2022 Capital Markets Forecast

2022 CAPITAL MARKETS FORECAST

Beyond the Horizon

Dedication This year’s Capital Markets Forecast is dedicated to our longtime colleague, Robert E. “Bob” Reiser, Jr., who retired from our firm last year after more than two decades of service.

A lifelong learner, Bob honed his quantitative skills while earning his Master’s Degree in Business Administration from the University of Chicago. He began his career in the Treasurer’s Office of the Standard Oil Company of New Jersey and later worked at Connecticut Robert E. Reiser, Jr. General Life as a securities analyst, where he discovered his love for the investment business. In 1971, Bob joined the investment counseling firm of Montag & Caldwell in Atlanta, earning his Chartered Financial Analyst® (see here: https://www.cfainstitute.org/en/programs/ cfa) designation the following year. In 1982, he founded his own investment management and consulting firm, Reiser-Builder, and in 1998, merged his firm with Balentine & Company. As Partner and Chief Investment Officer, he created a unique model-driven, repeatable investment process which became the foundation for the firm’s investment management capabilities. After Balentine & Company was acquired by Wilmington Trust in 2002, Bob served as the company’s Chief Investment Officer. When Balentine LLC was formed in 2009, Bob joined the firm as Senior Investment Advisor, a role he held until his retirement in 2020.

As a leader, mentor, and friend, his selfless contributions to our industry and community exemplify servant leadership. Bob has left an indelible impact on Balentine, and we honor him with this year’s CMF edition.

Contents Executive Summary

1

Inflation, Interest Rates, and Secular Cycles

2

Choosing an Investment Path

12

Beyond the Horizon: Themes for Intergenerational Clients

24

Considerations for Allocating to Private Capital

26

Appendix

32

In Closing and Disclosures

34

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WELCOME TO OUR

2022 Capital Markets Forecast The CMF draws from our research to identify realistic market expectations over the next year and align them with opportunities we foresee to achieve portfolio goals.

In 2020, we experienced the genesis of the global COVID-19 pandemic, which spurred a market bottom on March 23, 2020. Much of the easy money to be made off the bottom was made in 2020 and early 2021. In 2021, the pandemic continued, and the markets performed in line with the historical template for a second year coming off a major bottom. While the overall market rose another 15% throughout the rest of 2021, that money was anything but easy, as different areas of the market ebbed and flowed during the year.

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We see tough sledding on the horizon for 2022.

History has been generally unkind to midterm election-year markets, and the confluence of the election cycle with what is a generally weak third year off a major bottom likely makes for a tough grind in 2022. Additionally, as we get later into this bull market, which is about to complete its 13th year, active management becomes a much more important tool in driving investors toward goals. As the cycle matures, beta alone does not cut it; rather, alpha becomes an even more crucial lever for the portfolio. While this is generally always the case in the private markets, it becomes increasingly more so in the public markets the later into the cycle we get, hence the need for an active approach such as that taken by Balentine. With all that said, all signs from our end continue to point to any challenges this year as a healthy pause that refreshes the bull.

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Inflation, Interest Rates, and Secular Cycles The month of March will mark the 13th anniversary of the secular bull market that began in March 2009.1 Secular bull markets include interludes that refresh the journey higher, so multiple market and economic cycles can transpire over their duration.

The challenge for investors is twofold:

1. when a bear cycle commences, assessing whether it is the start of a new secular bear market or merely a bear cycle that will rejuvenate the ongoing secular bull, and

2. if the latter, determining how much of a refresh the cyclical bear provided (i.e., where we are in the secular bull).

In our 2019 Capital Markets Forecast,2 we wrote about the nature of the economic cycle and the characteristics of each phase. This structure remains generally intact as it relates to both the economic cycle and the resulting market cycle.

But we would be remiss if we did not explore the possibility that increased central bank intervention over the past 12-plus years has distorted the cycle template. For example, was it a coincidence that the bull cycle that ended in February 2020 was the second-longest in the post-depression era?

And for good measure, add in the ongoing, and unprecedented, multi-trillion-dollar fiscal stimulus: How does that impact the economic cycle and the secular bull market?

At this point, several important questions pose themselves:

1. How will the sudden, sharp inflation we’re now experiencing play into the remainder of the cycle?

2. What is the future of interest rates, both in the short term and the longer term?

3. As it relates to our asset-return projections, what do questions 1 and 2 mean for valuations over the next seven years?

Recall the distinction between secular markets and cyclical markets, about which we recently wrote here: https://balentine.com/insights/publications/market-update-may-04-2021/

1

https://balentine.com/insights/publications/2019-capital-markets-forecast/

2

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Inflation Inflation has reared its ugly head for the first time in a while, and to little surprise, the financial media is all over the story. However, the real story is a little more complicated than the headlines suggest.

Firstly let’s dig into what is being reported. The financial media have reported year-over-year price increases that are greater than any in the past 30 years. And while the facts presented may be technically accurate, we don’t believe they tell the whole truth. It is important to remember that

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not much more than a year ago, the coronavirus commenced, and a deflationary vortex on par with the one seen during the Global Financial Crisis was feared. Within that context, it makes sense to look at price increases over a two-year period and remove the denominator effect of the low Consumer Price Index levels of 2020. When viewed from this angle, the level of inflation we are experiencing was last seen all the way back in …

2008! (Figure 1)

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Figure 1. Although year-over-year inflation is running at its highest level in 30 years, accounting for the deflationary effects of the coronavirus paints a modestly different picture.

