Fiscal 2015 INVESTMENT PLAN
June 19, 2014
60-118, 6/14/75
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Fiscal 2015 Investment Plan
Table of Contents
I. Purpose.................................................................................................................................1
II. Investment Plan Overview.................................................................................................3 • Forecast in Brief................................................................................................................3 • Economic Overview..........................................................................................................3 • Total Fund Outlook...........................................................................................................4 • Investment Plan Themes...................................................................................................5 III. Asset Allocation/Risk/ERM Matrix...................................................................................7 • Risk Budget.......................................................................................................................8 IV. Fiscal 2015 Economic Outlook.........................................................................................13 • U.S. Economic Growth and Inflation Outlook................................................................13 • U.S. Economic Forecast..................................................................................................19 • International Economic Growth and Inflation Outlook..................................................20 • International Forecasts....................................................................................................23 V. Fixed-Income Investments...............................................................................................25 • Outlook...........................................................................................................................25 • Strategy...........................................................................................................................28 VI. Domestic Equities Investments........................................................................................31 • Outlook...........................................................................................................................31 • Strategy ..........................................................................................................................35 VII. International Investments................................................................................................37 • Outlook...........................................................................................................................37 • Strategy...........................................................................................................................40 VIII. Real Estate Investments....................................................................................................43 • Outlook...........................................................................................................................43 • Strategy...........................................................................................................................46 IX. Alternative Investments — Private Equity.....................................................................51
X. Alternative Investments — Opportunistic/Diversified .................................................55
Fiscal 2015 Investment Plan
I. Purpose The Investment Plan provides strategy for fiscal year 2015 based on the State Teachers Retirement Board’s long-term objectives and the forecasted climate. Because the staff forecast is based on estimates of a future economic climate, modifications to the plan may be necessary. Modifications will be communicated to the Retirement Board in monthly reviews of the plan as needed.
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Fiscal 2015 Investment Plan
II. Investment Plan Overview FORECAST IN BRIEF Fiscal 2015 Projected Ranges
Fiscal 2014 Forecast
Real Gross Domestic Product
2.25%–3.75%
2.4%
Real Personal Consumption
2.25%–3.75%
2.9%
0%–10%
3.2%
1.1–1.3
0.966
Real Net Exports (billions)
($460)–($400)
($408.4)
Consumer Price Index
1.25%–2.75%
1.7%
S&P 500 Earnings
$108–$126 (2.6%)–13.7%
Real Business Fixed Investment Housing Starts (millions)
$110.83 11.6%
Fiscal 2015 Projected Ranges
End-of-April 2014
Federal Funds Target Rate
0%–0.75%
0.13%
10-Year Treasury Note Yield
2.25%–4%
2.65%
ECONOMIC OVERVIEW U.S. real economic activity grew only an annualized 0.1% in fiscal 2014’s third quarter — a number that seemingly would warn about an imminent recession. However, an abnormally cold and snowy winter in much of the country limited consumer spending and housing-related activity. Foreign trade also detracted from growth after contributing a large part of the 2.6% total growth in the second fiscal quarter, while business inventory drawdowns continued from huge increases at the end of fiscal 2013 and beginning of fiscal 2014. Furthermore, the new health care law pushed a great deal of personal consumption toward health care services spending and away from normal durables and non-durables spending that would have had larger multiplier effects on the rest of the economy. Nonetheless, economic activity is thawing from that deep freeze and is poised to grow above the long-term trend of roughly 2.5% because of gradually improving employment and income prospects, a rebound in housing activity, and a return to solid business fixed investment. Private domestic final sales (that excludes inventory changes, government spending and foreign trade from total economic activity) should continue to outgrow the overall economy, providing a strong foundation for any positive or negative economic surprises. Inflation pressures will likely grow but inflation itself should remain largely contained, allowing the Federal Reserve to end quantitative easing in the fiscal year’s first half before short-term interest rates edge higher around the end of the fiscal 2015. For the United States and elsewhere, here are some of the key points to the STRS Ohio economic forecast:
•
Real GDP (gross domestic product) in the United States is expected to grow 3.1% in fiscal 2015 after a 2.4% gain in fiscal 2014, but private domestic final sales growth should show a more robust 3.8% growth rate after a 2.9% advance in fiscal 2014. With persistent disinflationary
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trends in the midst of slow economic growth, developed countries’ central banks should maintain easy monetary policies in fiscal 2015. Meanwhile, emerging countries should grow moderately as they consolidate newly-elected governments and policies. China’s labor force growth is heading to a slowdown that will steadily lower the trend GDP growth rate for the country in the second half of this decade. In fiscal 2015, Chinese real GDP growth should ease into the 6.5–7% range. For most emerging countries, higher-than-desired inflation will remain an issue during fiscal 2015 and force them to maintain their current monetary policy constraints. •
In the United States, monthly employment gains have averaged 197,000 in fiscal 2014. Recent increases have averaged 238,000 per month. Job gains will likely remain in the 200,000–250,000 per month range during fiscal 2015 as public policy changes that affected employment continue to ease and businesses increase hiring plans. The unemployment rate should steadily decline from today’s 6.3–6.7% range to about 6% at fiscal year end, supporting solid consumer spending. Recoveries in the housing and business investment sectors will be needed to offset ongoing negatives to economic growth from the government and foreign sectors.
•
Inflation should move higher toward the Federal Reserve’s target of 2% growth in the second half of the fiscal year after economic activity accelerates through the first half. Consumer prices are expected to grow in the 1.5–2% range during the fiscal year, matching the range for broader inflation indices like the GDP price index. The Federal Reserve remains on course to end quantitative easing at either its October or December FOMC meeting. The Fed will then plan for gradual measured increases in the federal funds targeted rate that should begin in late fiscal 2015 or early fiscal 2016.
• Moderately above long-term trend economic growth with slowly building inflation pressures makes up the baseline economic forecast for the United States in fiscal 2015. Growth in the 2.25–3.75% range carries about a 70% chance of occurring. Growth below 2.25% and above 3.75% each carries about a 15% chance of occurring. The baseline forecast has nominal GDP growth of 4.8% — roughly in line with the consensus forecast though the STRS Ohio forecast expects a better mix of slightly stronger real GDP growth and smaller growth in inflation.
TOTAL FUND OUTLOOK During fiscal 2015, STRS Ohio investment assets are projected to be relatively flat from fiscal 2014 year end assets of approximately $73 billion. While this plan estimates a positive total fund return, the market environment we forecast will only roughly offset the $4 billion of net benefit payments (benefits and operating expenses less contributions) anticipated for fiscal 2015. The table on Page 5 illustrates the expected annual market forecast for each asset category for fiscal 2015 relative to the Retirement Board’s policy for expected average annual returns. As detailed in the various sections of this plan, we project fiscal 2015 to be below normal for the STRS Ohio total fund return based upon market levels in May 2014. With the fiscal 2013 and 2014 total fund returns exceeding +13%, a more moderate positive return is expected for fiscal 2015.
Fiscal 2015 Investment Plan
ANTICIPATED MARKET RETURNS Board Policy Expected Average Annual Benchmark Returns
Benchmark Annualized Return Expectation for Fiscal 2015*
Liquidity Reserves
3.00%
Below Normal
Fixed Income
3.75%
Below Normal
Domestic Equities
8.00%
Below Normal
International
7.85%
At Normal
Real Estate
6.75%
Above Normal
Alternative Investments
8.00%
Below Normal
Total Fund
7.61%
Below Normal
*Based upon market levels in mid-May 2014. Should market levels change significantly by late June 2014, an updated projection will be issued.
INVESTMENT PLAN THEMES •
The U.S. economy is forecasted to grow by at least 3% for the first time since the Great Recession ended. This should provide an environment with a more sustainable fundamental backdrop and less vulnerability to external shocks. While asset prices in most cases are not at extreme levels, we observe full valuations across most of our investment opportunities. This is reflective of the stable, strong returns experienced during the past several years.
• Following a comprehensive review and initial implementation of changes to enhance the structure and performance of domestic equities during fiscal 2014, staff will move forward with a second phase of changes to the asset class this year. An internal small cap value portfolio and a concentrated value portfolio will be initiated at the beginning of fiscal 2015. • The final phase-in of the STRS Ohio asset-liability study was completed during fiscal 2014. Staff anticipates the hiring and funding of two new international external managers by the start of fiscal 2015. This will add sufficient capacity in the combined internal/external manager platform to effectively manage to the higher international asset class target weighting as market conditions change. • The second asset class that received a higher target weighting from the asset-liability study was alternative investments. Staff will attempt to move the actual weighting closer to the target weighting during fiscal 2015. We anticipate that increasing the private equity weighting will continue to be challenging, but expect to make meaningful progress in opportunistic/diversified. •
The increase in funding of international equities and alternatives is likely to be drawn from the overweight in liquidity reserves and fixed income.
• The staff will closely monitor the ERM matrix for investments and make timely changes if needed.
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Fiscal 2015 Investment Plan
III. Asset Allocation/Risk/ERM Matrix AVERAGE LONG-TERM POLICY WEIGHT, ESTIMATED JUNE 2014 WEIGHT AND STRATEGY FOR FISCAL 2015 (as a percentage of total assets at market)
July 1, 2014 Neutral Weights
Estimated June 2014 Weight
Liquidity Reserves
1%
3.0%
Fixed Income
18%
19.2%
Domestic
31%
30.5%
International
26%
26.0%
Total Equities
57%
56.5%
Real Estate
10%
9.3%
Private Equity
7%
6.3%
Opportunistic/Diversified
7%
5.7%
Total Alternatives
14%
12.0%
100%
100.0%
Equities
Alternative Investments
Total
General Strategy for Fiscal 2015* The Federal Reserve will end QE3 during fiscal 2015 but will likely leave the federal funds rate unchanged during most of the year. The result will be short-term interest rates remaining near 0% for more than six consecutive years. Liquidity reserves will likely be moving closer to its target weighting during the year as it will become a source of funds, especially for international equities, alternative investments and payment of net benefits. We expect moderately rising interest rates/declining bond prices to roughly offset the low 2.5% yield on this asset class, causing total returns for fixed income to finish fiscal 2015 with flat or even slightly negative returns. The asset class begins the year above the target weighting, but will likely be declining. We will evaluate the relative value of fixed income compared to liquidity reserves during the course of the year to determine which asset class is a better source of liquid funds when needed. We are slightly more optimistic in our outlook for international equities relative to domestic equities, primarily due to valuations, especially in emerging markets. Correspondingly, we expect to begin the year near neutral in international, consistent with our expectation for fiscal 2015 returns to achieve our long-term policy returns. We will begin the year slightly below neutral in domestic, where we expect below policy returns. The real estate asset class is projected to have the best return compared to its long-term policy return of all of our asset classes. Real estate fundamentals are improving, but transaction activity is brisk with significant capital competing for the most attractive opportunities. We begin the fiscal year modestly below the target weighting, expecting to finish fiscal 2015 close to neutral. We expect to begin the year about two percentage points below the target weighting in aggregate. While we will actively seek opportunities in both areas of alternatives, the more attractive longterm investments are expected to be sourced in opportunistic/diversified (O/D). We expect O/D could be at or slightly above the 7% target weighting by the end of fiscal 2015, surpassing private equity, which will almost certainly remain below 7%. This should move the total asset class closer to the 14% target weighting.
* * More detailed asset weightings and projections are provided to the Retirement Board at its monthly meetings, which provides the Retirement Board more current updates to the overall strategy.
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RISK BUDGET Investment Portfolio Risk Introduction There are two primary types of investment risk that the Retirement Board and the staff need to manage: capital market risk and active management risk. The first type describes the volatility of the policy returns, and is a result of the plan assets being invested in the selected asset classes. The April 2012 asset-liability study determined an acceptable amount of capital market risk (14.6%) and established appropriate allocations. STRS Ohio actively manages most of its investments; therefore, the fund will have active management risk. This risk refers to the return fluctuations around the benchmark return that result from active management decisions. The amount of active management risk indicates how closely the portfolio returns will match the benchmark returns. The policy range of active management risk for the total fund is 20 to 160 basis points. The staff uses the risk budget to manage this risk. Although active management is a source of volatility, it is much lower than and uncorrelated with the capital market risk. This means that adding active management risk to the fund will not cause a large increase in total fund volatility. Thus, over the long run, the actions of the staff are not expected to change the total volatility of the fund materially. Asset Allocation and Capital Market Risk The appropriate amount of capital market risk for the STRS Ohio portfolio is determined in an asset-liability study. The study establishes an optimal target weight for each asset class. This means there is no other combination of asset classes that has lower risk while achieving the same expected return. The fiscal 2012 asset-liability study updated expected returns, risk levels and the asset mix for the fund. Over a 10-year period, the board’s investment consultant indicates that the accepted asset mix should generate a return of 7.61% (without value added), yet over a 30-year period the return should be in excess of 8%. The following table contains the current and target allocations for each asset class and the expected return and capital market risk. Estimated Expected Capital Market Target Rebalancing June 2014 Asset Class Return Risk Allocation** Range Weight Domestic Equities
8.0%
18.1%
31%
26%–36%
30.5%
International Equities
7.85%
20.9%
26%
21%–31%
26.0%
Fixed Income
3.75%
4.5%
18%
13%–25%
19.2%
Real Estate
6.75%
16.35%
Private Equity
9.0%
30.0% 7%
4%–9% 6.3%
Opportunistic/Diversified 7.0%
11.0% 7%
3%–9% 5.7%
Liquidity Reserves
0.9% 1%
0%–5% 3%
Total Fund
3.0% 7.6%*
* Does not include active management returns ** As of January 1, 2014
10% 6%–13% 9.3%
14.6%
Fiscal 2015 Investment Plan
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The expected capital market risk for the total investment portfolio benchmark is 14.6%, which means there is a 95% probability that the investment portfolio returns will be in the range of –20% to 42%. There is a 68% probability that the investment portfolio returns will be in the range of –8% to 23%.
•
Another risk concept we utilize is the “value-at-risk.” According to this measure, there is on average a 5% chance under the target allocation that the fund could decline $11.8 billion or more in a single year.
Risk Budgeting and Active Management Risk Active management risk refers to portfolio return fluctuations around the benchmark return that result from active management decisions. Risk budgeting is a tool used by the staff to efficiently allocate active management risk among the asset classes by assigning active management risk ranges. The goal of a risk budget is to maximize the active management returns earned within a board-approved active management risk range for the total fund. Empirical evidence shows that less efficient markets such as real estate and emerging markets offer greater opportunities for active management returns compared to more efficient markets such as domestic equities and domestic fixed income. Therefore, the estimated active management risk for real estate and international equities should be higher than the other asset classes. Based upon quantitative work developed by the staff, we estimate that the total fund level of active management risk is currently 87 basis points. The STRS Ohio total fund return should track within plus or minus two times the expected active management risk level relative to the total fund composite benchmark. Thus, if the total fund composite benchmark earns 8% for the year, the STRS Ohio return is expected to be within 1.74% (two times 0.87%) of this return, i.e., between 6.26% and 9.74%. Similarly, in a year when the benchmark return is –3%, the STRS Ohio return is expected to be between –4.74% and –1.26%. The policy range of active management risk for the total fund is established to achieve the net active management return goal of 40 basis points as specified in the Statement of Investment Objectives & Policy. This policy range is the basis for the policy ranges of the individual asset classes. Expected operating ranges for the asset classes are created by staff each year to efficiently achieve the desired level of active management risk for the total fund. Operating ranges must fall within the policy ranges for each asset class and for the total fund. The table on Page 10 shows the June 2014 estimate and the fiscal 2015 expected operating range of active management risk for each asset class. These measures are expected to fluctuate slightly during the fiscal year; however, no material deviations from these measures are anticipated. The active management risk of the total fund is expected to fall in the range of 60 to 120 basis points during fiscal 2015. This range includes tactical risk due to asset allocation bets that is not included within the individual asset class active management risk estimates. These asset allocation bets are likely to vary throughout the year, so this will result in various amounts of tactical risk.
