Back to Normal: 2018 Outlook Part II - Virtual Venues
←
→
Page content transcription
If your browser does not render page correctly, please read the page content below
January 2018
Back to Normal: 2018 Outlook Part II
“You may delay, but time will not.” —Benjamin Franklin
Benjamin Franklin (1705 – 1790) was a Founding Father of the United States as a signer of both the Declaration of
Independence and the Constitution. His many occupations included politician, inventor, author, polymath, scientist,
printer, and civic leader. Mr. Franklin was granted the title “The First American” for his enduring campaigning for
colonial unity.
This month’s Investment Outlook reflects our view that given the strong growth in the U.S. and global
economies, the extraordinary monetary policies previously undertaken by the Federal Reserve (Fed) and
other major global central banks are becoming less necessary. The Fed is now firmly on a path of normal
monetary policy as we move into the ninth year of an economic recovery, much improved since the days
of the financial crisis and Great Recession. The Bank of England raised interest rates in 2017 for the
first time in a decade, despite the ongoing Brexit process. The European Central Bank (ECB) has made
adjustments to its monthly bond purchases, while not yet raising interest rates. Overall, the strength of
these and other nations show a picture quite different than during the global recession.
From a macro perspective, the markets were kept performance of the equity markets for more than a
busy digesting the many headlines that seemed few years now.
to come from every direction: a new U.S. political PNC expects the economic expansion to continue
administration and the uncertainties associated throughout 2017 and into 2018, forecasting 2.3%
with it, the projection of the path of forward interest growth for 2017 and 2.7% for 2018. The job market
rate moves from the Fed, unforeseen geopolitical should be close to full employment later this year;
events, and tax reform optimism, to name a few. job and wage gains are helping boost personal
U.S. stock indexes were mostly positive through the incomes; consumer spending should continue to
year, and volatility remained low relative to history. lead economic growth; and the housing market will
We were pleased with our 2017 themes. Our probably continue to gradually recover. The short-
themes for 2018 are: term impact from the hurricanes is likely to be offset
by rebuilding efforts in late 2017 and early 2018.
potential rifts in global growth
synchronization; We expect markets to continue to watch the Fed
volatility mean reverting; and other central banks worldwide for shifts
the impact of higher long-term interest rates in monetary policy. Movements in inflation and
on fixed income; currencies are key factors to watch. We believe the
potential of unforeseen outcomes in global politics
bitcoin frenzy and blockchain’s future;
remains in the new year.
the rebound in capital expenditures; and
While we acknowledge the difficulty for us, or
Global Industry Classification Standard (GICS)
anyone, to predict with great accuracy the short-
in the mix.
term behavior of stocks, we feel investors should
Annually, we review historical trends for stocks and continue to focus on their long-term goals,
bonds, and for the fifth year in a row stock returns working with their PNC advisors to develop an
have been better relative to bonds. The current asset allocation that matches their risk and return
10-year trailing return of stocks relative to bonds objectives. PNC’s six traditional asset allocation
reflects outperformance largely tied to the strong profiles are shown on the back page of this outlook.Back to Normal: 2018 Outlook Part II
2018 Outlook Part II ago, as measured by the S&P 500®. In March 2009,
equity investors sold stocks in a flight to safety amid
We began our review of 2017 and preview of 2018
the financial crisis. Markets have been in a strong
in our December 2017 Investment Outlook, 2018
bull pattern since the dark days of 2009. With the
Outlook Part I. As we close the books on 2017, we note
Dow Jones Industrial Average (DJIA), S&P 500, and
the bull market continued.
NASDAQ repeatedly testing new highs over the past
We believe the U.S. economic expansion will weeks, many investors are also wondering how far
continue in 2018, with the pace of growth this bull can run. On March 9, 2009, the S&P 500
accelerating from 2017. PNC is forecasting 2.3% closed at a low of 676.53; it now hovers around
growth for 2017 and 2.7% growth in 2018. As this the December 12, 2017, closing high of 2,664.11.
will mark the ninth year of economic expansion, we Despite the strength of the markets, 2017 has not
will continue to closely monitor economic data and been without surprises and market risks.
indicators for any shift in this forecast.
As we have done in the past, it is our intention to
While remaining mindful of the possibility of make educated projections for the upcoming year.
temporary setbacks, we believe the economic Since one cannot predict future events with any
recovery will continue in the near term. Looking great certainty, we will focus primarily on what
at long-term cyclical economic trends, typically is knowable. When determining a recommended
following a recession, GDP growth accelerates as a asset allocation for our clients we focus on their:
result of pent-up consumer demand for goods and
goals;
services. After this initial acceleration, growth tends
to settle into a more sustainable pace. In the last risk tolerance;
stage of an expansion, GDP growth slows further until income needs;
it collapses. The current U.S. recovery is a bit unusual investment holding period; and
in that there was not an initial surge in growth. personal situation.
