2019 Capital Markets Forecast - Insitutional

20 19

CAPITAL MARKETS FORECAST

RISK MARKETS

RESET WHERE ARE THE OPPORTUNITIES AMID MORE TURBULENT TIMES?

Executive Summary

1

Key Themes from our 2019 Capital Markets Forecast

2

The Nature of the Economic Cycle

6

The Current Economic Cycle

12

Capital Markets Outlook

16

TAB L E O F CONTENTS Appendix

23

Expected Return and Risk Assumptions

24

Drawdown Tolerances

24

Strategy Weights and Expected Returns

25

Index Projections

25

Disclosures

26

B

alentine’s annual Capital Markets Forecast is the foundation of our investment process.

The projections herein form the basis of portfolio construction both within and across building blocks. Balentine’s Investment Strategy Team has honed this process over many years, and it has a demonstrated positive track record, notably at market extremes. Projections in the Capital Markets Forecast help our team design strategies which increase the probability of reaching goals by maximizing risk-adjusted returns. Though strategies are tailored to the unique objectives of our clients, we illustrate the tradeoffs between expected return and risk from today’s starting point by evaluating four different levels of risk aversion.

Risk budgets are based on long-term historical outcomes of bond and equity benchmarks.

Strategies range from Conservative (with volatility characteristics of a 100% bond portfolio) to Aggressive (with volatility characteristics of a 100% equity portfolio); in between are Balanced and Growth strategies.

EXECU TI VE

SUMMARY Balentine’s Global Asset Allocation framework is as follows:

ixed Income – Fixed Income assets primarily play a role as a “shock absorber” to strategies, with the F goal of providing protection when risk assets experience short-term duress. Secondarily, at higher interest rate levels, Fixed Income provides cash flow while managing against interest rate fluctuations, credit risks, currency movements, and unexpected inflation.

Market Risk – The most volatile component of strategies, Market Risk aims to capture public market equity returns, as they are driven by exposure to underlying economic growth, earnings, and current and expected future interest rates.

C A P I TA L M A R K E T S F O R E C A S T 2019

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KEY THEMES FROM OUR 2019 CAPITAL MARKETS FORECAST The last ten years in capital markets have been anomalous in many ways. Gains in global equities have exceeded the gains in the worldwide economy, as measured by gross domestic product (GDP), since the onset of the bull market almost ten years ago. To some degree, this is an unfair comparison; it is often the case that returns in equity bull markets outpace GDP and wage growth since investors are willing to pay more for an earnings stream when growth prospects are more optimistic, a phenomenon known as equity multiple expansion. However, multiple expansion has been even more pronounced during this recovery. Equally as anomalous, market performance has substantially rewarded one asset class: U.S. equities. What this may mean going forward is the subject of a deeper discussion later in this piece, but suffice it to say when diversification fails investors over a large swath of time, it is atypical.

Early last year, we projected volatility to increase in 2018, coming off a strong 2017 which featured the lowest volatility on record for the MSCI All Country World Index (ACWI) and the second-lowest volatility in the past 100 years for the S&P 500 index. This turned out to be a prescient call. Volatility of 15.3% and 13.5% in 2018 represent the largest standard deviation in the S&P 500 and MSCI ACWI, respectively, since 2011. The choppiness has rattled investors, if for no other reason than instability following a period of abnormally low volatility typically feels more unsettling. This is evidenced by weakness during 2018 in almost all assets outside of cash, a mirror image of the strong results in 2017 (Figure 1). The silver lining to a year like 2018 is the performance of the economy exceeding the gains of the equity markets. While this may serve as a painful adjustment in the short-term, it has historically proven to be a necessary breather for longer-term health in the equity markets.

All of this begs the question of where to from here, for both the economy and the markets. To answer that we need to assess: 1) from where have we come, 2) where are we now, and 3) where are we going? Per our investment process, our goal is to understand what we are seeing in the context of historical data and to use this information to assess the likelihood of what will come next. There are compelling quantitative and qualitative reasons to argue the economy, and thus the stock market,

2

Figure 1. Asset class returns in 2018 were negative across the board, in stark contrast with 2017.

80%

Asset Class Total Returns in 2017 and 2018

60%

40% 20%

0%

(20%)

(40%) (60%) l s y a a a e o 0 ia ia ia ia th blic nds 00 00 nds and lue ary and eru AE ds pan ore nce alia ark SA ope om ain MU ypt Oi in ine xic ore ium fric rke ss w 00 mb lays Valu nes lan 5 10 a g rl U P il o E Eg ude Ja gap Fra ustr nm ex U Eur ngd Sp Ch ipp Me K elg A Ru Gro epu t Bo &P Tu a R2 olo R tB ha 00 V Hun itze 0 ndo her i e I l h B r n T R 0 M i S A v v K D t C hi C I ut S 0 0 o w e d I 00 ch Go P W o 2 1 S G e T 0 N S e R R l . it AC W R1 Cz U.S ba Un lo G

2017 Total Return

2018 Total Return

Source: FactSet

has more room to run despite the worst December in nearly 100 years. There are, however, no assurances, especially given the length of the bull market and our belief that volatility is here to stay for the foreseeable future, particularly when taken into historical perspective (Figure 2). Looking at Cboe Volatility Index® (VIX) data going back to 1990, we find there are instances of bullish price action with a VIX above 20. From the middle of 1997 through the end of the bull market three years later, the VIX was routinely over 20. With a current market which has spent the bulk of the last seven years under 20 (the first three years of the bull market were spent whittling down volatility from bear market highs), this is a feeling to which investors are not accustomed. This leaves us with two important points: 1) because volatility has been abnormally low by historical norms, volatility could still be low by historical standards even as it moves higher, and 2) higher volatility does not preclude equity markets from rising further.

