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2018

CAPITAL MARKETS

FORECAST

PARADIGM

SHIFT I M P R O V I N G F U N D A M E N TA L S T U R N

S K E P T I C I S M TO O P T I M I S M


TABLE OF CONTENTS Executive Summary

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Key Themes from this Year’s Capital Markets Forecast

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The 2017 Tax Reform Bill: How Will it Impact the Investment Landscape?

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Don’t Let “Buy and Hold” Leave You in the Cold: The Case for Global Asset Allocation 12 World Crises & the News Cycle: Investment Opportunities or Investment Calamities? 17 A Primer on Environmental, Social and Governance (ESG) Investing

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A Current Investment Approach to Blockchain and Cryptocurrencies

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Appendix

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Expected Return and Risk Assumptions across Building Blocks

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Correlation Assumptions across Building Blocks

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Drawdown Tolerances

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Strategy Strategic Weights and Expected Returns

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Index Projections

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Disclosures

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C A P I TA L M A R K E T S F O R E C A S T 2018

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EXECUTIVE SUMMARY

alentine’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. 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 the unique goals of each of our clients, we illustrate the trade-offs of expected return and risk from today’s starting point by evaluating four different levels of risk aversion. Risk budgets are based on the long-term historical outcomes of bond and equity benchmarks. They are bookended by the Conservative strategy, which represents the risk level of a 100% bond portfolio, and the Aggressive strategy, which 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, both with and without Private Capital, 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 risk and credit risk. 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, currency movements, and unexpected inflation. Market Risk – The most volatile component of strategies, Market Risk aims to capture public market equity returns, as they are driven by exposure to underlying economic growth, earnings, and current and expected future interest rates. 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 fixed income 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.

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KEY THEMES FROM THIS YEAR’S CAPITAL MARKETS FORECAST Although the Capital Markets Forecast is a strategic document (i.e., the focus is longer term), we would be remiss not to offer a short-term tactical outlook to address market conditions entering 2018. Because our near-term perspective is far enough out of sync with our longer-term slant, we do not want the longer-term outlook to erroneously skew in investors’ minds our short-term, tactical perspective. While the divergence in outlooks is not new this year, the magnitude of the divergence has increased to the point that we feel now is the time to juxtapose the two. However, our longer-term viewpoint continues to be the focus of both this document and our investment process, and it is where investors are best served focusing in order to achieve their financial goals.

Equities should experience further gains in 2018, on top of 2017’s stellar market performance, as investors have become more confident— but expect increased volatility.


C A P I TA L M A R K E T S F O R E C A S T 2018

Last year was yet another impressive year for equity prices. With a 24.6% total return, the MSCI All Country World Index (ACWI) experienced the best annual performance of this bull market aside from the rebound from the bottom in 2009. Since the commencement of this bull market through the end of 2017, ACWI has now experienced a total return of 275%, or 16.2% annualized. For comparison purposes, ACWI returned a total of 346%, or 13.0% annually, from January 1988 through the bull market peak of March 2000, making the current bull market even more powerful per annum than that of the 1980s and 1990s. Yet, despite its strength, this bull market has exemplified the familiar adage that “bull markets climb a wall of worry,” as skepticism of equities over the past nine years has been consistent and pervasive. However, we are finally seeing signs of abatement in the apprehension upon which this bull market has been built. To be clear, this wall of worry has not fully been ascended; rather, concerns are expressed less often and with less trepidation. Beyond a decline of anxiety, there has been a resurgence of general “animal spirits” over the last year, as evidenced by the price action in cryptocurrencies and the increases in margin debt. Additionally, surveys now show that a majority of investors finally deem this a good time to invest. A paradigm shift from skepticism to optimism typically marks a transition from the end of the beginning of the bull market to the beginning of the end. Having said that, it historically has not been an indication of market peaks; mere optimism is not enough for the market to crescendo. Rather, market sentiment must move from optimistic confidence into euphoric exhilaration, and we are not seeing anything near that right now. Yes, we see some examples of potential excesses fueled by cryptocurrencies and record prices in art and ultra-luxury real estate. However, the last two market peaks experienced extreme exhilaration. Notably, in 1998-2000, “clicks and eyeballs” were the golden ticket to riches, while in 2005-2007, “housing prices will never go down” was the latest version of “this time is different.”

AS WE APPROACH 2018, WE ARE FINALLY SEEING SIGNS OF ABATEMENT IN THE APPREHENSION UPON WHICH THIS BULL MARKET HAS BEEN BUILT.

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However, that is not what we are seeing today for numerous reasons: 1. While the market is by no means inexpensive right now, valuation levels need to be normalized for interest rate levels. At today’s lower interest rates, current valuations are still high, but they are not as excessive as they would be under a higher interest rate regime. 2. The most often-quoted valuation measure, the 10-year cyclical adjusted price-to-earnings ratio (i.e., the CAPE/Shiller PE) is poised to decline as the earnings collapse of 2008 rolls out of the 10-year lookback period.

OVERVALUATION IS A CONDITION THAT IS NECESSARY BUT NOT SUFFICIENT FOR AN EQUITY MARKET TOP, AS ANYONE WHO INVESTED IN THE LATE 1990S CAN ATTEST. IN OTHER WORDS, EXPEN­SIVE ASSETS CAN BECOME FAR MORE EXPENSIVE BEFORE THE MARKET WAKES UP TO ANY CONCERNS

3. Although some companies today are trading at high valuations, they are real companies with real products and cash flow; this is in sharp contrast to the Internet bubble in which many companies were highly valued without any particular product or service of note. 4. The leverage in the system today is nothing like the peak of the housing bubble, when leverage was fueled by cashing out home equity which led to excessive spending on credit. 5. Breadth is still strong across different sectors and across the globe. Cracks began to assert themselves well in advance of the prior market tops. While things appear pricey on the surface, there is more underlying strength than at first glance. Overvaluation, the bears’ number one argument, is a condition that is necessary but not sufficient, as anyone who invested in the late 1990s can attest. In other words, expensive assets can become far more expensive before the market wakes up to any concerns. It is an exercise in futility to attempt to predict specifically when the peak will come. Indeed, our process intentionally waits until the market’s momentum confirms a turn for the bearish (or, conversely, a turn for the bullish during a bear market) is at hand. Evidence shows that the amount we gain by listening to our model and not selling out of bull markets or buying into bear markets too early more-than offsets what we forfeit by the inability to perfectly time peaks and troughs. Our current model readings indicate an equity market top is not imminent; subsequently, we continue to participate in the market’s ascent as fully as possible across all strategies, all the while keeping a close eye on our models. Investors are


C A P I TA L M A R K E T S F O R E C A S T 2018

becoming more optimistic, but there are still many out there who will be surprised by how much more life this aging bull market has left in it; this is a contrarian indicator that will propel stocks. In his book The End of Alchemy, Mervyn King, former governor of the Bank of England, references a cricket fielder who sees the ball come off the bat and, in an instant, takes off to catch it. This player can make the best possible calculations that a human is able to compute, all the while knowing that his route to the ball will likely be imperfect. Our investment philosophy is similar: we make the best possible calculations and use our understanding of the context of the market situation to maximize our odds of investment success. The current context, gleaned via our model readings and understanding of the world economy, is that there is more to laud than fear. Our calculations may be as imperfect as the fielder’s route to the fly ball, but, as our model has repeatedly demonstrated, adhering to its discipline will maximize our chances of investment success. This, of course, does not mean that our outlook cannot change, but that the outlook for equities remains favorable at this time. As a result, we must not fail to take advantage of these near-term opportunities provided by the markets. The transition to fiscal policy in the U.S. should allow for stronger earnings growth, meaning that domestic equity prices can continue their ascent in 2018 without the need for multiple expansions. To that end, we expect that domestic wage growth can reassert itself on continued tailwinds in both deregulation and fiscal policy. One of the Trump administration’s goals is to drive sustained economic growth, and the new tax law is one avenue through which it aims to accomplish that. Some cite increased hourly rates and bonuses from large corporations (rather than solely funneling earnings to dividends and stock repurchases), as early examples of reinvestment in business and productivity growth. While it’s too early to know whether the tax package will be successful, these actions exemplify the shift from monetary policy to fiscal policy, which we believe will lead to yet another transition, this time from fears of deflation to fears of inflation. Our preference for international equities over domestic equities remains unchanged. Given that our preference for international equities is more strategic in nature, domestic equities could continue their recent streak of annual outperformance in 2018. While we have no way of knowing what will occur over the next 12 months, we are confident that this outperformance will not continue for the next nine years.1 Our preference stems from looser international monetary policy, more compelling valuations, and expected mean reversion in performance. Our models began to pick up on a change in this trend late in 2016, leading us to initiate a position in Emerging Markets. Then equities of international developed markets became in favor and, as a result, were added to portfolios in mid2017. Both trends continue in spite of the modest drift back toward domestic markets during the second half of 2016. We remain optimistic that international equities are the superior way to achieve outsized returns moving forward.