Quarter-over-quarter annualized real GDP growth
In addition, the PNC Investment Policy Committee
has trended at about 2% since the recovery began.
considers PNC’s general recommendations,
Headline GDP growth illustrates the continued concentrates on the intrinsic value of possible
recovery, with some challenges to growth in investments, and weighs the estimated risk versus
2017. Third-quarter 2017 real GDP growth reward.
surprised most estimates by accelerating to 3.3%,
after growing 3.1% in the second quarter. The Macro Views of the Markets
economic resiliency surprised to the upside as From a macro perspective, we characterize 2017
most economists were expecting a temporary, as a year of relatively low volatility despite a host
yet markedly negative, economic impact from of uncertainties the markets needed to digest,
Hurricanes Harvey, Maria, and Irma. Data points including unforeseen geopolitical events, a new
through the fall have made some noise, including
U.S. presidential administration, and other moving
the jobs report, housing market updates, and retail
economic data points. Continued growth, together
sales. PNC economists expect a quick rebound due
with solid corporate earnings growth and optimism
to rebuilding, which is funded by federal aid and
over tax reform, was supportive of stocks, and U.S.
insurance payments. Owing to solid fundamentals
indexes mostly moved higher.
for consumer spending, business investment,
and the housing market, economic growth should Forecasting the Fed’s path of interest rates was
continue to expand through 2018. GDP growth another focus of the markets, and in line with
will likely accelerate in 2018, supported by the forecasts, the Fed most recently raised rates at
rebuilding efforts, expected tax cuts, and an the December Federal Open Market Committee
expanding global economy. (FOMC) meeting.
The financial markets have also come a long way The S&P 500 had a strong start in 2017, up 5.5% in
since the market bottomed more than eight years the first quarter, and 6.1% if you include dividends
2Back to Normal: 2018 Outlook Part II
reinvested back into the index. Following the In order to evaluate the returns to investors over a
blistering start, the second-quarter S&P 500 longer holding period, we have analyzed the 10‑year
performance was 2.6%, with the total return including cumulative total returns for each asset class
dividends at 3.1%. Third-quarter performance did not updated monthly. For example, the most recent
disappoint either, with the S&P 500 up 4.0%, and 4.5% 10-year cumulative returns are for the period
including the reinvestment of dividends. Year to date from November 30, 2007, to November 30, 2017;
through December 12, 2017, the S&P 500 is up 19.0%, in that period, cumulative returns for stocks were
with the total return up 21.3%. 122%, while bonds returned 78.8%, and cash 3.2%.
These returns reflect the strong recovery in stocks
From a fundamental perspective, corporate earnings
following the financial crisis, recession, and flight
are supportive of stocks. Overall we expect earnings
to safety in a decade plagued with several severe
growth for the S&P 500 to be in the upper-single-digit
market shocks. Cash shows a smooth upward ride,
range. Energy earnings have led the way in 2017,
as expected, while bonds and stocks at times can
as comparables are easier, given that 2016 earnings
be more volatile (Chart 1).
from the sector were largely negatively affected
by the sharp drop in oil prices. Earnings from the
Materials sector are forecast to grow over 20% for
Stocks versus Bonds
2017, while Information Technology earnings should The 10-year rolling data for stocks and bonds show
grow 14%. The weakest growth is forecast for the very few negative periods for stocks and almost
Utilities and Telecommunication Services sectors. no losses for bonds. Stocks tend to outperform
following periods of distress. Bonds do not exhibit
Historical Returns this type of behavior to the same extent (Chart 2,
page 4).
Over the long term, stocks have been the best
performing asset class among stocks, bonds, and Over a set historical period, the rolling 10-year
cash (Table 1). While the long-term total return cumulative total returns of stocks versus bonds
of stocks is attractive, average annual returns shows the average outperformance of stocks
have been a different story. Individual annual has been 114% (Chart 3, page 4). The most
returns indicate performance for any given year is recent data show stocks outperforming bonds
unpredictable. Markets can reward and punish to by just over 43%. The worst underperformance
the extremes at times. of stocks versus bonds occurred during the
financial crisis, with the nadir in March 2009 at
History of Stocks, Bonds, and Cash -146%. Performance of stocks relative to bonds
Average returns and differentials of returns among
asset classes vary in any given calendar year. When Chart 1
examining performance history since 1926, we will 10-Year Cumulative Returns, All Asset Classes
define the S&P 500 as “stocks,” long-term Treasury As of 11/30/17
bonds as “bonds,” and the 30-day Treasury bill as 450
S&P 500
“cash.” 400
Treasury Bond
350
Treasury Bill
Index 100 = 11/30/99
300
Table 1
Average Annualized Returns 250
January 1926 to November 2017 200
Real Nominal 150
S&P 500 7.06% 10.15% 100
Long-Term Govt 2.57 5.53 50
30-Day T-bill 0.45 3.36 0
2003 2005 2007 2009 2011 2013 2015 2017
Inflation N/A 2.89
Source: Morningstar, Ibbotson Associates, PNC Source: Morningstar, Ibbotson Associates, PNC
3Back to Normal: 2018 Outlook Part II
Chart 2 Chart 4
10-Year Returns, Stocks versus Bonds 10-Year Returns, Stocks versus Cash
As of 11/30/17 As of 11/30/17
600 600
S&P 500 S&P 500
Treasury Bond Cash
500 500
400 400
300 300
Percent
Percent
200 200
100 100
0 0
-100 -100
1936 1943 1950 1957 1964 1971 1978 1985 1992 1999 2006 2013 1936 1944 1952 1960 1968 1976 1984 1992 2000 2008 2016
Source: Morningstar, Ibbotson Associates, PNC Source: Morningstar, Ibbotson Associates, PNC
has improved steadily since then, turning from In comparing the rolling 10-year cumulative
underperformance to consistent outperformance total returns of stocks versus cash (Chart 5), the
beginning in January 2013. average outperformance of stocks has been 150%.
Beginning in mid-2008 and through 2010, not
Stocks versus Cash surprisingly, cash outperformed stocks. With a
The 10-year rolling data for cash, not surprisingly, rebound in the market and low interest rates, the
show no negative periods (Chart 4). However, tide turned in 2011, and the most recent data show
cash has experienced times of very low returns. stocks outperforming cash by 119%.