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FISCAL 2015 ACTIVE MANAGEMENT RISK Asset Class
Estimated Expected June 2014 Active Fiscal 2015 Management Risk Operating Range (basis points) (basis points)
Liquidity Reserves
Policy Range (basis points)
N/A
N/A
N/A
Fixed Income
38
25–85
10 –150
Domestic Equities
90
70–150
20 –150
International Equities
78
70 –170
70 –250
Real Estate
350
350* 200 –700
Alternative Investments
N/A
N/A
N/A
Tactical Asset Allocation
63
20 –80
N/A
Total Fund
87
60–120
20–160
*As explained in the paragraph below, this estimate is static unless a significant portfolio adjustment occurs.
Unlike other asset classes, real estate does not have a model that can be used to accurately estimate active management risk. Instead the estimate is based on historical active management returns, the amount of leverage in the portfolio, and past real estate market volatility. These factors are unlikely to change much over time without a significant change to the portfolio; therefore, the estimated active management risk for real estate will be static most years. The following chart explains where the active management risk for the total fund is generated.
CONTRIBUTION TO ACTIVE MANAGEMENT RISK
Domestic Equities 15%
International Equities 5% Fixed Income 2%
Tactical Asset Allocation 61%
Real Estate 17%
Private Equity 0% Opportunistic/ Diversified 0% Liquidity Reserves 0%
Fiscal 2015 Investment Plan
IMPACT AND PROBABILITY ANALYSIS FOR INVESTMENTS PROBABILITY
LOW MEDIUM HIGH
MEDIUM
LOW
• Long-Term Sovereign Deficit and Debt Issues
• Poor Asset Class Returns Long Term • Diversification Ineffective
• Recession
• Not Earning 7-3/4% in a Fiscal Year
s
FINANCIAL IMPACT
HIGH
• Not Earning 7-3/4% Longer Term • Recession
• Global Financial Stress Related to Low Economic Growth
• Deflation
• Corporate Fraud (Securities Litigation)
• Poor Investment
• Buy Ohio
• Ethics Violations
• Long-Term Inflation Greater Than 3.5%
• Divestment • Investment Operations Failures
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Fiscal 2015 Investment Plan
IV. Fiscal 2015 Economic Outlook U.S. ECONOMIC GROWTH AND INFLATION OUTLOOK Though the economy appeared to finally gain momentum during the first half of fiscal 2014 when real gross domestic product grew 3.4%, the slowest post-World War II recovery tripped up further in the fiscal year’s third quarter when real GDP advanced only 0.1% at an annualized rate. Revised monthly economic data released since the first report of that quarter’s economic activity point to a downward revision to real GDP growth, making it the first negative quarter in three years and prompting questions about the economic expansion’s durability. The five-year-old economic expansion has gone through many fits and starts that have limited average real economic activity to just 2.25% while average growth over similar postwar periods has been almost double that. In the fiscal year’s third quarter, abnormally cold and snowy weather throughout much of the country drove headline economic activity downward even as underlying consumer, housing, and business investment demand continued to cruise along in the low 2% range. The third fiscal quarter — like so many before it — was representative of an economy that has been incapable of generating broad-based, stronger activity in what has now become an economic expansion that matches the average expansion length of the postwar period.
LEADING INDICATORS ANTICIPATE AN IMPROVING ECONOMY Conference Board Leading Economic Indicators Growth Rate % ECRI Weekly Leading Index Growth Rate (Avg. %) % 30 30
30
20 20
20
10 10
10
0 0
0 Conference Board ECRI
-10 –10
–10
-20 –20
–20
Jan 5 1990 1990 - Jan Apr 20 1990 1990 - May Aug 3 1990 1990 Sep Nov 16 1990 1991 - Jan Mar 1 1991 Jun 14-1991 1991 May Sep 27 1991 1991 Sep Jan 10 1992 1992 - Jan Apr 24 1992 1992 - May Aug 7 1992 1992 Sep Nov 20 1992 1993 - Jan Mar 5 1993 1993 May Jun 18-1993 Oct 11993 1993 Sep Jan 14 1994 1994 - Jan Apr 29-1994 1994 May Aug 12 1994 1994 - Sep Nov 25 1994 1995 - Jan Mar 10 1995 1995 May Jun 23-1995 1995 Sep Oct 61995 Jan 19 1996 1996 - Jan May 3 1996 1996 - May Aug 16 1996 1996 - Sep Nov 29 1996 1997 - Jan Mar 14 1997 1997 May Jun 27-1997 1997 Sep Oct 10 1997 Jan 23 1998 1998 - Jan May 19988-1998 May Aug 21 1998 1998 - Sep Dec 4 1998 1999 - Jan Mar 19 1999 1999 May Jul 2-1999 1999 Sep Oct 15 1999 2000 - Jan Jan 28 2000 May 12-2000 2000 May Aug 25 2000 2000 Sep Dec 8 2000 2001 - Jan Mar 23 2001 2001 - May Jul 6 2001 2001 Sep Oct 19 2001 2002 - Jan Feb 1 2002 2002 May May 17-2002 Aug 30 2002 2002 Sep Dec 13 2002 2003 - Jan Mar 28 2003 2003 - May Jul 11 2003 2003 Sep Oct 24 2003 2004 - Jan Feb 6 2004 2004 May May 21-2004 Sep 32004 2004 Sep Dec 17 2004 2005 - Jan Apr 1-2005 2005 May Jul 15 2005 2005 - Sep Oct 28 2005 2006 - Jan Feb 10 2006 2006 May May 26-2006 2006 Sep Sep 82006 Dec 22 2006 2007 - Jan Apr 6-2007 2007 May Jul 20 2007 2007 - Sep Nov 2 2007 2008 - Jan Feb 15 2008 2008 May May 30-2008 2008 Sep Sep 12 2008 Dec 26 2008 2009 - Jan Apr 10-2009 2009 May Jul 24 2009 2009 Sep Nov 6 2009 2010 - Jan Feb 19 2010 2010 May Jun 4-2010 2010 Sep Sep 17 2010 2011 - Jan Dec 31 2010 Apr 15-2011 2011 May Jul 29 2011 2011 Sep Nov 11 2011 2012 - Jan Feb 24 2012 2012 - May Jun 8 2012 2012 Sep Sep 21 2012 2013 - Jan Jan 4 2013 2013 May Apr 19-2013 Aug 22013 2013 Sep Nov 15 2013 2014 - Jan Feb 28 2014
–30 -30
1990 1995 2000 2005 2010
Source: Haver Analytics
Conference Board ECRI Note: Shaded areas denote recession.
–30
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Even with another likely negative growth quarter being added to the current expansion’s unsatisfying history, there are increasingly robust indicators that the U.S. economy is entering a more sustainably stronger growth phase — one that should be similar to those experienced in the mid-cycle periods of the prior two long expansions shown in the chart on Page 13. Other than the burst in leading economic indicators in the first year following the Great Recession and a short rebound in 2011, there have not been instances where various macroeconomic models of future economic activity agreed that economic growth would move to a higher range. Since the middle of winter, however, the ECRI leading index (a measure that is heavily influenced by weekly financial market series) has projected stronger economic activity in coming quarters and is now aligned with the signal from The Conference Board’s series (a measure that is heavily influenced by monthly economic series) and other economic variables that had previously pointed to stronger future growth. In fiscal 2015, the STRS Ohio economic forecast expects real GDP growth of 3.1% — resulting in activity that would be greater than the economy’s long-term potential growth of roughly 2.5%. Gradually improving employment and income prospects, a rebound in housing activity, and a return to solid business fixed investment should push economic growth back toward the three-decade average annualized growth in the economy before the Great Recession struck. The long-term drags of negative demographic changes from Baby Boomers exiting the labor force and an ongoing unwinding of too much debt across the economy (particularly with unresolved entitlement financing and spending problems for current and future federal fiscal policy) will continue to weigh upon potential economic growth. In the mid-cycle phases of the 1990s and 2000s expansions, real economic activity consistently grew between 3% and 5%.
REAL AND NOMINAL ECONOMIC GROWTH SHOULD ACCELERATE IN FY2015 Real Gross Domestic Product % Change — Year to Year Nominal Gross Domestic Product % Change — Year to Year 8 8
8
6 6
6
4 4
4
2 2
2
0 0
0
Real GDP
–2 -2
–2
–4 -4
–4
–6 -6
–6 1995 2000 2005 2010 2015
Source: Bureau of Economic Analysis
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90
90 Q1 - 91 Q3 19 - 91 Q1 19 - 92 Q3 19 - 92 Q1 19 - 93 Q3 19 - 93 Q1 19 - 94 Q3 19 - 94 Q1 19 - 95 Q3 19 - 95 Q1 19 - 96 Q3 19 - 96 Q1 19 - 97 Q3 19 - 97 Q1 19 - 98 Q3 19 - 98 Q1 19 - 99 Q3 19 - 99 Q1 20 - 00 Q3 20 - 00 Q1 20 - 01 Q3 20 - 01 Q1 20 - 02 Q3 20 - 02 Q1 20 - 03 Q3 20 - 03 Q1 20 - 04 Q3 20 - 04 Q1 20 - 05 Q3 20 - 05 Q1 20 - 06 Q3 20 - 06 Q1 20 - 07 Q3 20 - 07 Q1 20 - 08 Q3 20 - 08 Q1 20 - 09 Q3 20 - 09 Q1 20 - 10 Q3 20 - 10 Q1 20 - 11 Q3 20 - 11 Q1 20 - 12 Q3 20 - 12 Q1 20 - 13 Q3 20 - 13 Q1 20 - 14 Q3 20 - 14 Q1 20 - 15 Q3 - Q 1
1990
19
19
14
Real GDP Nominal GDP Note: Shaded areas denote recession.
Nominal GDP
Fiscal 2015 Investment Plan
The chart on Page 14 shows real (inflation-adjusted) economic growth and nominal (inflation included) economic growth during the prior two long and productive business cycles and the current sluggish one. Looking at the latest expansion following the long and deep recession of 2008–2009, the forecast of 3.1% real GDP growth for fiscal 2015 previously happened in the first year of the economic expansion and during fiscal 2012. However, in each of those instances, the improving trend was not sustained. The STRS Ohio economic forecast of 4.8% nominal GDP growth during fiscal 2015 would also be similar to nominal growth during those two prior years of the current economic expansion. More importantly, with private domestic final sales (a measure that includes personal consumption, residential investment, and business fixed investment) expected to grow 3.8% in fiscal 2015, the fundamental building blocks of the economy would reach a new high for growth that previously peaked at 3.5%. Greater clarity from federal fiscal policy with no significant likely changes in the upcoming year and the expectation of fewer problems overseas should finally provide the backdrop where better economic activity is sustainable beyond fiscal 2015. In fiscal 2015, stronger economic growth will be heavily dependent upon greater jobs and income gains. During fiscal 2014, monthly employment gains have averaged 197,000 — slightly better than the average 195,000 monthly increase in fiscal 2013. The unemployment rate has fallen from 7.5% at the end of fiscal 2013 to 6.3% today, though a large part of that significant drop can be attributed to an unwanted fall in labor force participation by discouraged workers opting out of the jobs market. Recent employment gains have averaged 238,000 a month and have coincided with improving consumer sentiment, anecdotal accounts of better retail sales activity, and hard economic data of stronger consumer spending after the winter doldrums. Income growth has reaccelerated as well, with wages and salaries growth at an annualized 5% in the third fiscal quarter after growing half as much in the first half of the fiscal year. The STRS Ohio economic forecast expects job gains will likely remain in the 200,000 to 250,000 per month range during fiscal 2015 while the unemployment rate should steadily decline from today’s 6.3% to 6.7% range toward 6% at the end of fiscal 2015. While substantial fiscal policy changes slowed employment gains since the expansion’s beginning, businesses have increasingly adapted and now plan to increase hiring. Real disposable (after-tax) personal income is expected to grow by 3% after advancing only 2.1% in fiscal 2014 and 0.9% in fiscal 2013. urther gains in jobs and income growth should help maintain real consumer spending at 3% in the F upcoming fiscal year and contribute to stronger recoveries in the housing and business investment sectors of the economy — areas where better growth will be needed to offset ongoing lack of contributions from the government and foreign sectors. Business orders for new capital equipment and new housing starts (particularly apartment and condominium housing starts) are showing signs of renewed surges following a slow winter. Capital equipment orders grew an annualized 19.3% in the last two months of third fiscal quarter after being flat during the first half of the fiscal year. Meanwhile, seasonallyadjusted housing starts have moved back over one million units (at an annual rate) in April following a dip below 900,000 units during the worst part of winter. While the monthly National Association of Home Builders survey of conditions has been stagnant from current activity since mid-winter, the International Strategy and Investment weekly survey of single-family homebuilders has soared since the end of winter as it picks up trends of better prospective buyer traffic and sales. usiness fixed investment makes up roughly an eighth of the real economy while the housing B sector is now only 3% of the economy after peaking at 6% during the housing boom that preceded the Great Recession. The STRS Ohio economic forecast expects business investment will reach 5.5% growth over fiscal 2015, returning to growth recorded during the first half of fiscal 2014 before it fell during the third fiscal quarter. The forecast also expects residential investment will surge to roughly 1.2 million housing starts in fiscal 2015 from just short of one million units in fiscal 2014. Residential investment, therefore, is expected to grow 13.7% in the upcoming fiscal year from a soft 2.4% in fiscal 2014. Housing activity grew 15.2% in fiscal 2013 and 11.6% in fiscal 2012. Though the return
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Fiscal 2015 Investment Plan
to double-digit growth rates in housing would appear to make it a significant contributor to overall economic growth, its actual contribution to the projected 3.1% growth in real GDP during fiscal 2015 is a smaller 0.4 percentage point because of the reduced role of the housing sector within the overall economy. s the real economy starts to accelerate, inflation pressures will likely build even as reported inflation A remains largely contained (see the chart below). Food and energy costs will remain volatile due to unstable supply issues, yet core rates of inflation that exclude those segments will likely edge higher in the second half of fiscal 2015 after real economic activity accelerates through the first half. After growing a modest 1.3% in fiscal 2013, the GDP price index (the broadest measure of economy-wide inflation) likely advanced by about 1.5% in fiscal 2014. For fiscal 2015, that trend should continue with the broad price measure growing 1.7% while the personal consumption expenditures price index grows a similar 1.7% and moves closer to the Federal Reserve’s long-term target of 2%. Consumer prices will likely behave in a similar manner as it brushes up against the 2% rate in fiscal 2015 from roughly 1.75% in fiscal 2014.
