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2020 Capital Markets Forecast

Steady at the Helm M A INTA INING IN V E S TMENT DI SCIPLINE W HILE N AV IG ATING THE CUR R ENT S


B A L EN T INE

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2020 C A PI TA L M A R K E T S F O R EC A S T

Contents Overview 1 Maintaining Investment Discipline

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Peak Private Equity? Time for Patient Caution at a Crossroads for Private Capital

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With Today’s Low Rates, What About Income?

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Appendix 17 Expected Return and Risk Assumptions Across Building Blocks

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Correlation Assumptions Across Building Blocks

18

Drawdown Tolerances

18

Strategy Weights and Expected Returns: Public Markets

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Strategy Weights and Expected Returns: Fully Diversified

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Index Projections

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Disclosures

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Overview Balentine’s building blocks framework is as follows:

Balentine’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

Liquid – Assets in this building block insulate near-

blocks. Balentine’s Investment Strategy Team has

term spending needs and seek to protect against

honed this process over many years. Projections

interest rate risk and credit risk. Allocations to cash

in the Capital Markets Forecast help our team

help avoid permanently impairing capital when

design strategies which increase the probability

portfolios need to make frequent distributions.

of reaching individual goals by maximizing riskadjusted returns. Though we tailor strategies to the

Fixed Income – Fixed Income assets primarily

unique objectives of our clients, we illustrate the

play a role as a “shock absorber” within strategies

trade-offs between expected return and risk from

to provide protection when risk assets experience

today’s starting point by evaluating four different

short-term duress. Secondarily, at higher interest

levels of risk aversion.

rate levels, Fixed Income provides cash flow while managing against interest rate fluctuations, credit

We base risk budgets on long-term historical

risks, currency movements, and unexpected inflation.

outcomes of bond and equity benchmarks. Strategies range from Conservative (with volatility

Market Risk – The most volatile component

characteristics of a 100% bond portfolio) to

of strategies, Market Risk aims to capture public

Aggressive (with volatility characteristics of a

market equity returns, which are driven by

100% equity portfolio), with Balanced and Growth

exposure to underlying economic growth, earnings,

strategies in between. For each level of risk, we

and current and expected future interest rates.

construct Public Market and Fully Diversified options, both with and without Private Capital, to

Alternatives – We allocate capital in this building

exhibit compromises among reducing volatility

block to investments which seek to generate

and the ability to achieve outsized upside.

returns by capturing risk premia generally not available in the public market arena. The primary goal of Alternatives is to provide additional diversification to portfolios with relatively limited correlation to equity and fixed income markets.

Private Capital – Private Capital investments are not available in public markets and are characterized by illiquidity. Private Capital can achieve strong returns over the long-term, enhancing income generation and capital appreciation. 1


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2020 C A PI TA L M A R K E T S F O R EC A S T

Maintaining Investment Discipline In some ways, we live and invest in atypical times,

volatility on top of a robust return, 2019 was the

at least from a financial markets’ perspective. Take

best year for global equities that this historic bull

the rate on the 10-year Treasury note. In 2019, the

market 3 has seen (Figures 1 and 2).

rate briefly fell below 1.5%. Almost 40 years ago, in the 1980s, the 10-year Treasury note yielded more

Figure 1. Best year of this bull market? 2019’s total return exceeded 2017’s...

than ten times that amount. To earn $150,000 in interest last year, an investor needed $10 million

2010–2019 Annual Returns (MSCI ACWI), Ranked

in principal—versus less than $1 million in 1981. Believe it or not, despite the scorn directed at current rates, buying a 10-year Treasury bond

25%

may be reasonable when you compare it to the

20%

$14 trillion changing hands in negative-yielding global debt. Think about this for a minute: investors

15%

are paying governments to loan to them, not

10%

vice versa.

1

5% 0%

Despite the unusual environment, 2019 was a phenomenal year for capital markets with equities

(5%)

returning 27.3%.2 In fact, aside from 2017, which

(10%)

may go down as one of the best years in stock market history given the tremendously low

2019 2017 2013 2012 2010 2016 2014 2015 2011 2018

Source: FactSet

Governments are not paying coupons; instead, these are zero-coupon bonds in which the bondholder will receive less money back than originally loaned. As measured by the MSCI All Country World Index (ACWI) 3 This bull market, the longest running in history, will turn 11 in March 2020. 1 

2

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S T E A DY AT T HE HEL M

Figure 2. ‌but low volatility within equities may make the case for 2017. 2017 vs. 2019 Returns Across Indices 25%

20%

15%

In 2017, equity volatility was historically low across global regions, making the path higher much smoother.

10%

5%

0% 2017

2019

(5%) MSCI ACWI

Russell 1000 Value

Russell 2000 Value

MSCI EAFE Small Cap

Russell 1000 Growth

Russell 2000 Growth

MSCI EAFE

MSCI EM (Emerging Markets)

Source: FactSet

Nevertheless, sentiment remains tepid at best.

Adding to what should be more bullish sentiment is

Despite solid fundamentals, some surveys show

the possibility of improved growth due to thawing

bearish outlooks are more pervasive than they

trade tensions. More importantly, the Federal

have been in two decades. Domestically, although

Reserve has pivoted from its hawkish tendencies to

economic growth has slowed, the trajectory

favor rate cuts and more data dependency, helping

remains positive, buoyed by a robust consumer

the yield curve regain a positive slope. Following

resulting from historically low unemployment and

are promising developments we observed toward

wage gains. Globally, growth remains lukewarm,

the end of 2019.

but signs of improvement have made their way into global equity prices. In prior eras, these conditions would have infused optimism.

