2017 Capital Markets Forecast

CAPITAL MARKETS

FORECAST

2017

NAVIGATING GLOBAL MARKET, POLITICAL, AND ECONOMIC TRANSITIONS

PROJECTIONS MADE IN THE CAPITAL MARKETS FORECAST HELP DESIGN STRATEGIES THAT INCREASE THE PROBABILITYOF HITTING FINANCIAL GOALS.

TABLE OF CONTENTS

Executive Summary

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Key Themes from this Year’s Capital Markets Forecast

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The Political Cycle and Markets: Does the Rising Tide of “Populism” Matter? 8 The Skill of Active Management

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Assessing Tradeoffs in the Paths to Achieving One’s Financial Goals

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Strategy Design

22

Appendix 25

Expected Return and Risk Assumptions across Building Blocks

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Correlation Assumptions across Building Blocks

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Strategic Benchmark Weights

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Building Block Ranges

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PRISM (Portfolio Risk and Investment Strategy Monitor) Inputs

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C A P I T A L M A R K E T S F O R E C A S T 2017

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BALENTINE’S ANNUAL CAPITAL MARKETS FORECAST RESEARCH PIECE IS THE FOUNDATION OF OUR INVESTMENT PROCESS.

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EXECUTIVE SUMMARY

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Balentine’s annual Capital Markets Forecast research piece is the foundation of our investment process.

The projections herein form the basis for portfolio construction both within and across building blocks.

The Investment Strategy Team has honed this process over many years, and it has a demonstrated positive track record, notably at market extremes. Projections made in the Capital Markets Forecast help design strategies that increase the probability of reaching individual goals by maximizing risk-adjusted returns at different levels of risk aversion. Though strategies are customized for each of our client’s unique goals, we illustrate the trade-offs of expected return and risk from today’s starting point by evaluating four different levels of risk aversion.

The risk budgets we use are based on the long-term historical outcomes of bond and equity benchmarks. They are bookended by the Conservative strategy that represents the risk level of a 100% bond portfolio and the Aggressive strategy that represents the risk level of a 100% equity portfolio. In between are our Balanced and Growth strategies. Moreover, for each of these four levels of risk aversion, we have Public Market and Fully Diversified options, which exhibit tradeoffs between reducing volatility and the ability to achieve outsized upside.

Balentine’s building block framework is as follows: Liquid – Assets in this building block insulate near-term spending needs and seek to protect against interest rate and credit risks. An allocation to cash helps avoid permanently impairing capital when portfolios need to meet frequent distribution requirements.

Fixed Income – Fixed Income assets primarily play a role as a “shock absorber” to strategies, with the goal of providing protection when risk assets experience short-term duress. Secondarily, they provide income while managing against interest rate fluctuations, credit risks, unanticipated movements in inflation, and currency movements.

We have renamed this building block because, although we still expect it to blunt the impact of equity market declines when needed, the risk of capital losses from increasing interest rates is more substantive than ever.

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.

Manager Skill – Manager Skill assets are allocated to highly active managers who seek to generate excess returns over the medium term by managing towards an absolute return target. The primary goal is to play an offensive role with relatively limited correlation to equity and bond markets.

Private Capital – As they are illiquid, Private Capital assets are not available in public markets. Private Capital assets can achieve strong returns over the long term significantly in excess of public markets, enhancing income generation and capital appreciation.

C A P I T A L M A R K E T S F O R E C A S T 2017

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KEY THEMES FROM THIS YEAR’S CAPITAL MARKETS FORECAST

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As 2017 dawns, there is a stark contrast from the environment the world experienced one year ago. The beginning of 2016 saw

• Equity markets that had suddenly become more volatile the previous summer and showed signs of having peaked (a suspicion further reinforced by sharp, sudden declines in January and February of 2016).

• An oil price that was in the midst of another steep drawdown following a brief rally earlier in the year.

• A bottom in the price of gold as central banks stepped up their bets on increased monetary inflation through negative interest rates and increased “quantitative easing.”

• Polling figures in the United Kingdom (UK) which suggested that the “Remain” campaign had about a 10-point lead over “Leave” among those who had decided their vote on whether the UK should exit the European Union (EU).

• A Donald Trump candidacy still relatively off the radar, having around only a 20% chance of winning the Republican nomination and around an 8% chance of winning the presidency.

In contrast, today • Equity markets have made all-time highs across many global markets.

• The oil price bottomed in February, stabilized by mid-summer, and ended 2016 at the year’s highs.

• The gold price increased by 30% into the summer, then sold off on more hawkish rhetoric from the world’s central banks.

• The United Kingdom is making preparations to leave the EU, leading to similar voting sentiment elsewhere in Europe.

• The election of Donald Trump as president of the United States, which is perhaps the greatest upset in US political history.

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THE MOST NOTABLE OF THESE SHIFTS IS THE POLITICAL TREND TOWARDS GREATER POPULISM, BECAUSE IT IS THE MAIN CATALYST FOR THE OTHER TRANSITIONS TO UNFOLD.

What a difference a year makes.

Given the sharp turns we saw during 2016 in both the financial markets and the political cycle, we believe the world is on the cusp of some important transitions. Globally, we see three prominent transitions that began in 2016 and will likely accelerate in 2017: 1. A movement from globalism to populism 2. A shift in emphasis from monetary policy to fiscal policy 3. A change from low economic growth to inflation as the primary economic concern Additionally, the transition from increased regulation to deregulation is primarily domestic in nature but may slowly increase globally.