1-Year Inflation Rate 15% 10% 5% 0%

1/1998

1/2001

1/2004

1/2007

1/2010

1/2013

1/2016

1/2019

1/2022

1/1998

1/2001

1/2004

1/2007

1/2010

1/2013

1/2016

1/2019

1/2022

1/1995

1/1992

1/1989

1/1986

1/1983

1/1980

1/1977

1/1974

1/1971

1/1968

1/1965

1/1962

1/1959

1/1956

1/1953

1/1950

(5%)

2-Year Inflation Rate 15% 10% 5% 0%

1/1995

1/1992

1/1989

1/1986

1/1983

1/1980

1/1977

1/1974

1/1971

1/1968

1/1965

1/1962

1/1959

1/1956

1/1953

1/1950

(5%)

Source: St. Louis Federal Reserve and Balentine

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Secondly it is important to distinguish between supply-driven inflation (i.e., price increases driven by reduced supply) and demand-driven inflation (i.e., price increases driven by increased demand). The former is more of a temporary phenomenon that eventually resolves itself, whereas the latter generally necessitates action by either the monetary authority (reducing the money supply) or the fiscal authority (reducing the velocity of money via tax increases and/or fiscal contraction). This is an important distinction because as supply-driven inflation resolves itself, it does not necessarily choke off an economic cycle, whereas the resolution of demand-driven inflation typically does.

Inflation’s Relationship to Capital Markets Before we get into which is the more likely situation at present, let’s discuss why inflation is significant in relation to economic cycles and capital markets.

We recently explored inflation’s impact on the economic cycle, so we would like to focus here on why it’s of concern to investors. This may seem obvious, but as we have mentioned in the past, the economic cycle and capital markets are not always tethered at the hip over the short term or the medium term.

To determine how inflation affects market returns, we analyzed annual data going back to 1928; we went farther back than 1950 in order to include the highly inflationary periods pre-Great Depression and post-World War II as well as the highly deflationary period during the Great Depression.

We found, unsurprisingly, that stocks, bonds, and

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cash react differently to varying levels of inflation.

In the analysis, we looked at both nominal and real returns.

The nominal data, in Figure 2, suggest the perfect spot for inflation has been 0% to 2%, which happens to be where we spent almost the entirety of the 2009–2020 cyclical bull. Importantly as it relates to today’s concerns, stocks have struggled in highly inflationary environments, which occurred mostly during the 1970s but also in the first few years after WWII. The most lucrative nominal period for bonds and cash was during the 4%–6% inflation regimes. Of course, that is somewhat misleading, since purchasing power was eroding quickly during said regimes. Thus it is crucial to look at real returns, which we show in Figure 3.

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Figure 2. Nominal returns of stocks, bonds and cash under varying inflation scenarios suggest different optimal scenarios for each asset class. But this can be misleading …

Figure 3. … which is why we need to focus less on nominal returns and more on real returns.

Nominal Returns

Real Returns

Inflation

% of Years

Stocks

Bonds

Cash

Inflation

% of Years

Stocks

Bonds

Cash

<0%

11%

7.7%

1.3%

1.5%

<0%

11%

11%

4.7%

4.9%

0%–2%

24%

12.4%

5%

2.1%

0%–2%

24%

11.2%

3.8%

0.9%

2%–4%

34%

9.6%

5.6%

3.3%

2%–4%

34%

6.6%

2.6%

0.3%

4%–6%

13%

9.3%

8.8%

5.9%

4%–6%

13%

4.5%

3.9%

1.1%

>6%

17%

7.4%

3.7%

5.4%

>6%

17%

(1.8%)

(5.5%)

(3.7%)

Source: Aswath Damodaran

Source: Aswath Damodaran

Not surprisingly, real returns are far worse during the periods of higher inflation, and in the highestinflation environments, the returns go negative. On the other hand, the real returns during periods with negative inflation (i.e., deflation) are better than they appear at first glance because deflation improves upon real returns. To summarize, some inflation (often dubbed “disinflation”) is good for financial assets, but excessive inflation is not. Additionally, while positive real returns can occur during periods of somewhat high inflation, it is clear that rising inflation does have a corrosive effect as the erosion of purchasing power outweighs inflation-related gains such as rising corporate revenues.

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Determining the Cause of Inflation So, back to the question at hand: Is the current inflation problem supply- driven (i.e., more than likely transitory) or demand- driven (i.e., more than likely non-transitory)? Current inflation readings are somewhat unique in that they include components of both reduced supply and increased demand.

There are good reasons why inflation may be either transitory or non-transitory:

Reasons inflation may be non-transitory: 1. Unprecedented amounts of fiscal and monetary stimulus, including direct payments to employers (via the Paycheck Protection Program) and citizens. Consumer balance sheets are robust, owing to money saved during the pandemic. While they have begun to spend, consumers have as yet barely whittled down their cash balances.

2. A potential structural change in the labor market, with a structural deficit of labor.

Reasons inflation may be transitory: 1. Supply chain disruptions and shortages are

3. Unemployment benefits have been reduced, which should help lower the potential for the sort of structural change in the labor market referenced above.

4. As powerful as the economic rebound has been, we would expect the economic growth to revert to the mean. This would likely head off some of the inflationary pressures.

5. The structural technology gains made during the pandemic should continue to bring about deflationary pressures.

The Federal Reserve has championed the view that inflation is transitory, but of late it has ratcheted back that rhetoric. This is vitally important because transitory inflation would likely not lead to upward pressure on interest rates, whereas a more permanent inflation likely would. Although there is compelling reason to suggest that the inflation will abate, properly gauging the inflation’s permanence will dictate the proper interest rate policy moving forward, which is of vital significance.

Alongside inflation, interest rates are an important determinant of both short-term and long-term equity valuation and price action.

likely to be ephemeral, albeit not as ephemeral as we all would want. That said, it is not reasonable to expect the global supply chains to simultaneously begin to function efficiently, so there would be fits and starts.

2. While consumers still have a lot of cash on their balance sheets, we would expect that the explosion we saw in consumer spending as the world has reopened over the past year is larger than the spending we will see going forward.

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Interest Rates Why do interest rates matter to businesses?

Most notably, higher interest rates increase companies’ cost of capital and discount rates.