C A P I TA L M A R K E T S F O R E C A S T 2019

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Figure 2. As Federal Reserve policy normalizes, equities may be on the cusp of a new volatility regime.

Cboe Vola lity Index® (VIX) 80 70 60

The start of a new vola lity regime?

50 40 30 20 10 0 1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

2014

2016

2018

Sources: FactSet and Balentine

This analysis may seem to contradict our recent decision to reduce exposure to equities across all strategies. However, history is replete with examples of corrections within bull markets which lack depth and duration but during which it is still optimal to reduce risk, including as recently as late 2015 and early 2016. The idea of repositioning risk within our portfolios during market turbulence does not mean we are expecting a repeat of the last two bear markets. In fact, history demonstrates that years in which the equity markets have taken a breather while the real economy continued to chug along (e.g. 2018), have not occurred near the tops of market cycles. Instead, they have taken place in the middle of market cycles, as equity valuations readjust and set the stage for another leg in an underlying bull market. Two notable recent cases of this are 1984 and 1994. The obvious counterpoint to 2018 serving as a repeat of 1984 and 1994 is they occurred only a few years removed from respective recessions1, whereas the current market is almost 10 years removed from the recession that ended in June 2009.

¹ Per the National Bureau of Economic Research (NBER), the recessions ended in November 1982 and March 1991, respectively.

4

We believe the length of a recovery is less significant than its magnitude. Age, in and of itself, is not necessarily the determination, but rather what comes with age. This is a key point when reconciling where we actually may be in the business cycle and in a corresponding bull market/bear market cycle. It is crucial to comprehend the dynamics of a typical business cycle and to understand why this one may be different.

In addition to supplying strategy ranges and expected returns, this year’s Forecast will focus on the nature of the economic cycle, analysis of our current positioning within the cycle, and implications for economic growth and capital markets expectations. We continue to expect public market returns to be relatively anemic over the next seven years. However, we are more optimistic IT IS CRUCIAL TO than at this time last year despite a litany of investor worries, including central bank policy, trade, rising interest COMPREHEND THE rates, yield curve inversion, and potential inflation. Our DYNAMICS OF A TYPICAL optimism primarily relates to improved equity valuations and higher interest rates. The incremental uptick in BUSINESS CYCLE AND TO optimism will likely be met with higher volatility, which UNDERSTAND WHY THIS ONE is to be expected as the economic cycle ages. Increased volatility should lift the equity risk premium, thus MAY BE DIFFERENT. compensating investors more for taking on risk. Across our strategies, higher equity risk premiums increase our ability to maximize equity exposure given a lower probability of breaching drawdown targets. Additionally, higher projected rates from Fixed Income should allow our strategies to be more effective in maintaining goals when equities go out of favor. For capital markets, an increase in alpha (i.e., the active return on an investment) is to be expected from both active managers and active rebalancing after a long period of underperformance relative to passive strategies.

C A P I TA L M A R K E T S F O R E C A S T 2019

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THE NATURE OF THE ECONOMIC CYCLE Economists break down the economic cycle into four phases: 1) expansion, 2) peak, 3) contraction, and 4) trough. An expansion is typically characterized by month-over-month economic growth (with adjustments necessary sometimes to account for seasonality) until such growth peaks and activity begins to contract. After the contraction concludes, expansion begins anew. Such activity typically occurs on a secular growth trajectory with each successive contraction bottoming at a higher level than the prior cycle, as depicted in Figure 3.

Figure 3. The typical business cycle pattern.

Growth Trend Line

Prosperity/Late Expansion

ve Posi Gap u p t Out

Early Contrac on

Peak

a ve Neg t Gap pu Out Recession/Late Contrac on

Recovery/Early Expansion

Trough

Source: Balentine

This oversimplification conveys a high-level understanding of an economy’s current positioning, which will suffice for standard inquiries on questions such as, “How is the economy?” Of course, the economic cycle is far more complex, advancing in fits and starts rather than via a smooth cadence of progress. In fact, while the term “cycle” implies phases occur at predictable intervals, the opposite is actually the case; economic cycles are irregular in both duration and magnitude. Put differently, within a cyclical expansion phase, there will often be episodes of expansion, stagnation,

6

and contraction. The duration of these episodes is usually short in nature and the magnitude typically does not take away from the overall cyclical trend. As such, separate cycles will typically play out differently at a micro level even if they generally rhyme on a macro level. This explains why the beginning and ending dates of different phases are known only in hindsight; just because we experience modest deceleration in economic activity does not necessitate the start of a contraction. Economic indicators categorized as leading, coincident, or lagging are used to help assess the ongoing phase. Because it often takes more prolonged periods of declines (or growth at the end of a contraction), the underlying economic phase is often known only after we are already well into it.

Digging deeper, historical economic cycles provide insight into the current cycle and our positioning therein. Economies have a growth trajectory which tends to follow a regular trend for decades, as seen by the gray trendline in Figure 3.

Economies in the earlier stages of a lifecycle often exhibit stronger, yet more volatile, trend growth. Conversely, more established economies will exhibit less, but more consistent, growth. Finally, in rare cases, an economy will show secular decline—Japan’s last few decades serve as a recent example. The economic cycle is, quite simply, the measurement of volatility around a growth trend. Think of it as a pendulum in which the pendulum’s equilibrium (i.e., the point where the pendulum is at rest) is the growth trend and the phases of the economic cycle reflect the swings around that equilibrium. The greater magnitude the pendulum swings in one direction (i.e., the greater the economic boom), the greater the pendulum will swing in the other direction to offset it (i.e., the greater the economic bust).