The most notable of these shifts is the political trend towards greater populism, because it is the main catalyst for the other transitions to unfold. The seeds of this voter outcry were sown long ago, as central bank policies in the wake of the burst internet and subsequent housing bubbles have done little to foster true economic resurgence, a burden which has been disproportionately borne by those on the lower end of the income spectrum. This populism has asserted itself quite vociferously around the world in the wake of the United Kingdom vote to exit the European Union. On the back of the “Brexit� vote, additional populist referendums in Europe have led to leadership resignations, third parties with prior insignificance obtaining more clout and credibility, and, most notably, the election of Donald Trump as president of the United States. We do not see this trend slowing anytime soon but rather accelerating into the new year as additional countries come to the realization that the policies that have been in place this century are not delivering the economic results for which many had hoped.

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So, how do we expect these new regimes will influence economy policy? Most notably, we expect fiscal policy (spending on infrastructure and lowering tax rates) to take over from monetary policy (artificially low interest rates). Monetary policy

KEY THEMES

has reached its limits, as the unfavorable reaction to negative interest rates in Europe and Japan highlighted. We expect both tax reform and increased government spending. Tax reform will likely be at the individual and corporate levels and should reflect the effects of both lower rates and tax repatriation, in addition to the repudiation of onerous tax structures such as those in the European Union. Government spending is likely to be targeted toward investments which have been long deferred, such as infrastructure, rather than toward direct government transfer payments.

This increased fiscal spending will likely lead to the next big shift, as concerns about deflation and economic stagnation will be overtaken by inflation concerns. As monetary policy has reached the point of essentially “pushing on a string,” the ability of fiscal policy to stimulate demand should be the missing ingredient to the recovery. That said, we do expect this transition to take some time. Fresh concerns about bloated government balance sheets behind increased government deficits from looser fiscal policy will likely lead to much debate about the potential for higher inflation.

Lastly, rolling back domestic regulation where industries have been handcuffed—notably energy, healthcare, and banks—won’t be easy, either.

Whether the benefits of deregulation exceed the unintended consequences remains to be seen. But we expect this to expand worldwide as the shackling effect of economic, tax, and geopolitical regulation is challenged by the new populist governments.

Our Capital Markets Forecast process always begins with an assessment of the starting point for our upcoming seven-year forecast window. The beginning of 2017 marks almost eight years into a domestic equity bull market that stagnated for a few years but has recently seen another leg up. Moreover, equity markets are showing signs of breaking out all over the globe despite many economic and geopolitical headwinds. As markets continue to defy many investors’ expectations, today’s high starting valuations likely imply that returns should be weak, in aggregate, over the next seven years. However, this does not mean there will not be pockets of opportunity or that equity markets cannot exhibit

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THE COURSE TO ACHIEVING A SUSTAINED ECONOMIC RECOVERY WILL NECESSITATE COORDINATION AND DISCIPLINE THAT WILL TAKE SOME TIME TO EFFECT.

strength in spurts over the next seven years. Rather, we do expect there to be opportunities, including at the present time, as demonstrated by our overweight position to Market Risk as we enter 2017. Finding those opportunities will be more daunting than the bull market to date; reiterating our thinking in the 2016 Capital Markets Forecast, finding such opportunities will require acumen in a regime change during which central banks are no longer supplying as much punch to the bowl.

Our Key Themes for 2017 are: 1. The course of achieving a sustained economic recovery will necessitate coordination and discipline that will take some time to effect. There is a particular prescription to unshackle the economy from the weak growth we have seen for almost a decade. However, these actions won’t come easily from governments that are feeling populist pressure to “rip off the Band-Aids” and establish reforms quickly and efficiently. As a result, the path to get there should encounter further turbulence in the near term.

2. Interest rates will remain lower than normal as the economy gradually reflates. While the path of least resistance for interest rates is higher, rates should remain lower than history demonstrates in a rate-tightening cycle. Our observations have not changed much from one year ago. The difference now is that the rate hike cycle has begun in earnest; consequently, people are apt to extrapolate occurrences from prior cycles to the current cycle. This is not prudent given the continued meager growth we foresee.

3. Manager Skill and Private Capital take on even more importance in strategy design as equity markets begin to experience decreased correlations and increased dispersion. More so than in the recent past, these building blocks will be key for strategies to achieve their long-term objectives as equity markets are not expected to be a one-way ride higher while fixed income markets experience some turbulence as interest rates rise. The contributions from active management in both building blocks must be weighed against the tradeoffs to determine the suitability for each investor.

In the following sections, we expand on the following important assumptions underpinning these key themes: • H ow does the rising tide of political populism shape the outlook for capital markets?

• G iven the poor performance of active management during recent years, what skills are crucial for an active manager, and what do we seek when considering active management?

• W hat are the tradeoffs in making portfolio decisions as clients look to balance their long-term financial targets with risk tolerance, spending needs, and a desire for absolute returns?

C A P I T A L M A R K E T S F O R E C A S T 2017

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THE POLITICAL CYCLE AND MARKETS: DOES THE RISING TIDE OF “POPULISM” MATTER?

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While it is rare to have an explicit evaluation of politics in the Capital Markets Forecast, 2016 was rife with global political surprises. These

cycles have become microcosms of a much larger global theme: politics are now increasingly a place for the “have nots” to wage war on the “haves,” rather than a battleground for those aligned with the more traditional liberal vs. conservative party lines. For domestic markets, a Trump victory has, so far, propelled equities to new highs amid the prospect of increased spending, reduced taxes, and pared regulation. The ideas that fiscal deficits may soon begin to expand and that central banks are nearing the limits of their effectiveness have provided a tailwind to rising interest rates as well.

However, much of “Trumponomics” has so far been devoid of transparent, substantive recommendations, and the resultant policy mix remains vague.

Subsequent market reactions will depend on the extent to which a Republican sweep of Congress affords Mr. Trump a carte blanche agenda. This will not become readily apparent until policies are proposed in the months following his inauguration. The political debate occurring in the United States is similar to debates occurring elsewhere in the developed world, especially in Europe. Many are asking whether and how this rising tide of “populism” matters. To address these questions, it is helpful first to understand what is driving voter angst.

