differece was i domestic large cap, with the Russell 1000 Growth Idex outperformig the Russell 1000 Value Idex by more tha 500 basis poits (bps) aualized (Chart 1). Market evets that ifluece style returs ofte affect several years of performace. As show i Chart 1, style trade-offs or large performace Chart 1 Russell 1000 Value Idex versus Russell 1000 Growth Idex (rollig three-year periods) As of February 2018 Percet Value Outperforms Growth Outperforms Russell 1000 Value Russell 1000 Growth Source: FactSet Research Systems Ic., PNC differeces betwee the Russell 1000 Growth ad Value idexes have ofte bee the result of a major market evet. Followig the savigs ad loa crisis, Growth outperformed Value for three cosecutive years i the late 1980s ad early 1990s. From , large-cap Growth beat large-cap Value by more tha 5,000 bps as the Iformatio Techology (Tech) bubble formed. Followig the burstig of the Tech bubble, however, Value dramatically outperformed util the global fiacial crisis, which created a backdrop more favorable for Growth. From (the five-year period whe the bulk of the curret ecoomic expasio occurred), style-based performace differetials were much tighter. Durig 2017 ad the first quarter of 2018, Growth has domiated Value. There are may ways to defie Value ad Growth, so it is importat to uderstad how the style idexes 2

3 used i a aalysis are costructed. I this paper, we choose to evaluate the FTSE Russell idexes, which use three variables to determie Growth ad Value. A book-to-price ratio is used for Value while Growth uses two variables: I/B/E/S two-year earigs per share growth forecast ad historical sales per share growth over the prior five years. 1 Stocks are classified based o these metrics without regard to sector, which has historically led to sector weights that differ dramatically betwee the Value ad Growth idexes. The simple reaso is that compaies i certai sectors, such as Iformatio Techology, are more likely to have higher growth rates tha compaies i more mature sectors. I the Russell 1000 Value ad Growth idexes, the largest average sector differeces have bee i Fiacials, Iformatio Techology, Health Care, Cosumer Staples, ad Eergy (Table 2). Not surprisigly, large differeces i sector weights ca lead to large differeces i performace betwee the Growth ad Value idexes. The key driver of the differig performace could very well be a ecoomic factor specific to oe or more sectors or idustries rather tha a bias amog ivestors about ivestmet styles. A aalysis of caledar year returs ad the cotributio (sector weight multiplied by sector retur) of Iformatio Techology ad Cosumer Staples to the Russell 1000 Growth Idex ad Fiacials ad Eergy to the Russell 1000 Value Idex demostrates that sector differeces have played a large role i performace variatio of the Russell 1000 Growth ad Russell 1000 Value idexes over the past 30 years. I Chart 2 (page 4) we plot the differece i aual performace betwee the Russell 1000 Growth ad Russell 1000 Value idexes (red lie) compared to the cotributio to the Growth idex from Iformatio Techology ad Cosumer Staples mius the cotributio to the Value idex of Fiacials ad Eergy (the blue bars). Whe Iformatio Techology ad Cosumer Staples outperform Fiacials ad Eergy (the tall blue bar), it is ot surprisig to see that Growth beats Value ad vice versa. To take our aalysis a step further, we attempt to eutralize the impact of sector weight differeces betwee the Russell 1000 Growth ad Russell 1000 Value idexes. We created sector-eutral versios of these two idexes by reweightig the sectors i each of the Value ad Growth idexes to match the Table 2 Russell Value ad Growth Idexes Sector Differeces Average aual sector weight Q2018 Average Russell 1000 Average Russell 1000 Growth Idex Weight Value Idex Weight Average Sector Neutral Value ad Growth Idex Weights Differece Cosumer Discretioary Cosumer Staples Eergy Fiacials Health Care Idustrials Iformatio Techology Materials Real Estate Telecommuicatio Services Utilities Source: FactSet Research Systems Ic., PNC 1 I/B/E/S stads for Istitutioal Brokers Estimate System, which compiles the differet stock aalysts estimates o the future earigs for the majority of U.S. publicly traded compaies. 3

4 Chart 2 Russell 1000 Growth Idex versus Russell 1000 Value Idex Aalysis As of 3/10/ Chart 3 Rollig Five-Year Aalysis 1989 February Value Outperforms Percet 0-10 Percet Growth Outperforms Iformatio Techology ad Cosumer Staples Sector Cotributio to the Russell 1000 Growth Idex Retur - Fiacials ad Eergy Sector Cotributio to the Russell 1000 Value Idex Retur Russell 1000 Growth Idex Retur - Russell 1000 Value Idex Retur Source: FactSet Research Systems Ic., PNC sector weightigs of the mai Russell 1000 idex ad the calculated the returs of each reweighted idex. This reweightig elimiates the large sector weight differeces show i Table 2 (page 3), ad differeces i performace betwee these sectoreutral versios of the Growth ad Value idexes should more closely reflect true style differeces rather tha simply sector differeces. We aalyzed the spread betwee the stadard Russell 1000 Value Idex