INFLATION SHOULD MOVE MODESTLY HIGHER GDP Price Index % Change — Year to Year Consumer Price Index % Change — Year to Year 7 7
7
6 6
6
5 5
5
4 4
4
3 3
3
2 2
2
1 1
1
0 0
0
GDP Price Index
-1 –1
–2 -2
–1
1990
–2 1995 2000 2005 2010 2015
19 90 19 90 Q1 19 - 91 Q3 19 - 91 Q1 19 - 92 Q3 19 - 92 Q1 19 - 93 Q3 19 - 93 Q1 19 - 94 Q3 19 - 94 Q1 19 - 95 Q3 19 - 95 Q1 19 - 96 Q3 19 - 96 Q1 19 - 97 Q3 19 - 97 Q1 19 - 98 Q3 19 - 98 Q1 19 - 99 Q3 19 - 99 Q1 20 - 00 Q3 20 - 00 Q1 20 - 01 Q3 20 - 01 Q1 20 - 02 Q3 20 - 02 Q1 20 - 03 Q3 20 - 03 Q1 20 - 04 Q3 20 - 04 Q1 20 - 05 Q3 20 - 05 Q1 20 - 06 Q3 20 - 06 Q1 20 - 07 Q3 20 - 07 Q1 20 - 08 Q3 20 - 08 Q1 20 - 09 Q3 20 - 09 Q1 20 - 10 Q3 20 - 10 Q1 20 - 11 Q3 20 - 11 Q1 20 - 12 Q3 20 - 12 Q1 20 - 13 Q3 20 - 13 Q1 20 - 14 Q3 20 - 14 Q1 20 - 15 Q3 - Q 1
16
Source: Bureau of Economic Analysis, Bureau of Labor Statistics
GDP Price Index Consumer Price Index Note: Shaded areas denote recession.
Consumer Price Index
Fiscal 2015 Investment Plan
The Federal Reserve has maintained a stimulative monetary policy since the beginning of the Great Recession. Policymakers at the Federal Reserve understood that they had to do everything in their power to prevent a deflationary spiral developing out of the recession — an issue stagnant Japan dealt with for two decades. Initially, the Federal Reserve drove short-term interest rates significantly lower to roughly 0% by using its main policy tool — the federal funds targeted rate (shown in the chart below) — but it did not stop there. Quantitative easing has led to an expansion of assets on the Federal Reserve’s balance sheet from roughly $900 billion prior to the recession to nearly $4.5 trillion today. The Federal Reserve made sure the banking system was flooded with cash for future loans that would eventually spark a credit cycle, leading to ever stronger economic growth.
STIMULATIVE MONETARY POLICY WILL END WITH A STRONGER ECONOMY Federal Reserve Total Assets Trillions of $
t
t
Federal Funds Targeted Rate %
99
4.5 4.5
88
4 4.0
77
3.5 3.5
66
3 3.0
55
2.5 2.5
44
2.0 2
33
1.5 1.5
22
1 1.0
11
0.5 0.5
Fed Assets
0 0.0 1990 1995 2000 2005 2010
Jan 3 Apr 11 Jul 18 Oct 24 Jan 30 May 8 Aug 14 Nov 20 Feb 26 Jun 3 Sep 9 Dec 16 Mar 24 Jun 30 Oct 6 Jan 12 Apr 20 Jul 27 Nov 2 Feb 8 May 17 Aug 23 Nov 29 Mar 6 Jun 12 Sep 18 Dec 25 Apr 2 Jul 9 Oct 15 Jan 21 Apr 29 Aug 5 Nov 11 Feb 17 May 26 Sep 1 Dec 8 Mar 15 Jun 21 Sep 27 Jan 3 Apr 11 Jul 18 Oct 24 Jan 30 May 8 Aug 14 Nov 20 Feb 26 Jun 4 Sep 10 Dec 17 Mar 24 Jun 30 Oct 6 Jan 12 Apr 20 Jul 27 Nov 2 Feb 8 May 17 Aug 23 Nov 29 Mar 7 Jun 13 Sep 19 Dec 26 Apr 2 Jul 9 Oct 15 Jan 21 Apr 29 Aug 5 Nov 11 Feb 17 May 26 Sep 1 Dec 8 Mar 16 Jun 22 Sep 28 Jan 4 Apr 11 Jul 18 Oct 24 Jan 30 May 8 Aug 14 Nov 20 Feb 26
1990 1990 1990 1990 1991 1991 1991 1991 1992 1992 1992 1992 1993 1993 1993 1994 1994 1994 1994 1995 1995 1995 1995 1996 1996 1996 1996 1997 1997 1997 1998 1998 1998 1998 1999 1999 1999 1999 2000 2000 2000 2001 2001 2001 2001 2002 2002 2002 2002 2003 2003 2003 2003 2004 2004 2004 2005 2005 2005 2005 2006 2006 2006 2006 2007 2007 2007 2007 2008 2008 2008 2009 2009 2009 2009 2010 2010 2010 2010 2011 2011 2011 2012 2012 2012 2012 2013 2013 2013 2013 2014
00
Fed Funds
Source: Federal Reserve Board
Federal Funds Targeted Rate Federal Reserve Total Assets Note: Shaded areas denote recession.
At its December 2013 monetary policy meeting, the Federal Reserve began to taper the purchases of securities from quantitative easing because the labor market was showing signs of better growth and the overall economy was finally gaining traction. At each subsequent meeting, it has reduced the size of further quantitative easing purchases so that the monetary policymakers are on track to end QE in the first half of fiscal 2015. By the end of fiscal 2015 or early part of fiscal 2016, the Federal Reserve will also begin to raise short-term interest rates through its main policy tool of the federal funds rate. While the Federal Reserve believes the long-term neutral position for the federal funds rate is about 4%, it will likely take many years to get there. Indeed, changes to short-term interest rates should be
17
18
Fiscal 2015 Investment Plan
gradual and measured throughout fiscal 2016 as the Federal Reserve gauges the impact from higher interest rates on jobs growth, inflation, and the overall economy. Only a modest change in the federal funds rate should be expected in the upcoming fiscal year as shown in the table below.
Period
Federal Funds Rate
10-Year Treasury Yield
Fiscal 2015 Ranges
0% –0.75%
2.25% – 4%
Note: The ranges listed anticipate capturing 90% of the daily closes during the period described. Brief excursions above or below these ranges that are quickly reversed should not be considered violations of the forecast.
The baseline economic forecast during fiscal 2015 of moderately above long-term economic growth with slowly building inflation pressures carries a 70% chance of occurring. Downside risks to that forecast where economic activity would fall below 2.25% and upside risks where economic activity would rise above 3.75% each carry 15% chances of occurring. The consensus forecast for real GDP growth during fiscal 2015 is 3% — roughly the same as the STRS Ohio economic forecast of 3.1%. However, the consensus forecast for the GDP price index is 1.9% versus our 1.7% and each expects 1.9% growth in consumer prices. The combination of real economic growth and inflation generates a nominal GDP forecast of 4.8% versus the consensus estimate of 4.9%.
Fiscal 2015 Investment Plan
U.S. ECONOMIC FORECAST Fiscal Year Ranges
FY 2015
FY 2015 H1 H2
FY 2014
FY 2014 H1 H2
FY 2013
Gross Domestic Product
2.25%–3.75%
3.1%
3.0%
3.2%
2.4%
3.4%
1.5%
1.6%
Personal Consumption
2.25%–3.75%
3.0%
2.9%
3.1%
2.9%
2.6%
3.1%
1.9%
0%–10%
5.5%
5.4%
5.6%
3.2%
5.3%
1.2%
2.4%
Residential Investment
13.7%
15.0%
12.5%
2.4%
1.2%
4.6%
15.2%
Exports of Goods & Services
5.4%
4.8%
6.0%
2.5%
6.7%
(1.3%)
2.0%
Imports of Goods & Services
5.6%
5.1%
6.0%
1.7%
2.0%
1.5%
1.2%
Federal Consumption & Investment
0.8%
1.1%
0.5%
(3.5%)
(7.1%)
0.4%
(4.1%)
State & Local Consumption & Investment
0.6%
0.6%
0.6%
0.2%
0.8%
(0.4%)
(0.5%)
Final Sales
3.2%
3.1%
3.2%
2.3%
2.6%
2.0%
1.7%
Domestic Final Sales
3.2%
3.2%
3.3%
2.1%
1.9%
2.3%
1.5%
Private Domestic Final Sales
3.8%
3.7%
3.9%
2.9%
2.9%
2.9%
2.4%
3.0%
2.9%
3.1%
2.1%
1.9%
2.3%
0.9%
0%–10%
6.1%
6.5%
5.8%
7.0%
9.0%
5.0%
6.4%
1.25%–2.75%
1.9%
1.7%
2.0%
1.7%
1.6%
1.7%
1.4%
Personal Consumption Expenditures Price Index
1.7%
1.5%
1.9%
1.4%
1.5%
1.3%
1.1%
GDP Price Index
1.7%
1.5%
1.9%
1.5%
1.8%
1.3%
1.3%
($408.4)
($401.3)
Composition of Real GDP
Nonresidential Investment
Incomes Real Disposable Personal Income Nominal GDP Corporate Profits, After Tax Prices Consumer Price Index
Other Key Measures Real Net Exports ($B)
($460)–($400)
($433.9)
($427.5) ($440.4)
($415.5) ($423.8)
Real Change in Business Inventories ($B)
$63.8
$67.5
$60.0
$96.8
$113.7
$80.0
$45.8
Light Vehicle Sales (M)
16.50
16.38
16.63
15.77
15.70
15.83
15.07
1.206
1.163
1.250
0.970
0.954
0.987
0.875
Industrial Production
3.9%
3.8%
4.1%
3.8%
3.7%
4.0%
2.5%
Unemployment Rate
6.2%
6.3%
6.1%
6.8%
7.1%
6.5%
7.8%
New Housing Starts (M)
1.1–1.3
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Fiscal 2015 Investment Plan
INTERNATIONAL ECONOMIC GROWTH AND INFLATION OUTLOOK Real economic activity in developed countries such as Germany, the United Kingdom, and Japan should advance at healthier rates than in countries such as France, Italy, Spain, and other eurozone members that are struggling to gain traction. With inflation subdued, central banks will allow time for economic growth to become more broad-based and will remain wary of tightening monetary policy too soon. Some major central banks, such as the European Central Bank (ECB) and the Bank of Japan (BoJ), will be inclined to ease monetary conditions further. In general, policy interest rates are expected to remain near zero for fiscal 2015.
POLICY INTEREST RATES IN MAJOR DEVELOPED COUNTRIES TO REMAIN VERY LOW Eurozone (%) Japan (%) U.K (%) 7 7
7
6 6
6
5 5
5
4 4
4
3 3
3
2 2
2
1 1
1
2014 - Jan
2014 - Mar
2010 2011 2012 2013 2014
Source: European Central Bank, Bank of Japan, Bank of England
2014 - May
2013 - Jul
2013 - Sep
2013 - Nov
2013 - Jan
2013 - Mar
2013 - May
2012 - Jul
2012 - Sep
2012 - Nov
2012 - Jan
2012 - Mar
2012 - May
2011 - Jul
2011 - Sep
2011 - Nov
2011 - Jan
2011 - Mar
2011 - May
2010 - Jul
2010 - Sep
2010 - Nov
2010 - Jan
2010 - Mar
2004 2005 2006 2007 2008 2009
2010 - May
2009 - Jul
2009 - Sep
2009 - Nov
2009 - Jan
2009 - Mar
2009 - May
2008 - Jul
2008 - Sep
2008 - Nov
2008 - Jan
2008 - Mar
2008 - May
2007 - Jul
2007 - Sep
2007 - Nov
2007 - Jan
2007 - Mar
2007 - May
2006 - Jul
2006 - Sep
2006 - Nov
2006 - Jan
2006 - Mar
2006 - May
2005 - Jul
2005 - Sep
2005 - Nov
2005 - Jan
2005 - Mar
2005 - May
2004 - Jul
2004 - Sep
2004 - Nov
2004 - Mar
0 0
2004 - Jan
Euro-zone(%)
2004 - May
20
Japan (%) U.K.(%)
0
Eurozone Japan U.K.
In the eurozone, monetary policy in fiscal 2015 will focus on combating disinflation, on stimulating credit growth and on raising inflation expectations. The ECB is expected to maintain near-zero nominal policy interest rates and short-term real interest rates should stay negative as policymakers try to lift inflation expectations toward their 2% policy target. The dominant risk is that economic growth turns out to be worse than expected and disinflation increasingly gives way to deflation in most member countries — making economic adjustments more arduous for debtors, reducing overall demand, and subduing prices even more. That would call for more aggressive monetary policy from the ECB, including a quantitative easing program.
Fiscal 2015 Investment Plan
21
Meanwhile, sounder domestic economic fundamentals than in recent years indicate that real economic activity in the U.K. should strengthen further. The Bank of England (BoE) will likely change its monetary policy stance toward the end of fiscal 2015, raising the policy interest rate by 0.25 percentage point. The main risk is that the economy grows faster than expected, leading the BoE to act even earlier. Despite that change of stance, policy rates are expected to be raised only gradually as the BoE will remain cautious about damaging hard-won gains in economic activity over the past six years. By contrast, the Bank of Japan is likely to maintain its expansionary monetary policy until a 2% annual inflation rate is sustained. Together with the fiscal stimulus from infrastructure reconstruction, the Japanese policy is likely to boost real GDP growth, though the gains are expected to be cyclical instead of structural. Government and private investment demand are likely to remain the main sources of economic growth as consumers and small businesses gradually leave behind the psychological trap caused by two decades of persistent deflation.
DISINFLATION TO PERSIST IN THE EUROZONE Headline Consumer Price Inflation (% Change — Year to Year) Core Consumer Price Inflation (% Change — Year to Year) 5 5
5
4 4
4
3 3
3
2 2
2 Headline Consumer Price Inflation (% Change - year-on-year) Core Consumer Price Inflation (% Change - year-on-year)
0
2014 - Jan
2014 - Mar
2013 - Jul
2013 - Sep
2013 - Nov
2013 - Jan
2013 - Mar
2013 - May
2012 - Jul
2012 - Sep
2012 - Nov
2012 - Jan
2012 - Mar
2012 - May
2011 - Jul
2011 - Sep
2011 - Nov
2011 - Jan
2011 - Mar
2011 - May
2010 - Jul
2010 - Sep
2010 - Nov
2010 - Jan
2010 - Mar
2010 - May
2009 - Jul
2009 - Sep
2009 - Nov
2009 - Jan
2009 - Mar
2009 - May
2008 - Jul
2008 - Sep
2008 - Nov
2008 - Jan
2008 - Mar
2008 - May
2007 - Jul
2007 - Sep
2007 - Nov
2007 - Jan
2007 - Mar
2007 - May
2006 - Jul
2006 - Sep
Sources: ECB, ES/H
2006 - Nov
2006 - Jan
2006 - Mar
2006 - May
2005 - Sep
2005 - Jul
–1 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2005 - Nov
2005 - Mar
2004
2005 - May
2004 - Sep
2004 - Nov
2004 - Mar
2004 - May
-1 –1
2005 - Jan
0 0
2004 - Jul
1
2004 - Jan
1 1
Headline Consumer Core Consumer Note: Shaded areas denote recession.