1 Since global equity markets bottomed in March 2009, the S&P 500 has experienced annual total returns of 19.4%, handily trouncing the 13.3% posted by the ACWI ex. U.S. index.

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In contrast to our near-term outlook, the long-term outlook for equity returns remains weak, but diligently sticking to our process will allow clients to achieve their financial targets. Although our outlook for 2018 maintains our bullish posture, our strategic outlook over the next seven years continues to remain meager. This is not a new theme for us; in fact, our seven-year outlook is even weaker than that of a year ago. The most effective determinant of an asset’s long-term returns is the starting valuation; expensive assets generally lead to poor returns, whereas inexpensive assets produce strong returns. Therefore, strong performance in the equity markets often leads to a reduced forecast in long-term returns. Adding to our projection is what we perceive to be an increase in global uncertainty, owing not just to geopolitical issues (e.g., North Korea, Mideast tensions, terrorism, populism, etc.), but also due to the effects of central bank’s actions, such as those first implemented in the throes of the 2008 Global Financial Crisis. Owing to their actions over the last nine years, central bankers and central planners have created a world in which uncertainty looking forward has substantially increased because they effectively borrowed certainty from the future in smoothing equity price returns during that time period. This was not by chance, as the central banks have been rather explicit about targeting asset prices in their quest for reflation. Unfortunately, these policies tend to be asymmetric in that central banks are often proactive in preventing further downside, but reactive in slowing asset price inflation. Economist Hyman Minsky famously noted that stability begets instability; unless wage growth can be sustained, a rise in asset prices will not last, which could lead to exacerbated volatility in equity markets. Put differently, this bull market’s ability to persist is less about reflation and more about income gains from stronger capital investment than we have seen to date. What do we do in the face of uncertainty? Quite simply, we hold the course on creative solutions previously introduced while depending on our models to deliver excess returns to benchmarks both within Market Risk, as well as across Market Risk and Fixed Income. The models’ track records have demonstrated an ability to do this consistently over seven-year periods, and we expect no differently going forward. While market turmoil may cause short-term weakness during some point in the forthcoming seven-year cycle, we are confident in our ability to drive the returns necessary for clients to achieve their goals. In the following sections, we discuss important, timely subjects as the investment world experiences seismic shifts: 1. The 2017 Tax Reform Bill: How Will it Impact the Investment Landscape? 2. Don’t Let “Buy and Hold” Leave You in the Cold: The Case for Global Asset Allocation 3. World Crises and the News Cycle: Investment Opportunities or Investment Calamities? 4. A Primer on Environmental, Social and Governance (ESG) Investing 5. A Current Investment Approach to Blockchain and Cryptocurrencies


C A P I TA L M A R K E T S F O R E C A S T 2018

THE 2017 TAX REFORM BILL: HOW WILL IT IMPACT THE INVESTMENT LANDSCAPE? The Trump administration ended its first year in office by securing its first major legislative victory, the Tax Cuts and Jobs Act.1 Signed into law on December 22, 2017, it amended the Reagan administration’s Internal Revenue Code of 1986, the last time the tax code was comprehensively overhauled. Unlike then, these reforms were agreed to more quickly, but without bipartisan support.2 The 2017 bill is also likely to be more expensive, because it was not designed to be “revenue neutral”; according to the non-partisan Congressional Budget Office, it will add as much as $1.5 trillion to the national debt over the next 10 years.3

1 See https://www.congress.gov/bill/115th-congress/house-bill/1 for details. 2 Unlike 1986, the 2017 bill was agreed to by a process of “reconciliation” between versions proposed by the House of Representatives and the Senate, allowing the Republican Party to take advantage of its simple majorities in both chambers of Congress. 3 Such a significant increase in the deficit could trigger automatic spending reductions under Senate PAYGO (i.e., pay-as-you-go) rules. This could reduce the ultimate cost of the bill, as could higher tax revenue received if economic growth picks up in a sustained way.

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The goals that the Trump administration set forth for this legislation were clear: • Increase the competitiveness of the United States economy by lowering the corporate tax rate from one of the highest in the world; • Promote  job creation in the U.S. by moving from a worldwide tax base to a territorial tax base so that U.S. companies are no longer taxed on profits they earn abroad. This should incentivize companies to repatriate profits earned abroad, rather than “inverting” themselves to take advantage of lower overseas tax rates; •E  ncourage business investment to drive economic growth and reduce financial engineering by introducing generous depreciation allowances and reducing the deductibility of interest on debt; •S  implify the tax code by eliminating many personal deductions and reducing the number of personal tax brackets; and • Provide  a tax cut for the middle class by lowering marginal personal tax rates until 2025 and reducing the effective tax rates of many pass-through entities through which many small businesses are owned in non-service related industries.

CAPITAL MARKETS, ON THE OTHER HAND, ARE RUTHLESSLY APOLITICAL, AND INVESTORS SEEK SOLELY TO COMPARE CURRENT AND FUTURE FUNDAMENTALS AGAINST TODAY’S PRICE LEVELS.

However, the bill has not been universally well received. A wide variety of polls have consistently shown that more people disapprove than approve of the new legislation because they doubt whether it will achieve its objectives. Other reasons for its unpopularity arise from concerns that it may worsen the fiscal and trade deficits, increase income inequality, create disproportionate winners and losers amongst states and industries, and increase the costs of health care while lowering coverage. Isolating the long-run impact of such sweeping changes to the tax code is always fraught with danger. The future rate of economic growth and its distribution will be determined by the interaction of many powerful forces beyond fiscal policy, including the cyclical effects of monetary policy, technological changes, and productivity growth of the economy—not to mention any unforeseen geopolitical shocks. It is difficult to disentangle these forces. As a result, the conclusions often drawn by economists follow from the simplifying assumptions—frequently influenced by predetermined political biases—that must be made to perform such an analysis.


C A P I TA L M A R K E T S F O R E C A S T 2018

Capital markets, on the other hand, are ruthlessly apolitical, and investors seek solely to compare current and future fundamentals against today’s price levels. How might tax reform influence the investment landscape over the next market cycle? That broad question can be boiled down to one key issue: Will the new tax law successfully set the stage for a sustained higher trend rate of economic growth, or simply provide a short-term boost that does not sustain the economic expansion that began in 2009? Economic expansions don’t die of old age; they typically end when the Federal Reserve (Fed) is forced to raise interest rates to contain growing inflation.4 The dawn of 2018 brings into sight the ninth year of uninterrupted economic growth, making it the third longest in the history of the United States.5 Though this expansion is one of the longest on record, it has also been one of the slowest and has failed, thus far, to improve living standards significantly. While the unemployment rate has drifted back down to about 4%, real economic growth has averaged around 2%, far lower than the trend rates of economic growth enjoyed in previous expansions (Figure 1). Figure 1. The current recovery has exhibited weaker GDP growth, inflation, and productivity growth than prior recoveries. 6.0% 6.0% 5.0% 5.0%

4.0% 4.0%

4.8% 4.8% 3.6% 3.6%

3.0% 3.0% 2.0% 2.0%

2.1% 2.1%

2.5% 2.5%

3.0% 3.0% 2.0% 2.0%

2.3% 2.3% 1.5% 1.5% 0.9% 0.9%

1.0% 1.0% 0.0% 0.0% GDPGrowth Growth (Real) GDP (Real)

2/1961-12/1969 2/1961-12/1969

Inflaon (Core Inflaon (CorePCE) PCE)

3/1991-3/2001 3/1991-3/2001

Producvity Growth Producvity Growth

6/2009-present 6/2009-present

Source: Federal Reserve Bank of St. Louis

In other words, the economy has suffered a significant decline in productivity growth since the Global Financial Crisis. Some economists suggest that this decline in living standards has been the inescapable result of “secular stagnation,”6 such as the impact of aging demographics, that has gripped much of the developed world. Others point to cyclical factors, such as anemic rates of business investment during this recovery, which have failed to drive stronger economic growth. 4 Cycles also end, less predictably, when they suffer an unforeseen geopolitical shock, as “World Crises & the News Cycle: Investment Opportunities or Investment Calamities?” explores. 5 Having recently surpassed the 1980s expansion, only the 1960s and 1990s have enjoyed longer periods of sustained economic growth since records began in the 1850s. See http://www.nber.org/. 6 See http://larrysummers.com/2016/02/17/the-age-of-secular-stagnation/ for a description of these forces. Many have pointed to widespread frustration as a reason for the more “populist” political campaigns seen in the western world today.