ad the Russell 1000 Growth Idex ad compared this with the spread betwee the sector-adjusted Value ad Growth idexes that we created over rollig 5- ad 10- year periods. The 5-year ad 10-year rollig returs (Charts 3 ad 4) show that divergece betwee the Russell 1000 Value ad Growth idexes has occurred over a few distict time periods (for example, the Tech bubble ad global fiacial crisis), but the effect is much more muted whe takig out the sector variatios. Over the past 35 years, the oly period of large Growth outperformace was durig the Tech bubble. It is otable that over the past decade, while the stadard Russell 1000 Growth Idex has cosistetly outperformed the Russell 1000 Value Idex over rollig five-year periods, this is ot true for the sector-eutral versios of the idexes, which have performed relatively i lie with each other Chart 4 Rollig 10-Year Aalysis 1994 February 2018 Percet Russell 1000 Value Idex - Russell 1000 Growth Idex Sector Adjusted Value Idex - Sector Adjusted Growth Idex Source: FactSet Research Systems Ic., PNC Value Outperforms -6 Growth Outperforms Russell 1000 Value Idex - Russell 1000 Growth Idex Sector Adjusted Value Idex - Sector Adjusted Growth Idex Source: FactSet Research Systems Ic., PNC Recallig that amog the key sector differeces are Fiacials ad Eergy (overweight i the Value idex) ad Iformatio Techology (overweight i the Growth idex), this is ot a surprisig result. The global fiacial crisis led to strog uderperformace of Fiacials durig the crisis ad the subsequet recovery. Simultaeously, there was a sharp drop i eergy prices that has caused a sustaied uderperformace for Eergy stocks. 4

5 Both of these treds were reversals of fortue from the mid-2000s, whe there was a fiacial boom ad high eergy prices that drove those two Value sectors to strog relative performace, helpig Value outperform Growth eve after the effects of the Tech bubble had waed. More recetly, Facebook, Amazo, Apple, Netflix, ad Google paret Alphabet alog with other Iformatio Techology stocks all i the Growth idex have bee the key drivers of the market s upward trajectory. We believe these factors are maily drive by ecoomic issues ad idustry-specific patters, ot style prefereces amog ivestors. The advet of the Iformatio Techology sector as a major idex force makes this story eve more powerful today, i our view. I 1985, the sector comprised 17.5% of the Russell 1000 Growth Idex but represets 38.3% of the idex curretly. Lookig at Growth s outperformace durig the Tech bubble, we ca make certai parallels to today s style relatioship. Our coclusio is ot that Iformatio Techology is i a bubble; however, over the past five years it has bee the best-performig sector by a wide margi (cumulative retur of 162% versus 115% for the Russell 1000 Growth Idex ad 93% for the broad Russell 1000 Idex). Lookig forward, the sector caot outperform forever, ad whe it turs, we believe Value will likely reassert itself, as it did quite forcefully post-tech bubble. The potetial regulatory issues surroudig Amazo ad Facebook may create a regulatory overhag that could make it more difficult for growth stocks to cotiue leadig the market. Fially, after a large market ru for Growth over Value, oe might ask whether Growth stocks are simply more expesive today compared to Value stocks as compared to historical orms. If that is the case, that would poit to a reaso to expect mea reversio at some poit, meaig a resurgece of the Value style. I Chart 5 we show the valuatio premium of the Russell 1000 Growth Idex over the Russell 1000 Value Idex for the past 20 years. We cautio that valuatio should ot be used as a market timig tool as valuatio premiums/discouts ca persist for very log periods. However, valuatio differetials ca oriet us to the relative log-term retur potetial of each style. O a forward P/E Chart 5 Growth Premium As of February 2018 Forward P/E 30x 25x 20x 15x 10x 5x 24.6x 17.6x 100 basis, the Russell 1000 Growth Idex is tradig at the largest premium to the Russell 1000 Value Idex sice just after the global fiacial crisis. I that regard, Growth is demadig a higher-tha-ormal valuatio premium compared to Value, limitig its comparative retur potetial over the loger term. I sum, we believe these data demostrate that the uusual outperformace of Growth over Value durig the past decade is largely due to a series of ecoomic ad idustry-specific coditios. Thus, due to the cyclical ature of these macro factors we do ot believe either a regime chage is occurrig or the value premium observed i equity markets datig back early 100 years has disappeared. Ecoomic Cycle Ifluece I our aalysis of Value performace through differet stages of the ecoomic cycle, we use the Fama-Frech High-Mius Low (HML) value factor. This factor represets the retur differetial betwee a high book-to-market (Value) portfolio ad a low book-to-market (Growth) portfolio. Furthermore, the HML value factor has prove to be statistically sigificat through various market periods ad is a coservative yet effective represetatio of the historical value premium. The first part of our aalysis uses data from the Natioal Bureau of Ecoomic Research (NBER) to idetify U.S. expasio ad cotractio periods. We coclude that Value is a cyclical factor, performig best i periods of strog ecoomic growth (Chart 6, page 6). 40% 0x Russell 1000 Value Idex NTM P/E Russell 1000 Growth NTM P/E Growth Premium % (Right Scale) Source: FactSet Research Systems Ic., PNC Growth P/E Premium (Percet) 5