Thus, future cash flows are discounted back more heavily, leading to a lower present value of those cash flows. This affects asset classes differently, based most notably on the duration of cash flows: Shorter-duration assets are affected less than longer-duration assets. While this sounds a little bit like one of those theoretical business school concepts, the reality is that the excess return on capital over the cost of capital for a company (or for an individual project) matters tremendously when it comes to long-term valuations. Asset prices are very sensitive to disruptions in the cost of capital.

And the cost of capital, in turn, is highly sensitive to perturbations in capital supply and demand.

In fact, prices are often more sensitive to these factors than to changes in fundamentals.

This is a crucial point: Fundamentals often determine which specific asset is superior within an asset class (e.g., do I buy Apple, or do I buy Bank of America?). However, discount rates and the cost of capital are more important in determining the superiority of the overall asset class (e.g., do I buy more stocks, or do I buy more bonds?).

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Comparing Current and Historical Interest Rates So if we assume that at least some of today’s inflation is demand-driven, what are the implications for interest rates, and what is the corresponding impact on asset prices? As economies cycle through periods of inflation, disinflation and deflation, interest rates have historically adapted to the changing conditions.

Conventional economics suggests that in the face of inflation, interest rates will rise, and this has generally been the case. Look no further than the period from the late 1960s into the early 1980s as inflation ramped up quickly (Figure 4).

Of course, no two periods are the same, and as a result, the trajectories of interest rates will vary.

Case in point: during and in the aftermath of WWII, from 1941 to 1952 (Figure 5), inflation was arguably more rampant than during the period from 1968 to 1982, yet interest rates in the earlier period essentially did not rise.

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Figure 4. Interest rates rose during the strong inflation of the late 1960s to the early 1980s Inflation vs. Interest Rates: 1968–1982 20%

15%

10%

5%

0% 1/68

1/69

1/70

1/71

1/72

1/73

1-Year Inflation Rate

1/74

1/75

1/76

1/77

2-Year Inflation Rate

1/78

1/79

1/80

1/81

1/82

10-Year Treasury Rate

Source: FactSet and Balentine

Figure 5. … yet rates did not rise throughout the even stronger inflation that occurred during and after World War II. Inflation vs. Interest Rates: 1941–1952 20% 15% 10% 5% 0% (5%) 1/41

1/42

1/43

1/44

1-Year Inflation Rate

1/45

1/46

1/47

2-Year Inflation Rate

1/48

1/49

1/50

1/51

1/52

10-Year Treasury Rate

Source: FactSet and Balentine

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We think the WWII period is a logical parallel for today, given that fighting the pandemic is in a sense a war. So what happened back then? Prior to the current period, the highest debt-to-GDP on record in the U.S. occurred around 1946, on the heels of robust spending for WWII — we recently surpassed that high, with a debt-to-GDP ratio currently over 120% (Figure 6). During that era, there were three independent episodes of inflation, and not one of them drove interest rates higher. Quite simply, the economy grew into the extra debt, which led the debt-to-GDP ratio to fall precipitously over the subsequent years — which in turn, allowed borrowing costs to remain low. That scenario certainly could recur this time around, given the pent-up demand for the economy to get going after all its fits and starts relating to the coronavirus.

So, even if inflation does rear its ugly head in a less transitory fashion, it is by no means a given that rates will rise.

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Conclusion So, in summary, what does this all mean?

1. Inflation and the level of interest rates will factor heavily into how the secular bull market progresses from here.

2. Inflation does not preclude interest rates from remaining low.

3. Against the backdrop of low interest rates, asset values can continue to rise as the cost of capital and discount rates remain relatively low, providing reasonably low hurdle rates for corporations.

4. When the secular bull inevitably ends and the secular bear begins (again, the timing of this is uncertain; it could be any number of years away), the bear will likely be either longer or deeper than previous ones. But importantly, it does not mean that the underlying bull will meet its demise more quickly. Markets can defy longer-term trends for far longer than any investor can imagine, even if it means harsher consequences down the road when the bull ends.

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Figure 6. After WWII spending drove the debt-to-GDP ratio to ~120%, a level breached only recently, strong economic growth brought the ratio down quickly.

Debt-to-GDP Ratio 140% 120% 100% 80% 60% 40% 20% 2021

2017

2013

2009

2005

2001

1997

1993

1989

1985

1981

1977

1973

1969

1965

1961

1957

1953

1949

1945

1941

1937

1933

1929

0%

Source: FactSet and Balentine

Figure 7. A change in direction for interest rates can take far longer than expected.

10-Year Treasury Rates 16% Rates take another 7 years to sustainably break 4%

14% 12% 10%

Rates take 15 years to sustainably break 3%

8% 6%

Rates bottom at 1.95%

4% 2%

1/1/21 1/1/23 1/1/25 1/1/27 1/1/29 1/1/31 1/1/33 1/1/35 1/1/37 1/1/39 1/1/41 1/1/43 1/1/45 1/1/47 1/1/49 1/1/51 1/1/53 1/1/55 1/1/57 1/1/59 1/1/61 1/1/63 1/1/65 1/1/67 1/1/69 1/1/71 1/1/73 1/1/75 1/1/77 1/1/79 1/1/81 1/1/83 1/1/85 1/1/87 1/1/89 1/1/91 1/1/93 1/1/95 1/1/97 1/1/99 1/1/01 1/1/03 1/1/05 1/1/07 1/1/09 1/1/11 1/1/13 1/1/15 1/1/17 1/1/19 1/1/21

0%

Source: FactSet and Balentine

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The past 40 years of investing have provided investors with such a tailwind of returns in most asset classes that they did not have to think about the goals of their portfolios. As the capital markets continue to evolve, investors find themselves at a fork in the road.

Given how low interest rates are today, leading to higher equity valuations than in the past, investors who do not make conscious decisions on their portfolio diversification and asset allocation strategies could find themselves in twenty years wishing they had.