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Whatever the underlying reasons, the Federal Reserve has kept interest rates at rock-bottom levels to stimulate consumption and economic activity. Meanwhile, inflation has persistently fallen far short of levels that have heralded the end of previous expansions. While monetary policy has been extraordinarily loose, fiscal policy has been more austere, focused on containing the growth of long-run deficits that exploded in the immediate aftermath of the Global Financial Crisis. The tax reform bill of 2017 may change both this dynamic and the character of further economic expansion, with looser fiscal policy ushering in tighter monetary policy. Furthermore, this change may occur more quickly than investors expect. By some estimates,7 the bill provides about $200 billion of tax cuts—adding around 0.7%-1% of GDP in 2018 alone and more than 1% of GDP in 2019—leading many to revise expectations of economic growth to more than 3% in 2019. Whether that acceleration can be sustained beyond 2018 will much depend on how inflation expectations react to tighter labor markets and longer-term interest rates. The Federal Reserve’s economic model estimates that for every 1% of GDP in tax cuts, interest rates will eventually rise by 0.4%.8 Despite today’s low unemployment rate, the annualized rate of wage growth remains just over 2%, a long way from the 4% level that has typically brought the economy within spitting distance of sharply higher interest rates and an imminent slowdown. Moreover, if the tax reform bill is successful in unleashing dormant business investment and boosting productivity growth,9 the runway for an accelerating expansion may be longer, as inflationary pressures will be kept at bay. That will allow the Fed more time to continue its slow transition to a tighter, more normal monetary policy stance. Bond markets will provide an indication of whether the Fed is “removing the punch bowl” too quickly. Although flatter today than in previous years, the yield curve is still a long way from inverting, a reliable sign that short-term interest rates will soon have to decline again because the economy is on the cusp of a major slowdown. Business investment and productivity growth hold the keys to the longer-run effects that the 2017 tax reform bill is likely to have on the rate, nature, and duration of future economic growth. Therefore, an investor crafting an investment strategy for the next market cycle should be aware that the range of expected outcomes over the next couple of years may be affected by the 2017 tax reform bill in the following ways: • More supportive stock market valuation levels for U.S. exposure if estimates of corporate earnings growth are revised up further due to lower corporate taxes and higher economic growth. That would reduce the magnitude of the negative valuation adjustment in our total return estimate for equities, thus increasing expected returns.

7 Source: Strategas Research Partners 8 See https://www.federalreserve.gov/econresdata/notes/feds-notes/2014/a-tool-for-macroeconomic-policy-analysis.html. 9 There are signs that the administration is focused on this in the form of an infrastructure bill designed to address deferred maintenance and needed improvements. We have identified infrastructure as an important opportunity for investors within Private Capital.


C A P I TA L M A R K E T S F O R E C A S T 2018

• The possibility of interest rates rising more quickly if inflation perks up because business investment and productivity growth fail to materialize as economic growth accelerates. That would mean greater capital losses in the immediate future for holders of fixed income before they have an opportunity to reinvest at higher future interest rates. After such a long period of tranquil markets, 2018 and beyond are likely to see more volatility (given today’s starting point), as a real business cycle finally emerges. For investors in public market bond and stock portfolios, yesterday’s winning strategy of simply “buying and holding” the index is likely to be severely challenged. For those seeking to spend out of portfolios, the case for diversifying into strategies beyond bonds and stocks has seldom been clearer.

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DON’T LET “BUY AND HOLD” LEAVE YOU IN THE COLD: THE CASE FOR GLOBAL ASSET ALLOCATION Research shows that the vast majority of portfolio returns can be explained by asset allocation.1 Investors therefore design strategic asset allocations to meet their objectives and execute using both passively and actively managed strategies. Some may take the additional step of formalizing a policy to rebalance back to strategic targets. But what if that typical, long-term “buy-and-hold” approach with calendar-driven rebalancing is missing a key source of potential return? One underappreciated and misunderstood candidate is Global Asset Allocation (GAA). GAA strategies implement a more proactive, actively managed stance towards asset classes to take advantage of expected performance dispersion created by shifts in investor sentiment.

1 Source: Ibbotson, Roger G. and Paul D. Kaplan. “Does Asset Allocation Policy Explain 40, 90 or 100 Percent of Performance?” Financial Analysts Journal, Jan/Feb 2000, pp. 26-33.


C A P I TA L M A R K E T S F O R E C A S T 2018

When adopted in a repeatable way, GAA strategies offer a complement to strategic asset allocation. A fundamental premise for GAA managers is that asset classes exhibit cycles in performance dispersion over the medium-term, which can be exploited more fully than tradition calendar-driven rebalancing. Figure 2 simulates the growth of $100 from two hypothetical strategies: a portfolio rebalanced back to strategic targets on January 1st of each year versus an illustrative GAA strategy. Over the last 30 years, the buy-and-hold strategy (with calendar-driven rebalancing) was trounced by an illustrative GAA approach, despite the fact that the GAA approach only made seven shifts to buy and hold’s 30. Though “proactive� may imply otherwise, the GAA strategy recognized that domestic stocks cycle in and out of favor versus international stocks over time frames far longer than one year. Figure 2. Buy and Hold vs. Illustrative GAA Strategy GROWTH OF $100

$3,000

$2,502

$2,500 $2,000 $1,500

$1,125

$1,000

Annual Rebalancing

GAA

Source: Balentine Annual rebalancing refers to 50% Russell 1000 index and 50% MSCI that is rebalanced back to 50/50 on January 1st each year. The Illustrative GAA Strategy is a portfolio that emphasizes domestic or international stocks based on relative momentum indicators.

1/17

1/15 1/16

1/14

1/12 1/13

1/10 1/11

1/09

1/06 1/07 1/08

1/05

1/03 1/04

1/02

1/00 1/01

1/99

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1/92 1/93

1/91

1/89 1/90

$0

1/88

$500

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In addition, the ideal GAA manager offers other benefits: • An independent, uncorrelated source of value-add. The ideal GAA manager seeks to identify opportunities in asset class selection opportunities, not security selection.

AS EQUITY MARKET VOLATILITY IS POISED TO PICK UP, NOW MAY BE A PARTICULARLY OPPORTUNE TIME TO IMPLEMENT A GAA STRATEGY.

• Limit downside risk in difficult markets. By constructing portfolios with specific drawdown tolerances, ideal GAA managers should also operate within a variety of risk budgets, whether that be a “vanilla” 60% stocks/40% bonds benchmark or a stock-bond split that is more closely aligned with a board’s strategic objectives. • Efficient, liquid, and scalable implementation. Since GAA managers typically operate across public fixed income and global stock markets they are able to use liquid, transparent, and low-cost index funds to implement their desired exposures. As a result, ideal GAA strategies act nimbly and decisively, are cheap to implement, offer a high level of transparency, and are not capacity constrained. Despite these distinctive benefits, many boards have been slow to adopt GAA strategies, typically for two main reasons: • GAA is sometimes seen as displacing the board’s role of driving a plan’s asset allocation. Well-designed GAA strategies complement, not substitute for, a plan’s strategic asset allocation. Not only do GAA strategies offer a source of alpha diversification, they also offer time diversification by acting within the confines of a plan’s overall risk and return objectives. One of the biggest challenges boards confront is that they only formally meet to approve investment action a few times a year. Moreover, there is often a time delay between decisions and implementation. To address this vulnerability in governance, boards sometimes pursue a full-scale outsourced chief investment officer (OCIO) approach, in which a board delegates full authority to a firm to take investment action under guardrails in between meetings.2 Even in this setting, a GAA strategy can be additive for its source of uncorrelated alpha.

2 For more about the OCIO strategy, read Balentine Chairman and CEO Robert Balentine’s “In Search of an Honest Man” from the November/December 2009 issue of Investments and Wealth Monitor.


C A P I TA L M A R K E T S F O R E C A S T 2018

• GAA is often associated with the perceived risks of “market timing.â€? Actually, many GAA approaches remain fully invested over time and resist hyper-frequency attempts to move from cash into public markets and back again. Moreover, the asset class dispersion cycles often unfold with such extended duration and large amplitude that there is no need to capture the exact bottom or top of every cycle. GAA managers with a repeatable process do not worry about missing out on a few months of the early stage of a new cycle. This also lowers the risk of inviting “whipsawâ€? from trying to be too precise, as shown in Figure 3.

Figure 3. GAA strategies don’t have to market time perfectly to add value. The cycle gives large trend deviaons between equity market classes. When done correctly, the trend can drive substanve outperformance.