6 Chart 6 Fama-Frech Value Factor Media Quarterly Returs By Real GDP Growth Media Quarterly Retur (Percet) %: 28.4% of time 2-3%: 21.8% of time 3-4%: 25.9% of time 4-6%: 23.9% of time 0.2% 1.9% -0.1% -0.2% Real GDP Growth (Percet) Source: FactSet Research Systems Ic., PNC Ituitively, this makes sese to us: I high ecoomic growth periods, may ivestors elect to allocate to cheaper Value-orieted equities ad are oly willig to pay a growth premium (higher price) i slower growth eviromets or whe Growth is cosidered scarce. Of course, the growth trajectory of a ecoomy ca vary widely over the course of a sigle cycle, hece the high degree of variability i performace patters for Value ad Growth. Ofte the most robust ecoomic growth, as measured by real GDP, occurs i the early stages of the busiess cycle ad tapers off as the expasio period matures. Sice 1940, there have bee 13 ecoomic expasios, ad our aalysis shows that i ie of these the Value factor has exhibited its most robust performace early i the cycle 2 whe the ecoomy begis to accelerate after the precedig cotractio (Chart 7). Over these ie periods, which for simplicity s sake we have titled high HML, the Value factor posted a average aualized retur of 19% 3 versus a average aualized retur over the correspodig full expasioary cycles of 3.2%. Over these same ie high HML periods, the average real GDP quarter-over-quarter growth rate was 6.3%, well ahead of the historical Chart 7 Fama-Frech HML Value Factor Performace over Expasio ad Cotractio Periods (Rollig 12-Moth Returs ) HML Value Factor Performace (Percet) Value factor (HML) performace historically has doe best early 50 i the busiess cycle (expasioary periods) whe ecoomic growth Tech Bubble 40 is strogest NBER Expasioary Periods HML Value Factor NBER Cotractios Source: FactSet Research Systems Ic., PNC average of 3.2% ( ). Coversely, durig cotractioary periods, defied by the NBER, the value factor posted some of its worst performace. These fidigs closely alig with our ow proprietary busiess cycle framework. Our busiess cycle aalysis uses various ecoomic ad marketrelated leadig idicators to project cycle turig poits that allow us to calibrate curret market valuatios with the state of the ecoomy. We fid evaluatig busiess cycles i biary expasio/ cotractio terms less useful whe makig ivestmet decisios. Cosequetly, our framework divides busiess cycles ito four distict stages: cotractio; recovery; acceleratig expasio; ad slowig expasio (Chart 8, page 7). The strogest ecoomic growth occurs i the acceleratig expasio phase, which typically aligs with the early expasioary periods via the NBER. Usig traditioal market-cap-weighted domestic equity idexes, we foud that sice 1989 Value stocks across large, mid, ad small 2 I our HML value factor performace review, we defie early cycle as the low poit of the rollig oe-year HML value factor performace comig out of each NBER-defied cotractioary period to the esuig expasio period HML value factor peak. O average, these periods bega 3 moths of postcotractio ad lasted for a average of 14 moths ito the correspodig expasioary period. 3 High HML performace periods less tha 12 moths are ot aualized; if the period was less tha 12 moths, cumulative returs were used. 6

7 Chart 8 PNC Busiess Cycle Leadig Idicator Idex: Four Stages of the Busiess Cycle PNC Busiess Cycle Leadig Idicator Idex Real GDP Growth (R) Cotractio Recovery Acceleratig Expasio Slowig Expasio Source: PNC Real GDP Growth (Quarter over Quarter, Percet) cap outperformed Growth stocks durig the acceleratig expasio phase, cosistet with our HML value factor coclusios. Also over this same period, Iformatio Techology was the most egatively correlated (-0.42) sector to the HML value factor. This is cosistet with our coclusio that the sector is ofte a key driver i Growth outperformace. Other cyclical factors, which are ofte iflueced by the uderlyig ecoomic backdrop, ca also help provide isight ito what eviromets ted to favor oe style over aother. Corporate profits, iflatio, ad eve the size of the Federal Reserve s (Fed s) balace sheet ca demostrate historical patters related to style performace. Each Valuefriedly eviromet listed below teds to occur i periods of acceleratig ecoomic growth. Corporate profits: From 1982 to the preset, periods of acceleratig earig growth have favored Value, with a retur of 38% durig such periods versus 29% for Growth. 