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Choosing an Investing Pathway As it pertains to decisions around the goals for a portfolio, we believe investors need to choose one of three pathways. Selecting a pathway for investment can allow investors to correctly assess whether they are achieving what they set out for and have less concern about daily market fluctuations.

1. Goals-Based investing My goal is to grow my portfolio relative to inflation over seven or more years so I can preserve purchasing power for myself and for the legacy I want to leave.

2. Relative investing I would like to outperform certain benchmarks on a pre-tax or after-tax basis with a high degree of certainty over a shorter term (around three-year) period.

Though each investing pathway uses the same tools, they are driven by different goals and time horizons. We recommend custom strategies for portfolio diversification and asset allocation to accommodate these differences. Below, we will expand on these three pathways and discuss the customized portfolio diversification and asset allocation for each one.

3. Drawdown investing I am willing to take active risk in my portfolio to outperform, as long as I do not lose a certain percent in a 12-month period.

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Portfolio Diversification Strategies Goals-Based Investing A goals-based investor identifies a desired outcome and acknowledges that the investments in their portfolio are the tools to help them achieve that outcome. At Balentine, we believe investors want to achieve one of three high-level goals, and we have created portfolio strategies to match each goal:

1. Capital appreciation Goal: Investors want to attain a set dollar amount over a defined period, or they want their investment to grow faster than the broader market.

Our Strategy: At Balentine, our Appreciation strategy is geared to do just that. We recommend 100% equity exposure with factors that have shown the ability to outperform the broader market over time. We also recommend a healthy weight to private capital to leverage a longer time horizon and add excess return from illiquidity.

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2. Spend off the corpus of the portfolio Goal: Many investors spend their life building wealth, and they want that stored wealth to provide income.

Our Strategy: A portfolio that meets this goal has a material weight to equities paired with diversification from stocks to ensure spending can be met even in down markets. At Balentine, our Growth & Income strategy provides 30% diversification to ensure both investment in equities and satisfaction of spending needs. In addition, the equities we recommend have a higher dividend yield to increase the amount of spending covered by higher confidence cash flow.

We recommend private capital here as well. Private capital should be sized according to the spend rate on the portfolio and the overall return needed to support the desired lifestyle.

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3. Preserve the portfolio Goal: The last set of goals-based investors we see are those who want to take as little risk as possible in the public markets and need returns slightly over inflation to meet their goals.

Our Strategy: Balentine created the Capital Preservation Strategy to meet these needs.

The portfolio is split 50% bonds, 50% stocks, and stocks are tilted towards low volatility. We also recommend private capital that emphasizes lower-risk debt based on spend rate and return goals.

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Each of these portfolios continue to use our momentum-based models that can help lower risk ahead of potential bear markets.

They also use our tactical rebalancing of global equities, though they are at a lower weight than other strategies. This lower weight allows us to allocate to equity factors tailor-made to help the strategy reach its goal. The longer time horizon of these strategies is ideal, as it allows the factors, diversification, and active management to work.

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Relative Investing The relative investor comes to the capital markets with a specific benchmark in mind and is looking to outperform that benchmark in a shorter period, typically three years. This goal and time horizon leads to a portfolio that should stay close to the benchmark weight, deviating only with high confidence moves.

For these investors, Balentine recommends investors start at benchmark weight (i.e., 60% MSCI ACWI and 40% Bloomberg Municipal) and deviate in the following three ways:

1. Overweight and underweight stocks based on our Stocks vs.

Bonds model.  Our Stocks vs. Bonds model has been on the right side of the market more times than not, so we have high confidence in it. A 60% stock portfolio should move to 80% stocks, 20% bonds when the model is in favor of stocks and 40% stocks and 60% bonds when the model is in favor of bonds.

2. Index asset classes with tax-loss harvesting  For relative investors, we recommend taking very little active risk within stocks and bonds.

Instead, they should look to outperform these benchmarks on an after-tax basis by replicating the indices with active tax-loss harvesting.  At Balentine, we use a program called Custom Core with our partner Parametric that allows investors to replicate a stock index with single securities and actively harvests losses when any of those securities are negative. This harvesting allows investors to offset future gains, creating a higher after-tax return.

 A similar approach can be taken in bonds with separate account managers.  T ax-exempt investors can simply buy index funds to replicate their benchmark, as there is no value in tax-loss harvesting.

3. No J-Curve private capital  O ne drawback to private capital is it typically takes three to four years before a manager starts to show meaningful return. For relative investors with a three-year time horizon, traditional private capital will be a drag through the entire assessment period and is therefore not recommended.  However,

Balentine has a handful of private capital managers with evergreen funds that are near-fully invested and allow a dollar of investor capital to go to work as soon as it is invested.

This structure has two main advantages: 1) the absence of a J-curve allows the fund to immediately start adding value over a client’s benchmark, and 2) the evergreen structure allow for flexibility in allocation if the investor wants to change the strategy.

Relative investors should be very intentional when they take active risk versus their benchmark, preferring high confidence moves that introduce a controlled amount of tracking error. This should allow them to track ahead of their benchmark, even over shorter time periods.

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Drawdown Investing The goal of a drawdown investor is to outperform a benchmark, but with high confidence that they will not lose a certain percentage of their portfolio over a 12-month period. These investors should be willing to take sizable tracking error to reach that goal. Balentine has four specific strategies that target this goal, Aggressive, Growth, Balanced, and Conservative. Each of these strategies use the following tools in different proportions, based on the investor’s risk tolerance:

1. Smart portfolio construction

4. Private capital

 We limit the number of equities a strategy can have based on the likelihood that the drawdown tolerance will be violated.

 W e recommend a full allocation to traditional private capital. J-curves are less of an issue here as slow-moving private capital tends to smooth the ride for investors looking to limit drawdown.