Causes of voter angst Unquestionably, developed economies across the Western world have experienced a severe drop in productivity growth since the global financial crisis. From the end of World War II through 1973, labor productivity (as expressed by output per hour of work) grew at an annual rate of 3.3%, and per capita GDP growth nearly doubled. After a dearth of real income growth from 1974-1995 and a resurgence of growth from 1996-2004, we have experienced labor productivity growth at a paltry rate of 1.3% per year. Within economic policy circles, the causes of this retrenchment are debatable; some believe that output

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THE DANGER OF “POPULISM” IS THAT IT TREATS THE SYMPTOMS RATHER THAN THE CAUSES OF UNDERLYING FRUSTRATION.

mismeasurement is the culprit. Others speculate that we are yet to reap the benefits of new technology and are instead experiencing less productivity either from diminishing returns on recent innovation or suboptimal technological use by existing firms. Economists Robert Gordon and Tyler Cowen argued in their respective books The Rise and Fall of American Growth and The Great Stagnation that today’s innovations are not keeping pace with those of the past because the low-hanging fruit has already been picked. Accompanying this productivity decline has been a widening of income inequality, concentrating wealth in the hands of a select few. The overwhelming theme of the past seven years has been to target the “wealth effect” via higher asset prices in the capital markets as a result of central bank stimulus; bond and stock owners have benefitted at the expense of savers due to central bank policies aimed at asset price inflation, while workers’ real wages have remained stagnant.

Globalization is now being met with skepticism, mainly because the more unattractive effects of the phenomenon were historically masked by strong economic growth and financial well-being. The signing of NAFTA in 1994 coincided with a period of global economic prosperity that resulted largely from the technological innovation of the Internet. Additionally, China’s 2001 entrance into the World Trade Organization came just before the construction boom in the run-up to the global financial crisis.

An unfortunate reality has surfaced: it is much easier to point to the visible lack of jobs from an abolishment of tariffs than it is to find intangible, indirect benefits of globalization. To be fair, the decline in prime-age men in the workforce that began in the 1960s and the fall in the relative pay that less-educated men receive cannot be blamed entirely on trade deals inked in the 1990s and 2000s. To quote Dartmouth economist Douglas Irwin: “We have a public policy toward trade. We don’t have a public policy on automation.”

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THE POLITICAL CYCLE AND MARKETS

This overt observation of financial divergence and the growing class divide is nothing new; a cursory survey of 2016 best sellers includes titles such as Hillbilly Elegy, The Upside of Inequality, and other memoirs and investigative tales that address class dynamism and wage gaps in America and beyond. As Neil Irwin, senior economist at the New York Times, pointed out: “Perhaps the pursuit of ever-higher gross domestic product misses a fundamental understanding of what makes most people tick. Against that backdrop, support for Mr. Trump and for ‘Brexit’ are just imperfect vehicles through which someone can yell, ‘Stop.’”

This backdrop is driving “populist” candidates to argue for bringing about change for the sake of change. A backlash has erupted against any institution presumed to be run by “elitists” or “technocrats,” and skeptics of free trade and financial alchemy have gained a substantial following. Brexit, the rise of the Eurosceptic Alternative for Deutschland (AfD) party in Germany, and the comedian-led Five Star Movement in Italy—and subsequent ousting of Italian Prime Minister Matteo

“PERHAPS THE PURSUIT

Renzi—immediately come to mind as beneficiaries of such a power rotation in

OF EVER-HIGHER GROSS

Europe. To make matters even more challenging, a tidal wave of immigrants is

DOMESTIC PRODUCT

exposing the mechanical flaws in a union where policies are set in Brussels, but

MISSES A FUNDAMENTAL

the implementation is left to the devices of each member state.

UNDERSTANDING OF WHAT MAKES MOST PEOPLE TICK. AGAINST THAT BACKDROP, SUPPORT FOR MR. TRUMP AND FOR ‘BREXIT’ ARE JUST IMPERFECT VEHICLES THROUGH WHICH SOMEONE CAN YELL, ‘STOP.’” – Neil Irwin, New York Times

The danger of “populism” is that it treats the symptoms rather than the causes of underlying frustration Alarmingly, the rising tide of “populist” sentiment has manifested in a backlash against some of the drivers of economic prosperity. Immigration, free trade, and the independence of central banks (both in the UK and in the US) have been called into question. By only addressing these symptoms of voter angst, such attacks may hinder the ability of new governments to enact a policy mix to end the long period of low growth and deflation that has gripped the developed world.

Rather, countries that treat the actual underlying causes of economic stagnation, including weakness in both productivity and real income growth, should be the beneficiaries of higher expected capital market returns over the next cycle. This would promote more sustainable, balanced, and inclusive economic growth and would therefore elevate the potential for earnings growth from corporate sectors. Such prospects would also reduce the equity risk premium for stock markets, which would, in turn, support higher valuation levels.

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GOVERNMENTS MUST PROMOTE PRODUCTIVITY GROWTH BY CULTIVATING ENTREPRENEURSHIP AND COMPETITIVENESS.

Treating the causes of economic stagnation The need for structural reform has been the least-touted ingredient of past economic success throughout this election cycle. While much attention has been paid to changing the emphasis of the current policy mix from monetary policy to fiscal policy and to deregulating industries, the role of structural reform in increasing productivity growth is now more important than ever considering the increased concentration of market share that American businesses maintain.

New firms are entering the marketplace at a slower rate while old firms decay at a slower pace. Those startups that do come into existence are employing fewer workers: in the 1990s, new firms in the US employed, on average, 7.5 workers. Today, that number has fallen to 4.9 workers. A study conducted by The Economist in March of 2016 concluded the total market share held by the leading four firms in each of some 900 sectors covered by the US Census Bureau rose from 26% in 1997 to 32% by 2012. Furthermore, incumbents are engaging in acquisitions of smaller companies before they become independently large and increasingly competitive.