4 Iflatio: From a factor perspective, periods of risig core iflatio favor Value over Growth. Fed balace sheet: Historically, whe the Fed is shrikig its balace sheet, Value outperforms Growth. The media outperformace durig such periods sice 1948 is 12%. Our fidigs may seem somewhat obvious, but the typical patter of Value performace has ot materialized durig the curret busiess cycle. We believe the rather subdued growth dyamic of the curret expasio may play a key role i Value s ogoig uderperformace. I our view, the curret cycle s persistetly slow real GDP growth has cotributed to the HML value factor closig 2017 with a 10-year aualized retur of -1.1%, which is the third worst 10-year stretch sice 1940, oly outdoe i 2015 at -2.1% ad 2016 at -1.4%. Value ofte lags durig periods of fallig iflatio, slow ecoomic growth, ad slow earigs growth. Sice the begiig of the curret expasioary period i Jue 2009, real GDP growth has averaged just 2.2% quarter over quarter, below the historical average of 3.2% ad well below the 6.3% average experieced durig the ie historical early cycle periods i which Value performed best. Iflatio ad earigs growth have similarly lagged log-term averages durig this period. If the curret pace of growth persists, it will be the lowest average growth rate of ay expasioary period. Value s uderperformace has likely bee compouded by the cycle s historical legth (secod logest ever recorded by the NBER at 108 moths), prologig may ivestors search for growth ad ecouragig a willigess to buy more expesive, higher-growth compaies. O a cumulative retur basis, the Russell 1000 Growth Idex has retured 87% more tha the Russell 1000 Value Idex sice Jue The ature of the Fed-aided recovery may also help explai the outperformace of Growth stocks durig this cycle. Specifically, the prologed zero iterest rate eviromet from helped keep the cost of capital very low, eablig compaies to fud growth cheaply. I a risig iterest rate eviromet, Value should typically outperform because of its shorter duratio. 5 4 Based o retur data from Russell 1000 Growth ad Value idexes, excludig the Tech bubble. 5 Growth stocks exhibit higher duratio tha value stocks cosistet with the expectatio that a higher proportio of cash flows from growth stocks will be received i the more distat future. 7

8 However, for much of the past 10 years, domestic iterest rates were actively suppressed by the Fed i a effort to support the broader ecoomy. Iterest rates, already ear historic bottoms i 2010, oly drifted dow further through For example, the 10 year Treasury yield reached a ear-term low of aroud 1.4% i 2012 ad has yet to firmly break above 3%. Key Observatios Although Value has meaigfully uderperformed i recet years, our aalysis offers some importat observatios ad potetial explaatios. I combiatio with a uusually slow ecoomic expasio that has helped perpetuate ivestor appetite for Growth, sector differetials betwee the idexes have had a major ifluece. Is it time to give up o Value? We do t thik so. Our view is that the factors drivig Value s uderperformace are trasitory i ature ad should ot lead to perpetual uderperformace. I fact, quite the opposite is true. We believe that as cetral baks begi to loose their ifluece, ecoomic growth patters will likely start to ormalize. Further, we view sector leadership as a cyclical pheomeo; that is, as highly ifluetial sectors such as Iformatio Techology experiece a degree of mea reversio, Value ca agai outperform. Lastly, the curret valuatio gap betwee Growth ad Value idicates to us the relative retur potetial betwee the two styles curretly favors Value. The questio is, whe will this style shift occur? Geerally, our view is we are later i the busiess cycle, ad as we have detailed, that ofte favors Growth. Growth is also ejoyig tremedous mometum, which ca be a powerful market force. That said, i the immediate future there are compoets of the backdrop that could offset the forces of the uderlyig busiess cycle. For example, we believe fiscal policy may help ecourage a short-term acceleratio of ecoomic growth, iterest rates ad iflatio seem to be risig, ad the Fed cotiues to shrik its balace sheet all historically positive dyamics for Value. A Iteratioal Perspective Does the Value Story Apply There Too? Developed Iteratioal Markets Over the last 20 years, 6 developed iteratioal Value has outperformed its Growth couterpart by more tha 150 bps o a aualized basis. I the 10 years edig December 31, 2007, Value outperformed Growth by early 500 bps o a aualized basis. With performace differetials eve more proouced tha i the Uited States over the same periods, similar style patters ca be observed. While the data help support the idea that a Value premium exists i iteratioal equities, the MSCI World ex-us Growth Idex has outperformed its Value couterpart over the last five years by about 100 bps aualized. Agai, this is similar to the treds observed i the Uited States, but there are otable differeces. First, we believe similar macroecoomic forces have iflueced style performace withi developed iteratioal equities. As with the Uited States, ecoomic mometum is ofte a powerful force i equity style performace (Chart 9, page 9). Our view is these same forces that have iflueced domestic Value ad Growth performace treds have similarly affected iteratioal markets slow ecoomic growth, low iflatio, ad easy moetary policy, to ame a few. From a sector perspective, a aalysis of the MSCI World ex-us Idex (all developed coutries excludig the Uited States) idicates weightigs that have ot chaged drastically over time (Table 3, page 9). Both loger-term averages ad curret weightigs highlight the domiace of Fiacials ad Eergy i the Value idex. The two sectors aloe comprise early 50% of the etire Value idex. Ulike its U.S. couterpart, however, the World ex-us Growth Idex is ot led by Iformatio Techology. Almost couterituitively for domestic/u.s.-based ivestors, Cosumer Staples is the largest compoet of the Growth Idex, with large weightigs to tobacco ad alcohol compaies. Aother key differece for iteratioal 6 Both the MSCI World ex-us Growth ad Value idexes were lauched i December