The rolling 10-year annualized return for November
2017 was a mere 0.3%. We would expect continued
low 10-year returns on cash for some time, given
2017 Themes Revisited
our forecast for short-term interest rates, which At the outset of 2017, we introduced our themes for
we believe will remain at low levels with likely the year:
slow and gradual subsequent rate increases reflation nation;
from the Fed. infrastructure/fiscal policy;
Chart 3 Chart 5
10-Year Cumulative Total Returns, Stocks vs. Bonds 10-Year Cumulative Total Returns, Stocks vs. Cash
As of 11/30/17 As of 11/30/17
600 600
+3 Std Dev
500 +3 Std Dev 500
400
+2 Std Dev 400 +2 Std Dev
300
300
Percent
Percent
+1 Std Dev +1 Std Dev
200
Average 200
100
Average
0 -1 Std Dev 100
-100 0 -1 Std Dev
-2 Std Dev
-200 -100
1936 1944 1952 1960 1968 1976 1984 1992 2000 2008 2016 1936 1944 1952 1960 1968 1976 1984 1992 2000 2008 2016
Source: Morningstar, Ibbotson Associates, PNC Source: Morningstar, Ibbotson Associates, PNC
4Back to Normal: 2018 Outlook Part II
global politics; going back to 2009. If this trend persists in the
life or death of active management; and fourth quarter, this year would be the first year
tax reform, repatriation, and earnings. since 2007 that the majority (greater than 50%) of
active funds outperformed their benchmarks.
It was our expectation that Treasury yields would
move higher with higher inflation expectations. We expected tax reform would be an important
While inflation moved higher early in 2017, it then topic to watch, and as we saw in the later months
eased and the Consumer Price Index (CPI) now sits of 2017, tax reform was optimistically received
at a similar level as it did ending 2016. by markets, which continued to trade higher.
Tax reform, according to sell-side analysis, should
We expected to see an increase in infrastructure provide a boost to earnings. In 2018, Strategas
spending in 2017; we now look to the next few years Research estimates a $10-per-share boost to
to see whether this spending increase will occur. S&P 500 earnings from tax reform, with Evercore
Global politics continued to surprise in 2017. Brexit ISI estimating approximately $8 per share.
talks continue, and as we end the year, United
Kingdom (U.K.) and European Union leaders are
busy hammering out the details of the divorce Themes for 2018
bill between the two nations. There were a few Potential Rifts in Global Growth
unexpected election results this year, with the Synchronization
vote for Catalonia to leave Spain grabbing the Since market pessimism bottomed in February
most media attention. The constitutionality of 2016, the global economic recovery has morphed
that vote remains in dispute. We expect surprise into synchronized global growth for the first time
votes to continue into 2018, as Italy gears up for its since the 2009 recovery began. Key contributors
presidential election along with other key elections. have been global central bank easing, a global
The macro environment for active managers decline in interest rates, lower inflation following
improved marginally in third-quarter 2017. a precipitous decline in commodity prices, an
Correlations among S&P 500 stocks did not improvement in credit market access, and
increase materially after reaching their 17-year low a parlayed rebound in capital spending for
in early February. According to Bank of America commodity-sensitive industries. These variables
Merrill Lynch, about 54% of active managers were are key determinants of corporate credit access,
ahead of their benchmarks year to date, the highest financing costs, and business and consumer
hit rate at this time of the year in their data history sentiment. This global easing of business conditions
propelled a coordinated global manufacturing
Chart 6 recovery and boosted many countries’
Manufacturing PMI by Country manufacturing Purchasing Managers’ Indexes
As of 11/30/17 (PMIs) to currently robust levels (Chart 6).
60 65
Brazil (L) China (R)
Japan (R) United Kingdom (R)
Nearly two years into this cyclically coordinated
55 Germany (R) Canada (R) 60 recovery, we are beginning to observe diverging
United States (R)
financial conditions across previously synchronized
50 55 regions. Throughout 2017, U.S. business conditions
have continued to ease through a combination of
45 50
tighter credit spreads and lower long-term interest
rates (reducing borrowing costs), a weaker dollar
40 45
(improving international competitiveness), and
lower inflation (reducing input costs and benefiting
consumers). As these can often provide some
35 40
12/14 4/15 8/15 12/15 4/16 8/16 12/16 4/17 8/17 visibility into the future state of regional economies,
domestic business conditions suggest to us there is
Source: Bloomberg L.P., PNC
continued support for solid U.S. economic growth.
5Back to Normal: 2018 Outlook Part II
Chart 7 Chart 8
Eurozone Inflation as a Leading Economic Indicator ECB Monetary Tightening Cycles
As of 11/30/17 As of 11/30/17
70 4
70 -6
65
65 -4
60 3
60
-2 55
55 50 2
0
Percent
Percent
50 45
2
45 40 1
4 35
40
30 0
35 6
25
30 8 20 -1
2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
2000 2002 2004
2006 2008 2010 2012 2014 2016
Markit Eurozone (L) Manufacturing PMI Index
Average of Eurozone HICP (R) and PPI (Inverted) (Advanced 18m Forward) Monetary Tightening Cycle
Normalized Eurozone Economic (L) Surprise Index 10m Moving Average Markit Eurozone Manufacturing PMI (L) ECB Deposit Rate (R)
Source: Bloomberg L.P., BCA Research, PNC Source: Bloomberg L.P., BCA Research, PNC
However, several developed international economies, Signs of diverging business conditions globally
including the Eurozone and the United Kingdom, have indicate the potential for synchronized growth
experienced some tightening of business conditions to begin separating as we progress through
throughout 2017. In particular, stronger currencies 2018. While U.S. financial conditions suggest
(decreasing international competitiveness) and a rise potential for near-term sustained growth, several
in headline inflation (increasing input costs hurts the international developed economies, including
purchasing power of consumers) have contributed the Eurozone and the United Kingdom, may
to tighter financial conditions. Advancing current experience a moderation in growth. At a time
inflation conditions (as represented by an average when renewed optimism has surfaced in many
of the Eurozone Harmonized Index of Consumer international markets, should this moderation in
Prices [HICP] and Producer Price Index [PPI]) by growth occur, it holds the potential to disappoint
18 months can serve as a leading indicator for the the consensus.