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Equity markets experienced a sustainable breakout following 21 months of little progress. From the peak in January 2018 until

There was movement toward cyclicality across sectors, regions, and the cap scale.

the October 2019 breakout, we saw many subtle

when investing in U.S. large-cap technology stocks

bear markets. Entire cyclical sectors (e.g.,

was the only game in town. Breadth is widening

semiconductors, autos, banks) were down

tremendously both domestically and globally. In

30%–40%, and leaders turned into laggards.

the U.S., industrial and financial stocks are breaking

For example, prior market leader Apple fell 40%

out, while consumer discretionary stocks remain

before regaining its footing and going on to

strong, shaking off concerns about the economy,

exceed prior highs.

global trade wars, and idiosyncrasies about their

This is vastly different from the peak in 2018,

largest respective securities, Boeing and Amazon.

Yields came off their lows, and the yield curve steepened out of an inversion.

Except for energy (which is still languishing), all

The bond market, which is traditionally a better

utilities and consumer staples are performing

predictor of economic weakness than the stock

decently despite the move toward riskier assets.

other sectors continue to trade strongly. Even

market, backed off its doomsday stance. The

Almost half of global markets broke out to new 52-week highs toward the end of the year. Notably, this included a swath of European

10-Year Treasury looked ready to break the all-time low of 1.39% before its reversal.

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FAANG5 stocks reasserted themselves.

nations which were recently lagging (e.g., Germany,

Facebook, Apple, Netflix, and Google pushed

France, Italy, and even Greece). Keep in mind that

higher despite consistent concerns about

capital markets historically tend to lead economies.

regulation (Facebook and Google) and potential

In other words, by the time the economic data

growth erosion from competition (Apple and

changes, the market has already detected the

Netflix). While Amazon has yet to get its mojo back,

likely shift and has repositioned accordingly. In

investors have taken a liking to companies poised

this case, we believe the market is telling us next

to compete—including Walmart, Target, Costco,

year’s growth will be better than people think, thus

Home Depot, and Lowe’s.

removing another brick from the “wall of worry.”

High-yield spreads remained low. Although energy high-yield spreads began to tick up as the relative woes of the energy sector continue five years after the great oil price collapse, the remaining sectors are not indicating any abnormal stress. This is a crucial point, as bond market anxiety has typically preceded equity market tension in cases of structural concern. The 10-Year Treasury sank to 1.43% on September 2, 2019. FAANG is the acronym for five of the market’s most widely held technology and communications stocks: Facebook, Apple, Amazon, Netflix, and Google (now Alphabet).

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Given this broad participation, a short-term risk

in tandem with weakness in recent public offerings

in 2020 is investors finding themselves offsides,

(e.g., Uber, Lyft, Peloton, Slack), reinforces our

yet again, by being under-allocated to stocks. We

belief that current sentiment is far from the

have identified potential challenges in the private

euphoria and irrationality typically associated with

market, but we believe those concerns are being

market tops. While not guaranteed, the continued

addressed. As a result, we remain optimistic overall

lack of bullish sentiment and positioning should

on private equity (which we touch upon later in this

serve as a tailwind for public markets.

publication). However, the WeWork debacle,

As Worries Become Structurally More Excessive than Appropriate, an Investment Process Should Keep Investors Grounded Why are investors so anxious and concerned? We

not immune from criticism. Populism is raging

believe the answer is twofold: 1) residual scarring

against the upper class and, in many cases,

from the Global Financial Crisis (GFC), and

against capitalism in general. Corporate tax rates

2) information overload which tilts investors’

and stock repurchases have become fodder for

biases toward fear and greed more than ever

populist torches and pitchforks. Similar to negative

before. We believe the latter is a more serious

bond yields, did we ever foresee a time when the

concern because it indicates a structural change

capitalist system in the U.S. would be questioned

to the investment landscape which will likely never

to such a degree that political candidates would

disappear. Although it has been almost 11 years

suggest socialism as a viable alternative?

since the end of the GFC, the former will inevitably prove to be transitory; it took decades after the

How does an investor confidently invest their

Great Depression for animal spirits to return, but

wealth under such conditions? The key is to have an

return they did. The information age, for better or

investment process that works through thick and

for worse, is here to stay.

thin, allowing the client to cut through the noise

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and focus on what matters. Portfolio shifts and It is no secret that the media’s quest for clicks

reallocations are often integral to this process, but

and eyeballs have led them to bias their financial

wholesale buying and selling on respective feelings

stories toward sensationalism and fear rather than

of greed and fear in response to market noise is

conveying true, useful financial news—but that is

not. This leads us to two questions:

not the only problem. Extreme market responses

1. What makes up an investment process?

to monetary policy and a highly partisan political culture also play a role. Social concerns such as

2. How does an investment process determine what is simply noise?

wealth inequality run rampant; even CEOs who have created tremendous shareholder value are 6

British economist John Maynard Keynes coined the term “animal spirits” to refer to emotional (versus rational) mindsets that influence and guide human behavior.