9 Table 3 MSCI World ex-us Idex Weightigs MSCI World ex-us World ex-us Value World ex-us Growth 10-Yr. 10-Yr. 10-Yr. Sector Curret* Avg. Chage Curret Avg. Chage Curret Avg. Chage Cosumer Discretioary 11.3% 9.9% 1.4% 10.6% 8.2% 2.4% 12.0% 11.5% 0.5% Cosumer Staples 10.4% 10.4% 0.0% 3.3% 3.2% 0.1% 17.3% 17.6% -0.3% Eergy 6.4% 8.9% -2.5% 10.0% 12.0% -2.0% 2.9% 5.9% -3.0% Fiacials 23.2% 22.0% 1.2% 36.9% 34.6% 2.3% 9.5% 9.6% -0.1% Health Care 9.1% 9.1% 0.0% 6.3% 6.5% -0.2% 11.9% 11.7% 0.2% Idustrials 13.1% 11.7% 1.4% 8.8% 8.4% 0.4% 17.3% 14.9% 2.4% Iformatio Techology 7.3% 5.2% 2.1% 1.4% 2.6% -1.2% 13.1% 7.8% 5.3% Materials 8.9% 10.0% -1.1% 6.9% 7.4% -0.5% 10.8% 12.6% -1.8% Real Estate 3.5% 3.3% 0.2% 4.8% 4.1% 0.7% 2.1% 2.5% -0.4% Telecomm. Services 4.0% 5.3% -1.3% 6.1% 7.0% -0.9% 2.0% 3.7% -1.7% Utilities 3.0% 4.2% -1.2% 4.9% 6.0% -1.1% 1.1% 2.3% -1.2% *Curret as of the ed of 1Q2018 Source: FactSet Research Systems Ic., PNC Chart 9 Value Factor Media Quarterly Retur by Real GDP Growth As of 3/10/18 Media Quarterly Retur (Percet) %: 12.5% of time 2-4%: 6.9% of time 4-6%: 11.1% of time 6-12%:19.4% of time >12%: 9.7% of time 0.4% 0.9% 1.1% 1.8% >12 Real GDP Growth (Percet) Source: FactSet Research Systems Ic., PNC Chart 10 Five-Year Cumulative Retur Compariso: Iteratioal ad Domestic Growth versus Value As of 4/1/ Year Cumulative Total Retur Compariso Iteratioal ad Domestic Growth v Value 100 4/3/13 4/3/14 4/3/15 4/3/16 4/3/17 2/3/18 Russell 1000 Value MSCI World ex US Value Russell 1000 Growth MSCI World ex US Growth Source: FactSet Research Systems Ic., PNC 38% 5% markets is exposure to the Materials sector. Not eve 3% of the S&P 500, the Materials sector plays a importat role withi both Growth ad Value idexes abroad. Therefore, eve withi a portfolio s Growth allocatio, meaigful diversificatio ca be achieved by allocatig to differet geographies. Give the sector disparities, Iformatio Techology i particular, differet outcomes may be expected betwee domestic ad iteratioal Growth exposures. For example, ot oly has the Russell 1000 Growth Idex outpaced the MSCI World ex US Growth Idex by a cumulative retur of 55% over the past five years, but the spread betwee developed iteratioal Growth ad Value has bee far tighter tha the spread betwee domestic Growth ad Value (Chart 10). For additioal cotext, over the past 12 moths, the correlatio betwee U.S. ad developed iteratioal growth idexes has oly bee a weak That compares to a 0.82 correlatio betwee the Russell 1000 ad MSCI ex US core idexes. 9

10 Table 4 MSCI Emergig Markets Weightigs MSCI Emergig Markets EM Value EM Growth 10-Yr. 10-Yr. 10-Yr. Sector Curret* Avg. Chage Curret Avg. Chage Curret Avg. Chage Cosumer Discretioary 11.1% 8.1% 3.0% 6.7% 6.9% -0.2% 15.4% 9.7% 5.7% Cosumer Staples 6.4% 6.6% -0.2% 3.1% 3.3% -0.2% 9.6% 9.9% -0.3% Eergy 6.9% 10.5% -3.6% 12.2% 15.7% -3.5% 1.6% 6.3% -4.7% Fiacials 24.1% 22.7% 1.4% 36.0% 28.9% 7.1% 12.3% 18.1% -5.8% Health Care 2.7% 1.9% 0.8% 1.2% 0.5% 0.7% 4.2% 3.2% 1.0% Idustrials 4.6% 6.4% -1.8% 5.4% 5.3% 0.1% 3.8% 6.5% -2.7% Iformatio Techology 26.7% 18.1% 8.6% 10.2% 9.6% 0.6% 43.0% 25.1% 17.9% Materials 7.8% 11.6% -3.8% 11.3% 13.6% -2.3% 4.3% 10.3% -6.0% Real Estate 2.8% 2.1% 0.7% 3.3% 1.9% 1.4% 2.1% 2.2% -0.1% Telecomm. Services 4.7% 8.5% -3.8% 6.6% 10.0% -3.4% 2.7% 6.3% -3.6% Utilities 2.4% 3.4% -1.0% 3.9% 4.4% -0.5% 0.8% 2.4% -1.6% *Curret as of the ed of 1Q2018 Source: FactSet Research Systems Ic., PNC We highlight that style exposures are ot cosistet across differet geographies. Withi developed iteratioal markets, Growth i particular is far less exposed to sectors such as Iformatio Techology ad has t ejoyed quite the same advatage over Value i the past few years. We thik this meas that whe the ievitable style shift occurs, U.S. markets could see a bigger correctio withi Growth compared to developed iteratioal markets. Emergig Markets Iterestigly to us, the pursuit of strictly defied Value ivestig has ot proliferated withi emergig markets yet. I the Uited States, 20 25% of the Morigstar uiverse idetify as Value. I developed markets excludig the Uited States, that umber drops to 11 15% of the foreig fud category i Morigstar. However, less tha 3% i the emergig market (EM) uiverse pursue Value-orieted strategies. We fid it curious that the popularity of Value ivestig has ot yet traslated to emergig markets give the relative pricig iefficiecies of the asset class. With the expadig depth ad