During periods of positive growth, the growth rate tends to surpass the secular growth trend. Alternately, during periods of negative growth, the trend will not only fall short of the secular trend but also will decline, as demonstrated in Figure 3. What drives these fluctuations has been the subject of much debate over the years (often between “demand siders” and “supply siders”), serving as the basis for policy formulation. Further explanation of each phase of the cycle follows on the next page.

C A P I TA L M A R K E T S F O R E C A S T 2019

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EXPANSION • Economic growth is the default state of the economy; thus, expansions are the longest and largest stage of the cycle. During expansions, the economy is strong and company profits are rising as demand for goods and services is robust. Real GDP is rising and the unemployment rate is generally falling, both of which drive higher disposable income stemming from increases in wages and appreciation in the value of capital as corporate earnings grow.

• Higher incomes drive an increase in the velocity of money as both consumers and businesses begin to spend more. As a result, companies’ revenues grow even further, and a feedback loop ensues wherein an increase in corporate revenues begets an increase in money for other companies and consumers, which begets a further increase in corporate revenues, and so on.

TWO IMPORTANT INPUTS WHICH TYPICALLY DRIVE EXPANSIONS, WAGE GROWTH AND CAPITAL EXPENDITURES, HAVE BEEN NOTICEABLY PALTRY DURING THIS CYCLE.

• Income growth also leads to an increase in consumer confidence and business confidence as employment is strong and earnings growth is consistent, which leads both consumers and businesses to forecast even more strength into the future. As a result, consumers and businesses take on additional debt; consumers borrow to fund “big ticket” items and corporations borrow to fund projects they deem additive to corporate earnings. In both cases, consumers and businesses would not make purchases without confidence in the future.

• The combination of strong velocity of money, growth in corporate earnings and labor wages, and increased borrowing typically drive prices higher as aggregate demand consistently stays one step ahead of aggregate supply. Initially, this price inflation is typically benign, as it actually produces further strength in the economy. However, at a certain level, inflation becomes detractive as corporate margins shrink and consumers experience less discretionary income since more of their wages are applied to food, transportation, housing, and clothing costs.

• Once inflation becomes detrimental, the central bank feels the need to get involved. Central banks usually try to be proactive in advance of such an inflection point. In practice, however, they are typically behind the curve because they are leery of proactively slowing the expansion (proverbially speaking, they are loath to take away the punch bowl while the party is still going). When the central bank decides it is time to quell a rise in inflation, they raise short-term interest rates. Long-term interest rates frequently rise in concert as bond markets anticipate inflation and corresponding central bank response.

The expansion continues, albeit at a slower pace, as the cost of funds begins to rise.

8

C A P I TA L M A R K E T S F O R E C A S T 2019

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PEAK • At some point in the economic expansion, interest rates have risen enough not only to mitigate inflation but also to dampen consumer demand and make corporate projects infeasible. At this point, interest rate increases have reached their inflection point.

• At a macroeconomic level, GDP stops increasing, unemployment stops decreasing, and inflation generally peaks.

• At a corporate level, managers are more meticulous in their stewardship of corporate capital as they see fewer projects able to surpass more stringent hurdles brought on by higher rates. Concurrently, consumers begin to reduce borrowing and spending as they revise their heretofore optimistic outlook on personal wealth and income situations. Thus, the expansionary feedback loop which drove growth higher starts to reverse.

•O ther factors can also contribute to an economic peak, notably negative shocks to the economy (e.g., commodity price spikes in the 1970s, terrorist attacks such as in 2001).

CONTRACTION • Not all contractions become recessions or, in more severe cases, depressions. A recession is defined as two consecutive quarters of contraction. Most recently, GDP contracted during the first quarter of 2014, but the weakness lasted only one quarter—hence there was no recession. The genesis of a contraction comes from rising prices and higher interest rates which drive corporations and consumers to retrench, thus slowing the velocity of money and leading to decelerating corporate revenue growth. As sales slow, inventories rise with waning demand for products. Elevated inventories lead to lower gross margins from price cuts, production cutbacks, and employee layoffs.

• A new feedback loop ensues, a mirror image of the expansionary loop; decreased revenues beget less money in the economy as monetary velocity slows, which begets even fewer corporate revenues. As corporate expenses begin to outgrow revenues, companies cut costs in labor, production, and capital spending.

10

• GDP is decreasing, unemployment is rising, and inflation is falling. To offset declines in aggregate demand, it is common for the federal government to step in with fiscal stimulus to limit declines in monetary velocity. Ideally, the federal government could spend enough to offset the decline in corporate and consumer spending; however, because the size of the economy is larger than the size of the federal government’s ability to spend, fiscal stimulus serves to stem the tide of economic weakness but cannot halt the decline in its entirety. Put differently, the government fiscal stimulus may be able to limit the magnitude of a contraction, but it will be unable to prevent or end the contraction.

• Because demand for money has decreased, interest rates decline. Pullbacks occur in short-term rates due to central bank actions to combat deflationary pressure and in long-term rates as the bond market focuses on lower-trend growth. The interest rate declines on top of government fiscal stimulus serve to lessen the gap between relatively depressed aggregate demand and relatively abundant aggregate supply, thus setting the stage for an eventual end of the phase.