Once fully deployed, however, the private capital portion becomes a powerful tool to add excess return to the portfolio.

2. Stocks vs. Bonds model  Our Stocks vs. Bonds model will move portfolios to the limit mentioned above when stocks are in favor, but more importantly, it will aggressively derisk portfolios when stocks appear to be moving out of favor.

3. Intra-equities model  We will tactically rebalance equities based on the momentum signals of our model that looks within equities. This is a high tracking error model that will reweight our benchmark MSCI ACWI index aggressively to ensure we are in the best spots. While this can cause short-term underperformance, it typically happens in bull markets when absolute returns are high and therefore does not infringe upon drawdown maximums.

5. Options  L astly, an investor can use options to help mitigate the downside. The buying of put options, which provide investors the ability to sell a security at a certain price, can add a floor to a portfolio that will give the investor comfort that a certain drawdown level will not be violated.

Drawdown-built portfolios can also function as a catch-all for investors who do not have a clearly-stated goal but are looking to outperform a given benchmark over a set period. We recommend that period be over three years given the tracking error that this process can introduce.

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Asset Allocation Strategies Now that we have outlined the portfolio strategies employed by different types of investors, we will discuss important differences in how these portfolios should be invested.

How should this affect asset allocation?

It depends on an investor’s goal.

For the last 40 years, there has typically been a significant decrease in interest rates during stock crashes and bear markets in stocks. During this period, investors seeking diversification away from stocks needed only to look to high-quality bonds. Because bond prices increased when rates fell, a portfolio that consisted of 60% stocks, 40% bonds had a natural shock absorber in it. Not only were bonds offering that volatility dampener, but they were also outperforming inflation during that time. A combination of high starting yields and falling rates caused the Bloomberg Aggregate index to return 7.3% over the last 40 year versus 2.7% of inflation. This allowed investors to have both a volatility buffer and an asset protecting the purchasing power of their money through time.

With the goal of protecting purchasing power and moving money through time, goals-based investors should own only a small amount of bonds. Why not zero? Part of protecting the purchasing power of money is to not sell stocks when they are at depressed values. To ensure that does not happen, investors need five years of spending in cash or high-quality fixed income. This, coupled with the cash flow off the portfolio, should allow an investor to withstand all but the absolute worst bear markets without having to sell stocks at depressed levels.

Those times have passed. Low interest rates suggest bonds will not be a meaningful hedge during the next bear market, and negative real interest rates ensure bond allocators are NOT protecting the purchasing power of their money through time.

Goals-Based investor

Relative investor If the benchmark is the goal, there is little reason to deviate away from it. Accept the diversification recommendation of the bond benchmark, acknowledging value will be added by being overweight or underweight when our models call for it.

Drawdown investor The cornerstone of the drawdown strategy is confidence in how bonds react when stocks behave badly. Due to this, we do not advise drawdown investors seek diversification outside of bonds.

We do, however, believe a disciplined use of options is an acceptable step outside of bonds for those desiring additional levels of diversification.

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Alternatives to Bonds If investors are not advised to purchase bonds for diversification, then what should they purchase? We believe there are three options for those who need to employ diversification strategies and protect the purchasing power of their money through time.

Real Assets First, we propose investing in real assets.

Investors with long time horizons should seek diversification in private core real estate and core infrastructure. These asset classes are an attractive alternative to bonds for the following reasons:

1. Attractive spreads to bonds  Cap rates, which are a good a proxy for projected rates of return on high quality core real estate and infrastructure, are between 3–4%.

2. Built-in inflation hedge  The

price of real assets is linked to inflation through replacement cost increases. The higher inflation is, the more expensive it is to build a building, which begets a higher selling price.  Real assets are also linked to inflation through rent escalation clauses or contracted inflation premiums. Both real estate and infrastructure can have mechanisms that allow cash flow to be increased alongside inflation. An increase in cash flow tends to increase net operating income, which then increases the worth of the asset.  Inflation is the enemy of bonds because they have a fixed interest rate that becomes increasingly unattractive as inflation and interest rates increase.

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3. Low correlation to stocks  One way bonds provide portfolio stability is that they have a low correlation to stocks — around -0.2. On a scale of -1.0 to 1.0, where -1.0 represents assets moving in opposite directions, and 1.0 represents assets moving in the same direction, a correlation of -0.2 means assets are largely unaffected by the movement of the market, which provides a strong foundation for returns. Through differing in return drivers and quarterly pricing, core real assets also exhibit low correlation to stocks, around 0.2, which is low enough to provide stability and significant diversification.

4. Favorable structures  Most core real estate and infrastructure funds are open-ended with quarterly liquidity. This allows for investors to consistently allocate funds.

5. Risks  These assets have risk, and they will most likely lose value during a bear market. With these assets, however, the goal to protect the purchasing power through time. These assets have a positive real return, unlike bonds, and while they will be more volatile than bonds, they should outperform over a full cycle.  Evergreen structures are both a boon and a curse. These structures do not tend to have liquidity when investors need it the most. This is why a long-time horizon is a requirement for investing in this type of diversification.

Private Credit The second investment we believe can be a better place to find diversification is private credit.

Private credit can be attractive versus bonds for the following reasons:

1. Attractive spreads  Like real assets, private credit can see 200–500 bps of spread over high-quality bonds.

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2. Floating rate  Most private credit is floating rate. This means the yield will increase as inflation and rates increase, protecting an investor against a rising rate environment.

3. Low correlation to stocks  Private credit tends to have a zero correlation to stocks given the secure place its sits in the capital structure, making it less susceptible to fluctuations in growth.