breadth of the equity markets i developig regios, we have o reaso to believe Value s ability to geerate outperformace over the log term would ot persist withi EM equities. However, the ability to ivest i specific styles (Value i particular) is geerally more limited i these markets, at least for ow. From a exposure perspective, eve passively ivestig i so-called core emergig markets typically results i a Growth bias. With a 30% weightig toward Iformatio Techology, MSCI s core emergig market exchage-traded fud (EEM) is geerally closer to Growth tha Value. For perspective, the Russell 1000 Growth Idex has a 39% weightig toward the Iformatio Techology sector. The sector has come to represet a larger proportio of EM idexes, with emergig ecoomies cotiuig to evolve from heavy idustrial ad productio (commodity-based, value sectors) toward oe of cosumptio ad services (cosumer, growth sectors) (Table 4). Oe example of the move to cosumptio is the geeratioal shift toward e-commerce. For referece, less tha 10% of e-commerce i the Uited States is trasacted via mobile devices versus 80% of e-commerce i Chia. Alibaba (Alipay) ad TeCet (WeChat), two of the three largest compaies i the MSCI EM Idex, cotrol well over 50% of the growig Chiese third party paymet market. 7 Our message i this sectio falls uder the category of kow what you ow. Not oly are EM idexes tilted toward Growth, but also the 7 Source: iresearch, Bloomberg, pymts.com,

11 exposures are more cocetrated compared to developed iteratioal ad U.S. markets. I the curret eviromet of scarce growth, it s o woder the EM asset class has bee a strog performace leader. For example, the top five stocks i the S&P 500 Iformatio Techology sector accout for about 11% of the overall idex. Withi EEM, the top five Tech ames accout for 20% of the overall idex, with Tecet ad Samsug comprisig more tha 10% aloe. Chia (roughly 25% of the EM Idex) is also likely to skew further ito growth as more A shares 8 are icluded i the idex. The MSCI EM Idex covers oly 31% of the market capitalizatio of the uiverse (excludes A shares ot cross-listed i Hog Kog) versus the Russell 1000 Growth, which covers more tha 95% of the U.S. large-cap growth uiverse. Our view is that whe Growth outperformace ultimately shifts i favor of Value, core EM equity exposure may be more vulerable compared to other regios give its iheret style bias. Ratioale for a Strategic Value Tilt 9 Uderstadig the curret eviromet ad how it affects style performace is critical i determiig whether there has bee a fudametal shift i the Value versus Growth relatioship. As we have stated above, we do ot believe this to be the case. Therefore, it is importat to provide more detail as it relates to our log-term preferece for Value. This discussio goes far beyod the preset, examiig the ratioale for our strategic Value tilt. We start with the Capital Asset Pricig Model (CAPM), which was developed i the 1960s ad published i 1970 by William Sharpe, a fiacial ecoomist, i his book Portfolio Theory ad Capital Markets. The research posed that idividual ivestmets face two risks: systematic, or risks that caot be diversified away (such as macro evets like recessios), ad usystematic risk, which is kow as specific risk that ca be diversified. Accordig to the CAPM, a stock s risk premium, that is, its expected retur relative to a risk-free asset, should be completely ad exclusively determied by its sesitivity (beta) to the retur o the capitalizatio-weighted portfolio of all available assets (the market portfolio). Thus, it should ot be possible to ear a higher riskadjusted retur by selectig stocks based o ay other characteristic. Sice the CAPM was developed more tha 50 years ago, there has bee much literature documetig ad tryig to explai how stocks with certai characteristics ted to geerate higher risk adjusted returs. The early literature referred to these results as aomalies, but as the evidece accumulated it became accepted that various characteristics other tha beta were give a retur premium by the market. 10 With this acceptace came a shift i termiology. The hut for aomalies became a search for factors to measure risks ad geerate additioal returs. Virtually ay observable, measurable characteristic ca be used to defie a factor. Give a set of factors, oe ca estimate the exposure/sesitivity of idividual stocks to each factor, form portfolios based o these exposures, ad measure factor returs based o the performace of these portfolios. It is the possible to see which factors have bee workig ad, if we believe that performace will persist (or we ca predict the factors that will work ext), make tactical allocatios based o factor exposures. For our strategic, baselie asset allocatio recommedatios, however, we are primarily iterested i factors that: are likely to ear a positive retur premium over itermediate-to-log horizos; have proved to be sigificat i various sample periods, with various data sets, ad usig various empirical defiitios ad methodologies; ad are associated with reasoably well-defied, stable subsets of stocks (asset classes) rather tha reflectig active portfolio strategies. 8 Shares that are purchased ad traded o the Shaghai ad Shezhe stock exchages. This is i cotrast to B shares, which are owed by foreigers who caot purchase A shares due to Chiese govermet restrictios. 9 This sectio relies heavily o two previously published PNC reports: A Guide to the Hawthor Strategic Balaced Portfolio (2015) ad Ivestmet Outlook Quest for Value (May 2011). 10 The theoretical foudatios for multifactor valuatio were established by, for example, Ross (1976). 11