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2020 C A PI TA L M A R K E T S F O R EC A S T

First, there are two axioms which give an investment process its foundation: 1. I nvesting must come with some level of uncertainty.

There is a level of uncertainty inherent in investing; without it, there would be no risk premium and prices would already be high to reflect the lack of

2. H  aving a defined investment process increases the chances of success amid uncertainty by sticking to a discipline which works more often than not, preventing emotions from taking over decision-making.

need to discount for risk. Thus, there would be no opportunity to make money. But why does it always seem as if uncertainty is more elevated than usual? Our hindsight biases cause us to forget there were concerns during previous up phases of bull markets. Instead, we focus on the results and assume everything was copacetic during those periods. But make no mistake, the stresses were there. Figure 3 shows a sampling of fears during the 1982–2000 bull market.

Figure 3. The Wall of Worry During the 1982–2000 Bull Market S&P 500 Index: 1982–2000 Bull Market

Bear Market Peak...Finally Clinton Impeachment

1,600

Russian Ruble Crisis Savings and Loan Crisis Onset

800

Alan Greenspan’s “Irrational Exuberance” Warning

S&L Crisis Climax and Resolution

Unexpected Return of Inflation

Black Monday

Louvre Accord 400

Great Bond Massacre

Junk Bond Crash Asian Currency Crisis

Iran-Contra Hearings Recession ar

dW

200

100

Y2K

Col

Plaza Accord

Long-Term Capital Management Collapse and Bailout

Mexican Peso Crisis

Gulf War

Latin American Debt Crisis 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

Sources: FactSet and Balentine

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There will always be concerns in the markets, which is why there are always some investors who position themselves more defensively than offensively. To date, none of these worries have resulted in permanent ruin, as the broader market has always regained its footing. In his noteworthy “Buy American. I Am.” op-ed, published in The New York Times during the heart of the Great Financial Crisis, Warren Buffett wrote:

“

...bad news is an investor’s best friend. It lets you buy a slice of America’s future at a marked-down price. Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.”

Market guru Peter Lynch, who ran the Fidelity Magellan Fund from 1977–1990, took a different tack. Not only are such market episodes inevitable, but their timing is the ultimate in uncertainty:

“

Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves...If you’re in the market, you have to know there’s going to be declines. And they’re going to cap and every couple of years you’re going to get a 10% correction. That’s a euphemism for losing a lot of money rapidly...And a bear market is a 20–25–30 percent decline…If you’re not ready for that, you shouldn’t be in the stock market.”

Uncertainty is a given in investing. In fact, outside of a risk-free investment, which begets the lowest guaranteed rate of return, the only certainty is that there will be uncertainty. Furthermore, the timing and magnitude of such episodes is anyone’s guess. If these anxieties did not exist there would be no compensation for taking equity risk; consequently, there would be far fewer opportunities for investors to generate reasonable returns from their investments. To take this argument a step further, investor anxiety prevents investors and traders from overweighting their portfolios with equities. This, in turn, prevents the stock market from getting too far ahead of itself.

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2020 C A PI TA L M A R K E T S F O R EC A S T

What about the wall of worry during this bull run? Let us count the ways... Figure 4. The Wall of Worry During the Current Bull Market S&P 500 Index: 2009–2019

ar

a Trade W

.-Chin U.S.-North Korea Tension U.S

Greek Bailout Referendum 2,400

U.S. Government Shutdown

Zika Virus Epidemic Donald Trump Elected U.S. President

U.S. Debt Downgrade Japan Earthquake

Oil Price Collapse

BP Oil Spill

Brexit Referendum

Federal Reserve Policy Anxiety

U.S.-led airstrikes in Syria, Hong Kong Protests, and Ebola Contagion Fears

1,200

Trump Impeachment

Taper Tantrum Arab Spring Flash Crash

600

Chrysler/GM File for Bankruptcy 2009

2010

2011

Mueller Report

Cyprus Financial Crisis U.S. Fiscal Cliff Concerns European Debt Crisis 2012

2013

2014

2015

2016

2017

2018

2019

Sources: FactSet and Balentine

This chart is analogous to the prior bull market

to a focus on short-term outcomes and assuming

shown (Figure 3). Reiterating our earlier point,

those outcomes can be extrapolated into the

following a defined process allows investors to

future with little or no regard for the process which

tune out the noise in the market and focus on

generated the original decisions. The reality is

what matters. People often make the mistake of

that process and outcome are, unfortunately, not

assuming good outcomes necessarily stem from

perfectly correlated; while a good (or bad) outcome

good processes and vice versa. This is colloquially

is likely a product of a good (or bad) process, this

known as “resulting.” Perhaps no space embodies

is not always the case. Figure 5 demonstrates a

this more than the investing world. Resulting leads

matrix of different process/outcome combinations.