Rather than overstating the importance of low tax rates, increased government spending, and businessfriendly regulations, policy can “set the table” for increased productivity growth by promoting greater entrepreneurialism and competitiveness. A January 2014 World Economic Forum survey of more than 1,000 small business owners in 43 countries found that the areas of the “ecosystem” most important to entrepreneurs are funding and finance, human resources, and market opportunity. Through policies that remove obstacles to new business formation and incentivize investment, small businesses are likely to flourish and resume the key role they have played in job creation in the past.

In terms of increasing competitiveness, narrowing the profitability gap across firms could begin with the diffusion of innovative technologies (multinationals) to laggards (nationals) to allow mobility of skilled labor across borders. Small businesses can be incentivized to foster dynamism by pressuring incumbents to adopt newer technologies and practices, thereby increasing productivity. Rather than being simply “business friendly,” deregulation should help market entrants overcome the steep “compliance curve” and in-house regulatory expertise that incumbents enjoy. In fact, a study conducted by the Mercatus Center of George Mason University in May of 2016 concluded that the cumulative effects of federal regulation on economic growth created a 0.8% drag on GDP per year, from 1908-2012.

Conclusion As the motif transitions from monetary to fiscal policy in the coming years, a swelling tide of “populism” risks encumbering this handoff by treating only the symptoms and failing to produce an actual cure. To decisively overcome secular stagnation, governments must promote productivity growth by cultivating entrepreneurship and competitiveness within their respective economies. Countries that embrace such structural improvement are likely to benefit from higher expected returns in the future.

C A P I T A L M A R K E T S F O R E C A S T 2017

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THE SKILL OF ACTIVE MANAGEMENT

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July 15, 1924 marked the birth of the first mutual fund and started what would be a near-century of stock pickers looking to beat the market.

The MFSÂŽ Massachusetts Investors Trust fund is still around today, approaching 100 years of active management. Since its inception, thousands of funds have opened and closed with varying levels of success in adding value above broad benchmarks.

These funds are launched with the promise of bringing the skill of stock picking to the average investor hoping for returns far in excess of a simple passive investment. This skill, necessary in order to justify the material fee, is based on the ability to dig through company financials, talk to the right people at the company, or draw variant conclusions on public data. Each stock picker believes there is a level of inefficiency in the market which causes certain stocks to be mispriced. If he can just single out enough of them, he can populate his portfolio and diversify away risk.

It is naĂŻve to believe markets are perfectly efficient; there will always be a level of mispriced information upon which investors can act. However, stock picking is only one of the skills required of active management, and more importantly, the least reliable one. There are three reasons for this: 1. O utperforming is difficult: Over the last 10 years, out of 110 large-cap equity managers, only 54 of them have outperformed their benchmark before fees.

2. F ees are a drag: When a standard fee of 60 bps is subtracted from that return, the number of outperforming managers drops to 22.

3. T here is a cyclical element to active management: Of those 22 managers, every single one of them experienced at least one 3-year period during which they lagged their benchmark.

Figure 1 depicts both the difficulty of outperforming a benchmark like the S&P 500, as well as the cyclical nature of active management.

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Figure 1. The success of active management is cyclical Percen le Rank of S&P in US Large-Cap Universe – 3-Year Return 100% S&P 500 outperforming average ac vity manager 75%

50%

25% S&P 500 underperforming average ac vity manager

Mar-16

Mar-15

Mar-14

Mar-13

Mar-12

Mar-11

Mar-10

Mar-09

Mar-08

Mar-07

Mar-06

Mar-05

Mar-04

Mar-03

Mar-02

Mar-01

Mar-00

Mar-99

Mar-98

Mar-97

Mar-96

Mar-95

Mar-94

Mar-93

Mar-92

Mar-91

0%

Source: FactSet, Morningstar

For these reasons, and in order to be tactical, Balentine typically chooses to be passive in efficient asset classes. However, there are instances in which active management may be more appropriate: the ability to simply access a market (Manager Skill), and the ability to effect change within an investment (Private Capital).

Real estate investing has always been a promise in the US, but for much of our history it was left to wealthy magnates. This changed somewhat in 1960 when President Eisenhower signed into law the Cigar Excise Tax Extension Act. Buried in the law was a provision that gave birth to the Real Estate Investment Trust, or REIT. The following year, Thomas Boyhill founded American Realty Trust, which allowed the average person to become a real estate investor overnight. This instantly granted them access to the cash flows of commercial and residential real estate companies without ever leaving their houses.

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ACTIVE MANAGEMENT

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THERE ARE INSTANCES IN WHICH ACTIVE MANAGEMENT MIGHT BE MORE APPROPRIATE: THE ABILITY TO SIMPLY ACCESS A MARKET (MANAGER SKILL), AND THE ABILITY TO EFFECT CHANGE WITHIN AN INVESTMENT (PRIVATE CAPITAL).

While many would hail Boyhill as a skilled investor (others as an insider given that his cousin, Joel Boyhill, was the sponsor of the bill), he was really more of a skilled inventor—he simply solved problems of access into the real estate market. Investors who held two asset portfolios of stock and bonds could now expand and hold real estate, albeit with stock-like volatility.