12 The first criterio elimiates factors that add o value o average, but which might add value if we actively icreased/decreased exposure to them at the right times. The secod criterio meas we wat to have cofidece that the evidece supportig the factor is ot a artifact of particular time periods or data sets ad is reasoably robust to variatios i how the factor is defied ad/or measured. Oe way to iterpret the third criterio would be to say that, for our purposes, we wat factors that ca be reasoably represeted by passive portfolios. Two well-kow factors, value ad size, meet our criteria. Fama ad Frech (1992, 1993) foud that the variatio i expected stock returs ca be explaied by these two factors i additio to market beta. Numerous other studies, both before ad after, have cofirmed these two factors ear a positive premium o average. Specifically i this case, Value stocks ted to ear a higher retur tha Growth stocks havig the same sesitivity to the overall market. A additioal factor, price mometum, is also widely ackowledged to geerate predictably positive excess returs. Although we believe some exposure to mometum may be suitable for some ivestors, we will ot focus o it here because it reflects a strategy that may be defied as active i the sese that it relies o buyig a subset of stocks with the biggest recet gais. Historical aalysis supports the otio that a strategic portfolio tilt toward Value is likely to be additive to returs over time. For example, we looked at the aualized retur differetial betwee two portfolios (oe Growth ad oe Value) 11 for every 10-year period from July 1926 through March A Large Cap Value portfolio outperformed a Large Cap Growth portfolio i 74% of the 10-year periods. The media differetial was 2.9% ad the average was 2.6%. The differece was eve stroger i small cap, where Value outperformed i 90% of the 10-year periods; the media differetial was 5.3% ad the average was 4.7%. Give the historically strog performace of the Value style, there are three primary reasos we have ot built eve larger tilts ito our strategic baselie asset allocatios: We believe the historical results likely overstate the impact of these factors goig forward. The beefits of tiltig toward Value are well kow. This does ot ecessarily mea the beefits have bee elimiated but that they are likely to be less proouced. Although a Value tilt has worked well o average, there have bee periods whe it was a sigificat drag o performace, as see over the past decade. Value stocks ted to be more cyclical. Therefore, prudece dictates our Value tilt ot be extreme. Puttig It All Together Our message here is geerally a simple oe: We still believe Value works i the log ru ad the coditios that have perpetuated Growth s outperformace i recet years are explaiable ad temporary. Markets have experieced log stretches of persistet style leadership, ad our view is that we are merely i the midst of aother oe of those periods. So, is Growth the ew Value? We do t thik so. We coted that a log-term Value tilt provides ivestors with the opportuity to geerate outperformace, ad we should oly be tactically overweightig Growth if our covictio is high. Curretly, that is ot the case give the complexity of the backdrop certai precoditios may be i place (for example, short-term ecoomic acceleratio, shrikig Fed balace sheet, ad acceleratig profit growth) that geerally favor Value i the ear term. However, we believe we remai i the later iigs of the busiess cycle, so may ivestors may still be willig to pay up for Growth as the cycle matures. Fially, it is importat for ivestors to uderstad that Value ad Growth styles will likely behave 11 The portfolios are determied as follows. The dividig lie betwee Growth ad Value is determied by the ratio of book equity (BE) to market equity (ME) with value portfolios cotaiig the 30% of stocks with the highest BE/ME ratios, growth portfolios cotaiig the 30% of stocks with the lowest BE/ME ratio, ad what we have labeled as core portfolios cotaiig the middle 40% with respect to BE/ME. 12 Returs are cotiuously compouded growth rates. 12

13 somewhat differetly whe ivestig iteratioally due to sigificat variaces i the uderlyig style idex exposures. Specifically, whe style performace evetually shifts i favor of Value, we expect developed iteratioal Growth may be less vulerable compared to the Uited States, while the Growth bias withi EM idexes may make core allocatios there more exposed. Amada E. Agati, CFA Chief Ivestmet Strategist Istitutioal Advisory Solutios Daiel J. Brady Ivestmet & Portfolio Strategist Erik Casaliuovo, CFA Seior Ivestmet Strategist Mark B. Hoffma, PhD, CFA Maagig Director of Portfolio Strategy ad Costructio Sea M. Keris, CFA Head of Traditioal Ivestmets Marsella Martio Seior Ivestmet Strategist Michael Zoller Ivestmet Strategist Che He, CFA Seior Portfolio Strategist 13