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Figure 5. Process and Outcome Are Not Perfectly Correlated Good Outcome

Bad Outcome

Good Process

Deserved Success

Bad Break

Bad Process

Dumb Luck

Poetic Justice

Source: Winning Decisions: Getting it Right the First Time by J. Edward Russo and Paul J.H. Schoemaker

When it comes to much of decision-making in

What makes a good process? For starters, it is

life and, specifically, investing, often the only

comprised of three steps: 1) investor analysis,

given is there is no given. In contrast with the

2) portfolio construction, and 3) evaluation.

deterministic (i.e., not random in the long run) risk

All three are critically important, but the focus

assumed by entities like casinos, the uncertainty in

of this piece is on portfolio construction.

investing has an undefined outcome distribution. In other words, when a casino takes risk, it knows

Balentine’s investment process follows this

statistically how many times a certain outcome will

paradigm, weighing probabilities and the risk/

come up for all its games. As a result, the casino

reward trade-off to determine the optimal decision.

can price the games such that even though it may

Although this publication assembles asset class

lose in the short run, it is statistically improbable

forecasts to best determine the appropriate

to lose in the long run. Investing rarely, if ever,

strategic allocations in each strategy, projections

features such a dynamic. The distribution of

have an infinite number of possibilities and paths

possible outcomes is essentially infinite and

as capital markets progress over seven years. As

relatively random, ranging from the “realistic”

a result, it is easy to get overly concerned about

outcomes to the highly unlikely “black swan”

the level of precision imputed on these forecasts

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outcomes. Such results make decision-making

rather than looking at the bigger picture of what

challenging not only because of the uncertainty

they are saying about markets directionally. We

of what may happen, but also because people are

know even if we hit our forecasts, the path to get

biased to believe the possible outcomes will fall

there will likely be lumpy. In fact, while the current

only in their perceived ranges, which are often

bull market has come with little volatility, the ten

too narrow.

years preceding it featured two bear markets. And, in our opinion, the next ten years are more likely to

This is where the investment process comes

look like the latter. As a result, our process employs

into play. A successful process is not about

a tactical approach to allow us to take advantage of

guaranteeing results in any specific instance;

different portions of the cycle, both in the bullish

rather, it is focused on maximizing overall chances

and bearish phases.

across the life of the process. An investment methodology should be dually focused on generating returns and managing risk.

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9

The term, popularized by investor and statistician Nassim Nicholas Taleb, refers to events characterized by their extreme rarity, their severe impact, and the practice of explaining widespread failure to predict them as simple folly in hindsight.


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Our process allows us to navigate various market conditions by sticking to a discipline predicated on two important points:

Additionally, within our allocations, momentum allows us to emphasize areas in which the market is applying capital while under-allocating to areas the market is avoiding. As an example, as growth stocks complete 13 consecutive years of relative

1. Momentum in an asset class is subject to Newton’s First Law in that it stays in motion until acted upon by an external force.

outperformance, many investors today have never seen a market in which value stocks were the superior market driver. Similar to the stocks versus bonds decision, some may extrapolate that growth’s run will continue indefinitely. Sticking

2. Investors will typically not sell one asset class in favor of another until it gets sufficiently expensive.

with a process will allow us to overcome these temptations and will put us in a position to select the equities viewed most favorably by the market at a given time. Again, there are no guarantees over

This philosophy has served us well; in the case

any specific time-frame with this methodology,

of assets with lower correlation (e.g., stocks and

but it does shift the odds in our favor in what is an

bonds), momentum begets momentum and reveals

inherently uncertain environment.

where the market is putting its money, and relative value signals when the money flow is poised to

When it comes to the evaluation part of investing,

change. The combination allows us not only to take

many investors unfortunately place too high a

advantage of excessively depressed prices when

premium on results over process. This is not to

the environment is too fearful, but also to sidestep

suggest results are not important in the long run.

problems when the environment is too greedy;

However, evaluating any decision based solely on

our model positioned us appropriately during both

the short-term results with no contemplation of the

traumatic bear markets during the decade from

process which went into the decision can lead to a

2000–2009. Although the discipline has not been

falsely high level of confidence in the repeatability

able to demonstrate its full prowess this decade

of the result. This will inevitably lead to investors

without a bear market, it has been, in general, on

either forgoing appropriate calculated risks for fear

the right side of the stocks versus bonds asset

of “bad breaks” or taking on inappropriate risk to

allocation decision. Assuming investors do not

repeat “dumb luck,” neither of which is part of a

inappropriately extrapolate the success of the last

suitable process for generating investment success.

decade to the next decade (i.e., assuming the next decade looks less like relatively smooth 2010–2019

The market has repeatedly proven that substantive

and, rather, more like the volatile 2000–2009

bear markets do not occur until equities become

period), we would be well served to stick with

sufficiently expensive relative to bonds. To get

the discipline our process affords us.

from where we are now to this point would require a combination of rising bond yields and an adequately large equity market multiple. Rising rates would not only drive bond prices down, but

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they would also make the risk-free rate compelling

As a classic example, recall former Federal Reserve

enough to offer an alternative to equities. Higher

Chairman Alan Greenspan’s famous “irrational

equity market multiples would result from growth

exuberance” 8 speech in which he warned the

in earnings lagging growth in equity market prices.

market had gone too high, too fast and investor

Furthermore, in the absence of sharply rising

zeal was not warranted. Ultimately, the internet

bond yields (a scenario which could play out given

bubble burst four years later, proving his point.

low inflation and vigorous central bank policy), it

However, the best returns of the market often

would take an even larger increase in equity prices

occur at the end of a growth cycle, and even the

relative to earnings. In either scenario, the bull

smartest person in the room can miss it by a

market should still have room to run.

few years.