4. Favorable structures  Private credit has open-ended structures with quarterly liquidity, so investors may allocate consistently

5. Risks  These assets have risk. Many companies come to the private credit space because they are small and looking for more leverage than they can obtain in the public markets. This adds an additional layer of risk over treasuries or municipals. Manager selection is key here.  Credit evergreen structures face the small challenges that real asset open-ended funds face, including lack of liquidity. Unlike real assets, private credit can create some liquidity with sidecars. A sidecar occurs when an investor wants out of a fund and instead of the manager giving the investor cash, they carve out a piece of the portfolio and give it to the investor. The investor then receives cash as the loans (typically one to three years) mature. This works in credit funds, as loans are typically short-term in nature. This would not work well in a real assets fund, as buildings are infrastructure assets, which typically have a very long hold period.

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Hedge Funds The next investment that we believe could offer a better deal to investors are long/short, market-neutral, hedge funds.

By design, these investments have a zero beta, or no risk, to the stock market and rely solely on a manager’s ability to pick stocks. This can be attractive for the following reasons:

1. No correlation  A s mentioned above, a market-neutral manager should have no net exposure to the stock market.

2. Higher level of liquidity  While most hedge funds have quarterly redemptions, the underlying assets are much more liquid than private real assets or private credit. This can lead to a much smoother exit.

3. Upside return potential  Given that all the excess return is actively generated by the manager, the potential for return in a market-neutral hedge is much higher than real assets or credit, which are bound by cash flows and appreciation.

4. Risks  Downside return potential  The flip side of the return being 100% alpha is a manager who is consistently on the wrong side of the trade can lose much more than a real asset or credit fund.

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Options The last alternative for diversification outside of high-quality bonds is options.

This refers to systematically buying options to narrow the outcomes of a portfolio to the downside by targeting specific levels of market drawdowns. The benefits of option buy are:

1. Liquidity  Listed options are extremely liquid and can be bought and sold on a daily basis with very little slippage.

2. Predictability  The value of the option is more or less governed by an equation that market participants keep in line through arbitrage. This leads to a very high confidence of outcomes given certain market conditions.

3. High-Efficacy

Conclusion We believe it is imperative for investors over the next market cycle to be clear on the goals of their portfolios and choose the right set of strategies that will meet those goals. Within these strategies, investors should consider time horizon, as deciding when to act can be just as important as deciding where to act; being wrong on timing can be the same as being wrong. For many investors, we also believe now is the time to rethink what diversification in a portfolio can look like.

We believe active asset management, in both liquid and illiquid investments, could allow investors to take advantage of market inefficiencies stemming from lower interest rates and higher equity valuations. In addition, high-interest rate bonds are a thing of the past and should force investors to consider diversification that not only can provide support in equity market distress but can protect the purchasing power of money through time.

 Options have a high amount of leverage embedded in them structurally. This allows for a small allocation to options to go a long way.

4. Risks  Buying options is a losing proposition long-term.

Investors must offset this loss through smarter portfolio construction. For example, a 60/40 portfolio that buys options at 2% will have lower outcomes over time if fully funded from bonds.

Instead, a portfolio that allows for a higher level of stocks could offset that loss. For example, a portfolio of 75% stocks, 20% bonds, and 5% options could outperform a 60/40 if the options were bought at the right levels.

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Beyond the Horizon:

Themes for Intergenerational Clients Generational themes identify long-term trends that will impact markets and livelihoods over a generation. These themes affect how we invest and how we work with clients. They are particularly crucial to our intergenerational clients and our private capital program, where long-term patient capital can outperform more liquid investment options. While our capital markets forecast looks at the medium term (three to seven years), our generational themes look beyond that, offering areas of interest and focus 15 years or more.

Generational Themes Decarbonization as an intergenerational investment opportunity

achine Learning and Artificial M Intelligence as a potential Third Industrial Revolution

A Biotech Revolution moving from potential to kinetic energy

Explosive Growth continuing in the Sun Belt

Decarbonization Decarbonization is the process of taking traditional carbon-based processes and either replacing them with non-carbon-based processes or capturing and mitigating the carbon in existing processes.

When it comes to decarbonization, several sub-themes exist with potential to disrupt and impact a generation of companies: reimagined mobility; renewable and clean energy; clean hydrogen and new fuels; and nuclear fusion.

Though decarbonization has been a politically sensitive area of investing, the opportunity for investment in decarbonization over the next generation is in the trillions, perhaps even tens of trillions, irrespective of politics.

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Machine Learning and Artificial Intelligence Machine learning and artificial intelligence are two related concepts that often merge. Machine learning is the ability for machines to learn from available data. With the advent of big data, machines that can improve their information analyses have led to some rapid economic advances. Artificial intelligence is a broader category, generally defined as the pursuit of machines developing the qualities of the human mind. Some of these qualities include language and pattern recognition and solving complex problems. Together, machine learning and artificial intelligence have the potential to harken a third industrial revolution that will transform our economy over the next generation.

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A Biotech Revolution The third wave of a long-standing biotech/medical revolution began a generation ago as efforts from the human genome project, advances in computing (see Machine Learning), and scientific breakthroughs combined to create what some have called the dawning of a new Golden Age of Medicine. This Golden Age of Medicine may offer a revolution in healthcare, pharmaceuticals, and biotech. Pundits have pointed to several trends to support this theory, such as the so-called “Moore’s Law for Medicine,” where the speed of discovery builds on itself and quickens, or “the biological century,” where innovations in medicine shift from a trial and error method in the past to an engineering science with predictable/scalable outcomes in the present and future. We saw this play out on a global scale in 2020, when, thanks to computing technology, the mRNA vaccines for COVID-19 were miraculous in their delivery mechanism, development speed, and emergency approvals. As the pandemic has shown, new diseases can emerge and spread rapidly, increasing the stakes and the potential role for government funding and public-private partnerships to speed drug discovery and delivery. Diseases such as cancer and Alzheimer’s are coming into the target range for solutions to transform the developed world’s life expectancy and quality of life.