This type of innovation continues today and is present in our portfolios. Last year brought allocations to two Stone Ridge Asset Management funds: reinsurance and alternative lending. While we label Stone Ridge an active manager, we believe its primary skill is providing access to these markets for our clients. Alternative lending, for example, is a fund made up of more than 150,000 loans, most which make monthly payments, or at least are supposed to. The logistics, reporting, and regulation around this undertaking requires an immense amount of skill, as it is more than the repackaging of stocks and bonds in an attempt to diversify a portfolio. Investing in these types of asset classes allows us to create excess return in our portfolios by allocating to an asset class not previously available, much like the traditional investor of the 1960s. This was a direct step away from strategies which looked to do nothing but repackage stocks and bonds in an uncorrelated fashion. These are the types of investments that fit well in our Manager Skill building block.

For our Private Capital building block, we prefer the ability to effect change in an investment. The “active” part of active management in stock picking typically ends after the point of purchase. After an analyst convinces her portfolio manager to buy her recommendation, she transitions to “watch mode” to ensure her thesis plays out. This consists of quarterly calls, an occasional conversation with management, and a yearly deep dive into the 10-K. Rarely during this process does the skill of the analyst actually create change in the company, and how could it when they represent 0.1% of the investor base? Their active approach has earned them a passive seat along the way.

Contrast this to active management in the private capital realm. A venture capital investor will conduct due diligence of a prospective company using financial statements, management discussions, and variant conclusions, all leading to an investment in the startup. Unlike the example above, this venture capitalist can own 25% or more of the company. It is at this point that the true skill of active management takes over. The seasoned venture capital investor will develop business plans, hold material voting rights, make introductions, place C-suite personnel, and do everything he can to ensure the company succeeds. We believe success in the private capital world is sticky due to this expertise and the ability to effect real change within a company.

For this reason, we are willing to ask clients to accept long lockups and to pay performance fees.

While the MFS® Massachusetts Investors Trust fund will likely endure another 100 years of active management, it is impossible to know which of those years are going to be feast and which are going to be famine. We choose instead to focus our active management efforts on the other two skills since we are more confident of their ability to drive returns in our portfolios.

C A P I T A L M A R K E T S F O R E C A S T 2017

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ASSESSING TRADEOFFS IN THE PATHS TO ACHIEVING ONE’S FINANCIAL GOALS

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There are many ways to build a portfolio to achieve an investor’s financial goals. As with many decisions, even those outside the investment realm,

each possibility comes with tradeoffs. These tradeoffs must be considered in order to arrive at the optimal path to suit each particular investor’s risk aversions, timelines, and liquidity preferences. These usually boil down to three primary tradeoffs: 1. H ow much return is an investor willing to give up in order to manage risk?

2. I s an investor willing to underperform the market on a relative basis in order to obtain a higher certainty of reaching an investment goal?

3. H ow much liquidity is an investor willing to lock up in order to achieve a higher return?

Giving up return to manage risk The benchmark for our Market Risk building block is the All Country World Index (ACWI). However, given the popularity of the S&P 500, we receive frequent requests for comparisons to that index. While this is not an entirely new phenomenon, it has become even more prevalent over recent years, which we attribute to the S&P’s outperformance of ACWI. Since the onset of the current bull market in March 2009, the S&P 500 has outperformed international equities (as measured by ACWI ex. US) by ~750 bps annually. When one asset consistently outperforms month after month and year after year, investors tend to forget about the benefits of diversification. However, the reverse was the case, from the middle of 2003 to the middle of 2008, with the S&P lagging international markets by a substantial margin (23% annualized for ACWI ex. US v. 10% annualized for the S&P 500).

While retrospective views are 20/20, prospective outlooks are rarely so clear.

As a result, we use diversification to capture the potential upside of many assets while taking advantage of reduced correlation among the assets to smooth the

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THERE ARE MANY WAYS TO BUILD A PORTFOLIO TO ACHIEVE AN INVESTOR’S FINANCIAL GOALS.

ride to our clients’ financial goals. Taking this one step further, the longer the time horizon (as defined as the length of time before the portfolio needs significant distributions), the more an investor can tolerate portfolio drawdowns. In fact, given a long enough time horizon, not only are drawdowns not detrimental, they are actually beneficial because they allow an investor to reinvest additional capital at lower prices.

Practically speaking, investors have relatively fixed time horizons during which they need to save toward a targeted amount or to fund spending requirements, thus raising the significance of portfolio drawdowns.

For example, if an investment drawdown leads to a reduction in principal or to an inability to fulfill a goal in the projected time frame, there is a substantive problem. This is the first tradeoff we encounter: giving up expected return towards an investor’s goals in exchange for a smoother projected path to those goals. Time horizon and spending requirements are not the only inputs here. An investor’s frequency and magnitude of projected future portfolio contributions, behavioral biases, and level of risk aversion can play key roles in determining which tradeoffs to tolerate when structuring a portfolio. This is why we diversify across a broad array of asset classes, both within and across building blocks.

In summary, given an ample time horizon, it is optimal to invest in the asset with the highest projected return; however, volatility in the short term may make the most aggressive portfolio suboptimal for those with shorter time horizons. To better illustrate this, let’s look at three possible portfolios: 1) the S&P 500, 2) the Barclays US Aggregate Bond Index, and 3) a blend comprised of 60% invested in the S&P 500 and 40% invested in the Barclays US Aggregate Bond Index. Since 1988, these portfolios have returned 10.4%, 6.4%, and 9.0%, respectively (Figure 2).

WHILE RETROSPECTIVE VIEWS ARE 20/20, PROSPECTIVE OUTLOOKS ARE RARELY SO CLEAR. AS A RESULT, WE USE DIVERSIFICATION.

C A P I T A L M A R K E T S F O R E C A S T 2017

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Figure 2. Riding market volatility is the best investment strategy given a long enough time horizon…

From 1/1/88 through Present

ASSESSING TRADEOFFS

10000 Given the ~30-year me frame from 1/1/88-present, an investor who wanted a sta c por olio was compensated well to be as aggressive as possible and ride the drawdowns.