This said, it is only a matter of time until this

Uncertainty, both in time and in magnitude, is

historic bull market comes to an end, the current

something with which all investors must live.

unknowns being when and why. As noted in

Following an investment process maximizes

Balentine’s 2018 Capital Markets Forecast, virtually

investors’ probability of success by maintaining

every bear market of the past 75 years has involved

discipline and reducing (if not eliminating)

either a military element or a domestic economic

the likelihood of biases and emotions driving

event. We saw signs of this in late 2017 and early

investment decision-making.

2018, but it became self-limiting as fear reemerged. If history is a guidepost, fear will need to decrease for an extended period while animal spirits assert themselves before this market tops out. Being bearish on stocks simply because of their valuations reminds us of the saying about the stopped clock being right twice a day. Valuations, in and of themselves, are terrible timing indicators.

8

T his term is used to describe a heightened state of speculative fervor.

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Peak Private Equity? Time for Patient Caution at a Crossroads for Private Capital An estimated $1.4 trillion of committed private

up to a point at which future returns may be

equity is uninvested. To put that number in

more meager. Additionally, and perhaps more

perspective, many suggested we had reached

concerning, the traditional spread between private

“peak” hedge fund when invested hedge fund

equity and public equity continues to narrow

assets reached $1 trillion. As we approach the

as large institutions are increasingly willing to

thirteenth anniversary of the largest buyout in

discount the illiquidity premium the asset class has

history, there is talk of peak private equity. While

historically provided. Due to the long-dated nature

flows into the asset class are unlikely to recede

of private equity, it is both difficult and dangerous

or stop, they may slow as investors become less

to make pronouncements based on short-term

satisfied with the asset class.

data. However, private equity’s historical 300–600

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basis points of outperformance over public equity There is a concern that the $1.4 trillion of uninvested

has narrowed in recent years to only a few basis

capital has caused private multiples to be bid

points, as shown in Figure 6.

Figure 6. The Performance Gap Between Private and Public Equity Has Narrowed Rolling Five-Year Annualized Returns 30% 20% 10% 0% (10%) 1991 Source: FactSet 9  As of Q3 2019

1993

1995

1997

1999

2001

2003

2005

2007

Cambridge Associates LLC U.S. Private Equity®

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2009

2011

2013

S&P 500 Index

2015

2017

2019


S T E A DY AT T HE HEL M

This phenomenon is a result of unprecedented

“Observe due measure; moderation is best in all things.”

flows into the asset class and the fact that an increasingly substantial portion of the economy remains private as companies delay or forgo going

public. In the 13 years since KKR’s buyout of TXU

–Hesiod (c. 750 BC)

marked the previous top for private equity, there are now 1,000 fewer public companies—a

As a result, we continue to encourage investors

reduction of nearly 20%.

to have meaningful exposure to private capital in a diversified manner, encompassing the

Despite these challenges, we remain constructive

gamut of funds engaging in venture capital,

on elements of private equity. We continue to

leverage buyouts, real estate, infrastructure,

believe that private markets provide a clear and

and natural resources. In this low-return

sustainable advantage over public markets,

environment, investors who have the requisite

with unique and diverse ways to add value.

illiquidity tolerance should allocate up to 20%

Our philosophy on private equity is to focus on

of their investable assets in private capital

finding managers in niche areas that benefit

vehicles. However, the overhang of excess cash

from market inefficiencies, which is an important

in funds’ pockets (commonly known in private

distinction to simply investing with the bigger

equity parlance as “dry powder”) combined

players such as Blackstone, KKR, Carlyle, and

with diminishing illiquidity premiums mean

TPG. Our managers play an active role in creating

investors need to be cautious when imitating the

value for the underlying investments, which we

endowment model of overweighting private equity.

believe is a repeatable process as opposed to the

As many well remember, disregarding a portfolio’s

mere financial engineering in which some private

liquidity needs was painful during the

equity managers engage. As such, we continue to

Great Financial Crisis, even for the industry’s

find sector-specific managers with track records

investment behemoths.

and approaches that present the possibility of outperforming their benchmarks, even as bigger

Nearly three millennia before the TXU buyout,

players in the industry dominate the headlines

the Greek poet Hesiod articulated his well-known

with limited outperformance.

philosophy of moderation in all things. Today, as we approach peak private equity, we would do well to remember his adage of discernment and finding the right sandboxes in which to play.

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With Today’s Low Rates, What About Income? Historically, the playbook for finding yield

Investors can move further along the Treasury yield

in portfolios has been an easy one: buy U.S.

curve and pick up another 0.5%, buy corporate

Treasuries. For the majority of the 1980s, an

bonds for an additional 1.5%–2.0%, or reach into

investor seeking $100,000 of annual income would

the high-yield market for 3.0%–4.0%. There are

have needed to buy $1,000,000 worth of 10-year

no free lunches, however. Credit spreads trend in

U.S. Treasuries and clip the coupons. Along with a

line with equity markets, and they have historically

healthy flow of income, investors benefited from

risen during times of economic stress. Rising

consistent rate declines. Since bonds gain value

spreads have the same effect as rising rates—

when rates go down, this provided an almost

bonds lose value.

no-lose scenario for bondholders. In addition to providing income, Balentine believes This paradigm no longer exists, unfortunately.