Eurozone economy (Chart 7). Our analysis suggests
that the tightening of real business conditions in the Chart 9
Eurozone may lead to a moderation in the regions’ U.K. LEI Index as a Leading Economic Indicator
economic momentum as we progress through As of 9/30/17
2018. Additionally, ECB monetary tightening has 10 1.0
historically led to a slowdown in future economic 0.8
Year-over-Year, 6-Month Moving Average
activity, and in our opinion a new tightening cycle 5 0.6 Year-over-Year, 6-Month Moving Average
officially began in October 2017 when the intention 0.4
0.2
to taper the current pace of quantitative easing was 0
0.0
announced (Chart 8). Furthermore, in relation to
(Percent)
(Percent)
-0.2
?
the United Kingdom, the year-over-year change -5
-0.4
in the Conference Board Leading Economic Index -0.6
-10
(LEI) has recently moved into contraction territory. -0.8
Historically, the LEI has led the U.K. manufacturing -1.0
-15 -1.2
production volume index, which is a broad measure 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012 2015
Conference Board U.K. LEI (R)
of economic output (Chart 9). This could suggest a U.K. Manufacturing Production Index (L)
further moderation of growth in the United Kingdom
Source: Bloomberg L.P., PNC
in 2018, in our opinion.
6Back to Normal: 2018 Outlook Part II
Chart 10 Chart 11
S&P 500 and CBOE Volatility Index Implied Volatility at Record Lows in 2017
As of 12/14/17 As of 9/30/17
2700 35
S&P 500 (L) CBOE VIX (R)
2600 28
30
2500
24 25
2400
20
2300 20
15
2200
16
2100 10
2000 5
12
1900
0
1800 8 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 2016
1/16 4/16 7/16 10/16 1/17 4/17 7/17 10/17 S&P 500 Implied Volatility Annual Average Long-Term Average
Source: Bloomberg L.P., PNC Source: Evercore ISI, PNC
Volatility We acknowledge the likelihood that volatility
Despite the many headlines in 2017, volatility in 2018 will rise from the low levels of 2017.
was kept mostly at bay while equities traded However, volatility in and of itself does not provide
higher (Chart 10). Support for stocks in the form any indication as to what will happen to equity
of continued domestic and global growth, solid markets. We note that following low volatility
corporate earnings, and tax reform optimism offset years, there is often an expected uptick in volatility,
risk factors through the year. Financial market with a less correlated performance of the market
volatility in 2017 was at record lows (Chart 11). (Table 2, page 8).
Empirical Research notes that third-quarter 2017
volatility registered in the bottom 2.5% of outcomes From a fundamental perspective, corporate earnings
noted in the past 90-plus years. Empirical also are supportive of stocks. Currently, we believe 2017
notes that the steepness of futures trading earnings will end the year in a range of $126–129 per
indicates that it is the expectation of the markets share for the S&P 500. As we look forward to 2018,
that volatility will revert closer to the mean. we believe continued global growth will be supportive
of earnings from a macro perspective, in addition to
A recent paper published by the Federal Reserve
stability in oil prices and a generally accommodative
Bank of New York and cited by Empirical Research
environment. Margins are likely to be somewhat flat,
illustrates the economists’ conclusion that
while volatility is mean reverting over time, low noting that 2017 margins are currently estimated
volatility typically begets more low volatility until at over 10.5%, which is a record high. Not factored
something occurs to change this pattern quickly, into our estimates for 2018 is the potential upside
like some sort of market shock1. Further, when recognized by our estimate from tax reform,
considering the term structure for volatility in which Strategas Research estimates could add
the futures market, what it appears to indicate is approximately $10 per share to S&P 500 earnings
most investors expect volatility to return to median growth in 2018. Further, Evercore ISI estimates
levels, not expecting low volatility to be some sort S&P 500 earnings of $146 per share, including an
of new normal at all. $8 benefit from tax reform.
1
Lucca, D., D. Roberts, and Peter Van Tassel, “The Low Volatility Puzzle: Are Investors Complacent?” Liberty Street Economics,
November 12, 2017, and Lucca, D., D. Roberts, and Peter Van Tassel, “The Low Volatility Puzzle: Is This Time Different?” Liberty Street
Economics, November 15, 2017.