TROUGH • As economic contraction evolves, the combination of monetary policy and fiscal policy creates a second-derivative effect: the economy begins to decline at a slower pace. With interest rates at cyclical lows, expansion in money from the central bank spurs additional consumer and corporate borrowing to invest in projects which heretofore were not profitable. Additionally, the federal government continues fiscal stimulus until there is clarity about whether the economy is beginning to recover.

• Much of the demand to initiate a recovery comes from the need to maintain and/or replace antiquated capacity, leading to increased capital expenditures.

This spurs a recovery as monetary velocity begins to accelerate, leading to growth in personal and corporate income. At this point, growth changes from negative to positive, signaling a hallmark of an economic trough. Since inflationary pressure has all but disappeared, increased spending has a limited effect on prices, so inflation remains tame.

C A P I TA L M A R K E T S F O R E C A S T 2019

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THE CURRENT ECONOMIC CYCLE How are we to assess what we see presently, and what does it mean for both the economy and the capital markets looking forward? We could take the standard approach of evaluating leading, coincident, and lagging indicators. However, this cycle is drastically different than those in the lifetimes of most people alive today because of the 0% interest rate policy our economy experienced for seven years (from December 2008 to December 2015). Based on the Q3 2018 GDP growth rate of 3.4%, it is apparent we are currently in the expansion phase of the cycle. However, whether we are approaching the peak is less clear. Although it is historically difficult to gauge a peak since it is usually known only in hindsight, we can do our best to evaluate our positioning given the aforementioned template. Before delving into economic fundamentals, it is important to note developments in capital markets usually lead the economy, as demonstrated in Figure 4. Thus, we cannot dismiss the possibility that the Q4 2018 declines in both equities and bond yields represent turbulence in advance of economic contraction.

Figure 4. Capital markets usually move in advance of the economy, not the other way around.

S&P 500

4,096 2,048 1,024 512 256 128 64 32

16 8 4 1928

1933

1938

1943

1948

1953

1958

1963

Equity market peak in advance of recession onset

1966

1973

1983

1988

1993

Equity market trough in advance of recession end

Sources: FactSet and the National Bureau of Economic Research (NBER)

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1978

1998

2003

Recession

2008

2013

2018

As stated in the introduction, we do not believe recent market deterioration marks the onset of a substantive bear market. From a capital markets perspective, equity valuations at their peak over the summer did not attain extremes in valuation when compared to fixed income (i.e., equity values relative to bond yields). This is not to say, of course, equities did not get expensive; to the contrary, valuations at recent equity peaks were indeed lofty. However, expensive equities can always get more expensive. For us to believe a brutal bear market akin to 2000 and 2007 lies in our near future, we would need to see equity valuations reach extreme levels.

If the fourth quarter capital markets turbulence is a harbinger of recession, it would be quite unique for two notable reasons: 1) the lack of yield curve inversion, and 2) the dearth of capital expenditures to date in the cycle. Although the yield curve has flattened, it has not yet inverted in key duration spreads, something which has always happened going back as far as yield data has been calculated. Recent market turbulence could be a foreshadowing of continued growth at a lower rate or even potentially short-lived negative growth. However, prolonged economic weakness has historically necessitated a more downwardsloping yield curve.

In addition to the yield curve, we find it implausible that the economic expansion has completed with such a scarcity of corporate capital spending. Historically, this would be unprecedented, as capital spending is often the engine which drives expansions via productivity gains. Companies in the current expansion have cut costs to boost productivity while doing little in the way of investing for future growth. During the initial stages of the recovery, this was understandable and in line with prior cycles. This time, though, the driver was the need to whittle away excesses from the prior cycle given the overhang in both debt and excess capacity. Rather than reinvesting top-line growth to drive productivity

C A P I TA L M A R K E T S F O R E C A S T 2019

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and efficiency, increases in profitability have come from two levers: 1) looser monetary policy via lower interest rates, and 2) burgeoning government deficits via expansive fiscal policy. In essence, the income statements and balance sheets of corporations have been subsidized by savers and U.S. taxpayers.

While these two levers always play a role in an economy coming out of recession, they undoubtedly played a much bigger role in this expansion. Companies have been all too eager to take what has been essentially free money because of rock-bottom interest rates to invest primarily in one “project”—stock buybacks. After all, if a corporate manager can borrow at a nominal percentage rate to repurchase company equity and accelerate earnings per share growth with basically no short-term risk, there is little incentive to take on projects which actually carry risk.

As a result, we are now experiencing improved GDP growth, and, not coincidentally, increased capital spending. We believe we are early in the capital expenditure cycle, which could certainly have more room to run (i.e., elongation). An important point when talking about elongation is that this cycle has Figure 5. As measured by cumulative GDP growth, the current cycle marks the weakest recovery since WWII. 55% 50% 45%

Cumula ve Real GDP

40% 35% 30% 25% 20% 15% 10% 5% 0% -5% 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40

Quarters since Prior Peak 48Q4

53Q2

57Q3

Source: Federal Reserve Bank of St. Louis

14

60Q2

69Q4

73Q4

80Q1

81Q3

90Q3

01Q1

07Q4

been subpar in terms of GDP growth, as shown in Figure 5. Therefore, if we think of growth not in terms of duration but rather in terms of magnitude, it would follow that the cycle can go on for longer than normal. After all, if the economy is destined to grow by a certain percentage during an expansion, it can take the hare route (i.e., fast growth for a short period), the tortoise route (i.e., slow growth for a long period), or some combination thereof.