bonds serve as a ballast to equities in today’s

With 10-year U.S. Treasury rates between 1.5% and

environment. As such, we construct portfolios

2.0%, investors must invest $5–$6 million for the

with a blend of bonds, stocks, and in some cases,

same amount of income. Compounding the issue,

alternatives, to provide a high level of confidence

the current environment does not promote much

around a worst-case scenario drawdown. We then

room for bond values to rise from falling yields.

tactically allocate to and away from fixed income

(This is not to say yields cannot go down further

based on the likelihood of stocks outperforming

in the near term, but the likelihood of a repeat of

bonds to create a portfolio minimally allocated to

the stellar capital gains during the last 37 years is

bonds when rates are rising (and values are falling),

relatively low.) The result is a thin margin of safety

and with increased exposure to bonds when rates

for any bond allocation. An investor holding a

are falling (and values are rising). At today’s lower

10-year bond can have three-to-four years

rates, bonds can provide stability given that a 1%

of income wiped out if interest rates rise 1%.

decline in interest rates would equate to a 6%–7%

While this sounds unenviable, the alternative of

return in bonds.

permanently low rates could be worse.

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S T E A DY AT T HE HEL M

Balentine believes investors in search of income should move beyond the two traditional levers, credit and maturity, to a third—illiquidity. By introducing illiquid investments (Figure 7), we

CREDIT

can add income well above U.S. Treasuries while

MATURITY

ILLIQUIDITY

achieving a new level of diversification.

Figure 7. Examples of Illiquid Asset Classes Senior Secured Lending

Pharmaceutical Royalties

Issuing money to smaller companies

Purchasing a future stream of cash

backed by the assets at that company

from drugs in the process of approval

Distressed Credit

Music Royalties

Purchasing loans of companies that

Purchasing the rights to a song in

have had some form of default and

exchange for royalties each time

working with them to recover

someone plays or streams it

Specialty Credit

Life Settlements

Esoteric lending typically backed

Purchasing and maintaining life

by assets

insurance policies in exchange for a lump sum when the holders pass away

Reinsurance Providing insurance to insurance

Litigation Finance

companies in exchange for premiums

Providing money for lawyers to prosecute cases in exchange for a portion of the settlement proceeds

Asset Leasing Owning and leasing significant assets such as airplanes, ships, and trains

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2020 C A PI TA L M A R K E T S F O R EC A S T

Illiquid investments can enhance private capital and/or income segments of a portfolio, as the diversified income streams typically begin paying distributions quicker than traditional private equity. An allocation to these assets can shorten the J-curve of a private portfolio, providing early success in a program. Importantly, these assets can produce uncorrelated returns to venture capital, buyout, real estate, or infrastructure. Dividends are an additional solution to the yield dilemma. For example, as we harvest tax losses on individual securities, we can tilt toward higher-yielding securities within the ACWI index as opposed to investing in riskier assets such as master limited partnerships (MLPs)10 and highyield bonds. (This is not to imply there is never a time for these securities; rather, they should not be purchased exclusively to generate yield without considering the potential for capital losses.) If the modern-day purpose of bonds is to diversify equity risk in a portfolio, a mix of private income investments can do one better, providing higher income along the way. The illiquid asset classes shown in Figure 7 are mostly disconnected from the gyrations of the macroeconomic landscape. While they do not provide the protection of bonds when equities suddenly drop, they offer de facto diversification by providing access to a different risk premium. So, while low inflation and slowing global growth will likely keep bond yields low, investors with a substantial portion of their assets in high-quality bonds can look to the private markets for further diversification and a high level of income.

This is a business venture that exists in the form of a publicly traded limited partnership. It combines the tax benefits of a private partnership (i.e., profits are taxed only when investors receive distributions) with the liquidity of a publicly traded company.

10 

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S T E A DY AT T HE HEL M

Appendix Each year, we update our forecast of capital market returns for the next market cycle (measured as seven years). Future market returns are a function of the starting point, projected income, and projected adjustments to valuation. We update our Capital Markets Forecast for asset classes and the corresponding strategy weights on an annual basis, but this does not mean these are tactical, one-year allocations. Instead, 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 occurs because high profits and momentum attract investors and drive down future returns in highly valued asset classes. Our annual update includes answers to the following questions:

• What returns are realistic during the market cycle? • What risks may have to be assumed to capture those returns? • What minimum acceptable real rate of return is expected from diversification, and how can we bridge the gap between what is possible and what investors require? • For portfolios supporting frequent distributions, what is a sustainable spending rate that minimizes the probability of permanently impairing capital after inflation? • What opportunities do investments in private markets have to offer? Based upon our updated projections, we restructure our strategic asset allocation targets in key areas to maximize the efficiency of our strategies and, therefore, to 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 2020 and beyond.