1000

100 S&P 500 Barclays Aggregate Index 60/40

12/31/15

12/31/14

12/31/13

12/31/12

12/31/11

12/31/10

12/31/09

12/31/08

12/31/07

12/31/06

12/31/05

12/31/04

12/31/03

12/31/02

12/31/01

12/31/00

12/31/99

12/31/98

12/31/97

12/31/96

12/31/95

12/31/94

12/31/93

12/31/92

12/31/91

12/31/90

12/31/89

12/31/88

12/31/87

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Source: FactSet

In looking just at these figures, one might assume that Portfolio 1 is automatically the best portfolio, but this is not necessarily the case. The risk taken to achieve the extra return in Portfolio 1 is far larger than the incremental return achieved (the volatility for Portfolios 1, 2, and 3, respectively, were 14.3%, 3.8%, and 8.9%). As a result, the path to one’s goal could be adversely affected by drawdowns. To illustrate this point, an investment in each of these portfolios at the peak of the equity market in October 2007 would have needed more than six years (until February 2014) to surpass the performance of an all-bond portfolio and nine years to surpass a 60/40 portfolio (until November 2016). If we look at the same portfolios going back even further and begin at the peak of the Internet bubble in March 2000, we see that the all-stock portfolio still lags both the all-bond and 60/40 portfolios almost 17 years later! (Figure 3) • Portfolio 1: 4.5% • Portfolio 2: 5.1% • Portfolio 3: 5.0%

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Figure 3. …but it is important to acknowledge the risk that any given time horizon may not be as “long” as previously thought.

From 3/31/00 through Present 1000 Assessing the length of a “long me horizon” is a challenge; an investor in the most aggressive of sta c por olios at the top of the Internet bubble is s ll not back to even with the benchmark 60/40 por olio a er almost 17 years!

100

12/31/15

12/31/14

12/31/13

12/31/12

12/31/11

12/31/10

12/31/09

12/31/08

12/31/07

12/31/06

12/31/05

12/31/04

12/31/03

12/31/02

12/31/01

12/31/00

S&P 500 Barclays Aggregate Index 60/40

Source: FactSet

Trading the potential for outsized equity returns for the higher likelihood of achieving goals This idea of the risk and return tradeoff can be further extrapolated to asset classes across building blocks besides Fixed Income and Market Risk, as we would see in Fully Diversified strategies. Diversifying across building blocks further smooths the return stream because the correlations of assets across building blocks is lower than the correlations of those within Market Risk, thus allowing the portfolios to achieve similar returns with less risk. This allows Fully Diversified portfolios to achieve a greater margin of safety than Public Market portfolios. But there is an even more important benefit: with respect to how we think about Manager Skill, there is an opportunity to capture returns with reduced volatility via sources that are not equity-oriented. In quantifying the “risk” in these investments, we do not concern ourselves with the normal volatility seen in standard public market investments. For example, reinsurance offers sustainable returns through collecting insurance premiums in exchange for taking on specific risks—the potential for one-time sudden drawdowns, akin to payments on an insurance claim. This stream of returns acts as a great diversifier given that the risks are decoupled from the drivers of equity markets and are not accessible in the public markets. Similar to reinsurance, direct lending allows us to take calculated risks on entities that need funds but are unable to access them due to lending voids resulting from onerous bank regulations. Investors agree to lock up their money in exchange for exposure to a myriad of lending streams once only available to banks.

C A P I T A L M A R K E T S F O R E C A S T 2017

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ASSESSING TRADEOFFS

As can be seen in Figure 4, these investments increase investors’ chances of achieving their objective; however, this comes at the cost of potentially lower returns in strong equity bull markets. Again, we return to how much relative return an investor is willing to give up in order to achieve absolute goals (tradeoff #2).

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Figure 4. Under our Manager Skill composition, Fully Diversified strategies increase the chances of achieving financial objectives. However, the upside in strong equity markets is far less compelling.