Source: Balentine

By recognizing the distinct advantages of a GAA approach and addressing its main misconceptions, boards can avail themselves of a key additional source of return at a critical stage of this cycle. Now may be a particularly opportune time to implement a GAA strategy. The current bull market in U.S. stocks is now the second oldest on record. It has been an unusually smooth ride; markets have not experienced a 20% drawdown for more than 3,000 days. A passive approach of buying and holding U.S. stocks and bonds has dominated a well-diversified strategic asset allocation strategy in risk-adjusted terms.

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However, an important shift may be occurring. Since the beginning of 2017, performance dispersion across asset classes has accelerated. After dramatically underperforming for the previous five years, 2017 saw a significant and sharp increase in outperformance of international over domestic stocks. Emerging Markets stocks outperformed U.S. stocks by approximately 17% in 2017. Those who were waiting to simply rebalance back to strategic international weights at the end of the year missed an important opportunity. They could have avoided that with a dedicated GAA strategy allocation—one that was able to match a buy and hold approach during the lean times and that now stands ready to benefit from a more fruitful environment in the coming years. This call option should prevent boards from being left out in the cold—now and in the future.


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WORLD CRISES AND THE NEWS CYCLE: INVESTMENT OPPORTUNITIES OR INVESTMENT CALAMITIES? You can blame the printing press. Before its invention, all news was local and shared by word of mouth. The introduction of printed news allowed for wider distribution and greater awareness; local news was magnified to world news, and a local crisis became a world crisis. What is a crisis, anyway? According to Webster’s Dictionary, a crisis is defined as “an unstable or crucial time or state of affairs in which a decisive change is impending; especially: one with the distinct possibility of a highly undesirable outcome.” The term is typically applied to all sorts of issues, including economic, financial, political, climate, immigration, military, and natural disasters. The key question is how crises and stock markets connect, if at all? Since history suggests that all bear markets are accompanied by crises, but not all crises lead to bear markets, we must answer two questions: 1) are we on the verge of a crisis today, and, 2) if so, is there a bear market in our near future?

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We certainly have not lacked for crises in the 21st century, which has experienced two deep bear markets in the United States, the former of which was ongoing when the century began. The bear market of 2000-2003 was exacerbated by the terrorist attacks of September 11, while the bear market of 2007-2009 followed the burst of the global housing bubble. Accompanying the worst bear market since the 1929-1932 crash was a society experiencing, among other things, increased income inequality, heightened threats of terrorism, and a surge of mass shootings. These crises have certainly not been confined to the United States, as we’ve seen a wide range of crises, including political (e.g., China’s occupation of the South China Sea islands), economic (e.g., the European debt crisis), military (e.g., Russia’s invasion of Ukraine), and humanitarian (e.g., migration). On top of that, the battle over climate change continues to rage as society becomes more polarized. Fortunately, capital markets do not care about most crises. What can we expect in the coming years? A look at the historical record since World War II (Figure 4) may provide a hint to our future: virtually every bear market of the past 75 years involved either a military element or a domestic economic event. A military element occurred in three instances (1961-1962, the Bay of Pigs Invasion and Cuban Missile Crisis; 1968-1970, the Vietnam War; and 1973-1974, Mideast tensions culminating in the Yom Kippur War), whereas the other bear markets involved a combination of economic, financial, and monetary developments. Figure 4. Major U.S. Bear Markets since 1946 Dates

Duration (months)

Loss

May 1946 to June 1949

37

29.6%

Post-war economic slowdown

December 1961 to June 1962

6

28.0%

Bay of Pigs Invasion; Cuban Missile Crisis

November 1968 to May 1970

18

36.1%

Vietnam War; weak economy

January 1973 to October 1974

21

48.0%

Arab oil embargo; rising inflation; Watergate

November 1980 to August 1982

21

27.8%

High interest rates; stagflation

August 1987 to October 1987

3

33.5%

“Program trading;” currency valuations

March 2000 to October 2002

30

49.1%

Market valuations; bursting of dot-com bubble

October 2007 to March 2009

17

56.4%

Mortgage delinquencies; credit panic

Source: NBC News

Associated Crisis


C A P I TA L M A R K E T S F O R E C A S T 2018

Expanding our scope, a broader list shows that at least 12 major crises occurred outside the U.S. during the same period. These crises included a number of Latin American financial stresses, Japan’s 20-year deflation, and the Emerging Asia debt crisis. A number of other countries, including Dubai, Greece, China, and Russia, had more localized crises. Notably, none of these was instrumental in triggering a U.S. stock market crash. What does that mean? The message appears to be that United States market crashes are caused by either domestic economic events or overseas military actions that impact our economy. Though other types of world crises often reflect tragic events and humanitarian issues, they have not been relevant to the U.S. stock market. If this is the case, then the future of the stock market will be determined by domestic economic and financial trends, monetary policy, and any military actions that impact the U.S. economy. The International Crisis Group, a news and advocacy organization, compiles an annual list of global conflicts to watch,1 and the 10 most critical issues identified for 2018 are: 1. North Korea

IN LINE WITH HISTORICAL

2. U.S.-Saudi-Iran rivalry

PRECEDENT, THE FUTURE

3. The Rohingya Crisis in Myanmar and Bangladesh

OF THE STOCK MARKET

4. Yemen 5. The War in Afghanistan

WILL BE DETERMINED BY DOMESTIC ECONOMIC AND FINANCIAL TRENDS,

6. Syrian Civil War

MONETARY POLICY,

7. The Sahel

AND ANY MILITARY

8. Congo 9. Ukraine 10. Venezuela

1 See https://www.crisisgroup.org/global/10-conflicts-watch-2018.

ACTIONS THAT IMPACT THE U.S. ECONOMY.

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From this group, only the confrontation with North Korea stands out as a significant risk to U.S. markets. All other military actions the U.S. has undertaken in the 21st century (e.g., Iraq, Syria, and Afghanistan) appear to have had no impact on U.S. stock markets, except perhaps in the funding of military expenditures. These are certainly positive for the business of military contractors, and short of a nuclear action with North Korea, any escalation of military activity will likely be a positive for American companies and thus a positive for the U.S. economy and stock market. It is worth noting that there are significant issues today that are frequently termed crises, but their impact on world economies and stock markets is either gradual or will not culminate until well into the future. The most obvious examples are climate change, aging populations, involuntary migrations, and water shortages. Ultimately, these issues will dramatically affect the U.S. economy and stock market, but within the timeframe of most investors, they are likely to remain news headlines instead of stock market breakers. While a crisis with the potential to cause a bear market does not seem imminent, there are a number of potential flash points that could ignite into full-blown crises; the notable ones include a financial bust in China, the Iranian and North Korean nuclear programs, or a Brexit meltdown. Interestingly, however, The Economist’s publication, “The World in 2018,” points to central bank policy as the most likely risk. Quoting from the report, “…central banks, perhaps grown complacent amid the return of steady growth and the retreat of deflation, tighten policy too much, too quickly.” The Federal Reserve Board of Governors, with five vacancies and only two nominees, may soon be comprised of members who have very different opinions from those of the Bernanke and Yellen years. It remains to be seen what that could mean for the Fed’s current priorities of reversing quantitative easing and gradually raising interest rates. In summary, the market’s current outlook is sanguine as far as a crisis is concerned. The economy is sound and growing, and the political environment favors corporations. Investors should enjoy these bullish conditions.


C A P I TA L M A R K E T S F O R E C A S T 2018

A PRIMER ON ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) INVESTING ESG investing has become a colloquialism for any form of investment strategy that incorporates certain “sustainability” factors or ethical considerations into the investment decision-making process. In its truest sense, ESG is simply a set of criteria—environmental, social, or governance—that businesses and investors can use to evaluate potential financial endeavors in a stakeholder-friendly context. Using ESG criteria as inputs, investors engage in socially responsible investing (SRI) and businesses engage in corporate social responsibility (CSR). For simplicity’s sake, we will use “ESG investing” as an all-encompassing term for both SRI and CSR, with criteria shown in Figure 5.