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Expected Return and Risk Assumptions Across Building Blocks Return

Risk

Fixed Income

2.3%

4.0%

Market Risk

7.4%

16.0%

Alternatives

6.0%

9.0%

Private Capital

10.4%

10.0%

Source: Balentine

Correlation Assumptions Across Building Blocks Fixed Income

Market Risk

Alternatives

Private Capital

Fixed Income

1.0

0.1

0.0

0.0

Market Risk

0.1

1.0

0.0

0.8

Alternatives

0.0

0.0

1.0

0.0

Private Capital

0.0

0.8

0.0

1.0

Source: Balentine

Drawdown Tolerances Public Markets

Fully Diversified

Aggressive

25%

20%

Growth

20%

15%

Balanced

15%

10%

Conservative

10%

5%

Source: Balentine

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S T E A DY AT T HE HEL M

Strategy Weights and Expected Returns: Public Markets Public Markets Aggressive Fixed Income

Growth

Balanced

Min

Strategic

Max

Min

Strategic

0.0%

0.0%

20.0%

5.0%

20.0%

40.0% 20.0%

40.0%

100.0% 60.0%

80.0%

95.0% 42.5%

60.0%

Market Risk 80.0% Return

100.0%

Max

Min

Strategic

Conservative Max

Min

Strategic

Max

57.5% 40.0%

60.0%

72.5%

80.0% 27.5%

40.0%

60.0%

7.4%

6.4%

5.4%

4.3%

Risk

16.0%

12.9%

9.9%

7.1%

Yield

2.5%

2.5%

2.4%

2.4%

Source: Balentine

Public Markets Strategic Global Allocation (SGA) Aggressive Fixed Income

Growth

Balanced

Min

Strategic

Max

Min

Strategic

0.0%

0.0%

20.0%

5.0%

20.0%

40.0% 20.0%

40.0%

100.0% 60.0%

80.0%

95.0% 42.5%

60.0%

Market Risk 80.0%

100.0%

Max

Min

Strategic

Conservative Max

Min

Strategic

Max

57.5% 40.0%

60.0%

72.5%

80.0% 27.5%

40.0%

60.0%

Return

6.6%

5.7%

4.9%

4.0%

Risk

16.0%

12.9%

9.9%

7.1%

Yield

2.5%

2.5%

2.4%

2.4%

Source: Balentine

Public Markets with Private Capital Aggressive

Growth

Balanced

Min

Strategic

Max

Min

Strategic

0.0%

0.0%

17.5%

7.5%

15.0%

35.0% 25.0%

32.5%

Market Risk 62.5%

80.0%

80.0% 45.0%

65.0%

72.5% 30.0%

47.5%

Fixed Income

Max

Min

Strategic

Conservative Max

Min

Strategic

Max

50.0% 42.5%

47.5%

62.5%

55.0% 17.5%

32.5%

37.5%

Private Capital

20.0%

20.0%

20.0%

20.0%

Return

8.0%

7.2%

6.3%

5.6%

Risk

14.4%

12.1%

9.5%

7.3%

Yield

2.0%

2.0%

1.9%

1.9%

Source: Balentine

Public Markets SGA with Private Capital Aggressive

Growth

Balanced

Min

Strategic

Max

Min

Strategic

Strategic

Max

0.0%

0.0%

17.5%

7.5%

15.0%

35.0% 25.0%

32.5%

50.0% 42.5%

47.5%

62.5%

Market Risk 62.5%

80.0%

80.0% 45.0%

65.0%

72.5% 30.0%

47.5%

55.0% 17.5%

32.5%

37.5%

Fixed Income

Max

Min

Strategic

Conservative Max

Min

Private Capital

20.0%

20.0%

20.0%

20.0%

Return

7.4%

6.7%

6.0%

5.3%

Risk

14.4%

12.1%

9.5%

7.3%

Yield

2.0%

2.0%

1.9%

1.9%

Source: Balentine

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Strategy Weights and Expected Returns: Fully Diversified Fully Diversified Aggressive