2017 GOALS

RISK

CPI +1%

CPI +2%

CPI +3%

CPI +4%

CPI +5%

Risk of Loss in 1 Year

Public Market Aggressive

82.1%

77.8%

72.5%

65.8%

59.8%

27.4%

15.5%

7.4%

Public Market Growth

81.2%

76.0%

68.9%

61.8%

54.7%

26.9%

15.0%

6.5%

Public Market Balanced

80.3%

73.0%

63.1%

54.4%

44.5%

25.1%

13.2%

4.9%

Public Market Conservative

77.8%

65.2%

53.2%

38.9%

26.4%

23.0%

10.6%

2.9%

Public Markets Aggressive w/ Private Capital

88.4%

83.6%

78.8%

72.8%

65.1%

23.2%

10.8%

3.1%

Public Markets Growth w/ Private Capital

88.0%

83.4%

77.0%

69.2%

60.5%

23.6%

11.3%

2.8%

Public Markets Balanced w/ Private Capital

88.6%

81.8%

73.7%

62.6%

53.0%

19.6%

8.0%

1.4%

Public Markets Conservative w/ Private Capital

89.5%

80.8%

69.1%

55.6%

41.3%

17.0%

5.5%

0.7%

Fully Diversified Aggressive

83.5%

78.5%

72.3%

64.4%

57.8%

25.6%

13.6%

5.3%

Fully Diversified Growth

84.9%

78.8%

71.3%

62.0%

53.7%

23.3%

11.1%

3.2%

Fully Diversified Balanced

84.5%

75.9%

63.2%

51.7%

38.3%

20.2%

8.5%

1.5%

Fully Diversified Conservative

83.9%

68.3%

49.5%

29.7%

14.2%

15.2%

4.0%

0.5%

Fully Diversified Aggressive w/ Private Capital

89.5%

84.6%

79.3%

72.1%

63.3%

21.4%

9.7%

2.1%

Fully Diversified Growth w/ Private Capital

91.5%

86.3%

79.6%

70.9%

60.6%

18.7%

6.8%

1.1%

Fully Diversified Balanced w/ Private Capital

92.8%

86.2%

77.0%

63.5%

50.9%

15.3%

5.0%

0.5%

Fully Diversified Conservative w/ Private Capital

94.4%

85.8%

72.8%

54.9%

36.2%

11.7%

2.3%

0.2%

60% ACWI / 40% Barclays Aggregate

66.3%

57.0%

47.7%

37.5%

28.0%

30.3%

19.8%

11.2%

Strategy

Risk of Loss in 3 Years

Risk of Loss in 7 Years

Source: Balentine

Liquidity Compromise A similar tradeoff exists with Private Capital. Though the risks and volatility of private capital are similar to public equity markets, higher returns are expected if one is willing and able to part with cash for a period of time (potentially the entire seven-year investment cycle). Because public instruments are liquid, and thus provide for the ability to access one’s liquidity at a moment’s notice, investors are willing to pay a premium for this privilege, which eats into the investor’s expected returns. Conversely, private capital requires the issuers of capital to provide a premium in order to compensate the investors for giving up their right to access their liquidity on demand. Investing in such asset classes is an optimal approach if spending needs allow for it, and we encourage investors who have ample liquidity to pursue this course of action.

C A P I T A L M A R K E T S F O R E C A S T 2017

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STRATEGY DESIGN

M

Many facets of our strategy design are unchanged from years past. The specifics have been updated owing to changed market conditions but the

process has not. We begin with a buildup of expected returns and risks for each building block and then combine those into investment strategies to create the optimal blends of risk-reward tradeoff. We focus on both return management and risk management; the absence of either makes it a challenge for an investor to reach desired financial goals.

Fixed Income Building Block The standard way to think about fixed income returns is to look at the real return and then layer on top a premium for expected inflation. Our process, however, finds it more accurate simply to project nominal returns by adding the current yield-to-maturity to expected capital appreciation or depreciation resulting from the projected path of interest rates over the next seven years.

This year, we followed up on last year’s process of looking at two projected paths of interest rate normalization, one in which interest rates normalize quickly and stay elevated v. one in which they normalize slowly. For the 2016 forecast, we projected that the slower path to normalization was the best projection, as we felt the pace of rate hikes would be slower than both the consensus expectations and the Federal Reserve’s projections of four 25 bp increases. We called for one 25 bp increase in March; though off on the timing of the increases, we were correct on the quantity.

Our 2017 projected trajectory for interest rate increases is mostly unchanged from what we projected a year ago. Because the Federal Reserve’s recent statements indicated a more hawkish tone than we had heard in some time, we lifted our projection for 2017 by 25 bps to a total increase of 50 bps for the year. The effect of this was to lift our projected return for the Barclays US Aggregate Index by 50 bps. When we consider the two potential trajectories of interest rate increases during the next seven years (one more swiftly than the other), there is no significant change in total return.

22

Market Risk Building Block This return is comprised of the

Figure 5. Our estimates for equity volatility as compared with realized volatility 25% Opera on Twist Extended

sum of: 1) the starting dividend yield on ACWI, 2) expected

20%

change in valuation over the

QE 3 Announced

QE 2 Announced

dividend growth, and 3) projected

Opera on Twist Announced

15%

seven-year period. This year’s projected return is essentially in

Fed Hikes Rates

10%

line with last year’s forecast. This is a result of an increase in our estimation of future dividend

QE 3 Ends 5% Realized Equity Vola lity Predicted Equity Vola lity

growth being offset by a larger forecast for valuation declines as a result of this year’s higher starting

0% 12/31/2009

12/31/2010

cyclically-adjusted PE multiple.

12/31/2011

12/31/2012

12/31/2013

12/31/2014

12/31/2015

Source: FactSet, Balentine

Unlike for the Fixed Income building block, we do estimate that a slower rate of increases would add about 150 bps in total return to ACWI over the next seven years.

More important than our projection for returns is the change in our volatility estimate. In late 2016, we completed an attribution of our projections over the prior seven years and concluded that we had been overestimating volatility, as seen in Figure 5. As a result of this deep dive into volatility across a gamut of historical market cycles, we have concluded that an estimate of 15% is more appropriate than our most recent estimates for 16.5%. Historical data bears this out when we exclude extreme volatility occurrences on both the upside and the downside, which we believe is appropriate given we do not project any long-lasting, extreme market conditions over the next seven years.

C A P I T A L M A R K E T S F O R E C A S T 2017

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Manager Skill Building Block Manager Skill’s returns and volatility traditionally come using a bottoms-up forecast based on the building block’s projected asset composition. We have

STRATEGY DESIGN

altered expectations about Manager Skill to be more offensive in nature rather than look for defensive properties during equity market drawdowns. Current investments in reinsurance and alternative lending reflect this, and we plan to look for more opportunities that fit within this mold. The risk in these investments is not so much volatility as it is one-time sharp drawdowns due to of intentional risks taken. We have incorporated a small component of volatility to account for a segment of the building block remaining in traditional hedge fund, volatility-like products. However, the main drivers of the return and volatility in the building block are now associated with our uncorrelated investments.

Private Capital Building Block Our assumptions here remain essentially unchanged from recent years. Based on our outlook for equities, we continue to expect this building block can achieve 500 bps in excess of what is available in public equity markets, which leads to an overall return expectation of 11%. This being said, each private capital investment is idiosyncratic and will have its own risk and return tradeoffs.