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Figure 5. Examples of Environmental, Social and Governance Criteria Climate Change Environment

Financing Environmental Impact

Product Carbon Footprint

Climate Change Vulnerability

Natural Resources

Water Stress

Raw Material Sourcing

Biodiversity & Land Use

Pollution & Waste

Toxic Emissions & Waste

Electronic Waste

Packing Material & Waste

Environmental Opportunities

Opportunities in Clean Tech

Opportunities in Renewable Energy

Opportunities in Green Building

Labor Management

Human Capital Development

Health & Safety

Product Safety & Quality

Privacy & Data Security

Financial Product Safety

Chemical Safety

Responsible Investment

Health & Demographic Risk

Access to Health Care

Access to Finance

Ownership

Pay

Business Ethics

Corruption & Instability

Tax Transparency

Anti-Competitive Practices

Financial System Instability

Human Capital

Social

Carbon Emissions

Product Liability Stakeholder Opposition Social Opportunities

Corporate Governance Governance Corporate Behavior

Supply Chain Labor Standards

Controversial Sourcing Access to Communications Opportunities in Nutrition & Health Board Accounting

Source: MSCI

Ethically motivated or “values-based� investing is nothing new; with religious underpinnings, ESG investing has been practiced in the West since at least the mid-17th century. The Quakers prevented followers from investing in companies that profited from slavery or other such activities deemed unethical, while John Wesley and his Methodist followers sought to gain all they could without hurting their neighbors. The creation of the Sullivan Principles, encouraging signatories to operate their businesses in a manner that treated all employees equally, laid the groundwork for a broader institutional divestment from South African businesses in the early 1980s, fueling the social angst that helped bring apartheid to an end. The Chernobyl disaster and the Exxon Valdez oil spill further propelled public demand for greater corporate culpability, and a full-scale ESG movement took root in the late 1980s.


C A P I TA L M A R K E T S F O R E C A S T 2018

Drivers of ESG demand What began as a European investment phenomenon is morphing into a genuine institutional overhaul. A 2016 survey commissioned by Natixis Global Asset Management found that 91% of institutional managers claim to incorporate ESG criteria into their investment analysis process.1 Institutional efforts are largely focused on risk management, with a recent CFA Institute survey finding that, of those investors making use of ESG criteria, roughly 63% are doing so primarily as a form of risk management.2 Given their long time horizons and institutional goals of societal betterment, endowments and foundations are adopting ESG policies at a rapid rate.3 In fact, CalSTRS and CalPERS, pension funds for public sector workers in California, are now required by state law to divest holdings in companies which derive more than half of total revenue from mining thermal coal.4 High-net-worth and retail ESG demand tends to reflect consumption choices. Millennials have taken a keen interest in the social impact of investments, despite beginning adult life with a financially tougher hand than previous generations. A Morgan Stanley survey found that, compared with 58% of the overall population, 75% of millennials believe that their investments could influence climate change, and millennials are twice as likely as the average investor to check product packaging or invest in companies that espouse social or environmental objectives.5 This type of ESG investing is typically exclusionary and highly personal but may come at the expense of performance. Growing demand is attracting the attention of investment managers, thus resulting in the proliferation of ESG products regardless of investor naiveté and ignorance of potential investment consequences. In many cases, the threshold for investor adoption is not that ESG strategies outperform non-ESG strategies; when presented with two similarly performing portfolios, one with an ESG label and the other without, investors will likely opt for the ESG lineup. For certain segments of the population, typically those engaged in values-based investing, this similar performance “burden of proof” is lower or nonexistent, with investors willing to sacrifice returns or significantly increase tracking error in order to construct a portfolio that aligns with their principles.

1 See https://www.im.natixis.com/us/resources/introducing-esg-into-your-practice-wp19. 2 See https://www.cfainstitute.org/ethics/Documents/issues_esg_investing.pdf. 3 See https://www.ai-cio.com/news/depth-esg-investing-stay/. 4 See https://www.theguardian.com/environment/2015/sep/02/california-pension-funds-divest-coal. 5 See https://www.economist.com/news/finance-and-economics/21731640-millennials-are-coming-money-and-wantinvest-it-responsibly-sustainable.

GROWING DEMAND FOR ESG INVESTING IS ATTRACTING THE ATTENTION OF INVESTMENT MANAGERS, THUS RESULTING IN THE PROLIFERATION OF ESG PRODUCTS REGARDLESS OF INVESTOR NAIVETÉ AND IGNORANCE OF POTENTIAL INVESTMENT CONSEQUENCES.

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Fiduciary duty and the investment consequences of ESG integration Is the use of ESG-tailored products offered by the investment industry consistent with a fiduciary duty to protect and grow capital in a prudent fashion? In an interpretive bulletin (IB) issued in 1994, the U.S. Department of Labor (DOL) permitted economically targeted investments only to the extent that such investments presented a similar risk and return profile to those of non-ESG focused investments; this became known as the “all things being equal” test. Then, reversing course in 2008, the DOL raised the hurdle for incorporating ESG factors, stating that their use as inputs into investment decision-making processes should be rare. Acknowledging its flaws and again changing position, the DOL clarified in IB 2015-1 that Employee Retirement Income Security Act (ERISA) money could once again take ESG factors into consideration, reinstating 1994 guidance and the “collateral goals as tie-breakers” maxim. This action acknowledged for the first time that, in some circumstances, utilizing ESG criteria may provide more than just collateral benefits to beneficiaries. The DOL claimed that not only had the 2008 guidance “unduly discouraged fiduciaries from considering ETIs (economically targeted investments) and ESG factors,” but also acknowledged that such factors may be included in the analysis of the economic merits of competing investment choices. The DOL went a step further in early 2016 when it stated that ESG factors may prove to be “intrinsic to the market value of an investment” while simultaneously citing growing institutional adoption.6 The Department of Labor’s ERISA guidance has some inferential value in determining fiduciary standards of care in non-ERISA money. Looking beyond the DOL to other domestic regulatory bodies, the Internal Revenue Service (IRS) permits foundation managers to consider the relationship between an investment and the foundation’s charitable purpose, thereby providing increased flexibility for foundations to pursue ESG-driven investments without violating the fiduciary standard of care. Internationally, trends in uniform standards adoption and signatory body membership suggest growing ESG alignment with fiduciary duty. These standards, while young, are quickly gaining traction; the United Nations-supported Principles for Responsible Investment (PRI) and Ceres Investor Network on Climate Risk and Sustainability provide guidelines that signatories agree to uphold, develop, and, in many cases, promote. Figure 6 shows the rapid rise of PRI signatories, totaling 1,885.

6 See https://www.dol.gov/agencies/ebsa.


C A P I TA L M A R K E T S F O R E C A S T 2018

80

2000

60

1500

40

1000

20

500

Asset under management (U.S.$ trillion)

‘1 7

Ap

ril

‘1 6

Ap

ril

‘1 5

Ap

ril

‘1 4

Ap

ril

‘1 3 ril

‘1 2

Ap

ril Ap

‘1 1

Ap

ril

‘1 0 ril Ap

‘0 9

Ap

ril

‘0 8 ril

Ap

ril Ap

ril Ap

‘0 7

0

‘0 6

0

Number of Signatories

Source: UN PRI

PRI signatories include asset owners (e.g., pension funds, foundations, and endowments), investment managers (e.g., BlackRock, Vanguard, etc.), and certain service providers to both. Should Balentine arrive at the conclusion that our fund managers and third-party providers insufficiently drive ESG research and dissemination, we may explore membership in the “service provider” category so that we might gain access to a valuable network that is otherwise inaccessible. Does the performance data merit the integration of ESG factors by so many parties? The investment consequences of ESG integration can be analyzed on two axes: returns and risk management. To assess such investment consequences, it is necessary to distinguish among the various methods used to invest along ESG guidelines.

NUMBER OF SIGNATORIES

AUM U.S.$ TRILLION

Figure 6. Growth in UN PRI signatories over the last decade has been strong.

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Socially responsible investing occurs along a continuum that can be reduced to roughly four degrees of implementation (Figure 7). Figure 7. The spectrum of SRI investing implementations

Negave Screening

Tilts or “Best in Class�

“Bo om-up� ESG Integraon

Impact Invesng

Source: Balentine

• Negative screening, or ethically motivated divestment, is the oldest and simplest form of ESG investing. It is exclusionary in nature and tends to hamper portfolio performance since the investment universe is smaller while simultaneously creating excessive tracking error to the investor’s benchmark. Exclusionary screens impose upon investors a constrained portfolio, one that is theoretically suboptimal and more idiosyncratically risky than an unconstrained offering. Consequently, lingering thoughts that ESG investing involves only ethical divestment may delay its broader adoption.7 • ESG tilts, or “best-in-classâ€? incorporation, do not necessarily require the omission of securities; they may instead involve the reweighting of those securities to favor those with higher ESG composite scores.8 The investor may place constraints on sector deviation or factor deviation9 to reduce portfolio tracking error to the benchmark, and will generally extend a level of tolerance to otherwise ESG-poor companies to hold deviations from index characteristics to a minimum. Best-in-class integration may also screen out those ESG factors that remain intolerable; it is not mutually exclusive with the more restrictive negative screening. Closely related but more in-depth (and costly) “bottom-upâ€? ESG integration tends to take a deeper look at any number of ESG factors (typically at the security level), and how those factors may or may not affect the profitability of an organization. Both methods are predicated on one of two (or both) premises: – ESG integration can improve portfolio performance on an absolute basis. – ESG integration can improve portfolio performance on a risk-adjusted basis. 7 See https://www.oecd.org/cgfi/Investment-Governance-Integration-ESG-Factors.pdf. 8 See https://www.parametricportfolio.com/insights-and-research/understanding-esg-screens-and-tilts. 9 See https://www.msci.com/documents/1296102/1339060/MSCI-FactorESG-TargetIndexes-marketing-factsheet.pdf/997a61b0-7094-469c-86a623161b6435c7.