In emerging countries, economic growth has been moderating as the business and the credit cycles have reached a more mature stage than those in developed countries. Though real GDP in some countries may shrink briefly, a prolonged slump is not expected in any major country other than Russia where the fallout from the Ukraine crisis will weigh on economic fundamentals and in Thailand where persistent political unrest is expected to hamstring the economy for an extended period.
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Fiscal 2015 Investment Plan
The trends in inflation across emerging countries have been mixed over the past two years. The pattern should persist in fiscal 2015 as inflation has become structural in some countries while remaining mainly cyclical in others. Inflation rates in Brazil, India, and Turkey will continue to be stubbornly high while it is expected to remain well-behaved in South Korea, China, and Mexico. In high-inflation countries, policymakers will continue to be cautious about easing monetary policy whereas policymakers in other countries will have more room to cushion any unexpected downside to economic growth. For example, in Brazil, the central bank has raised it policy rate from 8% to 11% in fiscal 2014 as inflation has been near the upper limit of the policy range. While the policy rate is not expected to rise any further, reductions in that rate are also not assured as long as inflation remains stubbornly high. Likewise, in India, the central bank has proposed a new policy for bringing inflation down from its current 8% to 9% range to about a 6% clip over the next two years and then reducing it further by adopting an inflation target. Though that policy has not yet been implemented, its potential adoption in fiscal 2015 could mean that the central bank would raise the policy interest rate by at least 3–4 percentage points over the subsequent 24 months. In China, besides cyclical headwinds from the housing market, the shrinking labor force is going to increasingly slow long-term trend economic growth to a 6% to 7% annual average rate over the next five years. That shift will be accompanied by more liberalization of the financial sector, greater urbanization, and policies that foster a better quality of labor force than in the past. Besides slower economic growth in China, economic activity in key emerging countries should remain restrained because of general elections. The new policies that usually accompany a change of administration can sometimes be unfavorable for investors. The onset of fiscal 2015, thus, will be marked by more than the usual political and policy uncertainty that should clear up only gradually as the year progresses and the new policies are rolled out. In sum, the global economy is largely expected to experience disinflationary pressures during fiscal 2015. That should allow central banks and policymakers in most countries, especially in Europe, to focus on improving economic growth and employment because many countries are still struggling to reverse the losses they suffered since the Great Recession. Economic growth in emerging countries should remain moderate, though constraints from inflation may prevent some of their central banks from easing monetary policy conditions.
Fiscal 2015 Investment Plan
23
INTERNATIONAL FORECASTS Real Gross Domestic Product Country/Region
Inflation
FY 2015
FY 2014
FY 2015
FY 2014
Canada
2.5%
2.3%
1.8%
1.6%
United Kingdom
2.8%
3.1%
2.0%
1.8%
Eurozone
1.1%
0.8%
1.0%
0.7%
Germany
1.8%
1.9%
1.2%
1.1%
France
1.1%
0.5%
1.2%
1.0%
Italy
0.8%
0.0%
0.9%
0.6%
Asia–Pacific
Japan
1.8%
1.5%
1.7%
1.4%
China
6.7%
7.0%
2.1%
2.6%
India
6.1%
5.0%
8.1%
8.0%
Australia
2.5%
2.4%
2.5%
3.0%
South Korea
3.1%
3.5%
2.6%
1.7%
Latin America
Brazil
2.2%
1.6%
5.5%
6.0%
Mexico
4.0%
3.0%
3.4%
3.8%
24
Fiscal 2015 Investment Plan
Fiscal 2015 Investment Plan
V. Fixed-Income Investments TREASURY YIELD CURVE 4.00%
3.50%
Percent Yield
3.00%
2.65% 2.50%
2.48%
2.00%
1.50%
1.00%
0.50%
0.00%
3m
6m
2yr 5yr
10yr
30yr
Maturity June 30, 2013
April 30, 2014
OUTLOOK Bond Market Returns  We forecast the total return of the fixed-income market to be below the STRS Ohio Policy return of 3.75% in fiscal year 2015. The fixed income benchmark yield begins the fiscal year below the policy return at 2.60%. Since we forecast overall prices in the benchmark to decline, we expect a benchmark total return to finish fiscal year 2015 with a low to negative return.
Federal Reserve The Federal Reserve has maintained a highly accommodative monetary policy to support the economic recovery. Aside from maintaining the federal funds rate at 0% for 66 months, further direct and indirect actions were employed to keep interest rates low and stable for an extended period of time. Directly, the Federal Reserve continued to use quantitative easing (QE) comprised of outright purchases of agency mortgages and longer-term U.S. Treasury debt. However, the Federal Reserve began to taper the QE policy, reflecting a general improvement in economic conditions. This round of QE will likely conclude during the first half of the fiscal year. Additionally, it continues to reinvest
25
26
Fiscal 2015 Investment Plan
agency mortgage principal payments and maturing agency debt into new agency mortgages and U.S. Treasury maturities into longer-term U.S. Treasury debt. The intent of these direct policies is to maintain downward pressure on long-term interest rates and support asset prices. Indirectly, the Federal Reserve employs a communication policy to establish long-term monetary policy guidance including an inflation target. Previously, it communicated economic conditions were likely to keep the federal funds rate near zero until at least a 6.50% unemployment rate is sustained or the inflation rate is in excess of 2.00% beyond transitory reasons. This policy was revised in favor of qualitative guidance linked to overall labor market conditions, inflation indicators and financial conditions. Additionally, the Fed guided that it may be warranted to keep the target federal funds rate below a neutral rate for a considerable period of time. Nevertheless, we believe the Fed will gradually and carefully transition to a less accommodative policy. Given the STRS Ohio economic forecast, the federal funds rate is likely to remain near zero until the later part of fiscal 2015 or early fiscal 2016. The long-standing policy objective is to achieve sufficient economic growth, which supports job creation without materially increasing long-term inflation expectations. The chief risk in maintaining an accommodative policy for an extended period of time is that long-term inflation concerns can develop. The abundance of resource slack and global economic uncertainty serve to curb these inflation concerns, and support the current policy stance. However, should inflation expectations become elevated in the near-term, the Federal Reserve has tools available to quell those expectations quickly. It may increase interest rates on excess reserves and engage in reverse repurchase agreements, term deposits and asset sales — all of which serve to remove liquidity from the financial system and increase interest rates. The Federal Reserve will continue to maintain an accommodative monetary policy, despite the end of QE and a potential increase in the federal funds rate during fiscal 2015. Although the level of accommodation is conditional, we expect a gradual and careful transition to a less accommodative policy. However, a stronger than expected domestic economy or an increase in inflation may warrant an alteration of long-term policy guidance. Conversely, a weaker than expected economy combined with discouraging global economic events may result in additional accommodation. Our forecasted range for the federal funds rate is 0.0% to 0.75%.
Market Interest Rates The expected interest rate range for the 10-year Treasury yield is based on the STRS Ohio economic forecast moderately above trend real growth near 3%, contained inflation, and a Federal Reserve that will maintain its accommodative monetary policy. Our forecasted 10-year Treasury range is 2.25% to 4.00%, with a baseline expectation of a rise from the current yield level of 2.50%, finishing slightly above the middle of our interest rate range (3.25%–3.50%). The factors that support a 2.25% lower interest rate bound include current Federal Reserve policy and supply and demand dynamics. We expect the Federal Reserve to maintain the federal funds rate near 0% through most or all of fiscal 2015. As long as the market perceives federal funds rate increases will occur further in the future, interest rates, particularly shorter-term rates, will be anchored. Reduced U.S. Treasury issuance due to the reduction in the U.S. budget deficit is limiting supply. At the same time, U.S. Treasury yield levels are attractive relative to the debt yields of some lower-quality sovereign countries that are suppressed — either by central bank policies or deflationary pressures — potentially increasing demand for U.S. Treasuries. The factors that support 4.00% at the upper end of the interest rate range are fundamentally driven. The STRS Ohio economic forecast expects a nominal GDP growth rate of 4.8% for fiscal 2015. The current 10-year U.S. Treasury yield is trading over 2.25% (225 basis points) below this forecast, a
Fiscal 2015 Investment Plan
historically rich valuation relative to economic fundamentals. In this regard, even if interest rates were to reach the high end of our forecasted range, they would remain low relative to nominal growth. Furthermore, the Federal Reserve is on course to end its quantitative easing program in the first half of fiscal 2015, relieving downward pressure on longer-term rates. Once it becomes clear the Federal Reserve will begin to raise rates, short-term market rates will likely increase more so than longer-term interest rates, causing the yield curve to flatten from historically steep levels.
Credit Quality Investment grade credit quality was stable in fiscal year 2014. As we enter fiscal year 2015, we expect financial firms to maintain credit quality. Credit quality at nonfinancial companies will experience modest deterioration, but remain generally stable. Financial firms, in response to heightened regulation post the financial crisis, maintain strong capital and high liquidity. Increases in capital and liquidity have slowed, but will be maintained at high levels, notwithstanding increases in shareholder payments that must be approved by regulators. Asset quality will continue to improve, albeit at a slower pace. Earnings growth will likely slow but remain positive as firms offset continued margin pressure with expense control. Financial firms should continue to experience moderate loan growth due to steady easing of lending terms and improving domestic economic growth. Credit quality at nonfinancial firms is stable with some deterioration due to rising leverage. Margins are likely to remain at historically high levels as firms continue to experience modest revenue and earnings growth; however, debt growth will continue to eclipse earnings growth. While the growth rate of shareholder payments has slowed, absolute levels remain high and the focus of management teams is centered on increasing shareholder value. This focus is further enhanced by the increasing presence of activist investors whose pressure often results in companies taking credit negative actions. Liquidity remains high and, coupled with a benign macroeconomic environment, may help sustain an increase in strategic mergers and acquisitions. Firms continue to maintain excellent access to capital markets. High yield credit quality is stable and is benefitting from moderate growth in the U.S. economy. Revenue and profits are growing steadily and profit margins are strong. High yield companies are increasing leverage but interest coverage remains solid given the low interest rate environment. Companies have strong access to the debt market and maturities have been refinanced and extended at attractive interest rates. These fundamentals should continue to support a benign default environment. Emerging market countries’ credit fundamentals are mixed. Credit quality continues to be supported by low debt levels on government balance sheets, low fiscal deficits, and high levels of foreign currency reserves relative to foreign debt. However, economic growth is slowing in many emerging market countries. The Federal Reserve’s tapering of bond purchases and resulting higher U.S. interest rates have caused capital outflows and currency weakness in several emerging markets, particularly ones with fiscal and current account deficits. Weak currencies and high inflation have prompted some emerging market central banks to raise interest rates. Capital investment has generally become less efficient and rapid growth in private sector debt raises concerns of credit misallocation. In addition, as evidenced by the situation involving Russia and Ukraine, geopolitical risk has increased in several emerging market countries threatening economic growth.
27
28
Fiscal 2015 Investment Plan
STRATEGY Overview. The fixed-income portfolio will begin fiscal year 2015 with an active management risk of 38 basis points. The following points summarize our outlook and portfolio strategy for fiscal 2015. • The STRS Ohio economic forecast predicts an environment that will likely keep the Federal Reserve from altering its zero interest rate policy until the end of the fiscal year. As economic conditions improve and confirmatory employment trends continue, the Federal Reserve will signal the eventual transition to a less accommodative monetary policy. The path to normalization of monetary policy is expected to be a long and patient process. As a result, we expect rates will rise and the yield curve will flatten gradually throughout the fiscal year. We expect a moderate increase in long-term rates. •
Globally, accommodative central bank polices are leading to supply and demand dynamics that support low interest rates, tight yield spreads, and low volatility. However, years of monetary accommodation have produced differing economic results, and monetary policies should continue to diverge in the fiscal year.
•
We are positioned with a portfolio relative duration of 91% (as of mid-May 2014). Our strategy reflects the STRS Ohio economic outlook, rich valuation of interest rates relative to economic fundamentals, and a less accommodative monetary policy leading to a rise in interest rates.
• The fixed-income portfolio has received more than $1.75 billion in allocations during fiscal 2014 near the upper end of our interest rate range, taking fixed income to a 2% overweight versus the policy benchmark. The allocations were invested in a diversified manner across all sectors of the portfolio. In the largest liquid sectors of the market, we maintained a modest overweight in U.S. Treasuries, and slightly reduced an underweight in agency mortgage-backed securities. In the credit sectors, we reduced an overweight in high yield and CMBS/ABS, and reduced our underweight in investment grade corporates and emerging market debt. Treasuries. We begin the fiscal year with a modest overweight in U.S. Treasuries. The Federal Reserve’s purchases of U.S. Treasuries are expected to be completed in the first half of fiscal 2015. A transition in demand from the Federal Reserve to traditional investors will be necessary. We will monitor this dynamic closely for opportunities, while using our large and liquid Treasury holdings to actively implement tactical yield curve strategies and efficiently manage the portfolio’s duration relative to the benchmark as interest rates move higher within our forecasted range. Government Related. We are forecasting low return opportunities at current valuations, so we begin the fiscal year with a large underweight. Supply has been moderate as Fannie Mae and Freddie Mac, the primary issuers, have reduced their balance sheets accordingly with regulatory-imposed portfolio asset limitations. While legislative and political issues remain unresolved, we expect the U.S. government to continue to support Fannie Mae and Freddie Mac. Thus, due to relatively narrow risk premiums for these larger issuers we will focus on other issuers within the sector. We will seek securities from countries with growing and diverse economies that exhibit stable credit quality, solid balance sheets, sound monetary policy and credible fiscal budget plans with yield premiums that compensate for their lower liquidity and credit quality. CMBS (Commercial Mortgage-Backed Securities) and ABS (Asset-Backed Securities). During fiscal 2014, we maintained an overweight position as commercial real estate fundamentals were stableto-improving and relative valuations remained attractive. The portfolio is positioned in a blend of seasoned, new issue and well-structured securities. We will continue to maintain an overweight position as relative value remains attractive. Security selection will reflect stable-to-improving fundamentals, emphasizing structure and underwriting.