7Back to Normal: 2018 Outlook Part II
Table 2
Historical S&P 500 Performance after Low-Volatility Years (since 1945)
Year S&P Intra-Year Drawdown Performance Next Year Drawdown Next Year Performance
1995 -3% 34% -8% 20%
2017 -3 16 — —
1964 -4 13 -10 9
1958 -4 38 -9 8
1954 -4 45 -11 26
1961 -4 23 -26 -12
1993 -5 7 -9 -2
1972 -5 16 -23 -17
1991 -6 26 -6 4
2013 -6 30 -7 11
Average -4 25 -12 5
Source: Strategas Research Partners, PNC
On a fundamental basis, however, excluding tax international competitiveness), and lower inflation
reform we forecast mid- to high-single-digit (which reduces input costs and benefits consumers)
earnings growth in 2018 based on our forecast for (Chart 13). This occurred despite the Fed delivering
global nominal growth of 5-7%. Consistent with this, three rate hikes (in March, June, and December)
we estimate 2018 S&P 500 earnings per share would and a formal announcement of balance sheet
grow to $135–140, with a target of $138 (Chart 12). normalization. Monetary tightening is simply not
constrictive if financial conditions do not similarly
Higher Long-Term Interest Rates to Present tighten; therefore we do not view actions taken by the
a Buying Opportunity in Fixed Income Fed as economically restrictive. Financial conditions
Domestic business conditions eased further can often provide visibility into the future state of the
throughout 2017 as a result of tighter credit spreads domestic economy over the subsequent six months
and lower long-term interest rates (which reduces and currently suggest to us that the U.S. economy
borrowing costs), a weaker dollar (which improves should continue to experience solid economic activity
Chart 12 Chart 13
S&P 500 Earnings Growth U.S. Financial Conditions Index Indicator
As of 12/31/16 As of 12/8/17
140 105
130
104
Earnings per Share (Dollars)
120
103
110
GSUSFCI Index
100
102
Tighter Financial Conditions
90 101
80 100
70
99
60
Accommodative Financial Conditions
98
50
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017* 2018*
97
2000 2002 2004 2006 2008 2010 2012 2014 2016
*PNC Estimates
Source: FactSet Research Systems Inc., PNC Source: Bloomberg L.P., Goldman Sachs., PNC
8Back to Normal: 2018 Outlook Part II
Chart 14 Chart 15
10-Year Treasury Futures Net Positioning Bitcoin/U.S. Dollar
As of 12/5/17 As of 12/14/17
800,000 5 18000
4 16000
600,000
3 14000
400,000
Number of Positions
2 12000
Price in Dollars
?
Percent
200,000 1 10000
Net Long
0 0 8000
-1 6000
200,000
Net Short
-2 4000
400,000
-3 2000
600,000 -4 0
2010 2011 2012 2013 2014 2015 2016 2017 1/17 3/17 5/17 7/17 9/17 11/17
10-Year Treasury Net Positioning (L) 10-Year Treasury Yield (R)
Source: Bloomberg L.P., PNC Source: Bloomberg L.P., PNC
through at least the spring of 2018. Additionally, power of consumers. This subsequent tightening
we believe domestic economic strength may of domestic business conditions may ultimately
finally aggravate inflationary pressures through a restrict future economic growth. For these reasons,
combination of wage growth and a broad rise in input we believe investors should enter 2018 with a
costs as we progress through 2018. short duration bias, but should be prepared to add
duration to fixed income portfolios throughout the
Furthermore, we continue to observe complacency year should higher interest rates materialize.
in interest rate markets through reduced interest
rate forecasts, net long Treasury futures market The Bitcoin Frenzy and Blockchain’s Future
positioning, the market-implied Fed rate path The rise of bitcoin is commensurate to the
significantly lagging the FOMC median forecast, a cryptocurrency’s increase in prevalence within the
compressed term premium, and sentiment regarding media and public’s collective mind. For instance,
the acceptance that interest rates are likely to stay Google Trends’ data show U.S. searches for
lower for longer. Historically, this magnitude of “bitcoin” have increased 3,233% over the preceding
net long Treasury futures market positioning has 12 months (through mid-December), a rate even
preceded rises in the 10-year Treasury yield in 2010, greater than bitcoin’s 2,220% gain over that time
2013, and 2016 (Chart 14). Should our expectations for frame (Chart 15). Such large-sized gains have
a combination of solid domestic economic growth and brought about analogies to the dot-com bubble
rising inflation materialize, we believe repositioning in of the early 2000s and the tulip mania of the early
the Treasury market may drive the 10-year Treasury seventeenth century.
yield as high as 3.00‑3.25% sometime in 2018.
Given these expectations, we recommend investors First, we believe it important to note the
philosophical drivers behind bitcoin’s creation.
maintain an underweight duration positioning going
The original cryptocurrency was born in the midst
into next year.
of the financial crisis, when trust in financial and
Ironically, these currently accommodative financial other institutions was at what could be described
conditions that may drive higher interest rates, as perilous levels. The creator, whose true identity
and higher inflation in turn, may result in tighter remains a mystery to this day, wrote the original
financial conditions. If our expectations prove white paper in 2008, operating under the pseudonym
correct, higher interest rates may raise borrowing of Satoshi Nakamoto. The idea: a mathematically
costs for business and higher inflation may broadly derived, digital, non-fiat currency that is not subject
increase input costs and hurt the purchasing to the whims of central banks, offering users both
9Back to Normal: 2018 Outlook Part II
an anonymous payment system and store of value Going forward, acceptance will continue to be the
in an otherwise inflationary (dollar-dilutive) world. primary driver of bitcoin, and while governments
The value itself would be based on scarcity, by have not yet moved to regulate the market, further
limiting the amount of bitcoins ever to be created, acceptance may spur regulatory institutions to take
and collective trust, a concept that while intangible, action given the potential for money laundering and
binds together societies across the world. Now, the terrorist financing, making its future all the more
only thing left to do was to create the technology ambiguous. Without being able to come to a clear
that would enable this grand idea to come to fruition. conclusion regarding the stability or future of bitcoin
Enter stage left: the blockchain. and other cryptocurrencies, we will continue to let
the market mature before recommending that our
The blockchain is the ever-growing distributed
clients invest. That said, we believe the blockchain
ledger, or database, by which all bitcoin
technology underlying bitcoin has far-reaching
transactions are stored, linked, and corroborated by
applications, not only in finance, but across many
participants on the bitcoin network. The fact that the
industries, carrying with it the potential to reshape
ledger is distributed means that the blockchain’s
the future.
record cannot be altered without the alteration of
all subsequent blocks, in effect facilitating trust and
Rebound in Capital Expenditures
verification without the need for an intermediary.