Growth

Balanced

Min

Strategic

Max

Min

Strategic

0.0%

0.0%

17.5%

5.0%

17.5%

37.5% 25.0%

Market Risk 72.5%

90.0%

90.0% 52.5%

72.5%

85.0% 37.5%

Alternatives

10.0%

Fixed Income

Return

Max

Min

Strategic

Conservative Max

Min

35.0%

52.5% 42.5%

55.0%

65.0% 22.5%

10.0%

10.0%

Strategic

Max

55.0%

67.5%

35.0%

47.5%

10.0%

7.3%

6.4%

5.5%

4.5%

Risk

14.4%

11.7%

9.1%

6.3%

Yield

2.9%

2.8%

2.8%

2.7%

Source: Balentine

Fully Diversified Strategic Global Allocation (SGA) Aggressive Fixed Income

Growth

Min

Strategic

Max

Min

0.0%

0.0%

17.5% 10.0% 90.0% 52.5%

Strategic

Balanced Max

Min

17.5%

37.5% 27.5%

72.5%

80.0% 37.5%

Strategic

Conservative Max

Min

35.0%

52.5% 45.0%

55.0%

62.5% 22.5%

Strategic

Max

55.0%

67.5%

35.0%

45.0%

Market Risk 72.5%

90.0%

Alternatives

10.0%

10.0%

10.0%

10.0%

Return

6.5%

5.8%

5.0%

4.2%

Risk

14.4%

11.7%

9.1%

6.3%

Yield

2.9%

2.8%

2.8%

2.7%

Source: Balentine

Fully Diversified with Private Capital Aggressive

Growth

Balanced

Min

Strategic

Max

Min

Strategic

Strategic

Max

0.0%

0.0%

17.5%

2.5%

15.0%

32.5% 12.5%

30.0%

47.5% 30.0%

42.5%

57.5%

Market Risk 55.0%

72.5%

72.5% 40.0%

57.5%

70.0% 25.0%

42.5%

60.0% 15.0%

30.0%

42.5%

Fixed Income Alternatives

Max

Min

Strategic

Conservative Max

Min

7.5%

7.5%

7.5%

7.5%

20.0%

20.0%

20.0%

20.0%

7.9%

7.1%

6.4%

5.7%

Risk

13.3%

11.0%

8.7%

6.9%

Yield

2.3%

2.2%

2.2%

2.2%

Private Capital Return

Source: Balentine

Fully Diversified SGA with Private Capital Aggressive Min

Fixed Income

Strategic

Growth Max

Min

Strategic

Balanced Max

Min

Strategic

Conservative Max

Min

Strategic

Max

0.0%

0.0%

17.5%

2.5%

15.0%

32.5% 15.0%

30.0%

47.5% 32.5%

42.5%

57.5%

Market Risk 55.0%

72.5%

72.5% 40.0%

57.5%

70.0% 25.0%

42.5%

57.5% 15.0%

30.0%

40.0%

Alternatives

7.5%

7.5%

7.5%

7.5%

20.0%

20.0%

20.0%

20.0%

7.3%

6.7%

6.0%

5.5%

Risk

13.3%

11.0%

8.7%

6.9%

Yield

2.3%

2.2%

2.2%

2.2%

Private Capital Return

Source: Balentine

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S T E A DY AT T HE HEL M

Index Projections Fixed Income YTM

Duration

Bloomberg Barclays U.S. Aggregate

2.3%

5.9

Bloomberg Barclays U.S. Treasury

1.8%

6.5

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

1.8%

7.6

Bloomberg Barclays U.S. Municipal Bond

2.0%

5.3

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

2.9%

7.9

Bloomberg Barclays U.S. Aggregate Credit - Corporate - High Yield

6.2%

3.0

Bloomberg Barclays Treasury Inflation Protected Notes (TIPS)

2.0%

4.6

Bloomberg Barclays Global Aggregate

1.5%

7.1

J.P. Morgan Emerging Market Bond Index (EMBI)

5.1%

8.0

Return

Risk

MSCI All Country World

5.4%

16.0%

Russell 1000

3.6%

14.5%

Russell 2000

3.8%

19.2%

MSCI EAFE

6.5%

17.0%

MSCI EAFE Small Cap

7.1%

19.7%

MSCI Europe

6.2%

17.0%

MSCI Japan

7.8%

21.0%

MSCI Emerging Markets (EM)

11.4%

23.5%

FTSE NAREIT

5.1%

20.0%

Alerian MLP

9.5%

17.6%

Bloomberg Commodity

5.0%

20.5%

Return

Risk

6.0%

9.0%

Return

Risk

Cambridge PE

10.4%

9.5%

Natural Resources

9.3%

24.0%

Source: Balentine

Market Risk

Source: Balentine

Alternatives HFRI Fund of Funds Composite Source: Balentine

Private Capital

Source: Balentine

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Disclosures General

Third-Party Data

This information has been prepared by Balentine

The information presented in this publication

LLC (“Balentine”) and is intended for informational

has been obtained with the greatest of care

purposes only. This information should not be

from sources believed to be reliable. However,

construed as investment, legal, and/or tax advice.

stated information is derived from proprietary

Additionally, this content is not intended as an offer

and nonproprietary sources that have not

to sell or a solicitation of any investment product

been independently verified for accuracy or

or service.

completeness. Some material may contain information and data provided by independent, third-party sources. While Balentine uses sources

Outlook

it considers to be reliable, no guarantee is made

Opinions expressed are solely the opinion

regarding the accuracy of information or data

of Balentine and should not be relied upon

provided by third-party sources. Balentine

for investment decisions. Certain statements

expressly disclaims any liability, including incidental

contained herein may constitute projections,

or consequential damages arising from errors or

forecasts, and other forward-looking statements

omissions in this publication.

that do not reflect actual results and are based primarily upon applying retroactively a hypothetical set of assumptions to certain

Risk

historical financial information. Accordingly,

Investing in securities involves risks, including the

such statements are inherently speculative as

potential loss of principal. While equity securities

they are based on assumptions that may involve

may offer the potential for greater long-term

known and unknown risks and uncertainties.

growth than most debt securities, they generally

These statements are based upon the available

have higher volatility. International investments

information and Balentine’s view as of the time of

may involve risk of capital loss from unfavorable

these statements, are subject to change, and are

fluctuation in currency values, from differences in

not intended as a forecast or guarantee of future

generally accepted accounting principles, or from

results. Actual results, performance, or events may

economic or political instability in other nations.

differ materially from those expressed or implied

Past performance is not indicative of future results.

in such statements. The appropriateness of an investment or strategy will depend on an investor’s circumstances and objectives. These opinions may not fit 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.

22


S T E A DY AT T HE HEL M

Terminology Balentine utilizes a building blocks approach to

against interest rate fluctuations, credit risks, and

asset management. Our five building blocks include

unanticipated movements in inflation and currency

Liquid, Fixed Income, Market Risk, Alternatives,

valuations. Fixed Income assets play an important

and Private Capital. While each building block plays

role as a short-term shock absorber, but there

a role in diversification and risk management, all

is no implication that these assets cannot lose

building blocks are subject to their risks and may

value. More information about our building blocks

lose value. Specifically, the assets in the Fixed

strategy can be found on our website.

Income building block are designed to protect

23


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Profile for Balentine

2020 Capital Markets Forecast