Fiscal 2015 Investment Plan
We begin fiscal 2015 with a large overweight to the ABS sector. We expect fundamentals will continue to be solid and valuations will remain stable. We have maintained a high quality, liquid portfolio of short-term fixed and floating rate notes. These securities reduce the interest rate risk of the portfolio, and are relatively more attractive than short-term Treasuries and government related securities. We are likely to maintain an overweight position and may selectively add provided relative value is attractive. Mortgages. We begin the fiscal year with an underweight to agency mortgage-backed securities. Early in fiscal 2014, a rapid rise in interest rates triggered by indications the Fed would begin tapering QE asset purchases caused valuations to fall, and we moved to a neutral position. As rates rose, valuations rebounded — given the orderly nature of tapering and lower level of new supply resulting from higher rates. Subsequently, we reduced our position to an underweight. As the end of QE nears we expect supply and demand dynamics will shift, leading to cheaper valuations. Notably, we expect an increase in production and the Federal Reserve to stop asset purchases. While currently underweight, we will opportunistically add exposure as anticipated attractive relative value opportunities become available. Investment Grade Corporates. We begin fiscal 2015 with a slight underweight to investment grade corporates, as yield spreads are at the tightest levels since the financial crisis. Going forward, spreads may tighten modestly, but we expect the potential for widening from current levels to be greater than that for tightening. The favorable supply and demand dynamics will likely keep spread volatility low; yield spreads could remain near current levels for most or all of fiscal year 2015. If spreads tighten further, we will increase the underweight. If spreads widen more than fundamentals suggest, we will increase the investment grade corporate weight toward neutral or overweight, focusing on industries and companies with stable credit profiles. Regardless of overall yield spread changes, we will tactically search for relative value across industries and companies. High Yield Corporates. We begin the fiscal year with a near-market weight in high yield corporates. During fiscal 2014, we decreased our high yield overweight as yield spreads continued to tighten. Current valuations are fair and reflect a benign default environment. While expected total returns in high yield are lower than in previous years as a result of tighter yield spreads, total returns should remain relatively attractive versus other fixed income sectors — especially in the rising interest rate environment that we predict. We will adjust our exposure to high yield debt as valuations evolve in fiscal 2015. Emerging Market Debt. We begin the fiscal year with an underweight to emerging market debt. Valuations have cheapened relative to other credit sectors and we will look for opportunities to reduce the underweight if yield spreads widen more than is justified by the fundamentals. We will closely monitor the evolving fundamental and geopolitical backdrop in emerging markets as we consider adjusting our exposure in fiscal 2015.
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BOND STRUCTURE REPORT (as of April 30, 2014)
Portfolio Annualized Tracking Risk1 — 38 basis points Portfolio Duration2 — 5.03 Years Relative to Index — 92% Market Value* ($ millions)
Sector Weights
Percent of Portfolio*
Yield
Relative to Index3
Treasuries
$4,541
31% 1.4%
1.05x
Government Related4
$ 313
2% 1.2%
0.17x
Mortgages5
$3,105
21% 3.0%
0.91x
CMBS & ABS6
$1,306
9% 1.2%
2.30x
Investment Grade Corporates7
$3,582
24% 2.6%
0.96x
High Yield Corporates
$ 975
7% 4.9%
1.02x
Emerging Market Debt9
$ 875
6% 6.1%
0.88x
$14,696
100% 2.5%
8
Total Fixed Income
A statistical model is used to generate tracking risk, which is an estimate of the expected difference in annual performance between the portfolio and the index. For example, the fixed income portfolio currently has a tracking risk of 38 basis points, meaning the performance of the portfolio relative to the index is expected to be within 38 basis points for 68% (one standard deviation) of all market outcomes.
1
A measure of the sensitivity of the price of the fixed income portfolio to a change in interest rates, expressed in years. The current portfolio duration of 5.03 years implies the average price of the portfolio is expected to rise by 5.03% for a 1% (100 basis point) decline in interest rates and is expected to fall by 5.03% for a 1% (100 basis point) increase in interest rates. The portfolio duration relative to the index, currently at 92.0%, is the portfolio’s duration divided by the duration of the index. A number less than 100% implies the portfolio has a duration less than that of the index and reflects an expectation of rising rates.
2
The relative exposure to each sector versus the index, based upon market value and duration. A number greater than 1.00x indicates an overweight, and reflects a sector that we believe is undervalued. A number less than 1.00x indicates an underweight, and a sector we believe is overvalued.
3
Consists of U.S. Government Sponsored Enterprise debt and other highly rated non-corporate debt.
4
Mortgages are secured by a diversified pool of loans on residential properties.
5
Commercial Mortgage-Backed Securities (CMBS) are secured by a diversified pool of loans on commercial property such as office buildings, industrial complexes, retail centers, hotels and multifamily developments. Asset-Backed Securities (ABS) are secured by diversified pools of consumer loans, including credit card receivables and auto loans.
6
Consists of debt from industrial, utility and financial institution issuers that is rated investment grade, which is BBB and above.
7
Consists of debt from industrial, utility and financial institution issuers that is rated non-investment grade, which is BB and below.
8
Consists of bonds issued by sovereign, quasi-sovereign, and corporate emerging market issuers. Country eligibility and classification as Emerging Markets is rules-based and reviewed annually using World Bank income group and International Monetary Fund (IMF) country classifications.
9
* Column may not add due to rounding.
Fiscal 2015 Investment Plan
VI. Domestic Equities Investments OUTLOOK Equity Market Return Expectations For fiscal year 2015 we forecast total returns to be slightly below the STRS Ohio policy return of 8.0%. Key factors behind this forecast are: •
Slow earnings growth, due to low nominal economic growth and an already high level of profit margins.
• Valuation levels that may decline because they are approaching the high end of the normal trading range. In addition, the Federal Reserve continues to gradually tighten policy, which could put added pressure on valuation levels.
Summary The U.S. equity market rose for the fifth consecutive year in fiscal year 2014, reaching a new alltime high as the U.S. and global economies continued to recover, albeit at a slow pace. Returns for the S&P 500 through the end of April are 19.2%, an extremely strong showing in the face of only a slowly growing economy. The market’s rise has far outpaced earnings growth, reflecting increasingly high valuation levels. This strong return far exceeded the long-term policy expectation for domestic equities of 8.0%, as well as our more modest single digit expectations for the year. The S&P 500 now stands at 1897.10 and, on a total return basis, has increased approximately 180% off the March 2009 low during the great recession.
S&P 500 PRICE INDEX Avg. 1941–43=10
Source: Wall Street Journal
Note: Shaded areas denote recession.
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Economic Drivers STRS Ohio’s economic forecast anticipates a modest acceleration in the U.S. economy into fiscal 2015, with real GDP growth rising 3.1%. Combined with inflation of 1.5–2.0%, this represents nominal GDP growth of only 4.5–5.0% for the economy — below levels we have seen in the past. Measured growth environments have historically been favorable for equities due to earnings growing strongly and valuations rising as the Federal Reserve usually is not in a tightening phase. There are reasons to believe that neither of those two factors will be present in 2015 and, consequently, gains in the equity market will be harder to come by. Earnings growth will be constrained by already high levels of profitability, and the STRS Ohio economic forecast sees quantitative easing ending in the first half of the fiscal year, with short rates edging higher toward the end of the fiscal year.
Earnings For fiscal 2015 we expect earnings to grow only modestly, increasing 6.7% to $118.25 from the $110.83 expected in the current fiscal year. This is down from the 11.6% growth expected for fiscal 2014 — a number that was inflated due to several one-time pension charges being taken in 2013 (the average of the past two years has been only 6.1%). Our forecast is also substantially below the consensus forecast of $128.59, which reflects much more rapid revenue growth and continued margin expansion.
S&P Operating EPS
FY 2013
FY 2014 (est.)
FY 2015 (est.)
STRS Ohio Forecast
$99.28
$100.83
$118.25
EPS Growth (YoY)
0.6%
11.6%
6.7%
Consensus Forecast
$99.28
$112.08
$128.59
EPS Growth (YoY)
0.6%
12.9%
14.7
Fiscal 2015 Investment Plan
S&P 500 OPERATING EARNINGS t
S&P 500 Composite: Operating Earnings per Share S&P 500 Composite: Operating Earnings per Share
t
4-qtr Moving Total $/share
% Change — Year to Year 4-qtr Moving Total $/share
Source: Standard and Poor’s
Note: Shaded areas denote recession.
S&P 500 earnings growth will likely be moderate in this low nominal GDP growth environment. Typically, S&P 500 revenues track fairly closely with nominal growth in the U.S. economy, plus a little extra for faster growing foreign economies. Foreign sales represent close to 50% of S&P 500 sales. This coming year, the global economy is not expected to expand at a rate much above that of the United States, so sales increases are likely to approximate U.S. nominal GDP growth. Revenues rising in the 4–5% range will require companies to continue to expand profit margins to drive earnings toward consensus expectations. Profit margins for S&P 500 companies, however, are already at or near all-time highs in this cycle and are unlikely to go substantially higher.
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Fiscal 2015 Investment Plan
S&P 500 COMPOSITE: OPERATING EARNINGS MARGIN %
Source: Haver Analytics
Note: Shaded areas denote recession.
Several factors have contributed to the high current level of margins. Interest expense has fallen as interest rates have come down over the past few decades. In addition, the capex recovery has been slow as corporations have been reluctant to take on more debt coming out of the great recession. The combination of low rates and lower debt levels has been a powerful contributor to strong profit margins. In addition, effective tax rates have declined over the past several years and are low by historical standards, even as headline tax rates are high. This has been due to corporations managing far more effectively for taxes and moving operations offshore to where tax rates are lower. Lastly, coming out of the great recession, companies have been relentlessly cutting costs — reducing the number of employees in operations as well as waste. All of these trends are likely to end or even reverse in fiscal 2015, making it increasingly difficult to increase profit margins. Companies are likely to resort to share buybacks to drive earnings per share growth, which is a very low quality way to expand EPS — and could further crimp long-term capital spending plans.
Valuations The S&P 500 is currently trading at roughly 17 times trailing 12-month earnings. This is above the historical average of 14–15 times earnings. We expect the P/E multiple for the market to contract slightly as corporate earnings growth remains slow and equity markets begin to factor in the prospect of a higher interest rate environment. Historically a P/E multiple of 17 is consistent with a twelve-month forward return of approximately 5%. Factors that could drive valuations higher are increased levels of merger and acquisitions (M&A) activity and/or increased confidence of corporate managements. With low interest rates, M&A activity has been on the rise, with both acquirers and target companies rising on the announcements of deals. This suggests that there may be some upside to the prices being paid for acquisitions.
Fiscal 2015 Investment Plan
Forecast Our point estimate forecast for the S&P 500 is 1925 representing a 4.7% total return from current levels. This uses a P/E multiple expectation of 16.3 times $118.25 in estimated earnings. We would expect a wide trading band around this forecast with the market potentially losing 5% or gaining as much as 15% — even under the central scenario. Several alternative scenarios exist with potential outcomes that could widen that band substantially.
Earnings
Multiple
Target
Total Return
Base Forecast
$118.25
16.3
1925
4.7%
Upside case
$122.00
18.0
2196
20.7%
Downside case
$105.00
14.0
1470
–20.0%
STRATEGY For fiscal 2015, we remain balanced in both style and market capitalization within the equity market. While we do not plan to make dramatic allocation changes, we believe large cap may be slightly more attractive than small cap, and value may have a slight edge over growth — but we are not making dramatic allocation changes based on those minor disparities. Although overall volatility has declined recently, the uncertain global environment may provide periods of elevated volatility in fiscal 2015. We would take advantage of any increases in volatility by opportunistically increasing our exposure to the market on pullbacks and decreasing our equity exposure on market rallies.
Initiatives As part of our ongoing review of domestic equities, we plan to fund two new internally managed portfolios from existing domestic equity allocations per recommendations from the Callan review of domestic equities. •
Small Cap Select Fund (SCS)
— Will develop new expertise within STRS Ohio in less efficient areas of the market
— Leverage existing analytical resources within Domestic Equities
— Significant up-front cost savings over external management
•
Concentrated Select Fund (CSF)
— 30–50 concentrated portfolio positions
— Leverages prior value team experience
— Utilizes an intrinsic value/contrarian style which will complement the existing portfolios
Lastly we will continue to move forward with a project to allow us to short equities. The first part of this project will be to evaluate the feasibility of a product from an external custodian that would facilitate the shorting of equities. This would enable domestic equities to better utilize poor performing stocks to fund our best ideas.
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Fiscal 2015 Investment Plan
Fiscal 2015 Investment Plan
VII. International Investments OUTLOOK The international markets in fiscal 2014 are recording a second consecutive year of robust returns, led again by the developed markets as the European stock markets benefit from an improvement in fundamentals and a sharp decline in bond yields. The MSCI World ex-US (50% Hedged) Index for developed markets has climbed 20% through May, while the MSCI EM Index for emerging markets has risen 12%. As a result, the STRS Ohio Blended Benchmark consisting of 80% of the MSCI World ex-US (50% Hedged) Index return and 20% of the MSCI EM Index return combined represents an increase of 18%. At this writing, the staff anticipates total returns earning normal levels in fiscal 2015.