From our perspective, the consumer is strong, with December’s holiday spending providing testament to this argument. Unemployment remains low, and consumer balance sheets are solid as consumers continue to improve their personal saving as a percentage of incomes. (While aggregate balance sheets are bloated, this is more a function of governments and corporations, not consumers.) Thus, consumer confidence remains high. Wages are finally increasing, which can get inflationary if they rise too quickly and the velocity of money becomes too strong. However, given the idleness of inflation, there is a lot of runway here.

Corporate investment is poised to continue to grow and business confidence remains high, which should only add fuel to the fire for corporate investment.

According to Strategas Research Partners, corporate tax benefits represent approximately $540 billion, of which dividends and stocks buybacks comprised merely $180 billion. This should serve as another catalyst for capital expenditures, which typically cycle for three to five years and are captured twice in GDP. The thought here is twofold: 1) additional revenues should flow to other firms, as one firm’s capital expenditure is another firm’s revenue, and 2) productivity gains should accrue, which is a goal of capital expenditures in the first place (companies invest to either expand capacity or make their capacity, the largest of which is labor, more productive). This should help to offset wage gains, thereby allowing companies to increase salaries without raising end prices.

C A P I TA L M A R K E T S F O R E C A S T 2019

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CAPITAL MARKETS OUTLOOK To summarize, as an economic cycle ages, inflation rises as demand outpaces supply. As a result, the central bank increases interest rates, thus lowering demand relative to supply. At an inflection point, demand is lowered by enough relative to supply that monetary velocity slows, excess capacity exists, and a contraction begins. In advance of the onset of a contraction, the central bank has lifted short-term interest rates above long-term yields (which represent the market’s price of money given projected inflation rates), thus inverting the yield curve. Since this has not happened yet, we believe there remains time in this secular bull market; however, just as importantly, investors should now expect periods of selloff and consolidation. This is not unheard of historically, with two notable examples in 1984 and 1994, as noted earlier. In both years, we saw market corrections when the Federal Reserve had not yet gone past the point of no return. Given the relatively uniform move higher in U.S. equity markets since 2009, investors may not be prepared to deal with the ramifications and are likely to view volatility as a sign of the beginning of a bear market resembling the last two bear markets. History, however, is chock full of examples of sharp equity market declines without recession. Again, while these can be painful in the short-term, they are healthy for the market longer-term.

Since the bottom in March 2009, only Thai stocks have outperformed U.S. equities, and it is unlikely there were many investors shrewd or bold enough to allocate a majority of their portfolio to Southeast Asian securities. Our takeaways are: 1) the gap between the economy and equities has been larger than in previous cycles, and 2) diversification of any kind outside of U.S. equities has led to underperformance. The latter’s impact on the hedge fund community over the past 10 years is illustrated in Figure 6. Quite simply, diversification has failed on the back of overzealous central bank policy which disproportionately affected U.S. equities at the expense of other asset classes. This has led not only to a gross underperformance in the hedge fund community, but among active managers in general. As can be seen in Figure 7, if we look at the percentage of active managers outperforming their benchmarks, it is surely no coincidence there is a large drop-off concurrent with central bank policy following the global financial crisis.

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Figure 6. Hedge funds (HF) have struggled to generate excess return during this period of zero interest rates.

YEAR

HFRI FUND OF FUNDS

S&P 500

Total Return

Total Return

HF OUTPERFORM?

1990

17.5%

(3.1%)

YES

1991

14.5%

30.5%

NO

1992

12.3%

7.6%

YES

1993

26.3%

10.1%

YES

1994

(3.5%)

1.3%

NO

1995

11.1%

37.6%

NO

1996

14.4%

23.0%

NO

1997

16.2%

33.4%

NO

1998

(5.1%)

28.6%

NO

1999

26.5%

21.0%

YES

2000

4.1%

9.1%)

YES

2001

2.8%

(11.9%)

YES

2002

1.0%

(22.1%)

YES

2003

11.6%

28.7%

NO

2004

6.9%

10.9%

NO

2005

7.5%

4.9%

YES

2006

10.4%

15.8%

NO

2007

10.3%

5.5%

YES

2008

(21.4%)

(37.0%)

YES

2009

11.5%

26.5%

NO

2010

5.7%

15.1%

NO

2011

(5.7%)

2.1%

NO

2012

4.8%

16.0%

NO

2013

9.0%

32.4%

NO

IS THIS THE START OF A

2014

3.4%

13.7%

NO

NEW TREND?

2015

(0.3%)

1.4%

NO

2016

0.5%

12.0%

NO

2017

7.8%

21.8%

NO

2018

(3.5%)

(4.4%)

YES

AS INTEREST RATES HAVE INCREASED, ACTIVE MANAGERS OUTPERFORMED FOR THE FIRST TIME IN 10 YEARS.