The best analogy would be a simple online bank Given expectations for an ongoing synchronized
transfer. After requesting a transfer, the bank’s global economic expansion, coupled with
database verifies that one has the funds and recovery efforts from the worst Atlantic
subtracts that amount from one account, adding it hurricane season in over 10 years, naturally one
to another within the database and creating a time- area where investors may expect to see a rebound
stamped transaction time for backward-looking is capital expenditures (capex). Capex is specific
verification. The blockchain performs those same to investments in a company’s fixed assets, and is
tracking processes, but without a bank or central viewed as a willingness to incur expenses today
authority needed to make those determinations as in order to create future benefits to the firm.
the network participants are able to use the publicly While tax reform could be a potential catalyst for
available “blocks” to verify the funds existence capex growth in the United States, it is important to
and historical ownership. In simplistic terms, the look at fixed asset investments on a global scale.
blockchain is a new kind of technology that allows In China, President Xi Jinping emerged from the
for tracking of the database’s contents over time, Communist Party congress as one of the strongest
constantly verifying a block’s content to be accurate. leaders in decades, and it is widely expected that
The ability to facilitate trust between two parties projects included in his Belt and Road initiative
without a middleman is perhaps the technology’s will spur new growth across Asia. As the European
greatest attribute. The technology’s applications economic expansion takes hold, so too should
are extensive and include governmental voting industrial production (Chart 16, page 11).
procedures, legal contracts, supply chains,
On the other hand, corporate earnings have
distribution networks, ecommerce, and even health
rebounded since the slowdown in 2015-16,
care records verified by biometrics.
generating positive growth for five consecutive
Ultimately, we view investments in bitcoin as quarters. Further still, free cash flow remains at
speculative in nature, with no true value to be healthy levels supported by historically low interest
derived outside of the collective trust held within rates. Given those positive developments, capex has
it. Should that trust wane or dissipate, there are continued to come in below economic forecasts,
no cash flows or assets to back it up, making it creating a conundrum for investors. While it is an
difficult to arrive at a logical base valuation. We exercise in futility to explain why capex remains at
would also be remiss if we failed to mention that subdued levels despite low interest rates, high cash
bitcoin prices have been quite volatile, with several levels on corporate balance sheets, and optimism
corrections of more than 70% in its short history. over synchronized global economic expansion,
10Back to Normal: 2018 Outlook Part II
Chart 16 Chart 17
Global Industrial Production Capital Spending
As of 9/30/17 As of 9/30/17
25 120 20
15
Year-over-Year Percent Change
20 100
Year-over-Year Percent Change
10
15
80 5
10
60 0
5
-5
0 40 -10
-5 20 -15
-10 -20
0
-15 -25
-20 -20 -30
9/06 10/07 11/08 12/09 1/11 2/12 3/13 4/14 5/15 6/16 7/17
-25 CEO U.S. Capital Spending Subindex (L)
12/07 02/09 04/10 06/11 08/12 10/13 12/14 02/16 04/17 U.S. Industrial Production (R)
Germany IP China IP U.S. Industrial Production (R) Capital Goods New Orders, Nondefense, ex-aircraft & parts (R)
Source: Bloomberg L.P., PNC Source: Bloomberg L.P., PNC
a near-term boost may be skewed by fiscal stimulus Services sector will be transformed into a new
nine years into an economic expansion. sector called “Communication Services,” with
two underlying industries: “telecommunication
For illustrative purposes, in a rational market,
services” and “media & entertainment.” The change
projects only get approved for capital budgeting if
will significantly disrupt the current Consumer
they are expected to provide a positive net present
Discretionary and Information Technology sectors,
value (NPV). If a project is estimated to generate
as the media industry will be moved from the
negative NPV, making it suboptimal, a rational
former, and the internet software industry will cease
company should not proceed. Therefore, if the goal
to exist in the latter. Specific companies will not be
of a rational company is to maximize shareholder
identified in the move until January 2018, but it is
wealth, it will only embark on projects with positive
widely expected to affect mega-cap companies like
NPV. If capex growth is slow, from a theoretical
Alphabet Inc. (GOOGL) and Facebook, Inc. (FB), as
perspective it would suggest there are not enough
projects estimated to generate long-term returns well as media companies like CBS Corporation (CBS)
that outweigh other uses of capital. Similar to and The Walt Disney Company (DIS). In the press
expectations that interest rates should have started release announcing the change, the global head
to meaningfully rise for some time, it begs the of Equity Solutions Research at MSCI stated, “The
question if we are actually in a new paradigm where GICS structure is evolving to stay abreast with the
lower levels of capex is the new normal. Capex ever-changing business environment. Convergence
growth has certainly rebounded from the negative between telecom and media companies is not just a
growth rates in industrial production and durable trend but a fact.”
goods orders (Chart 17); however when compared While the move will not have a direct impact on
with the Business Roundtable CEO U.S. Capital business, it will have an immediate impact on
Spending Subindex, which has already started to traditional growth and value indexes. It is expected
roll over, it suggests the growth may have been a the Information Technology sector will no longer
rebound rather than a sustainable recovery in capex. have growth mega-cap names included, and rather
will be mixed into the new Communication Services
GICS in the Mix sector. While company names have not officially
In November 2017 S&P Dow Jones Indices and been announced, based on the industries affected,
MSCI announced major changes to the GICS it is widely expected the industry changes will
structure in late 2018. The Telecommunication appear as listed in Table 3 (page 12).