Developed Markets After an impressive fiscal 2013, the developed markets have continued to perform strongly in fiscal 2014, with a 50% Hedged increase of 20% in U.S. dollar terms through May. Contrary to fiscal 2013 when market performance strength occurred in both Europe and Japan, strong market momentum has been concentrated in Europe in fiscal 2014. The strong returns achieved for two straight years in developed markets will likely restrain the potential return in fiscal 2015. The valuations are fair but not overly attractive, thus we do not expect any multiple expansion. We forecast that the developed markets in fiscal 2015 will achieve a total return slightly below its expected long-term average through moderate earnings growth and dividend yield. We believe that the U.S. dollar will strengthen in fiscal 2015, primarily versus the euro, so the return in dollar terms will be reduced by a small degree despite our 50% currency hedging policy. The European market strength has been propelled by an improvement in economic fundamentals and, in the case of peripheral countries, a sharp decline in bond yields. The eurozone economies overall are expected to improve in fiscal 2015, but inflation remains so low that the European Central Bank (ECB) will likely pursue new measures to help reduce the likelihood of deflation occurring. The monetary efforts by the ECB will be a benefit to the stock market and will help to weaken the euro. Historical relationships based on operating leverage suggest double digit earnings growth on a 1% real GDP growth rate in the eurozone. Earnings models have predicted 14% earnings growth when the real GDP growth rate falls between 1 and 2%. This makes the 11% earnings growth expectation for 2015 seem achievable relative to the likely real GDP growth. However, caution is warranted, as earnings growth estimates have been consistently revised down this year due to less than expected revenue growth and/or margin expansion at the corporate level. It appears that bottom-up earnings forecasts are trailing behind what would have been suggested by broader economic forecasts. Combined with the fact that valuation multiples are not low, markets may disappoint if earnings growth turns out weaker than expected. Several risks are worth mentioning in the eurozone economy, including a strong euro threatening export competitiveness and potential disruption of Russian gas supplies. Furthermore, harsh austerity measures have ravaged public approval of the current leadership in several countries, so political volatility is most likely rising. These risk factors, along with potentially overly optimistic earnings growth forecasts and unsupportive valuations, suggest that a cautious stance toward eurozone markets is warranted in fiscal 2015. Within the eurozone, there are varying economic conditions in the major countries. Germany is expected to continue to do well and achieve real GDP growth amongst the highest in the region. The combination of low inflation, low interest rates and a stable government paints a supportive backdrop for Germany. The positive outlook appears to have been well priced in however, with the German market trading over 10% above its historical averages on most measures. A higher valuation does not
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Fiscal 2015 Investment Plan
allow much room for surprises and a cautious stance is warranted. With the German economy being one of the most exposed to exports and one third of its natural gas needs met by Russian supplies, a strong euro and geopolitical tensions are two of the greatest threats to prosperity next year. The eurozone’s second largest economy, France, may continue to be constrained by twin deficits, an uncompetitive labor market, and high public debt. With the unemployment rate topping 10% and jobless claims running at record highs, President Hollande’s popularity rating has plunged below 20%, a level never before seen for a President in modern France. Hollande has pushed forward a landmark €50 billion deficit reduction plan in the lower house, serving to lower payroll taxes and encourage increased hiring by corporates. While the plan is still subject to European Commission approval and its effectiveness remains contested, it is a move in the right direction. In light of a sluggish economy, the consensus earnings growth estimate of 14% for 2015 appears aggressive and the market looks rich with valuation multiples at levels that are at or above historical averages. If Italy’s new Prime Minister, Matteo Renzi, succeeds in his multi-step reform program designed to stabilize government, improve labor laws and facilitate tax cuts, then the country’s economy may receive a much needed boost. Italian bank stocks have been amongst the best performing this year. While valuation multiples appear low relative to historical averages on a price to book basis, the quality of the banks’ book values remains suspect and warrants caution. In fact, findings from the highly anticipated Asset Quality Review by the European Central Bank, to be announced in late October 2014, may reveal irregularities and breaches that will require certain banks to raise capital, a tangible risk that has been downplayed so far. Outside the eurozone, the United Kingdom has engineered an earlier, stronger recovery than most of its peers. Despite a higher economic growth forecast than the rest of Europe, the United Kingdom’s earnings growth estimate of 9% in 2015 is below its peers, driven by a higher concentration of commodity stocks faced with a weakening global demand outlook, as well as consumer staples stocks challenged with strong competitive pressures. Bargains can be found in these sectors and valuation of the overall market is reasonable to attractive, particularly when the 4% dividend yield is considered in this low interest rate environment. After generating a strong return in fiscal 2013 in both yen and U.S. dollar terms, Japan’s equity market lost momentum in fiscal 2014 and has been a material laggard in performance versus other developed countries. Prime Minister Abe’s economic policies, famously nicknamed Abenomics, have shown initial success but longer-term fundamental improvement requires structural reforms that have yet to be launched or even fully planned. Also, there is uncertainty about the effects from a consumption tax increase, from 5% to 8%, that was implemented in April 2014. Massive monetary easing led to a sharp depreciation in the yen last year, but yen weakness is a double-edged sword. On the one hand, it has led to resurgence in the export competitiveness of Japan, particularly in industries such as auto and electronics manufacturing. Indeed, much of the high earnings growth with Japanese equities over the past year has come from the industrial and information technology sectors. On the other hand, energy import bills have escalated further following yen depreciation. Since the 2011 Fukushima earthquake, Japan has converted 30% of its electricity generation needs from nuclear to imported oil and gas. While nuclear plant restarts have been discussed ad nauseam, recent polls suggest a twoto-one ratio of opposition versus support. Research further indicates that less than two-thirds of the reactors will pass the current protocols and possibly only one-third of the reactors may eventually be restarted, threatening to turn Japan’s previous long-standing current account surplus into a persistent current account deficit. Earnings in Japan are expected to grow about 14% in 2015 if the economy can grow at a 1.5% real rate. While the yen is expected to depreciate modestly, it is not likely to influence earnings as much as it did during the past fiscal year. Hence, a more broad-based growth in revenues and margin expansion is required. While not without risk, the equity market has corrected approximately 10%
Fiscal 2015 Investment Plan
since its peak, and valuation multiples are at reasonably attractive levels relative to history on both an earnings outlook and asset value basis. A fundamental change in China’s growth model away from investments brings more challenges to Australia and Canada than other developed countries due to their high dependency on commodities exports. While the challenges they face will be lasting, both markets have found relief elsewhere in the near term. Canada has continued to lean on the strength of the U.S. economy, and Australia has relied on a sharp decline in short-term interest rates to support property prices and consumer spending. Earnings growth estimates for both markets are between 5%–8% for 2015, with the commodity segment projected to lag the rest of the market. Valuation multiples for both markets are at cycle average levels, though dividend yield in Australia is approximately two percentage points higher than in Canada, in line with historical norms. Somewhat more diversified, the Australian equity market also appears to offer better investment opportunities in select stocks with attractive valuations
Emerging Markets Emerging market returns in fiscal 2014 have been good and increased 12% in U.S. dollar terms through May, but the returns have lagged the developed markets. The emerging markets have been restrained by decelerating growth in several large emerging countries and concerns about how the tapering in U.S. quantitative easing would dampen liquidity in emerging markets. There have also been geopolitical issues such as the Russia/Ukraine crisis that have surfaced during the year. Geopolitical risks are always present within the emerging markets and these issues need to be recognized and considered, but when an actual event surfaces this often can become a buying opportunity. Focusing on just economic issues, we believe that the direction of the Chinese economy is a key determinant in how emerging markets will perform in fiscal 2015. If the Chinese economy can stabilize soon, then we forecast that the emerging markets overall in fiscal 2015 will earn a return moderately above its expected long-term average. We believe that the emerging markets remain an attractive long-term investment and the valuation is supportive. The overall valuations in emerging markets are attractive. The absolute valuations on earnings and book value are reasonable and trade below longer-term historical averages. The P/E multiple currently stands near 10.6X forward earnings and is at the widest discount to the developed world since the summer months of 2005. The valuation on trailing book value is at the widest discount to the developed world since 2003 when the emerging markets equity performance boom of that decade began. However, the widening valuation discount to the developed market on trailing book value is partly warranted as the premium return on equity in the emerging markets has narrowed to below one percentage point. The valuation discount in emerging markets varies by country and sector. Although it is normal for there to be valuation differences within the emerging markets by country and sector, much of the lowly-valued part of the market is currently in fundamentally unattractive areas such as Chinese financials, Russian government-controlled stocks, or commodity stocks in general. An investor would need to have a more contrarian mindset to invest heavily in such areas since there does not appear to be any likely catalysts over the next 12 months. However, if China’s economy is able to stabilize in the upcoming year, then some of the attractively-valued stocks could rebound. Our focus will be to invest in undervalued companies that have their own company-specific positive triggers to rerate upwards and have the balance sheet strength to endure possible tight market liquidity conditions. The deceleration in the Chinese economy is directly linked to a retrenchment in capital investments combined with tighter credit conditions. However, beneath the surface, slower growth is driven by policy directives from the new Xi Jinping administration that appears more conscientious about sustainability and tolerant of slower growth. Also, the Xi administration appears to have taken on a crusade against corruption, as evidenced by a number of high profile, unprecedented investigations. While highly positive for the country over the long run, curbing corruption and hence its effect on
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Fiscal 2015 Investment Plan
consumption and investments will further exacerbate the challenges the economy faces in the near term. Reflecting slower growth in the economy, the earnings growth estimate for the Chinese equity market is uninspiring relative to history, standing approximately 10% for 2015. It is worth noting that one-quarter of this growth is expected to be generated from Tencent Holdings, the dominant social media company, while the telecom, materials and financials sectors are expected to be sluggish. The valuations within China reflect the divergence in fundamentals, with Tencent Holdings trading at lofty multiples and the aforementioned sectors trading at historical lows. While banking sector valuations remain low on surface, the dubious quality of book value and earnings largely explains it. Despite appearing cheap overall, opportunities in the Chinese equity market will be selective in nature. In particular, select majority state-owned enterprises may receive valuation boosts if further reforms are carried out and greater merger and acquisition activities are allowed. During calendar year 2014, there have already been several national elections in emerging market countries with a few other important ones later in the year. While the status quo was maintained in national elections this year in Hungary and South Africa, a potentially transformative election was recently held in India where the incumbent party was decimated in the election and the more market friendly BJP party won majority control at the national level except for the upper house. There are still numerous obstacles that need to be overcome in India, but favorable demographics and a likely urbanization trend will possibly result in the country becoming a material source of global growth in the future if the government can implement supportive policies. Important elections are scheduled later this year in Brazil, Indonesia, Thailand, and Turkey. The upcoming presidential election in Brazil to be held in October 2014 is resulting in government delays in implementing needed policies. The incumbent President, Dilma Rousseff, is running for another term and she is hesitant to reform areas such as petroleum pricing that may result in higher prices for consumers who are already displaying a less favorable attitude toward her administration. Brazil suffered a poor rainfall season in 2014 that has led to concerns that electricity usage will have to be rationed because hydropower represents roughly two-thirds of power generation in the country. The government has refrained from implementing rationing before the election, but if the next rainfall season also is below average, then the rationing that will be needed could cause an unwelcome headwind to an economy that is already weak.
STRATEGY As fiscal year 2014 draws to a close, the international portfolio is approximately $18.2 billion or 25.0% of total assets (includes 1% of total assets in Global Equities), under the neutral target weight of 26%. The international asset class was underweight throughout the fiscal year, but $444 million was allocated when markets were weak. Staff is projecting a normal return for the STRS Ohio Blended Benchmark for the next 12 months, with the developed markets being the expected laggard. Therefore, the international asset class will likely be held in-line with the target weight in fiscal 2015 unless the risk/reward outlook becomes more favorable for equities. Dependent on market conditions at the time, the current underweight versus the 26% policy weight will likely be closed by the start of fiscal 2015 with the hiring of new external managers that are referenced below. The international portfolio will be tilted toward an overweight in emerging markets as market opportunities allow. There were several changes at the portfolio level during the fiscal year for both internal and external portfolios. There were two changes for internal portfolios. First, two portfolios, one with an emerging markets mandate and the other with a developed markets mandate, were combined into a single portfolio with an All Country World Index (ACWI) ex-US mandate (containing both emerging and developed markets stocks). Second, a new emerging markets quantitative portfolio was initiated to replace an external manager with an emerging markets mandate.
Fiscal 2015 Investment Plan
The external manager changes came in two phases in fiscal 2014. In the first half of the fiscal year, an external manager was terminated that had been managing two separate emerging and developed markets portfolios. The terminated emerging markets portfolio value was used to fund the new internally-managed emerging markets quantitative portfolio mentioned previously, while the terminated developed markets portfolio value was used to fund a new externally-managed portfolio with a developed markets growth mandate. In the second half of the fiscal year, a manager search was initiated to hire new external managers with an ACWI ex-US mandate. At this writing, staff anticipates that two new external managers will be hired and funded by the start of fiscal 2015. After the new external managers are hired, there will be sufficient capacity in the combined internal/external manager platform to make allocations to the asset class to meet targeted weightings as market conditions change. Staff anticipates that the current lineup of external managers will be reviewed in fiscal 2015 for proper balance and likely future performance. Looking at the portfolio from a risk budgeting standpoint, the highest amount of risk continues to come from the external managers. A lower amount of risk is coming from the internal managers, which is due in large part to the passive core-EAFE component (i.e., Europe, Australasia, Far East). The other internal portfolios are being run actively. The staff does not anticipate much of a change in the allocation of risk across the international portfolio in fiscal 2015. However, any new allocations to the asset class will very likely be made to actively managed portfolios and not to the passive coreEAFE component. The chart below shows allocations for internally managed, externally managed, developed and emerging markets investments. At fiscal year-end 2014, we will be near a 79%/21% split between the developed and emerging markets within the asset class, which is close to the neutral points (80%/20%) set for each. Staff anticipates slightly expanding the emerging markets weight above the targeted neutral weight of 20% in fiscal year 2015, as market opportunities allow, due to the higher return expectations versus the anticipated returns available in developed markets. As shown below, the split between externally and internally managed funds is 39% external and 61% internal.
FISCAL YEAR-END 2014 (estimated)
$ Invested (at Market)
Percent of International Assets
External Managers
$ 6,822 million
39%
Internal Managers
$10,658 million
61%
$17,480 million
100%
Developed Markets
$13,893 million
79%
Emerging Markets
$ 3,587 million
21%
$17,480 million
100%
• As of April 30, 2014, $769 million is in a global portfolio. This portfolio is not included in the table above due to the fact that it includes developed, emerging, and domestic equity securities.
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Fiscal 2015 Investment Plan
Fiscal 2015 Investment Plan
VIII. Real Estate Investments OUTLOOK Overview At this time last year, staff indicated it expected the Blended Real Estate Benchmark to return approximately 8% for fiscal 2014. Through March 31, 2014, the benchmark return stands at 7.8% and will likely exceed 9% for the fiscal year. The capital market for private real estate is still very strong, with price appreciation expected to be close to and possibly above 5% in fiscal 2014, which is slightly higher than last fiscal year — although down from almost 6% and 10% in fiscal 2012 and 2011 respectively. With the exception of apartments, new supply continues to increase at a modest rate and is expected to continue at historically low levels over the near term. Keeping new supply in check is important as job growth, albeit improving, is still modest and demand for real estate is dependent on job growth. As demand continues to increase, coupled with restrained additions to new supply, vacancy rates are expected to continue to decline — enabling landlords to increase rents, which leads to improved net operating income and thus returns. As fiscal 2014 comes to a close, private market commercial real estate, as measured by the NCREIF Property Index (NPI), has had positive price appreciation every quarter since June 2010. As of March 2014, the total return for NPI fiscal year-to-date is 8.1% — approximately 50 bps higher than this time last year. With a forecast of rising interest rates last fiscal year, price appreciation was expected to continue to decelerate. However, with interest rates falling since the beginning of the calendar year, cap rates have also declined, providing stronger than expected price appreciation. Transaction volume in the private markets, as measured by The National Council of Real Estate Investment Fiduciaries (NCREIF), has returned to pre-recession peak levels. The rolling four-quarter average is about 800 transactions, which is equal to the September 2005 quarter when pre-recession transaction activity peaked. For context, the June 2009 quarter was the bottom, with less than 200 properties sold. Current transaction volume represents almost 7% of the value of the index. Despite the number of transactions showing a decline over the last two quarters, we expect volume will continue to increase, albeit more slowly, given the relative appeal of the asset class. While REITs were down almost 4% over the first half of the fiscal year, they have been on an impressive run since January. REITs were hit hard in the first half of the fiscal year as interest rates were rising — coupled with the uncertainty over the full effect of tapering. However, now that the markets have had time to adjust to the reality of tapering, interest rates actually declining, and improving property fundamentals, REITs are up more than 16% since Jan. 1, 2014. REITs are up a total of 12% for the fiscal year through May. In fiscal 2015, staff anticipates a blended benchmark total return of approximately 8–9%. However, we expect private market transaction pricing on new acquisitions to be, on average, below the Retirement Board’s long-term expected return for the asset class (+6.7%).