14 Istitutioal Advisory Solutios Asset Allocatio Playbook As of 3/31/18 Asset Class Sub Asset Class - Favorability Neutral + Equities U.S. Equity No-U.S. Equity Large Cap Mid Cap Small Cap Public Real Estate (REITs) Itl. Large/Mid Cap Itl. Small Cap Emergig Markets Global Ifrastructure Taxable Fixed Icome U.S. Fixed Icome No-U.S. Fixed Icome Short Fixed Icome Core Fixed Icome U.S. High Yield U.S. Leveraged Loas U.S. TIPS Global Bod Ucostraied Bod Emergig Market Bod Poits of View Relative valuatio ad vulerability to what has bee a icrease i overall market volatility i 2018 cause us to arrowly favor large over small. Small caps have outperformed year to date as ivestor cocers related to trade have drive them to seek protectio from less-exposed small-cap stocks. However, we believe the trade overhag will ultimately lift, removig this particular tailwid. Smaller compaies may also beefit from positive tax reform-related forward guidace; however, valuatios remai quite expesive at 22.5x o a forward earigs basis. Despite heighteed market volatility, the fudametal backdrop for commercial real estate remais relatively stable; cap rates have ot materially rise. Valuatios are more attractive relative to the broad market, ad real estate fudametals are geerally healthy. That said, borrowig costs are fially begiig to rise ad ot all REITs have ample pricig power to pass o icremetal costs via higher rets. As such, earigs growth is likely to be muted ad positive catalysts hard to fid. Valuatios appear relatively more attractive versus domestic equities, potetially creatig opportuities i may iteratioal markets. Still largely accommodative moetary policy by global cetral baks ad strog earigs mometum should also provide additioal support for iteratioal equities. Although we like emergig markets for the log term give curret valuatios, we believe the rally to be overexteded. The shorter-term bear case for emergig market equities rests maily o Chia, which has a sigificat impact o performace with a weight of over 25% of the emergig markets idex. Year-to-date performace has bee good, but mometum has waed. We observe a attractive hybrid betwee fixed icome ad equities, geeratig cosistet ad typically iflatio-liked icome, with the ability to deliver capital appreciatio with lower exposure to the phases of the busiess cycle. With the likelihood of loger-term rates remaiig well below log-ru averages, we favor itermediate-duratio fixed icome. While midful of the umerous cross-currets affectig iterest rate movemets, we will ot attempt to time our duratio positioig, eve though we thik rates may drift higher i The credit cycle is agig, ad valuatios should become a icreasig headwid for most below-ivestmet-grade issuers. Leveraged loas remai more attractive tha high yield give their seiority i the capital structure, thus potetially providig more protectio from higher iterest rates. Although iflatio looks poised to rise later i 2018, the outlook is far from certai. We prefer to hedge iflatio over the log term via our equity exposure. We maitai our eutral stace o global bods, as sovereig debt looks fairly valued. The primary sources of retur are likely to come from coutervailig global treds i currecies ad iterest rates. Flexibility provides for diversificatio if iterest rates should steadily rise (a primary risk to fixed icome i this market). Spreads remai tight (that is, fudametals suggest wider spreads), ad we expect some wideig to occur i Relative yield advatage makes emergig market debt margially more attractive o a risk-adjusted basis tha emergig market equities. 14

15 Alteratives Real Assets Commodities We do ot believe log positios i commodities ear persistetly positive returs, ad the risk premium may actually accrue to the short positio. Private Hedge Fuds Cash Private Real Estate Private Debt Private Equity Equity Log/Short Evet Drive Relative Value Directioal Key drivers iclude a still relatively costraied supply backdrop, modest leverage levels, ad the fact that capital flows ito the asset class are becomig icreasigly global (that is, ivestor demad is quite robust). Middle market ledig i the corporate sector is still quite costraied, cotiuig to create opportuities for private debt ivestors. We cotiue to see ivestors rewarded with a substatial illiquidity premium for takig o urated, smaller-sized loas. There is opportuity i ew/less efficiet markets ad a more diverse ivestable opportuity set, for example, via secodaries ad coivestmet optios. A trasitio from a primarily macro-drive market eviromet to a more fudametally drive oe will be positive for these alpha-geeratig strategies. Cetral baks ow appear more committed to a steady ormalizatio of iterest rates tha they have i the past. However, should the market move steadily higher with little volatility, these allocatios will likely uderperform. 15

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