11Back to Normal: 2018 Outlook Part II
a tactical allocation to absolute-return-
Table 3
Current and Estimated Classification Impact oriented fixed-income strategies within the
bond allocation;
Sector Current Estimated
a tactical allocation to global bonds within the
Weight Weight
bond allocation; and
Consumer Discretionary 12.20% 9.10%
an allocation to alternative investments for
Consumer Staples 8.60 8.60%
qualified investors.
Energy 5.90 5.90%
Financials 14.00 14.00%
Baseline Allocation of Stocks Relative to Bonds
Health Care 14.70 14.70%
Since one cannot accurately determine the short-
Industrials 10.00 10.00%
term movement of stocks, we believe investors
Information Technology 23.30 18.40%
should focus on what is knowable and controllable.
Materials 2.90 2.90%
The one thing investors can truly control is asset
Real Estate 3.10 3.10% allocation reflective of their needs and risk
Telecommunication Services 2.10 10.10% tolerance. PNC’s six baseline asset allocation
Utilities 3.30 3.30% models are shown on the back page of this
Source: MSCI, Bloomberg L.P., PNC Outlook.
Preference for High-Quality Stocks
PNC Current Recommendations Any relapse to stressed capital markets or to another
PNC’s recommended allocations continue to credit crunch from a financial crisis likely poses a
reflect our positive view regarding the durability higher threat to lower-quality and highly leveraged
of the economic expansion while considering the companies. Companies with weak balance sheets
continued downside risks inherent in the market and less-robust business models have a much higher
and economic outlook: risk to their survival. Unfortunately, the economic
a baseline allocation of stocks relative to bonds; outlook continues to be subject to continued
a preference for high-quality stocks; downside risks in the wake of the financial crisis.
a tactical allocation of 52% value and 48% We favor a preference for high-quality stocks as a
growth within U.S. large-cap stocks; method of risk control against unexpected shocks
a tactical allocation to smart beta/core to the economic system. This is also consistent with
strategies; our explicit allocation to dividend-focused stocks.
a tactical allocation to Europe focused
Overweight of U.S. Large-Cap Value
equities—FX hedged within the international
Stocks Relative to Growth2
equity component;
We believe the majority of the seven components of
a tactical allocation to Japan focused
our decision framework—
equities—FX hedged within the international
equity component; earnings growth;
interest-rate level;
an allocation to emerging markets within the
international equity component; inflation;
a tactical allocation to global dividend-focused volatility;
stocks; foreign growth;
a tactical allocation to TIPS within the bond valuation; and
allocation; yield-curve slope—
a tactical allocation to leveraged loans within continue to support an overweight to U.S. large-cap
the bond allocation; value style relative to growth.
2
The March 2011 Investment Outlook, Quest for Value, provides details about the value style recommendation.
12Back to Normal: 2018 Outlook Part II
Chart 18 Chart 20
2-Year to 10-Year Treasury Yield Spread U.S. Banks’ Willingness to Make Consumer Loans
Weekly, 1/6/78 through 12/15/17 (percentage more willing minus percentage less
300
willing) Quarterly, 1Q00 through 3Q17
30
200 20
10
100
Basis Points
0
Percent
0
-10
-100 -20
-30
-200
2- to 10-Year Median -40
-300
1978 1983 1988 1993 1998 2003 2008 2013 -50
2000 2002 2004 2006 2008 2010 2012 2014 2016
Source: Bloomberg L.P., PNC Source: Federal Reserve, Bloomberg L.P., PNC
We focus on the yield-curve slope because results We continue to monitor the possibility that the
of our analysis show that a steep curve is typical impact of the steep yield curve might be
supportive of value style outperformance relative derailed by:
to growth. It is not a concrete rule that value the credit cycle;
always outperforms growth in a steep yield capital constraints; or
curve, but it is an indication of higher probability.
lack of loan demand.
Though recent Fed activities have flattened them
to a degree, both the 2 to 10year (Chart 18) and Bank loan data seem to be past their worst levels,
10- to 30year (Chart 19) Treasury slopes remain and we believe there are reasons for cautious
historically steep and supportive of a value optimism.
overweight. Banks are showing a greater willingness to
extend consumer loans (Chart 20).
Chart 19 Bank loan quality has continued to improve,
10-Year to 30-Year Treasury Yield Spread implying a tailwind to bank earnings and
Weekly, 1/6/78 through 12/15/17 a possible turn in the deleveraging cycle
200 (Chart 21, page 14).
10- to 30-Year Median Bank capital ratios have more than recovered,
150
which should allow for loan growth and likely
100 help prevent relapse of financial crisis within
the banking industry (Chart 22, page 14).
Basis Points
50
Our value allocation has underperformed in the
0 market downturn, given its more cyclical exposure.
We believe it will perform better as global growth
-50 concerns fade.