Property Markets Property operating fundamentals continue to improve across all property sectors and geographic markets. The coastal markets and/or gateway markets, with their inherent geographic supply constraints and greater participation in the global economy, lead the recovery relative to the rest of the country. In addition to the operating fundamentals, these markets also led the way in the pricing recovery, with most at or above pre-recession levels. While these markets are expected to continue to perform well, investors reaching for yield are turning to secondary and non-gateway markets. This increasing supply
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of capital is now pushing a price recovery in these markets, which could lead to them outperforming gateway markets next year. Long term, staff believes the fundamentals favor larger, more liquid gateway markets on both the supply and demand side of the equation. From a property-type perspective, apartments typically lead the recovery and this recovery in particular, given the housing crisis. This has led to extremely strong performance for several years, although slowing over the last year. Given the short-term nature of leases relative to other property types, apartments are able to benefit from increasing demand levels by raising rents more rapidly than other sectors. The long-term fundamentals, including new household formation, pent-up demand, and the propensity for renting vs. owning among the under 35 years-old demographic, bode well for the sector for the next several years. However, the ability to push rents further is meeting resistance due to the increase in new supply, as well as affordability issues in some markets. However, despite increasing supply, demand is expected to keep up. Both industrial and office, which have lagged the recovery, are seeing declining vacancies and rental rate growth. Office markets, particularly technology- and energy-related, are seeing the strongest gains in operating fundamentals. Not surprising, these are also the markets seeing the most new office supply coming online. However, much of the space is pre-leased and with demand expected to remain strong, the projects are expected to be full by the time the buildings are delivered. This is the case in San Francisco. Projects, totaling several million square feet are expected to be delivered over the next few years. However, the amount of supply relative to the overall size of the market is relatively low, and the explosive growth from companies in the technology sector will provide strong absorption. While San Francisco is a somewhat unique situation, overall, new supply is relatively muted and that is expected to continue. Loan availability is increasing, however, lenders are somewhat cautious on speculative development. Also, the development time involved in building new office product is typically a multiyear process — and in many locations even longer. While we expect continued strengthening in this sector as the economy continues to grow, the longer-term concern for the sector is the trend toward more efficient use of space and lower per person usage rather than excess supply. The fundamentals for industrial assets are highly correlated to GDP, so as the economy continues to improve, the sector should do well. Vacancies continue to decline and rents are starting to grow. While new additions to supply have been comparatively limited, industrial is the most prone to over supply as it is relatively quick and easy to build. This keeps a lid on significant or sustained rent growth as compared to the other property sectors. Like STRS Ohio, institutional investors look to increase their exposure to the industrial sector. This supply of capital will continue to provide support for current pricing levels. This is a sector that also can provide development opportunities on either a build to suit or speculative basis. The retail sector performed very well over the past year. This is largely attributable to the regional and super regional malls that saw significant appreciation as compared to other retail formats. Retail, like the other sectors, is seeing improvement in fundamentals. However, vacancy declines are less than what is seen in other property sectors and there is still excess space that may never be re-leased. This makes it challenging for landlords to push rents. Consistent again with the other sectors, new supply is very limited and this is expected to continue. While some retailers are expanding their number of stores, it is on a much smaller scale than before the recession and the store formats are also smaller. These more traditional retailers are looking to e-commerce to be an engine of growth going forward rather than the bricks-and-mortar stores. High street retail, open air centers, centers part of the livework-play environment have the best outlook. Shoppers enjoy the “experience” of these types of retail and the entertainment aspect keeps the consumer’s attention longer. Grocery-anchored shopping centers and centers with “convenience” retailers should also fare well as they are necessity-based retail centers and have the lowest risk to internet retailing. Success in retail, more than any other sector, is highly dependent on its location. Well located in-fill and urban locations offer the best insulation against competition.
Fiscal 2015 Investment Plan
Returns The table below demonstrates the changes in private real estate returns during the last three years as of March 31, 2014. Real estate returns are driven by both the underlying property fundamentals and the capital markets. Since before the recession, the capital markets have been the primary driver of returns, with the peak in calendar 2005 at 63% of total return attributable to price. In calendar year 2013, price accounted for 47% of total return. While the capital market influence is still significant, relative to historical measures, improving operating fundamentals are now having more of an impact. Excluding the two recession periods, it hasn’t been since 1999 that price has accounted for “just” 25% of total returns. Since the inception of the NPI (1978), calendar year appreciation has averaged 1.6% on an absolute basis, which represents roughly 17% of the average total return since inception. Price appreciation on a trailing 12-month period through March 31, 2014, represents 45% of the total return, slightly below the three-year average. With the gradual acceptance and expansion of the real estate asset class as part of a multi-asset class portfolio, it appears the higher impact of the capital markets on performance is likely here to stay. The NPI represents 85% of the STRS Ohio Real Estate Blended Benchmark. NCREIF Property Index (NPI) One-Year Ending March 31, 2014 March 31, 2013 March 31, 2012 Three-Year Annual Average
Income
Price
Total
5.5% 5.5% 11.2% 5.8% 4.5% 10.5% 6.0% 7.1% 13.4% 5.8% 5.7% 11.7%
Although our forecast is for rising interest rates, we do not expect a near term negative impact on private real estate values for several reasons. First, there is a significant amount of capital allocated to real estate which will continue to keep downward pressure on cap rates providing a floor for valuations. Second, the yield spread over 10-year Treasuries is above its long term average and at 300 bps (as of March 31, 2014) is double the spread at the peak of the real estate market. Staff would expect a continued narrowing of the spread to offset interest rate related increases. Over the past year, the spread declined about 100 bps. Lastly, with fundamentals continuing to improve, increases in operating income should also help to offset, or a least soften, an increase in cap rates. The public markets experienced wild swings in fiscal 2014. Despite the volatility, REITs stocks are in a fair value range on either a price-to-earnings or price-to-net asset value basis. Looking forward, total return for fiscal 2015 is expected to be close to 10% driven by growth in FFO of approximately 7%, with just over 3% dividend yield for the sector. Staff anticipates a blended benchmark total return for the asset class of approximately 8–9% in fiscal 2015. However, we expect private market transaction pricing on new acquisitions to be, on average, below the Retirement Board’s long-term expected return for the asset class (+6.7%). The table on Page 46 outlines the expected range of returns, based on property type, for transaction market pricing in fiscal 2015. There have been no adjustments to these ranges from fiscal 2014 as there has been no significant movement in either direction.
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Transaction Market Pricing Expectations for Fiscal 2015
Property Type
Initial Yield*
Retail 4.50%–6.50% Apartments 3.50%–5.00% Industrial 5.00%–7.00% Office 5.00%–7.25% *Average annual 10-year holding period returns are expected to range from 1.00%–2.00% higher than the initial yield.
STRATEGY Allocation Staff anticipates ending fiscal 2014 with approximately $6.9 billion in real estate — up from $6.7 billion at the beginning of the fiscal year. This translates into a weighting for the asset class of approximately 9.3% as compared to its 10% neutral allocation. In fiscal 2014, STRS Ohio sold five assets. Acquisition activity included the continued funding of two direct joint ventures, a new development joint venture in Rosslyn, Virginia, an industrial building in suburban Chicago, and an individual retail store contiguous to a shopping center currently owned by STRS Ohio in Southern California. Although assets at the total fund level are expected to be flat for fiscal 2015, approximately $500 million of new allocation will be needed to reach the 10% neutral weight for the asset class. Given current commitments to direct real estate as well as comingled opportunity funds (domestic and international) along with price appreciation of the portfolio, the neutral weighting should be attained even before factoring in new acquisitions. No dispositions are planned at this time and will be allocation dependent — meaning if there is sufficient acquisition activity, dispositions may be considered. As discussed earlier, the capital markets are very robust, with returns for new acquisitions below the Retirement Board’s long-term expected returns for the asset class.
Diversification Public Investment (REITs) The REIT portfolio will now be managed passively. Given the additional volatility of REITs, the portfolio is expected to be at or close to its 15% neutral weighting with quarterly re-balancing. Private Investment Geographic As shown in the table below, the direct portfolio — estimated to end fiscal 2014 at approximately $4.8 billion — is diversified across the four regions. The East and West regions are up slightly on an absolute basis; however, the relative weighting to the benchmark is essentially unchanged. The South and Midwest regions are both down slightly on an absolute and relative basis. Geographic Diversification (Core Only) (estimate as of June 30, 2014) STRS Ohio East Midwest South West
42% 15% 8% 35%
STRS Ohio vs. NPI 1.21x 1.55x .39x .98x
Fiscal 2015 Investment Plan
Staff will continue to focus portfolio holdings and acquisitions in major metropolitan markets across the country to provide for diversification — both geographic and economic. Major markets are emphasized given the need to hold a mixed portfolio with critical mass to enable efficient asset management, as well as to benefit from the increased liquidity typically found in these markets. However, on a very select basis, additional markets may be considered for a particular property type. The significant underweight in the South is expected to continue for the next several years as the portfolio is going through a rebalancing which will be a multi-year process. Staff is evaluating potential new acquisition opportunities but dispositions will continue in an effort to reposition the South region portfolio. The significant overweight to the benchmark in the Midwest, albeit down slightly from last year, is expected to continue until there is more acquisition activity in the other regions and properties slated for disposition over the next few years in the Midwest are completed. Property Type The table below details STRS Ohio’s weightings in the four property sectors, as well as the comparison to the benchmark. The portfolio has a large overweight to the benchmark in the office sector, which is up slightly on an absolute basis and essentially unchanged on a relative basis. The apartment sector is down slightly on an absolute basis and essentially unchanged relative to the benchmark. STRS Ohio’s industrial and retail weightings are unchanged from last fiscal year. Property Type Diversification (Core Only) (estimate as of June 30, 2014) Apartment Industrial Office Retail
STRS Ohio
STRS Ohio vs. NPI
23% .92x 14% 1.05x 47% 1.30x 16% .68x
The largest overweight in the portfolio is in the office sector. As mentioned in last year’s plan, two office properties, one in Southern California and the other in suburban New Jersey, totaling almost $200 million were sold this fiscal year. Notwithstanding these two sales, the reduction in allocation was completely offset by the strong appreciation from the office portfolio. There are additional office assets in the portfolio identified as disposition candidates over the next few years but they are largely allocation dependent. Staff may also explore the possibility of selling partial interests in select office assets. While the office sector lags the other property types in a recovery, we are seeing continued strengthening and expect the sector to have solid gains in the next one-to-three years. Relative to the existing inventory of office space, speculative new supply is relatively minimal and given the high barriers to entry in many of these markets, even a reasonable increase in demand will outstrip supply. It takes several years to complete an office building even under the best circumstances, so this sector is more insulated from near-term supply increases as compared to the other property types. While staff is not targeting acquisitions in the office sector, if there are opportunities next year that will allow us to “trade up” or fill in gaps in the portfolio, we will pursue them. If that is the case, we will continue to sell current office assets so as not to have a significant increase in the sector’s weighting. Although the portfolio is slightly below the benchmark in apartments, STRS Ohio has two projects under construction with expected completions in calendar 2015 and 2017. Both of these investments are consistent with staff’s strategy of focusing on urban in-fill or transit-oriented
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locations that appeal to the younger population. This demographic is biased toward rental housing and particularly in properties that provide a live-work-play environment. While apartments have led the recovery, rental rate increases are slowing as the supply pipeline increases. However, demographics and changing views of home ownership should provide continued strong demand. As discussed in previous years, it is difficult to scale an industrial portfolio as the individual asset sizes tend to be smaller. To broaden STRS Ohio’s access to the sector, particularly in the smaller assets, STRS Ohio has committed an additional $180 million to its partnership with a Chicagobased operating partner. This is expected to be funded over a multi-year period. The largest underweight in the portfolio is in the retail sector. As mentioned earlier, dominant centers — particularly in urban and in-fill locations — are expected to provide strong long-term return opportunities in retail. These types of centers are also part of the live-work-play environment described earlier. Staff continues to favor these types of centers as well as grocery-anchored neighborhood centers which are also more necessity based rather than discretionary. However, these centers must have one of the leading grocers in the market or a specialty type grocer. As discount retailers continue to expand into the grocery business, only the strongest will survive. It is important to be very selective in the retail sector, as location is critical to success. Staff will continue to look for these types of retail opportunities. Property Life Cycle As mentioned earlier, apartments are still in high demand by investors, given the positive outlook on the fundamentals. This puts additional pressure on yields that are already at or below 4%. Staff committed to a new high rise development in the sector this year (and one in fiscal 2013) and is currently in negotiations with a potential operating partner on another project. New development will most likely be limited to urban in-fill and transit oriented locations which typically are more supply constrained. This will enable STRS Ohio to invest in the property sector at “cost” rather than “retail.” Industrial is another sector that may be appropriate for investing at the development stage. Undertaking development entails additional risk that should be reflected in higher expected returns.
Leverage At fiscal year end 2014, we anticipate the leverage ratio to be approximately 24%, which is essentially unchanged from the beginning of the fiscal year. This is split roughly 55%/45% between assets wholly owned by STRS Ohio and joint venture investments. As mentioned in last year’s annual plan as a possibility, staff refinanced a $150 million loan at 3.5% on a five-year term. STRS Ohio has a $250 million portfolio loan which matures at the end of fiscal 2015. Staff will continue to monitor the debt markets as well as the asset class weighting to determine whether or not to extend the maturing loan. Staff will manage the use of leverage in the portfolio below the policy limit of 50%.
Fiscal 2015 Investment Plan
International Portfolio Composition: •
$618 million total portfolio
•
9.1% of total real estate
•
$430 million in unfunded commitments
•
16 funds with 11 managers
— 7 funds investment/active management stage
— 8 funds substantially completed investment/repositioning — evaluating exits
— 1 fund actively disposing of assets
•
205 total investments
— 42% Europe
— 37% Asia
— 11% United States (via global fund)
— 10% Latin America •
$140 million new commitments in fiscal year 2014 to two funds — targeting distressed sector in Europe
Life Cycle: •
Early Stage — $185 million (30%) — assets held less than 18 months
The going in basis achieved by the managers on these assets typically result in early gains, but full value gains are not recognized until sale. This segment becomes the building block of future gains as the managers execute their business plans.
•
Mid Stage — $ 228 million (37%) — assets held 18–36 months
These assets should be a major driver of performance as the asset quality continues to improve and value increases are recognized.
•
Mature Stage — $205 million (33%) — assets held at least 36 months
Once assets enter this stage, usually 75% of the value increase has been recognized and liquidation within the next six-to-twenty-four months is expected. Therefore, this segment will not only generate additional returns, but will also generate cash flow. Within the mature stage is $99.5 million of assets purchased before the global financial crisis which are expected to be substantially liquidated by the end of fiscal year 2016. While there is little prospect for near term value increase in this sector, it did produce a positive return in fiscal year 14.
