Staying Risk On in a Low Volatility Regime

2018 Global Market Outlook Step Forward, Look Both Ways Portfolio Positioning Staying Risk On in a Low Volatility Regime Lorne Johnson, Ph.D. Senior Portfolio Manager, Investment Solutions Group Overall RiskOn Positioning Backdrop for growth assets remains favorable as economic expansion likely to strengthen around the world Overweight Global Equities Largest exposure to developed markets outside the US where valuations look most favorable Selective in Fixed Income Underweight intermediate US bonds and nonus government bonds, where higher yields bring weaker performance

In 2018, the fundamental backdrop for growth assets remains favorable, as we expect economic expansion to strengthen around the world. So we are keeping our general riskon positioning in multiasset portfolios, maintaining a balanced overweight to equities going into the new year. It might be difficult, however, to replicate 2017 s serendipitous combination of growth surprising to the upside and inflation surprising to the downside, which proved to be a tonic for healthy earnings gains and only moderate monetary policy tightening. With the MSCI ACWI Index up 15.4% through the third quarter of 2017, and all major developed and emerging market regions posting doubledigit gains, such broadbased equity returns may be hard to repeat. 2

Figure 1 Asset Class Performance through Q3 2017 Percent Trailing 12 Month YTD Prior Month 3.5 US Corporate High Yield US Treasury Index Commodities Index Source: Bloomberg Finance, L.P. As of September 29, 2017. Past Performance is not a guarantee of future results. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect capital gains and losses, income, and the reinvestment of dividends. Performance returns for periods of less than one year are not annualized. Performance is calculated in USD. You cannot invest directly in an index. Also notable was the collapse in both realized and implied volatility in US equity markets to 24year lows in July 2017 (see Figure 2). Despite ongoing geopolitical uncertainty, this complacency could be chalked up to a number of factors, including robust growth in corporate earnings aided by a weakening US dollar and the absence of any material policy mistakes that might upset markets. Figure 2 Volatility Seasonality Percent Debt ceiling debate and Fed balance sheet talk may put the current low volatility market to a test. VIX Index in 2017 10Year Average If the VIX to reverts to its 10year average that would imply an increase of more than 100% from its current level. Source: 10Year Average is the daily average from 2007 to 2016. Bloomberg Finance, L.P. As of September 29, 2017. Past performance is not a guarantee of future results. 3

Current Positioning in MultiAsset Portfolios Overweight growth assets with a preference for diversified exposure to global equities that is set to continue to benefit from the synchronized worldwide recovery of earnings growth. Favorable growth environment also gives cover to central banks to gradually tighten policy, which would result in higher bond yields and weak performance in global government bonds, particularly those with intermediate maturities. With implied equity volatility at multidecade lows and credit spreads close to cycle lows at the close of 2017, chances are good we will see realized volatility rise on average during 2018. However, this does not materially alter our favorable view on growth asset exposures to start the year. Signs of economic recession the largest risk to global equity markets are almost nowhere in sight. In the US, fiscal policy should be no worse than neutral on growth and may have some upside as disaster recovery funds are deployed and corporatefriendly tax reform gets a serious hearing. Equity Overweight a diversified basket of global equities, with the largest overweight positions in developed markets outside the US where valuations look most favorable. Smaller overweight positions in US large caps and emerging market equities. Our 2018 global equity forecasts call for modest positive returns of 4.1% for US largecap equities, 4.7% for developed markets outside the US and 5.8% for emerging markets. Our positioning relative to fixed income is consistent with these outcomes, and we could see further upside if earnings growth strength continues as we are anticipating. US equities would also benefit if the lack of legislative milestones on a probusiness and investment agenda in 2017 gives way to some forward progress in 2018. And we hold a slightly smaller overweight to emerging markets given their outsized gains in 2017 and greater vulnerability to any tightening in global financial conditions. 4