Source: FactSet

C A P I TA L M A R K E T S F O R E C A S T 2019

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Figure 7. There is a clear correlation with the Federal Reserve interest rate policy and the ability of active managers to outperform their benchmarks. % of Ac ve Managers Outperforming their Respec ve Benchmarks; Rolling 1-Year Period

80%

Rolling 1-year periods before and during the Global Financial Crisis

70%

Rolling 1-year periods following the Global Financial Crisis

60% 50% 40% 30% 20%

0%

0

/0

12

01 01 /02 /02 /03 /03 /04 /04 /05 /05 /06 /06 /07 /07 /08 /08 /09 /09 /10 /10 /11 /11 /12 /12 /13 /13 /14 /14 /15 /15 /16 /16 /17 /17 /18 /18 6 12 6 6 12 6 6 6/ 12/ 6 12 6 6 12 6 6 12 6 6 12 6 6 12 6 6 12 6 12 12 12 12 12 12 12 12 12

% of Outperforming Managers

Pre-March 2009 Average

Post-March 2009 Average

Sources: S&P and Balentine

The move off a zero lower-bound interest rate is poised to effect changes in the capital markets, which is healthy in the long-run, thus creating opportunities. However, the flip side to the rate increase may be a painful adjustment period in the short term; we believe this may have been a large factor in the December selloff. The consumer remains strong and although the economy is showing signs of slowing, there appears to be a second-derivative effect, which, in our opinion, does not justify a ~10% decline in one month. Higher interest rates should continue to bring greater dispersion into the markets, thereby separating winners from losers rather than effecting a “no losers” market in which active managers are destined to underperform. As seen in Figure 6, 2018 was the first year since 2008 in which active management showed signs of adding value; given the move in interest rates, we do not believe this was coincidental. Higher rates also mean corporate managers should be more disciplined stewards of capital as hurdle rates make for more discerning projects, while earnings growth is poised to be stronger as the U.S. economy continues to prosper. Finally, equity valuations are poised to improve on the back of not only improved long-term earnings growth, but also as the wretched earnings numbers seen from late 2008 through early 2009 roll out of the cyclically adjusted price-to-earnings ratio (i.e., the CAPE ratio). To be clear, this does not mean public markets will go gangbusters, but our expectations are improved, especially after a year like 2018.

Of course, there are risks which could tip the economy into a more prolonged downtrend than expected: 18

• Federal Reserve Interest Rate Policy: The most notable risk is the Federal Reserve increasing rates too quickly. This was another potential catalyst in the December equity market selloff and yield declines, with markets telling the Federal Reserve it had moved interest rates far enough. There is an old saying: “Bull markets do not die of old age but rather by central bank tightening.” A quick ascension in interest rates was a big factor in pricking the housing bubble in 2006; the federal funds rate grew from 1% to 5.25% in a little more than two years.

While we are not experiencing that rate of change today (it has been around 0.75% per year over the past three years), the Federal Reserve does run the risk of moving too quickly. In hindsight, it may have been better to begin earlier and raise rates more slowly. For example, given the strong growth in 2013, perhaps starting with 0.25% and moving another 0.25% in 2014 would have been more effective, allowing the economy and the market to get used to the idea. Now, it appears the equity markets may have gotten ahead of themselves, leading to volatility as rates normalize. As American economist Hyman Minsky famously stated, “Stability begets instability.” Said differently, a larger level of stability will generally lead to a larger mean-reverting level of instability.

Recent flattening and slight inversion at the lower end of the yield curve has some fearing the bond market is forecasting a recession. We do not believe this is the case. If a recession is to occur, we believe it will manifest itself in an inversion in different durations. In fact, as shown in Figure 8, the yield curve has historically proven it can stay flat for a long time before inverting. The market’s outlook seems to be different from the Fed’s; interest rates fell on the Fed’s December announcement, indicating the market is not willing to tolerate any more hikes. In other words, the yield curve is telling the Federal Reserve that rates are closer to neutral than it may think. What this means for future hikes remains to be seen.

Dovish comments made by the Fed while hiking rates in December indicate it has adjusted its outlook to two rate hikes in 2019 versus the previously forecasted three to four hikes. Additional statements indicate it may be inclined to make further revisions, as necessary. Again, recent events do not signal the end of the hiking cycle is upon us; rather, they indicate the market would like a pause in Fed activity. Recency bias would lead investors to conclude a pause could mark the peak of this hiking cycle, but this is not historically the case. As shown in Figure 9, there are examples of a pause or even a modest decline in the federal funds rate before resuming hikes. As illustrated, there also were no recessions after hike slowdowns.

C A P I TA L M A R K E T S F O R E C A S T 2019

19

Figure 8. The yield curve can stay flat for a long time before inverting.

2-Year/10-Year Treasury Spread 400

The me lag from yield curve inversion to the onset of recession.

300

100

(100)

{

{

{

{

0

{

Basis Points

200

The yield curve can stay flat for a long me before inver ng.

(200)

2018

2016

2014

2012

2010

2008

2006

2004

2002

2000

1999

1996

1994

1992

1990

1988

1986

1984

1982

1980

1978

(300)

Recession

Sources: FactSet and the National Bureau of Economic Research (NBER)

Figure 9. A pause by the Federal Reserve does not preclude further rate hikes.

Historical Federal Funds Rate 20% 18% 16% 14% 12% 10% 8% 6% 4% 2%

Recession

20

Sources: FactSet and the National Bureau of Economic Research (NBER)

2019

2017

2015

2013

2011

2009

2007

2005

2003

2001

1999

1997

1995

1993

1991

1989

1987

1985

1983

1981

1979

1977

1975

1973

1971

1969

1967

1965

1963

1961

1959

1957

1955

0%

• Inflation: Inflation can be a funny thing. Many people clamor for it, do not really know it when they see it, and then feel buyer’s remorse when they get a potential whiff of it. Until the recent steep decline in the price of oil and other commodities, there was concern inflation was beginning to rear its ugly head. The reality is we have experienced a lot of inflation over the past ten years if we look at asset prices, but no one is concerned when asset prices rise above intrinsic value on the back of lower-than-normal interest rates. However, with interest rates normalizing, investors are starting to fear the corrosive effect of inflation on corporate margins and household wealth. The trickle down of corporate revenues to wage growth is the first step in bridging the disconnect we have seen between “Main Street” and “Wall Street” over the past ten years. Of course, we do not want wage pressure to get out of hand, as it would put a damper on corporate margins and likely lead to a reversal of unemployment declines. A bit of inflation at the bottom end of the corporate ladder is ultimately a good thing for the American economy in terms of spurring monetary velocity across a greater swath of income brackets. As such, we do not think there should be concern at this point if corporations give a portion of their amped-up margins to employees in order to boost retention.