C A P I TA L M A R K E T S F O R E C A S T 2018

Empirically, the investment merits of this portion of the implementation spectrum may be deemed the “muddy middle,” as the data is inconclusive. A 2012 survey of relevant ESG performance studies conducted by RBC Global Asset Management found minimal, if any, performance drag between ESG indices and comparable non-ESG indices.10 In fact, ESG indices often slightly outperformed non-ESG indices, though this can largely be attributed to the known ESG large-cap growth bias and the general outperformance of large-cap growth over large-cap value stocks since the early 1990s (when the first SRI indices were created). As reporting requirements improve, there will likely be greater exploration of the relationship between individual ESG factors and financial outperformance. • A growing body of evidence espouses ESG integration as a means to effectively mitigate transition risks (i.e., those risks not yet priced by the market, but whose incorporation would likely lead to the repricing of a swath of assets). This idea is salient to exceptionally large investors who effectively own the market and, by their very nature, cannot diversify away systemic risk. Some prominent financial academics, including Robert Litterman, co-developer of the Black-Litterman method for portfolio allocation, are particularly concerned with climate risk. Responding to hastening environmental change, governments may seek to limit carbon dioxide and sulfur dioxide output, which could lead to a sharp and sudden repricing of assets; market benchmarks such as the S&P 500 are typically overweight oil and gas markets relative to those companies’ share of U.S. GDP. Furthering the case for ESG as a risk management tool, those investors already using ESG criteria to manage risk have likely sidestepped losses related to regulation that targets negative environmental externalities or issues arising from poor governance. For example, MSCI ESG Research downgraded Equifax to its lowest possible rating, “CCC,” in the fall of 2016, citing poor data security measures.11 In September 2017, Equifax confirmed a massive cybersecurity breach that compromised the personal data of up to 143 million customers. Equifax stock tumbled nearly -26% by month-end.

10 See http://funds.rbcgam.com/_assets-custom/pdf/RBC-GAM-does-SRI-hurt-investment-returns.pdf. 11 See https://www.msci.com/equifax.

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•O  n the far-right end of the implementation spectrum, impact investing takes a proactive stance toward ESG investing, seeking to effect positive change while generating similar or above-average returns relative to non-impact investments.12 Impact investing is most often implemented through private equity, real asset, or private debt asset classes and typically affords the possibility of active investor-management engagement. Within public markets, impact investing is akin to thematic investing.

BALENTINE PLANS A PRELIMINARY IMPLEMENTATION WHILE MONITORING THE EVOLUTION OF ESG INVESTING AS CONSENSUS BUILDS AROUND WHERE AND HOW TO PROPERLY INTEGRATE ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONCERNS INTO THE INVESTMENT PROCESS.

Balentine: facilitating ESG investing at the ends of the implementation spectrum There is a fallacy that divestment and restricting the source of firm capital is the most effective way to bring about corporate change. Divestment seems to be a mostly theoretical proposition: increase firms’ cost of capital and they should engage in fewer ESG-unfriendly projects. This, of course, assumes no other opportunistic, unscrupulous investor is willing to step in and receive the “sin stock” premium and that funding for the firm will become increasingly difficult to source. Furthermore, as Vanguard Chairman Bill McNabb points out,13 persistent share price declines could lead to increased privatization of ESG-hampered firms, paradoxically leading to less disclosure and prolonging harmful activity. Making matters worse, conscious consumerism and selectively choosing which products to buy at the retail level are ineffective. The most likely avenue for effecting change has belonged (and will likely continue to belong) to the regulator. If the goal of the investor is simply to avoid benefitting from a “perverse” revenue source rather than truly bringing about change, most asset managers, including Balentine, can and often do provide a highly personalized, values-based option that satisfies this need, typically in the form of a separately managed account. The empirically ambiguous middle ground of the implementation spectrum suggests that some advantage for early adopters of ESG best-in-class or bottom-up integration may exist. However, the data still suffers from insufficient CSR reporting requirements and a lack of standardization of ESG metrics, many of which are qualitative. According to PwC, 92% of investors say companies are not disclosing ESG data in a fashion that promotes

12 See https://thegiin.org/assets/2017_GIIN_FinancialPerformanceImpactInvestments_Web.pdf. 13 See https://www.ft.com/content/a44dc59c-13ab-11e6-91da-096d89bd2173 (subscription required).


C A P I TA L M A R K E T S F O R E C A S T 2018

inter-company comparability, hindering investor ability to assess the efficacy of explicit ESG factor integration as a predictor of future portfolio outperformance.14 Furthermore, historical data may be ineffectual in understanding where a company’s approach to corporate social responsibility is heading. While there is prudence in large institutions acting as universal owners that use ESG criteria to assess market risk, there remains a great degree of uncertainty surrounding the timing of major “transition risks” such as climate change. The potency of ESG as a risk management tool may very well depend on the extent to which ESG issues catch the attention of policymakers. As an area of ongoing research, Balentine plans to explore the muddy middle of the implementation spectrum while monitoring the evolution of ESG investing as consensus builds around where and how to properly integrate environmental, social, and governance concerns into the investment process. Our efforts will likely invoke the aforementioned “all things being equal” test: if we can construct an ESGfriendly fund lineup using a best-in-class approach without sacrificing liquidity and while satisfying fee and tracking-error constraints, we will. However, such a portfolio will not become the default option for clients until the sources of ESG excess return have been rigorously tested and verified and have proven themselves to be durable in all market environments. More immediately, for those clients dissatisfied with separately managed accounts that utilize more restrictive ESG screens and who may be seeking to proactively effect change, we advocate impact investing within private markets. This allows for some level of active engagement without sacrificing returns. Options such as green energy and affordable housing real estate funds are readily available. Investing in private markets involves unique risks, including long lock-up periods, and requires a highly disciplined approach to improve the odds of investor success. The manager of the investment must offer active management beyond the point of commitment in exchange for the high fees charged and should not rely on excessive use of leverage to drive returns. Any impact investment we make in private markets will be subjected to such criteria. It is estimated that meeting UN Sustainable Development Goals will require nearly $7 trillion in investment through 2030.15 Our clients could help provide this capital and play a powerful role in bringing about meaningful, positive societal change while remaining firmly within the bounds of their financial goals.

14 See https://www.pwc.com/us/en/governance-insights-center/publications/esg-environmental-social-governance-reporting.html. 15 See http://www.un.org/sustainabledevelopment/sustainable-development-goals/.

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A CURRENT INVESTMENT APPROACH TO BLOCKCHAIN AND CRYPTOCURRENCIES When phenomena reach a certain level of public recognition, Balentine feels compelled to address the hysteria. Cryptocurrencies and other digital assets should not be completely dismissed; to do so would be a miscategorization of this movement as a fad rather than a force of creative destruction. However, it is important to address cryptocurrencies and digital assets1 in the context of the Balentine investment process and explain why we caution against investing in Bitcoin, et al., for the foreseeable future.

1 For the purposes of this article, we use the terms “cryptocurrency,” “crypto,” and “digital assets” interchangeably.


C A P I TA L M A R K E T S F O R E C A S T 2018

What is the investable universe? Asset classes generally represent a collection of risk premia—what might be thought of as the underlying “return drivers� of investment returns. The return on an investment exposed to a certain risk premium should be commensurate with the degree of riskiness (typically proxied by volatility) inherent in that premium. Balentine recognizes a particular risk premium if it is: a) intuitive (i.e., is the reason for return obvious?), b) pervasive (i.e., has this premium been consistent through time and is it found in multiple instruments?), and c) accessible (i.e., can this premium be readily accessed in a cheap and liquid fashion?). Examples include inflation, interest rate, credit, and equity risk premia. Some asset classes may not contain an embedded risk premium but serve some other useful portfolio function such as inflation hedging, portfolio diversification, or alpha generation. Additionally, asset classes must be sizeable. While we do not have an explicit market capitalization threshold before we consider investment inclusion, cryptocurrencies and other digital assets are only a small percentage relative to broader capital markets:2 1. Private real estate: $136 trillion 2. Global bonds: $57 trillion 3. Global equities: $42 trillion 4. Commodities: $16 trillion 5. Cryptocurrencies and digital assets: $700 billion We also need sufficient data that suggest that the expected return and risk of the asset class are persistent through time. For example, we can predict with reasonable certainty that global stocks will return somewhere around inflation +4% over the long run. As a relatively new phenomenon, cryptocurrencies do not yet have a track record through multiple cycles or different market environments.