Explosive Growth in the Sun Belt In the largest economy in the world, people are moving to the Sun Belt in droves, bringing their spending, businesses, education, and ideas. For example, three dozen people, net, move to Atlanta every day, double that in Nashville and nearly three times that to Jacksonville. Phoenix has about 200 net new residents per day. A mind-boggling

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average of 8,300 people per day, net, have moved into Texas over the last decade, attracted primarily to the large urban areas. This trend shows little to no sign of abating; with in-migration, high taxes in coastal capitals, and expanding transportation and cultural options in the Sun Belt, we believe it will continue to expand at or above the rate of growth over the last decade.

Conclusion Though generational themes do not change our core approach in private capital, where we look to allocate across vintages and managers to large areas that can absorb meaningful capital, they do play out in several ways in our current and evolving investment platform. They represent areas we are watching with particular attention as we craft portfolios to clients’ specific needs. These themes are not exhaustive, and though some will fade, and others will emerge, we are particularly interested in overweighting these areas as we look for private investment opportunities.

Balentine has proven its ability to balance strong investment performance in the long-term with client asset protection in the near term. We rely on science first and foremost to allow for unemotional decision-making in liquid markets. We are also able to move tactically when unexpected opportunities, such as the coronavirus pandemic, present themselves. Finally, we take an intergenerational view of macro themes that slowly but forever change the world in which we live. By blending these tested approaches together, we enable our clients to meet their goals with consistency through time.

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Considerations for Allocating to Private Capital In the next market cycle, we believe active asset management will be crucial to navigating the challenging environment created by high equity valuations and low interest rates. At Balentine, we look to spend our active management budget primarily in private capital.

Why Private Capital?

In Private Capital, meaningful excess returns are more persistent than in the public markets, and true active management beyond the point of purchase takes place. In our view, this persistence is due to the high growth nature of private companies and the control managers have over the outcome.

High growth: Companies in the private markets can double or triple earnings year-over-year as they expand from ideas to country-wide products.

Once a company has reached the public markets, the growth can continue but typically at a much slower pace.

Control: Private capital managers can also add value through the control they take of the company. Managers can take a long-term view on replacing management, starting or stopping a product line, or expanding into new markets all without the worry of missing a quarterly earnings number.

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Selecting A Private Capital Manager To capture the excess return that comes from high growth and control, investors must be willing to accept illiquidity, or not having access to their money for an extended period of time. This illiquidity is necessary as it gives private capital managers the resources to let their theses play out without selling assets crucial to their operations. The illiquid nature and dependency on the general partner for success drives our due diligence process to be robust and repeatable. We evaluate private capital managers with the following criteria:

People  Teams have a history of working together  General Partners have seen multiple economic cycles  Have proven ability in managing a fund — we typically stay away from first-time funds

Philosophy  P hilosophy aligns with current market opportunity  R eturn comes from the improvement of the underlying company or asset and not from leverage

 Have a clear succession plan in place

Process  Investment process is clear and repeatable  Manager has an apparent edge in deal sourcing  Changes in the process over time have led to better results

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Performance  T he People, Philosophy, and Process categories manifest themselves in consistent first and second quartile performance  U nderperformance is explainable and lessons learned have led to process improvements

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Where to Invest When assessing where to invest in the private markets, we look to asset classes that have an established history of excess return and that can absorb billions if not trillions of dollars and maintain that level of excess return. These asset classes are private equity, private real assets, and private debt. We then seek managers that align with our due diligence criteria in the following sub-asset classes:

Private Equity

Private Real Assets

 Venture capital is an investment in early-stage, emerging companies with high growth potential.

Venture capitalists typically take a minority stake in the company and use their talents to assemble the right leadership team, create repeatable processes across the company, and leverage their network to grow the business.

 V alue-add real estate investing is the purchasing, repositioning, and selling of real estate — typically involving older buildings in economically strong areas diversified across residential, commercial, industrial, and retail properties. The focus of value-add real estate investing is driving improvement, which is opposed to core real estate’s “buy and hold” process geared toward collecting rents.

 Growth equity is an investment in a more mature company which typically has a proven product and is looking to expand or restructure the company. Growth equity managers typically take a minority stake but can have a controlling stake.  Buyout equity, or leveraged buyout (LBO), is when a private investor borrows money to purchase a controlling stake in a company with the goal of creating efficiencies, increasing margins, and then either selling it to another private investor or taking it public.

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 I nfrastructure and natural resource investing is the purchase and operation of key infrastructure, such as sea ports, airports, or energy generation and distribution. Similar to value-add real estate investing, the manager will typically reposition the asset to garner a higher exit price while collecting cash flow from operations.

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Private Debt

Opportunistic investments

 Secured Lending is lending to small and mid-size companies which cannot access the public debt markets. These loans are high in the capital structure and typically have strong covenants. Loss rates tend to be low, and yield tends to increase as EBITDA of the borrowing company decreases.

 T he ebb and flow of markets bring myriad dislocations and therefore investment opportunities. Balentine is constantly on the lookout for these opportunities that can be accessed in the public or private markets.

 Non-secured Lending is junior to senior debt and therefore earns a higher yield. This debt is typically used for leveraged buyouts or when companies already have senior debt in place. Loss rates will tend to be higher than senior secured but can be offset from a return perspective by managers taking a small equity position in the company.

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Constructing Your Portfolio An investor’s private capital portfolio should be sized based on the need for return and balanced by the level of spending. The higher return an investor needs, the more private capital to which they should allocate. This needs to be balanced, however, on the level of spending from the portfolio. We complete strict scenario analyses to ensure we size the illiquid portion of a client’s portfolio under the level which would inhibit the same level of spending. Below is a chart that depicts this relationship: 7%

Yearly Spend Rate

6% 5% 4% 3% 2% 1% 0% 0%

10%

20%

30%

40%

50%

60%

Source: Balentine

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The size of the private capital portfolio determines the final allocation. The more assets that are allocated to private capital, the more funds can be used. Balentine utilizes a core – moon – satellite approach that goes from broad based, diversified funds to more focused, sometimes thematic investments. This is depicted in the following chart:

$5,000,000+ in private capital $2,500,000 in private Private capital Real $1,000,000 Assets in private capital 3c-1 options

Private Debt

Public Markets

Private Equity

Opportunistic

Conclusion We believe the next market cycle will be a defining one from a return perspective. Portfolios that can handle the complexity and illiquidity of private capital should distinguish themselves from portfolios that cannot. Balentine has invested material resources to ensure we can build the private capital portfolio that our clients are going to need for the next cycle.