While this may cause an adjustment in equity markets, we would not expect such an adjustment to be long-lived, assuming companies can continue to grow revenues on the back of a working population which suddenly finds itself able to spend more than in the recent past. Provided the Federal Reserve unwinds its balance sheet in a methodical manner, interest rate increases should remain contained and the economy should continue its positive growth trend. After all, the economy has never gone into a recession with a real federal funds rate of 0% (Figure 10), which represents its current level. We would feel more at ease if long-term rates would resume increasing, not only to steepen the yield curve but also to reflect the bond market’s perception of higher growth. That said, we know never to say never, but we think it wise to rely on historical patterns; at present, signs are not pointing to a recession or an imminent bear market.

• International Trade: There are concerns given the standoff we continue to see between the U.S. and China, but the magnitude of the proposed tariffs continues to be outweighed by the magnitude of the tax relief provided by the Tax Cuts and Jobs Act of 2017. Were this to change, we would reassess our position. Thus far, however, trade war concerns have had a disproportionate effect on the price of Chinese stocks versus U.S. equities. It is important to keep in mind that average tariff rates in the U.S. remain well below historical standards. This does not mean there won’t be fallout, but at this point we believe tariff-related volatility will be more bark than bite.

C A P I TA L M A R K E T S F O R E C A S T 2019

21

Figure 10. Since WWII, we have never had a recession begin with the real federal funds rate at less than ~2%.

Real Federal Funds Rate vs. Recessions 12% 10% 8% 6% 4% 2% 0% -2% -4%

Recession

2018

2016

2014

2012

2010

2008

2006

2004

2002

2000

1998

1996

1994

1992

1990

1988

1986

1984

1982

1980

1978

1976

1974

1972

1970

1968

1966

1964

1962

1960

-0%

Real Rate (PCE)

Source: Strategas REAL FUNDS RATE AT THE START OF RECESSION DATE

RATE

4/60

1.9%

12/69

4.2%

11/73

5.2%

1/80

5.6%

7/81

10.2%

7/90

4.1%

3/01

3.5%

12/07

1.9%

Current

0.0%

Source: Strategas

22

• Slower-than-Expected Earnings Growth: As referenced earlier, we are currently seeing the potential for a slowdown in earnings growth rather than earnings declines. This is a substantive difference, one which could define the gap between a garden variety equity market correction devoid of recession and a difficult bear market featuring an economic recession.

History suggests a slowdown without negative growth is a fairly common occurrence as companies right-size their businesses for a continuation of profitability. Unfortunately, our experience over the last 20 years reveals when growth slows, it turns negative. This has not always been the case, and at this juncture, signs point to a potential slowdown being just that—a modest slowdown, not a pullback. What it does mean for equity markets, however, is that multiples contract as investors are less willing to pay up for earnings streams. While current conditions may not necessarily translate into a substantive bear market, there is potential for a rolling bear market to persist as correlations decline and we see greater return differential among various sectors rather than a one-direction-fits-all market.

A P P E N DI X

C A P I TA L M A R K E T S F O R E C A S T 2019 23

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 are a function of the starting point, specifically, projected income and projected adjustments to valuation. 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.

It is important to note that just because we annually update our strategic forecast for asset classes and the corresponding strategy weights, that does not mean these are tactical, one-year allocations.

Rather, our updated weights 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 is because high profits and momentum attract investors and drive down future returns in highly valued asset classes. Our update includes answers to the following questions: • What returns are realistically possible during the market cycle?

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

• What minimum acceptable real rate of return can be expected from diversification, and in what ways can we bridge the gap between what is possible and what investors require?

Based on our updated projections, we restructure our strategic asset allocation targets in key areas in order 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 to both manage risk and maximize opportunities in 2019 and beyond.

Expected Return and Risk Assumptions Return

Risk

Fixed Income

3.2%

4.0%

Market Risk

7.3%

16.5%

Drawdown Tolerances Global Asset Allocation

24

Aggressive

25%

Growth

20%

Balanced

15%

Conservative

10%

Strategy Weights and Expected Returns Public Markets Aggressive

Growth

Balanced

Conservative

Minimum

Strategic

Maximum

Minimum

Strategic

Maximum

Minimum

Strategic

Maximum

Minimum

Strategic

Maximum

Fixed Income

0.0%

0.0%

20.0%

5.0%

20.0%

40.0%

20.0%

40.0%

60.0%

40.0%

60.0%

80.0%

Market Risk

80.0%

100.0%

100.0%

60.0%

80.0%

95.0%

40.0%

60.0%

80.0%

20.0%

40.0%

60.0%

Return

7.3%

6.5%

5.7%

4.8%

Risk

16.5%

13.4%

10.3%

7.5%

Yield

2.8%

2.9%

3.0%

3.0%

Index Projections Fixed Income YTM

Duration

Bloomberg Barclays U.S. Aggregate

3.2%

5.9

Bloomberg Barclays U.S. Treasury

2.6%

5.9

Bloomberg Barclays U.S. (7Y-10Y)