2 Source: Savills Studley, BIS, SIFMA, World Federation of Exchanges, UN Commodity Statistics Report, https://coinmarketcap.com/.

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Assigning an asset class to cryptocurrencies Where do cryptocurrencies fit in the investment universe? It’s not an easy question to answer, as cryptocurrencies force investors to consider with more scrutiny their investment philosophy and risk tolerance.

BALENTINE IS NOT COMPLETELY DISMISSING CRYPTOCURRENCIES AS AN ASSET CLASS. HOWEVER, WE ARE CONTENT TO LET THEM EVOLVE INTO A MATURE ASSET CLASS—WHETHER AS COMMODITIES, NEW FORMS OF VENTURE CAPITAL, OR MATURING CURRENCIES AND METHODS OF PAYMENT— BEFORE WE SERIOUSLY WEIGH THE INVESTMENT MERITS OF OWNERSHIP.

Cryptocurrencies as commodities. Commodities generally serve a utilitarian function (i.e., an input in the production of another good or service). By this simple measure, cryptocurrencies are not commodities. However, certain cryptocurrencies do exhibit inflation-hedging properties, which likens them to commodities and other real assets such as real estate. Cryptocurrencies may function as hedges and/or “safe haven” assets (though few would assign the “safe” label today), mimicking the role of precious metals as a sort of “digital gold.” There is a certain amount of mining terminology inherent in the protocol of Bitcoin and a few other cryptocurrencies that makes them analogous to precious metals, particularly the deflationary concept behind placing a hard cap on new coin “issuance.” We have yet to see how Bitcoin will behave in a severe recession, but the evidence we do have suggests that it may behave similarly to, if not better than, gold in periods of market duress.3 Though highly volatile, Bitcoin will likely exhibit shock-absorber properties during periods of widespread skepticism about the stability of economic institutions, as experienced during the 2013 Cypriot “bail-in”,4 and will likely serve as a hedge against stocks and bonds generally. Cryptocurrencies as currencies. Cryptocurrencies pass the test of what is typically considered “money”: they can and do function as mediums of exchange, stores of value, and units of account, though these functions are hampered by excessive volatility. But do more traditional fiat currencies exhibit a risk premium that warrants asset class designation, thereby securing their place as an investable asset class and opening the door for cryptocurrency investment? Theoretically, no, because the return on currencies should be zero in the long term; currency risk can be hedged away. But practically speaking, yes, because interest rate parity does not hold in actuality (i.e., investors can profit from the carry trade). Furthermore, cross-currency relationships may experience long periods of deviation from the mean in excess of what is suggested by macro fundamentals, thereby allowing investors to profit from certain currency positions. It is this potential generation of alpha by an investor that leads us to conclude that cryptocurrencies are an asset class. 3 See https://papers.ssrn.com/sol3/Papers.cfm?abstract_id=2994097. 4 See http://money.cnn.com/2013/03/28/investing/bitcoin-cyprus/index.html.


C A P I TA L M A R K E T S F O R E C A S T 2018

Cryptocurrencies as venture capital. If initial coin offerings (ICOs) are analogous to early-stage private equity investing, we might expect to find something closely resembling the VC-like equity risk premium. However, digital assets are not backed by the prospect of future earnings. Rather, they are supported by the prospect of mass adoption of some network and the future value of the services underlying that network. That is, they represent a claim on future services rather than on earnings. This difference does not preclude, and in fact may support, the existence of an equity risk premium with both high upside and tail risk in certain cryptocurrency “tokens,� similar to the equity risk premium we observe in private equity markets. Looking to regulatory bodies for asset class guidance is of little value. Both central banks and statutory authorities have provided loose guidelines as to the proper classification of cryptocurrencies, but these guidelines suffer from a great deal of bias since the bodies are opining through a selfish lens. There is, obviously, a natural tendency to label an emergent asset class as something that falls within your regulatory purview or to dismiss innovation entirely until it is more readily understood and widely used. The SEC asserts that tokens are equity-like securities and will likely treat ICOs as such in the future, the Commodity Futures Trading Commission (CFTC) says cryptocurrencies are commodities, the IRS claims that they are property like gold or real estate (assigning them to the real assets and commodities category), and the U.S. Treasury, unsurprisingly, labels cryptocurrencies as a form of currency. The European Central Bank (ECB) has called Bitcoin a virtual currency, and ECB President Mario Draghi publicly denounced Estonia’s recent attempt to introduce a cryptocurrency as a potential rival to the euro. Many Federal Reserve members, including new chairman Jerome Powell, have dismissed cryptocurrencies as posing no imminent threat to central-bank issued money. Cryptocurrencies and digital assets are constantly evolving, and there remains the possibility for cryptocurrencies to fall into one or more of the aforementioned asset classes. Investors may well see digital assets within these networks develop along traditional financial asset lines and witness an ecosystem of market-like instruments develop around cryptocurrencies in the future. These instruments, such as loans, could be seen as assets structured in a particular currency, thereby fitting into the current labeling scheme. Though a tall order, we could even see the birth of an entirely new asset class, one with properties different from anything in the history of global capital markets. The developing role of cryptocurrencies in portfolios Seeking to optimize and properly design strategic portfolios with cryptocurrency is difficult, as we quickly find that we have an input failure: we cannot derive reliable estimations of expected return and expected volatility, nor can we adequately assess portfolio drawdown using some other tested measure. There is not enough data to assess correlations between cryptocurrencies and other asset classes, so there are difficulties surrounding risk management efforts that attempt to dampen volatility while satisfying drawdown constraints.

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Difficulties in assigning intrinsic value and the absence of an observable yield (typically) mean that we cannot derive reliable estimations of expected return. Courageous investors may try, perhaps, to arrive at an expected return given estimates of intrinsic value, using asset class valuation methods as a framework. • As commodities: assess the role of cryptocurrencies as a new inflation hedge or as digital gold, and calculate the current market value of the “outdated” commodity and the effects of, say, a 2% shift of all gold holders to Bitcoin • As currencies: use the quantity theory of money5 and assess payment markets penetration • As equity-like securities: use traditional equity valuation methods and solve for a terminal value derived from the eventual value of the underlying services network Balentine will continue to monitor cryptocurrency and digital asset developments, but we do not currently recommend either for inclusion in client portfolios. Cryptocurrencies fail to satisfy our risk premium test; while the risk premia inherent in cryptocurrencies and digital assets may be intuitive, it is neither pervasive nor accessible. Furthermore, cryptocurrencies and digital assets are difficult to trade, and private key storage is complex. The introduction of Bitcoin futures could open the door for the proliferation of liquid, futures-based products such as ETFs, however. Cryptocurrencies and digital assets also fail to satisfy other criteria for asset class designation. Despite rapid expansion, the market remains both undersized and immature. We do not know how cryptocurrencies will behave in certain periods given their short track record. Since it is an evolving arena, the data is distorted by excessive and speculative inflows and outflows. Until maturation, buying cryptocurrencies is more speculation than prudent asset allocation. Investors hoping to preemptively capture budding risk premia before widespread adoption and recognition of cryptocurrencies as an asset class should not only hold multiple currencies and digital assets in small proportions, but should own only those coins and tokens that appear to have reached some level of critical mass. With cryptocurrencies, there remain many idiosyncratic risks—regulatory, technological, etc.—for which investors are not currently compensated. Cryptocurrencies and digital assets therefore fail to withstand the Balentine portfolio construction process. However, we are not completely dismissing cryptocurrencies, as we are likely experiencing a period of creative destruction and a “fattening” of the protocol layer that could produce significant societal and investor value in the long run.6 Cryptocurrencies are simply too new, and we are content to let them evolve into a mature asset class—whether as commodities, new forms of venture capital, or maturing currencies and methods of payment—before we seriously weigh the investment merits of ownership.

5 See https://files.stlouisfed.org/files/htdocs/publications/es/06/ES0625.pdf. 6 See http://www.usv.com/blog/fat-protocols.