Returns: •
Fiscal year-to-date as of March 31 — 13.2%
•
Trailing 10 years as of March 31 — 11.8%
The European property market fundamentals are stable with low vacancy and limited new supply. The forecast is for sustained annual rent growth of 2.5%–3.5% across the region through 2017. However, there continues to be uncertainty surrounding the European economies and the level of recapitalization required over the short to medium term. While banks will likely be a significant source
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of transactions, the distress is widespread, and investment sales are expected to come from a wide variety of investors — including German open-ended funds, REITs and CMBS, as well as regional and central governments throughout the region. This environment will provide the opportunity to acquire assets at an attractive basis in markets poised for growth. While the economies of the Asia–Pacific region are expected to continue to outpace the economies of North America and Western Europe, the lack of other compelling factors, which drive outsized returns, leads to a decision to underweight the region. Investment in China is subject to tremendous execution risk and therefore unlikely at this point. The principal guideline continues to be to invest in regions exhibiting multiple/compelling opportunistic factors with a focus on: core markets supported by improving property fundamentals; and emerging/developing markets exhibiting sustainable, strong growth underpinned by stable governments and functioning financial markets. For fiscal 2015 the focus for new investment will be on the following: 1) Participation in the distress caused by the liquidity shortage in the core markets of the U.K., Germany, France and other Western European markets; and 2) Select distressed opportunities in Japan.
Fiscal 2015 Investment Plan
IX. Alternative Investments — Private Equity Fiscal 2014 represents the 18th year since a statute revision removed a limitation that restricted alternative investments to Ohio companies or to venture capital firms having an office in Ohio. In May 1997, the Retirement Board approved a broad domestic and global investment plan for alternative investments. Since then, the allocation to alternative investments has increased with each asset allocation or asset-liability study. In 2009, the scope of the alternative investment portfolio was expanded through the establishment of two allocations, private equity and opportunistic/diversified. Both allocations are now at the 7% target allocation that was established in the fiscal 2012 asset-liability study. The private equity allocation is covered in this section and the opportunistic/diversified allocation is discussed in Section X. The following chart shows the fund commitment activity in the private equity portfolio since inception:
ANNUAL SUMMARY OF CAPITAL COMMITMENTS Fiscal Year
$ Committed
New Managers
Existing Managers
1996 and Prior
$ 49 million
7
3
1997
$ 124 million
4
2
1998
$ 682 million
13
2
1999
$ 160 million
4
1
2000
$ 641 million
5
10
2001
$ 582 million
7
9
2002
$ 270 million
2
5
2003
$ 95 million
3
0
2004
$ 306 million
3
6
2005
$ 460 million
1
7
2006
$ 1,155 million
0
9
2007
$ 1,225 million
3
8
2008
$ 888 million
2
11
2009
$ 867 million
3
7
2010
$ 395 million
1
2
2011
$ 78 million
0
2
2012
$ 531 million
3
8
2013
$ 487 million
3
5
2014
$ 764 million
2
9
Total
$9,759 million
66
106
2015 (projected)
$400 to $900 million
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Last year’s Investment Plan projected new commitments for fiscal 2014 ranging from $300 to $800 million. Favorable capital markets have persisted, allowing managers to exit their investments through sales and IPOs and return capital to their limited partners. This has caused many managers to come back to the market to raise subsequent funds, which is why STRS Ohio is at the high end of its projected new commitments for fiscal 2014. Investors’ liquidity concerns are now a faint memory. The market for private equity purchases continues to benefit from plentiful and attractive debt, which also supports the seller’s market — allowing many of our managers to either sell portfolio companies or refinance companies at lower costs of capital and, in some cases, issue dividends to investors. Obviously, a seller’s market creates challenges for managers and their latest funds that are still deploying capital, as we have seen purchase prices, along with the multiples of earnings they represent, increasing to levels that make it more difficult for managers to project attractive risk-adjusted returns. This requires managers to find acquisition prospects that present multiple opportunities to achieve additional upside (e.g., mergers and tactical acquisitions, geographic expansion, new sales channels and new and stronger management teams). For fiscal 2015, we project new commitments to private equity will range from $400 million to $900 million. This compares to an average of $539 million per year over the last 18 years and an average of $451 million over the last five years. The invested level of private equity was 6.3% at the end of April, which is below its 7% target allocation, but still within its 4% to 9% rebalancing range. We expect that the high level of distributions resulting from the sale or refinancing of portfolio companies will continue into calendar 2015 and will make it difficult to reach the target private equity allocation over the next two fiscal years. The 12 commitments made so far in fiscal 2014 are distributed (on a dollar-weighted basis) among domestic buyout funds at 63%, domestic venture capital funds at 26%, and global/international private equity funds at 11%. For fiscal 2015, the potential types of funds within each category are listed below: Domestic Private Equity Funds • General buyout funds • Industry-targeted buyout funds • Growth equity funds • Mezzanine and subordinated debt funds Domestic Venture Capital Funds • General, early- to late-stage venture funds • Industry-targeted, early- to late-stage investment funds • Structured venture finance funds Global/International Private Equity Funds • Private equity funds in established and/or emerging regions • Venture capital and other types of private capital
The primary vehicle for private equity investments is commingled partnership funds with a term of 10+ years. In addition, funds-of-funds and separate accounts are being used selectively, despite the additional layers of fees, as a cost effective way for STRS Ohio to gain exposure to funds or investments that are difficult to access (e.g., the very top-performing venture capital funds, emerging markets funds, small buyout funds, co-investments and secondary purchases that can produce attractive expected returns net of all fees). STRS Ohio does not expect to participate directly in the secondary market as a seller of funds in its portfolio, since this continues to be unattractive due to the discounts expected by buyers.
Fiscal 2015 Investment Plan
As in the past, the following investment opportunities will not be considered for the private equity portfolio: micro-cap stock funds; seed or “angel” funds; and economically targeted funds. Also, investments in first-time funds are highly unlikely due to the heavy emphasis placed on the proven ability of the entire investment team to work together to produce attractive returns, unless there is a compelling, attributable track record that was executed by the same team at a previous manager. New capital commitments projected for fiscal 2015 will be focused on existing managers and managers that are new to STRS Ohio that have the clear potential to sponsor funds that will be top performers in the categories listed below. The commitment amounts as of April 30, 2014, are shown with the current percentages shown in parentheses. During fiscal 2015, it is anticipated that the category allocations will generally stay within the percentage ranges shown in the right hand column.
ACTIVE COMMITMENTS BY CATEGORY Actual Commitments April 30, 2014
Projected Allocation Ranges Fiscal 2015
Domestic Private Equity Funds
$6,315 million (68%)
60%–75%
Domestic Venture Capital Funds
$2,198 million (23%)
15%–30%
Global/International Private Equity Funds
$1,829 million (9%)
5%–15%
$9,342 million
100%
TOTAL
Most private equity investment opportunities involve a long-term investment horizon, illiquidity and high volatility of returns. For these reasons, expected financial returns should exceed those of the other asset classes. Based on the fiscal 2012 asset-liability study, private equity returns are expected to be 9% (net of fees) over the long term with a volatility of 30%. In private equity, returns on individual funds generally follow a pattern referred to as the “J-curve,” which anticipates negative returns during the early years of the fund, caused by the payment of management fees charged on committed capital and early write-downs, followed by progressively increasing positive returns thereafter as portfolio companies mature and are sold. Fiscal 2014 year-to-date performance through April is 19.1%. The table below shows the one-, three-, five- and ten-year returns through March 31, 2014. The private equity benchmark is the Russell 3000 Index plus 1%, effective July 1, 2012, and was the Russell 3000 Index plus 3% prior to that. Comparisons to the private equity benchmarks are sensitive to start and end dates. With the continued strong performance in the public equity markets, total private equity returns fell short of the private equity benchmarks during the shorter time periods shown, especially the five-year period ended March 31, 2014, but did outperform over the ten-year period, beating the private equity benchmark by 200 basis points. The absolute return objective shown below represents the expected private equity return over the long term. Therefore, it is significant that total private equity exceeded the absolute return objective for all time periods as shown on Page 54.
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PRIVATE EQUITY PERFORMANCE
Annualized Returns for Periods Ending March 31, 2014
ONE THREE FIVE TEN YEAR YEARS YEARS YEARS
Domestic Private Equity
26.5%
16.4%
17.2%
15.0%
Global/International Private Equity
12.3%
13.7%
12.3%
11.3%
Venture Capital
16.3%
12.6%
10.1% 8.9%
Total Private Equity
23.5%
15.4%
14.7%
12.7%
Private Equity Benchmark
23.8%
16.7%
24.7%
10.7%
Absolute Return Objective 9.0%
10.1%
10.4%
10.7%
Over the last twelve months, continued progress was made on the general goals outlined in the fiscal 2014 annual plan by accessing several funds that were oversubscribed and liquidating $50.8 million of public shares held in the stock distribution portfolio during the twelve months ended Apr. 30, 2014. There is currently $9.6 million in the stock distribution portfolio as the result of $10.9 million of new transfers into the portfolio. During fiscal 2015, staff will: •
Continue to evaluate successor and new fund opportunities to improve the overall return potential of the portfolio;
•
Continue to seek relationships with managers whose funds are difficult to access; and
•
Continue to opportunistically sell public shares distributed to us by the general partners.
Alternative Investments For alternative investments, which combines private equity and opportunistic/diversified, the fiscal 2014 year-to-date performance through April is 13.2%. The table below shows the one-, three-, five- and ten-year returns through March 31, 2014. Similar to private equity, these returns lagged their public equity based benchmarks — the alternative investments blended benchmark — for the one-, three- and five-year periods but outperformed the ten-year benchmark with a return of 12.0%, which exceeded the alternative investment blended benchmark by 190 basis points. Total alternative investment performance exceeded the long-term absolute return objective for all time periods. For fiscal 2015, the projected return for the alternative investment asset class is a “below normal” return in the mid-single digits.
ALTERNATIVE INVESTMENTS PERFORMANCE Annualized Returns for Periods Ending March 31, 2014
ONE THREE FIVE TEN YEAR YEARS YEARS YEARS
Total Alternative Investments
18.4%
12.7%
13.3%
12.0%
Alternative Investments Blended Benchmark
22.7%
15.3%
23.2%
10.1%
Absolute Return Objective 8.0% 9.2% 9.8%
10.4%
Fiscal 2015 Investment Plan
X. Alternative Investments — Opportunistic/ X. Diversified The opportunistic/diversified allocation within alternative investments was established in 2009, growing steadily from an initial allocation of 1% to the 7% target allocation established by the fiscal 2012 asset-liability study. As the name implies, this allocation is open to a wide variety of investment types sourced from all asset classes, both liquid and illiquid. The goal of the opportunistic/diversified allocation is to earn equity-like returns net of fees over the long term, but with downside protection during equity bear markets. Investment activity falls within the six separate strategies shown in the Portfolio Summary below and is subject to the market value maximums for each strategy that were established during 2012 and have been updated over time as necessary. The following chart shows the dollar amounts that are committed to each strategy, the market value at April 30, 2014, and the market value maximums for each. The market value maximum for hedge funds has been increased by $400 million as part of this annual plan to provide sufficient capacity for anticipated new investments and market value increases during fiscal 2015.
PORTFOLIO SUMMARY (as of April 30, 2014)
Strategy $ Committed $ Market Value
$ Market Value Maximum*
Banking, Insurance and Asset Management
$ 421 million
$ 292 million
$1,000 million
Energy & Natural Resources
$ 796 million
$ 750 million
$ 900 million
Hedge Funds
$1,725 million
$1,792 million
$2,600 million
Infrastructure
$ 100 million
$ 87 million
$ 250 million
Public-Private Investment Funds
$ 138 million
$ 36 million
$ 100 million
Specialty Finance
$1,858 million
$ 764 million
$2,000 million
Total
$5,037 million
$3,720 million
$6,850 million
The total opportunistic/diversified market value shown above represents 5.1% of total fund, which is below the current target allocation of 7%, but within its 3% to 9% rebalancing range. Of the $5,037 million currently committed to opportunistic/diversified, $1,217 million is still unfunded. During fiscal 2014, 16 new investments were closed at an average of over $90 million per transaction for total closings of $1,444 million. During fiscal 2015, the opportunistic/diversified team will actively pursue a pipeline of potential investments that is expected to be in the $1,250 million to $1,500 million range. Of these, we expect to close on approximately $500 million of new investments, including $325 million (net) in hedge funds and $180 million in various opportunistic investments. During fiscal 2015, we are projecting to fund approximately $1,000 million toward our existing and future investments. Based on this forecast plus anticipated market value gains — along with a slower pace of distributions — the market value of the portfolio could grow to approximately 7.3% of total fund by the end of fiscal 2015, thus exceeding the 7% neutral allocation for opportunistic/diversified.
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Fiscal 2015 Investment Plan
The primary vehicles for opportunistic/diversified investments are direct investments in public or private companies, hedge funds and investments in and alongside commingled partnership funds, including secondaries and co-investments. A team of six senior portfolio managers representing all of the asset classes is responsible for sourcing investment opportunities and has the flexibility to react quickly to investment opportunities. Now in its sixth year, the opportunistic/diversified portfolio continues to build its core of sophisticated, well-respected managers with whom we have established strong relationships that provide us access to unique, high quality transactions and co-investment opportunities. These investments are shorter term than traditional private equity blind-pool funds and often provide STRS Ohio with preferred pricing in the way of lower fees. With the addition of two analysts during fiscal 2014, staff has the capacity to focus on more of these unique investment opportunities. Fiscal 2015 also marks the beginning of the sixth year of the recovery and, at this point, fewer assets are clearly mispriced, reducing the availability of new opportunistic investments for the portfolio. Asset prices are being supported and/or inflated by the actions of the central banks, creating a seller’s market. Therefore, it will be necessary to avoid auctions and/or paying the full prices set by the capital markets. The focus in fiscal 2015 will be on investments that result in the creation of assets, products or loans that can provide the option for cash returns. This will protect the portfolio over the longer term if holding periods are extended and will make the portfolio more defensive in nature. Fiscal 2014 year-to-date performance through April is 6.0%. The table below shows the one-, three- and five-year returns through March 31, 2014. The ten-year returns are not available because the opportunistic/diversified allocation was established in 2009. So far, this performance is consistent with the 8% to 13% expected net returns that are being underwritten for the investments in this portfolio, dampened by the lower expected returns in the hedge fund portfolio. The opportunistic/diversified benchmark is the Russell 3000 Index minus 1%. The total opportunistic/diversified returns fell short of the opportunistic/diversified benchmark for the one-, three- and five-year periods shown below. Based on the fiscal 2012 asset-liability study, the opportunistic/diversified returns are expected to be 7% over the long term with an estimated volatility of 11%. The opportunistic/diversified allocation successfully exceeded the absolute return objective for the one-, three- and five-year periods shown below.
OPPORTUNISTIC/DIVERSIFIED PERFORMANCE Annualized Returns for Periods Ending March 31, 2014
ONE THREE FIVE TEN YEAR YEARS YEARS YEARS
Banking, Insurance and Asset Management 1.9% 1.0%
NA
NA
Energy and Natural Resources
NA
NA
Hedge Funds 9.0% 5.8%
NA
NA
Infrastructure 4.7%
NA
NA
NA
14.5%
NA
Public-Private Investment Funds
13.5%
15.9%
NA
NA
Specialty Finance
20.3%
NA
NA
NA
Total Opportunistic/Diversified
11.8% 8.3%
12.1%
NA
Opportunistic/Diversified Benchmark
21.4%
13.5%
17.1%
NA
Absolute Return Objective 7.0% 7.2%
7.3%
NA