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Appendix Each year, we update our forecast of capital market returns for the next market cycle, as measured by the succeeding seven-year period, because future market returns, specifically, projected income and projected adjustments to valuation, are a function of the starting point. As a result, the goal for our strategic forecast is to update our outlook to account for year-over-year changes to the starting point of the new seven-year cycle. We update our strategic forecast for asset classes on an annual basis, but that does not mean these are tactical, one-year allocations. Instead, our updated returns contemplate the market’s actions during the preceding year and rely on mean reversion.

Over the long term, markets show a strong tendency to mean-revert to historical averages adjusted for underlying trends. This happens because high profits and momentum attract investors and drive down future returns in highly-valued asset classes. A classic example is the bifurcation we see at this point in U.S. Large Cap Growth vs. Value. These forecasts offer little insight into the tactical outlook over the next year or so, but over the next seven years, Value stocks are in a much stronger position to deliver superior returns owing mostly to superior starting valuation and dividend yield. The valuations in U.S. Large Cap Growth contemplate earnings growth that, if history is any guide, is likely to overstate what actually comes to pass.

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Our update includes answers to the following questions:

What public market returns are realistic during the market cycle?

What risks may have to be assumed to capture those returns?

What opportunities do investments in private markets have to offer?

Based on our updated projections, we restructure our strategic asset allocation targets in key areas to maximize the efficiency of our strategies and, therefore, better meet our clients’ objectives over the next market cycle. Our forecast provides the quantitative blueprint for the steps we are taking designed to both manage risk and maximize opportunities in 2022 and beyond.

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Fixed Income YTM

Duration

Bloomberg Barclays US Aggregate

1.8%

6.7

Bloomberg Barclays US Treasury

1.2%

7.1

Bloomberg Barclays US (7Y-10Y)

1.4%

8.2

Bloomberg Barclays Municipal Bond

1.3%

5.0

Bloomberg Barclays US Aggregate Credit - Corporate - Investment Grade

2.4%

8.6

Bloomberg Barclays US Aggregate Credit - Corporate - High Yield

4.8%

3.8

Bloomberg Barclays US Treasury Inflation Protected Notes (TIPS)

1.4%

4.5

Bloomberg Barclays Global Aggregate

1.3%

7.5

JP Morgan EMBI Global Diversified

5.3%

6.7

Return

Risk

MSCI All Country World (Global equities)

2.4%-5.0%

16.5%

Russell 1000 (U.S. Large Cap)

1.2%-3.4%

14.5%

Russell 1000 Growth (U.S. Large Cap Growth)

0.1%-2.3%

16.0%

Russell 1000 Value (U.S. Large Cap Value)

2.3%-4.5%

13.0%

Russell 2000 (U.S. Small Cap)

2.6%-4.8%

19.2%

MSCI EAFE (International Developed)

3.8%-6.0%

17.0%

MSCI EAFE Small Cap (International Developed Small Cap)

4.4%-6.6%

19.7%

MSCI Europe

2.6%-4.8%

17.0%

MSCI Japan

5.6%-7.8%

21.0%

MSCI Emerging Markets

7.3%-9.5%

23.5%

Return

Risk

2.7%-3.7%

6.0%

Return

Risk

7.4%-10.0%

9.5%

Market Risk

Alternatives HFRI Fund of Funds Composite

Private Capital Cambridge PE Source: Balentine

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In Closing We hope you find this year’s Capital Markets Forecast informative in understanding what is realistic to expect in the market in 2022 and what possibilities exist to achieve portfolio goals.

As portfolios ride the market cycles in periods of high inflation, low inflation, and even negative inflation, it is important to ensure they are set up to achieve goals in an environment with low interest rates and potential growth challenges. This is especially the case looking forward given the possibility of changes in both cost of living and tax rates, though recent developments in Washington D.C. suggest the latter may be less likely to occur. Nevertheless, accounting for all possibilities to inflation and tax rates will allow us to effectively balance portfolio risk and spending needs to build better portfolios for today’s generation as well as for the subsequent generations in multigenerational asset portfolios.

Though none of us can predict the future, time-tested research methods and innovative thinking provide pathways to move forward.

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Disclosures The opinions expressed are those of Balentine. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Forward looking statements cannot be guaranteed. Different types of investments involve varying degrees of risk. Therefore, it should not be assumed that future performance of any specific investment or investment strategy (including the investments and/or investment strategies recommended and/or undertaken by Balentine or any non-investment related services, will be profitable, equal any historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.

Material presented has been derived from sources considered to be reliable, but the accuracy and completeness cannot be guaranteed.

Balentine is an investment adviser registered with the U.S. Securities and Exchange Commission.

Registration does not imply a certain level of skill or training. More information about Balentine’s investment advisory services can be found in its Form ADV Part 2, which is available upon request.

Chartered Financial Analyst® (CFA®) are licensed by the CFA® Institute to use the CFA® mark. CFA® certification requirements: Hold a bachelor’s degree from an accredited institution or have equivalent education or work experience, successful completion of all three exam levels of the CFA® Program, have 48 months of acceptable professional work experience in the investment decision-making process, fulfill society requirements, which vary by society. Unless you are upgrading from affiliate membership, all societies require two sponsor statements as part of each application; these are submitted online by your sponsors.

For more important disclosures visit www.balentine.com/disclosures

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