APPENDIX


36 S K E P T I C I S M T O O P T I M I S M

Each year, the goal for our strategic forecast is to re-evaluate the starting point for the next market cycle (as defined as a forthcoming seven-year period) in order to answer the following questions: • What returns are realistically possible during the market cycle? • What risks may have to be assumed to capture those returns? • What minimum acceptable after-inflation rate of return can be expected from diversification, and what other ways can we bridge the gap between what is possible and what investors require? • For strategies that are required to support 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 on our updated projections, we restructure our strategic asset allocation targets in key areas in order to maximize the efficiency of our strategies and therefore better meet our clients’ objectives over the next market cycle. Our forecast provides the quantitative blueprint for the steps we are taking to both manage risk and maximize opportunities in 2018 and beyond. It is important to note that just because we annually update our strategic forecast for asset classes and the corresponding strategy weights, that does not mean that these are tactical, one-year allocations. Rather, our updated weights contemplate the market’s actions during the preceding year and rely on mean reversion. Put differently, the starting point for the succeeding seven years is critical because the dominant factor in forecasting asset class returns over a market cycle is the starting point of today’s valuation level. Over the longterm, markets show a strong tendency to mean revert to historical averages adjusted for underlying trends. This is because high profits and momentum attract investors and drive down future returns in highly valued asset classes.


C A P I TA L M A R K E T S F O R E C A S T 2018

An Overview of Balentine Strategies Though strategies are customized for the unique goals of each of our clients, we illustrate the expected return and risk trade-offs from today’s starting point by evaluating four different levels of risk aversion. Risk budgets are based on the long-term historical outcomes of bond and equity benchmarks. The Conservative strategy represents the risk level of a 100% bond portfolio, and the Aggressive strategy represents the risk level of a 100% equity portfolio. In between are the Balanced and Growth strategies. Moreover, there are Public Market and Fully Diversified options, both with and without Private Capital, which exhibit tradeoffs between reducing volatility and the ability to achieve outsized upside.

Expected Return and Risk Assumptions across Building Blocks Return

Risk

Fixed Income

2.7%

3.9%

Market Risk

6.7%

16.0%

Manager Skill

8.2%

6.0%

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

-0.2

0.2

Manager Skill

0.0

-0.2

1.0

-0.2

Private Capital

0.0

0.2

-0.2

1.0

Drawdown Tolerances Public Market

Fully Diversified

Aggressive

25%

20%

Growth

20%

15%

Balanced

15%

10%

Conservative

10%

5%

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38 S K E P T I C I S M T O O P T I M I S M

Strategy Strategic Weights and Expected Returns: Public Markets Aggressive Minimum

Strategic

Growth Maximum

Minimum

Strategic

Maximum

Fixed Income

0.0%

0.0%

20.0%

0.0%

20.0%

40.0%

Market Risk

80.0%

100.0%

100.0%

60.0%

80.0%

100.0%

Expected Return Expected Volatility Expected Drawdown

6.7%

5.9%

16.0%

12.8%

(25%)

(20%)

Balanced

Conservative

Minimum

Strategic

Maximum

Minimum

Strategic

Maximum

Fixed Income

20.0%

45.0%

65.0%

35.0%

65.0%

90.0%

Market Risk

35.0%

55.0%

80.0%

10.0%

35.0%

65.0%

Expected Return

4.9%

4.1%

Expected Volatility

9.0%

6.1%

Expected Drawdown

(15%)

(10%)

Strategy Strategic Weights and Expected Returns: Fully Diversified Aggressive Minimum

Growth

Strategic

Maximum

Minimum

Strategic

Maximum

Fixed Income

0.0%

0.0%

17.5%

0.0%

17.5%

32.5%

Market Risk

65.0%

82.5%

82.5%

50.0%

65.0%

82.5%

Manager Skill

15.0%

17.5%

20.0%

15.0%

17.5%

20.0%

Expected Return Expected Volatility Expected Drawdown

6.3%

5.6%

13.3%

10.6%

(20%)

(15%)

Balanced

Conservative

Minimum

Strategic

Maximum

Minimum

Strategic

Maximum

Fixed Income

15.0%

35.0%

70.0%

25.0%

50.0%

75.0%

Market Risk

10.0%

45.0%

65.0%

0.0%

25.0%

50.0%

Manager Skill

17.5%

20.0%

22.5%

22.5%

25.0%

27.5%

Expected Return

4.7%

4.0%

Expected Volatility

7.2%

4.7%

Expected Drawdown

(10%)

(5%)


C A P I TA L M A R K E T S F O R E C A S T 2018

Strategy Strategic Weights and Expected Returns: Public Markets with Private Capital Aggressive

Growth

Minimum

Strategic

Maximum

Minimum

Strategic

Maximum

Fixed Income

0.0%

0.0%

42.5%

17.5%

25.0%

62.5%

Market Risk

37.5%

80.0%

80.0%

17.5%

55.0%

62.5%

Private Capital

10.0%

20.0%

30.0%

10.0%

20.0%

30.0%

Expected Return Expected Volatility Expected Drawdown

7.6%

6.6%

13.7%

9.9%

(20%)

(15%)

Balanced

Conservative

Minimum

Strategic

Maximum

Minimum

Strategic

Maximum

Fixed Income

37.5%

55.0%

80.0%

62.5%

70.0%

80.0%

Market Risk

0.0%

25.0%

42.5%

0.0%

10.0%

17.5%

10.0%

20.0%

20.0%

10.0%

20.0%

30.0%

Private Capital Expected Return

5.7%

4.7%

Expected Volatility

7.1%

4.6%

Expected Drawdown

(10%)

(5%)

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40 S K E P T I C I S M T O O P T I M I S M

Strategy Strategic Weights and Expected Returns: Fully Diversified with Private Capital Aggressive

Growth

Minimum

Strategic

Maximum

Minimum

Strategic

Maximum

Fixed Income

0.0%

0.0%

42.5%

0.0%

17.5%

62.5%

Market Risk

20.0%

62.5%

62.5%

0.0%

45.0%

62.5%

Manager Skill

15.0%

17.5%

20.0%

15.0%

17.5%

20.0%

Private Capital

10.0%

20.0%

30.0%

10.0%

20.0%

30.0%

Expected Return Expected Volatility Expected Drawdown

7.2%

6.3%

11.1%

8.4%

(20%)

(15%)

Balanced

Conservative

Minimum

Strategic

Maximum

Minimum

Strategic

Maximum

Fixed Income

15.0%

30.0%

60.0%

30.0%

40.0%

55.0%

Market Risk

0.0%

30.0%

45.0%

0.0%

15.0%

25.0%

Manager Skill

17.5%

20.0%

22.5%

22.5%

25.0%

27.5%

Private Capital

10.0%

20.0%

30.0%

10.0%

20.0%

30.0%

Expected Return

5.8%

5.0%

Expected Volatility

6.4%

4.7%

Expected Drawdown

(10%)

(5%)


C A P I TA L M A R K E T S F O R E C A S T 2018

Index Projections Fixed Income YTM

Duration

Bloomberg Barclays U.S. Aggregate

2.7%

5.9

Bloomberg Barclays U.S. Treasury

2.1%

6.1

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

1.9%

7.6

Bloomberg Barclays U.S. Municipal Bond

2.8%

5.6

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

2.8%

7.4

Bloomberg Barclays Treasury Inflation Protected Notes (TIPS)

2.3%

6.2

Bloomberg Barclays Global Aggregate

1.4%

6.9

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

6.7%

3.9

JP Morgan EMBI Global Diversified

5.0%

6.6

Return

Risk

MSCI AC World

4.7%

16.0%

Russell 1000

3.1%

14.5%

Russell 2000

3.9%

19.2%

MSCI EAFE

5.7%

17.0%

MSCI EAFE Small Cap

6.3%

19.7%

MSCI Europe

5.1%

17.0%

MSCI Japan

7.1%

21.0%

MSCI EM (Emerging Markets)

8.3%

23.5%

FTSE NAREIT/Equity Diversified – SEC

6.0%

20.0%

Alerian MLP

7.5%

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

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42 S K E P T I C I S M T O O P T I M I S M

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

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

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


C A P I TA L M A R K E T S F O R E C A S T 2018

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, differences in generally accepted accounting principles, or 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 your financial status, risk, and return preferences. Investment recommendations may change and readers are urged to check with their investment advisors before making any investment decisions.

TERMINOLOGY Balentine utilizes a building blocks approach to asset management. Our five building blocks are 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 that these assets cannot lose value. More information about our building blocks strategy can be found on our website (www.balentine.com).

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.

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44 S K E P T I C I S M T O O P T I M I S M

Performance is presented net of (i.e., 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 from 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 in which 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 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.


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Profile for Balentine

2018 Capital Markets Forecast