24

APPENDIX

C A P I T A L M A R K E T S F O R E C A S T 2017

25

EXPECTED RETURN AND RISK ASSUMPTIONS ACROSS BUILDING BLOCKS

APPENDIX

Expected Return

26

Expected Volatility

Fixed Income

2.4%

6.0%

Market Risk

6.0%

15.0%

Manager Skill

6.7%

2.9%

Private Capital

11.0%

10.2%

CORRELATION ASSUMPTIONS ACROSS BUILDING BLOCKS Fixed Income

Market Risk

Manager Skill

Private Capital

Fixed Income

1.0

0.0

0.0

0.0

Market Risk

0.0

1.0

0.0

0.8

Manager Skill

0.0

0.0

1.0

0.0

Private Capital

0.0

0.8

0.0

1.0

STRATEGIC BENCHMARK WEIGHTS Fully Diversified Aggressive

Growth

Balanced

Conservative

0.0%

15.0%

30.0%

45.0%

Market Risk

75.0%

60.0%

45.0%

30.0%

Manager Skill

25.0%

25.0%

25.0%

25.0%

100.0%

100.0%

100.0%

100.0%

Fixed Income

Expected Return Expected Volatility Expected Yield Drawdown Tolerance

7.4%

6.7%

6.0%

4.9%

13.2%

10.8%

8.0%

5.1%

3.2%

3.2%

1.9%

1.9%

-­20.0%

-­15.0%

-­10.0%

-­5.0%

Public Markets Fixed Income Market Risk Manager Skill Expected Return Expected Volatility Expected Yield Drawdown Tolerance

Aggressive

Growth

Balanced

Conservative

0.0%

20.0%

40.0%

60.0%

100.0%

80.0%

60.0%

40.0%

0.0%

0.0%

0.0%

0.0%

100.0%

100.0%

100.0%

100.0%

7.7%

6.9%

6.1%

5.2%

15.0%

13.2%

10.5%

7.7%

2.5%

2.5%

2.6%

2.6%

-­25.0%

-­20.0%

-­15.0%

-­10.1%

C A P I T A L M A R K E T S F O R E C A S T 2017

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BUILDING BLOCK RANGES Fully Diversified (%) Aggressive Fixed Income Market Risk Manager Skill

Minimum

Strategic

Maximum

Minimum

Strategic

Maximum

0%

0%

30%

0%

15%

45%

60%

75%

90%

45%

60%

80%

0%

25%

30%

10%

25%

30%

Expected Return Expected Drawdown

APPENDIX

Growth

7.4%

6.7%

-20.0%

-15.0%

Balanced Fixed Income

Conservative

Minimum

Strategic

Maximum

Minimum

Strategic

Maximum

5%

30%

60%

20%

45%

80%

Market Risk

30%

45%

65%

10%

30%

50%

Manager Skill

10%

25%

30%

10%

25%

50%

Expected Return Expected Drawdown

6.0%

5.2%

-10.0%

-5.0%

Public Markets (%) Aggressive Fixed Income Market Risk

Growth

Minimum

Strategic

Maximum

Minimum

Strategic

Maximum

0%

0%

30%

5%

20%

50%

70%

100%

100%

50%

80%

95%

Expected Return Expected Drawdown

7.7%

6.9%

-25.0%

-20.0%

Balanced Strategic

Maximum

Minimum

Strategic

Maximum

Fixed Income

20%

40%

65%

30%

60%

90%

Market Risk

35%

60%

80%

10%

40%

70%

Expected Return Expected Drawdown

28

Conservative

Minimum

6.1%

5.2%

-15.0%

-10.0%

PRISM (PORTFOLIO RISK AND INVESTMENT STRATEGY MONITOR) DATA Fixed Income YTM

Duration

Bloomberg Barclays US Aggregate Government – Treasury

2.6%

5.8

Bloomberg Barclays US (7-10Y)

2.4%

7.8

Bloomberg Barclays Municipal Bond

2.7%

6.4

Bloomberg Barclays US Aggregate Credit – Corporate – Investment Grade

3.4%

7.2

Bloomberg Barclays US Treasury Inflation Protection Notes (TIPS)

2.3%

4.6

Bloomberg Barclays Global Aggregate

1.6%

6.8

Bloomberg Barclays US Aggregate Credit – Corporate – High Yield (1983)

6.5%

4.1

JP Morgan EMBI Global Diversified

5.8%

6.6

Return

Risk

MSCI AC World

6.2%

15.0%

Russell 1000

3.9%

14.5%

Russell 2000

5.1%

19.2%

MSCI EAFE

8.3%

17.0%

MSCI EAFE Small Cap

9.4%

19.7%

MSCI Europe

9.2%

17.0%

MSCI Japan

11.1%

21.0%

MSCI EM (Emerging Markets)

13.6%

23.5%

FTSE NAREIT/Equity Diversified-SEC

5.7%

20.0%

Alerian MLP

7.3%

17.6%

Bloomberg Commodity Index

4.2%

20.5%

Return

Risk

3.5%

4.9%

Return

Risk

11.3%

9.5%

9.3%

24.0%

Market Risk

Manager Skill HFRI Fund of Funds Composite

Private Capital Cambridge PE Natural Resources

C A P I T A L M A R K E T S F O R E C A S T 2017

29

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.

30

Terminology Balentine utilizes a building blocks approach to asset management. Our five building blocks include Liquid, Fixed Income, Market Risk, Manager Skill, and Private Capital. 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. More information on our building blocks strategy can be found on our website.

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. As an example of the compounding effect on advisory fees, a Balentine client paying an annual advisory fee of .90% (deducted monthly in arrears) would have experienced an average annual reduction of .904% from the performance data displayed. 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. The presentation of Public Markets (PM) strategies represents the fully diversified strategies excluding the allocation to hedge funds where the allocation to hedge funds is proportionally allocated to remaining asset classes. This performance information reflects asset allocation recommendations made to clients but assuming use of index funds only to implement. Accordingly, this

C A P I T A L M A R K E T S F O R E C A S T 2017

31

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.

32

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