Fixed Income Underweight intermediate US bonds and global government bonds outside the US. Slight overweight to long duration fixed income. Slight underweight to highyield credit. Though the longawaited selloff in sovereign bonds never came to pass in 2017, and yields on 10year US Treasuries dropped 60 basis points from March to August on a swoon in realized and expected inflation, we still expect a firming in inflation expectations consistent with renewed strength in the global economic cycle. And with monetary policymakers such as the European Central Bank (ECB) gingerly winding down stimulus programs and others like the US Federal Reserve (Fed) actively raising shortterm interest rates in 2018, we anticipate a move higher in yields with scope for further curve flattening in 2018 as demand for duration remains strong and yield movements will be greater at the front end where central banks have more direct influence (see Figure 3). Our credit positioning reflects that with spreads near cycle lows, we see limited upside from continued spread tightening and asymmetric downside to spread widening as the business cycle matures and financial conditions gradually tighten. Figure 3 Global Bond Market Perspective Yield to Worst (%) or Duration (Years) Credit Spread (%) Yield to Worst, lhs Duration, lhs Credit Spread Over Treasuries, rhs US Aggregate Bond Index (Agg) 20yr Average Yield = 4.2% Global Aggregate Government Index Global Aggregate Index US Treasury Index Global Aggregate Credit Index US Aggregate Index US MBS Index US Credit Index EM USD Aggregate Index US Corporate High Yield Index Source: Bloomberg Finance, L.P., as of September 29, 2017. 20 year average yield from 4th quarter 1997 to 3rd quarter 2017. Past performance is not a guarantee of future results. 5

Model Portfolio Figure 4 US Model Portfolio Tactical Position vs Benchmark Illustrative purposes only as of November 8, 2017 Tactical position Benchmark World Government ex US 6

Glossary Commodities Index A rolling commodities index composed of futures contracts on 19 physical commodities traded on US exchanges. The index serves as a liquid and diversified benchmark for the commodities' asset class. Emerging Markets (EM) USD Aggregate Index The index is a hard currency emerging markets debt benchmark that includes US dollardenominated debt from sovereign, quasisovereign, and corporate issuers in the developing markets. Global Aggregate Index A benchmark that provides a broadbased measure of the global investmentgrade fixed income markets. The three major components of this index are the US Aggregate, the PanEuropean Aggregate, and the AsianPacific Aggregate Indices. The index also includes Eurodollar and EuroYen corporate bonds, Canadian government, agency and corporate securities, and USD investmentgrade 144A securities. Global Aggregate Credit Index A benchmark that covers the global investment grade and highyield fixed income markets. Global Aggregate Government Index Represents primarily government bonds within the Global Aggregate Index. US Aggregate Index A benchmark that provides a measure of the performance of the US dollar denominated investment grade bond market, which includes investment grade government bonds, investment grade corporate bonds, mortgage pass through securities, commercial mortgage backed securities and asset backed securities that are publicly for sale in the US. US Credit Index An index designed to measure the investment grade, US dollar denominated, fixedrate, taxable corporate and governmentrelated bond markets. It is composed of the US Corporate Index and a noncorporate component that includes nonus agencies, sovereigns, supranationals and local author. US Corporate High Yield Index The index consists of fixed rate, high yield, USDdenominated, taxable securities issued by US corporate issuers. US Mortgage Backed Securities (MBS) Index Measures the performance of investment grade fixedrate mortgage backed passthrough securities of GNMA, FNMA and FHLMC. US Treasury Index A rulesbased, marketvalue weighted index engineered to measure the performance and characteristics of fixed rate coupon US Treasuries which have a maturity greater than 12 months. To be included in the index a security must have a minimum par amount of 1,000MM. Chicago Board Options Exchange (CBOE) Volatility Index (VIX) An index constructed using the implied volatilities of a range of S&P 500 options to forecast 30day volatility. Gold Spot The price quoted for gold for immediate delivery on the spot market. Implied Volatility A measure of the market s estimate of the future volatility of the price of an asset. MSCI EAFE Index Designed to represent the performance of large and midcap securities across 21 developed markets, including countries in Europe, Australasia and the Far East, excluding the US and Canada. The Index is available for a number of regions, market segments/sizes and covers approximately 85% of the free floatadjusted market capitalization in each of the 21 countries. MSCI Emerging Markets (EM) Index A free floatadjusted market capitalization index designed to measure equity market performance in 23 global emerging market economies: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey and the United Arab Emirates. MSCI All Country World Index (ACWI) A free floatadjusted market capitalization index that is designed to measure equity market performance in the global developed and emerging markets. Realized Volatility A measure of the historical volatility of the price of an asset. Russell 2000 Index An index comprised of the smallest 2000 companies in the Russell 3000 Index, representing approximately 8% of the Russell 3000 total market capitalization. S&P 500 Index A market value weighted index of 500 stocks that reflects the performance of a large cap universe made up of companies selected by economists; the S&P 500 is one of the common benchmarks for the US stock market, and investment products based on the S&P 500 include index funds and exchangetraded funds. YieldtoWorst A measure of the lowest possible yield that a bond would earn based on the terms of its indenture. 7

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