2.5%

7.5

Bloomberg Barclays U.S. Municipal Bond

2.6%

6.9

Bloomberg Barclays U.S. Aggregate Credit – Corporate – Investment Grade

3.9%

7.0

Bloomberg Barclays Treasury Inflation Protected Notes (TIPS)

2.8%

5.1

Bloomberg Barclays Global Aggregate

1.8%

6.9

Bloomberg Barclays U.S. Aggregate Credit – Corporate – High Yield (1983)

7.3%

3.9

JP Morgan EMBI Global Diversified

6.9%

6.7

Return

Risk

MSCI AC World

5.3%

16.5%

Russell 1000

3.8%

14.5%

Russell 2000

4.1%

19.2%

MSCI EAFE

6.3%

17.0%

MSCI EAFE Small Cap

6.9%

19.7%

MSCI Europe

6.0%

17.0%

MSCI Japan

8.0%

21.0%

10.8%

23.5%

FTSE NAREIT/Equity Diversified – SEC

6.0%

20.0%

Alerian MLP

7.5%

17.6%

Bloomberg Commodity Index

4.2%

20.5%

Market Risk

MSCI EM (Emerging Markets)

C A P I TA L M A R K E T S F O R E C A S T 2019 25

DISCLOSURES GENERAL This information has been prepared by Balentine LLC (“Balentine”) and is intended for informational purposes only. This information should not be construed as investment, legal, and/or tax advice. Additionally, this content is not intended as an offer to sell, or a solicitation of any investment product or service.

OUTLOOK Opinions expressed are solely the opinion of Balentine and should not be relied upon for investment decisions. Certain statements contained herein may constitute projections, forecasts, and other forward-looking statements that do not reflect actual results and are based primarily upon applying retroactively a hypothetical set of assumptions to certain historical financial information. Accordingly, such statements are inherently speculative as they are based on assumptions that may involve known and unknown risks and uncertainties. These statements are based on available information and Balentine’s view as of the time of these statements, are subject to change, and are not intended as a forecast or guarantee of future results. Actual results, performance, or events may differ materially from those expressed or implied in such statements.

THIRD-PARTY DATA The information presented in this publication has been obtained with the greatest of care from sources believed to be reliable.

However, stated information is derived from proprietary and nonproprietary sources that have not been independently verified for accuracy or completeness. Some material may contain information and data provided by independent, third party sources. While Balentine uses sources it considers to be reliable, no guarantee is made regarding the accuracy of information or data provided by third-party sources. Balentine expressly disclaims any liability, including incidental or consequential damages, arising from errors or omissions in this publication.

RISK Investing in securities involves risks, including the potential loss of principal. While equity securities may offer the potential for greater long-term growth than most debt securities, they generally have higher volatility. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles, or from economic or political instability in other nations. Past performance is not indicative of future results.

The appropriateness of an investment or strategy will depend on an investor’s circumstances and objectives. These opinions may not fit to your financial status, risk, and return preferences. Investment recommendations may change, and readers are urged to check with their investment advisors before making any investment decisions.

TERMINOLOGY Balentine utilizes a building blocks approach to asset management. Our building blocks include Fixed Income, Market Risk.

While each building block plays a role in diversification and risk management, all building blocks are subject to their own risks and may lose value. Specifically, the assets in the Fixed Income building block are designed to protect against interest rate fluctuations, credit risks and unanticipated movements in inflation and currency valuations. Fixed Income assets play an important role as a short-term shock absorber, but there is no implication these assets cannot lose value.

26

BALENTINE STRATEGIES PERFORMANCE DATA Performance information for Balentine Strategies (“Strategies”) is computed using weighted average performance of portfolio components (which may include public indices and/or specific investments managed by third-party providers) based on the recommended target weighting for each Strategy during the specified time period. Given that investors cannot invest directly in the indices, Balentine selects passive index funds as proxies for the underlying indices to manage the Strategies. These index funds may be changed from time to time in Balentine’s judgment to best reflect the performance of the indices.

Performance is presented net of (after deducting) the actual embedded expenses of the active or passive funds or vehicles in which investments were assumed to be made (2000-2009) or actually made (2010-Forward), but before deducting a) Balentine’s investment advisory fees which will vary depending on each client’s circumstances and b) transaction costs of implementation (between .15% and .20% per annum). Balentine’s investment advisory fees are described in Part 2 of Balentine’s Form ADV. The results of the Strategies reflect the reinvestment of dividends and other earnings.

Performance information presented for the Strategies for 2000-2009 represents back-tested information for the periods indicated, using monthly rebalancing. Back-testing of performance is prepared using Balentine proprietary asset allocation models that start with the first day of the given time period and evaluate the weighted average performance of the stated indices based on the recommended target weighting for each Strategy. This performance information reflects asset allocation recommendations made to clients but assuming use of index funds only to implement. Accordingly, this information does not represent actual account performance and should not be interpreted as an indication of such performance. Investment decisions during this period were made by members of Balentine’s Investment Strategy Team while employed by Wilmington Trust Company through 2009.

Conversely, all Balentine performance information presented beginning January 1, 2010, represents actual model performance rebalancing decisions in the investments for each Strategy as and when decided by Balentine’s Investment Strategy Team. Each Strategy is invested in the active or passive investment vehicles selected by the Investment Strategy Team and then implemented across all client portfolios. Individual client results may differ by reason of investment in underlying vehicles different than those assumed for the strategy.

As with any investment strategy, there is potential for profit as well as possibility of loss. Past performance is not a guarantee of future results.

C A P I TA L M A R K E T S F O R E C A S T 2019 27

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