-100
1978 1983 1988 1993 1998 2003 2008 2013 Allocation to Smart Beta/Core Strategies
Source: Bloomberg L.P., PNC Within the smart beta strategies, there is the
option to utilize the PNC STAR strategy, which
13Back to Normal: 2018 Outlook Part II
Chart 21 Chart 23
U.S. Delinquency Rates for Loans 10% PNC STAR/90% S&P 500 Combination Total
Quarterly, 1Q91 through 3Q17 Return
12 Monthly, 10/31/90 through 11/30/17
Residential
18
10 Total Loans
Credit Cards 16
S&P 500
Index, October 31, 1990 = $1
8 14
10% STAR/90% S&P 500 Combined
12
Percent
6 10
8
4
6
4
2
2
0 0
1991 1994 1997 2000 2003 2006 2009 2012 2015 1990 1993 1996 1999 2002 2005 2008 2011 2014 2017
Source: Federal Reserve, Bloomberg L.P., PNC Source: Bloomberg L.P., PNC
uses exchange-traded funds to systemically apply results, historically this model has produced
momentum exposure to industries, size, and outperformance of just under 0.40% per month. In
international factors. The PNC STAR strategy may addition, the drawdown analysis has shown that the
help a portfolio increase return without increasing strategy has handled periods of crisis better than the
risk and, with small allocations, marginally reduce S&P 500 did and was generally quicker to recover.
risk (Chart 23).
Momentum performance has dipped since the
In backtests, PNC STAR has produced excess financial crisis, but appears to be regaining some
returns with a volatility level similar to the momentum (to turn a phrase). If momentum
benchmark S&P 500®, resulting in a higher Sharpe
continues to work in the future as it has historically,
ratio. In addition, the analysis has shown that the
the strategy may lead to excess returns that should
strategy has handled periods of crisis better than
help improve the tactical allocation portfolios.
the S&P 500 and was generally quicker to recover.
While past performance is not indicative of future
International Equities
International equities offer geographic diversification
Chart 22
U.S. Bank Core Capital Ratio
and open the opportunity set to invest in firms
Quarterly, 1Q84 through 3Q17 worldwide. Beyond the benefits of diversification and
10
exposure to many of the world’s leading companies,
there are other potential benefits to investing outside
9 U.S. borders, including unique opportunities in
Asia and Europe. Within the international equity
8
component we recommend an allocation to
emerging markets.
Ratio
7
It is reasonable to assume that the United States
6
and other developed markets have similar
5 long-term expected returns. Much of the difference
is likely to come from currency gains or losses.
4
1984 1988 1992 1996 2000 2004 2008 2012 2016
We remain mindful of the currency risk inherent
in international investing. While at times the weaker
Source: Federal Deposit Insurance Corporation,
dollar makes international investing look more
Bloomberg L.P., PNC
attractive than underlying fundamentals might
14Back to Normal: 2018 Outlook Part II
Chart 24 Chart 25
FX Hedged Europe and Japan Dividends and Dividend Growth around the World
Monthly, 4/30/08 through 11/30/17 12/31/96 to 12/14/17
150 Japan 1.9 6.2 0.2
MSCI US (dollars)
MSCI Europe (local currency)
Canada 2.8 7.5 1.0
Monthly Percentage Change
MSCI Japan (yen)
100
Australia 4.4 5.7 1.0
Germany 2.4 7.2 0.8
50
France 3.0 5.5 0.3
0 United States 1.9 6.4 1.3
United Kingdom 4.3 5.3 1.4
-50 0 2 46 8 10 12
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Percent
Dividend Yield Dividend Growth Multiple Expansion
Source: Bloomberg L.P., PNC Source: Bloomberg L.P., MSCI, PNC
opening up the opportunity to invest in firms
dictate, the reverse is true when the strong dollar
outside the United States, including emerging
punishes U.S. investors’ international returns.
markets. In addition, focusing on the combination
of dividends and dividend growth has historically
Allocations to Europe- and Japan-Focused
been a winning combination.
Foreign-Exchange-Hedged Equities
The reinvestment of dividends greatly enhances
Our tactical allocation within the international
an investor’s return and is a large component
allocation focuses on Europe-based and Japan-
of the dividend-focused strategy. Over time,
based holdings. Stabilizing recoveries in both
the compounding of dividends drives the total
Europe and Japan, relative valuations, improving
return. As an investor’s investment holding period
corporate earnings, and low energy prices are
increases, dividends typically comprise a larger
a few of the dynamics that support strength of
portion of return. As a reference point, from 1926 to
equities in the regions. Equities in both regions have
1959 dividends contributed more than 50% to total
underperformed in recent years, but we believe the
returns for the S&P 500.
aggressive monetary policy actions by both the Bank
of Japan and ECB are supportive of financial assets We believe the global dividend-focused allocation is
(Chart 24). Our view is these asset purchases should positioned to take advantage of global opportunities
support their economies and function to continue and diversify across countries and sectors (Chart 25).
to make equities in their respective countries more A globally generated income stream is inherently
attractive relative to fixed-income assets and to more diverse than one from a single country or
bolster equity valuations. region. This can help to avoid concentration in
terms of end markets, which may drive sales and
The hedged currency recommendations reduce revenues. A global dividend allocation may also
currency risk for our U.S.-based investors who allow an investor to invest in sectors perhaps
have most, if not all, of their liabilities denominated underrepresented by a particular country.
in dollars.
Allocation to Treasury Inflation-
Allocation to Global Dividend-Focused Stocks Protected Securities
A global dividend-focused allocation expands the The Treasury yield curve is anchored at the
opportunity set to invest in high-quality dividend- short end due to continued accommodative U.S.
paying stocks, where in some cases companies monetary policy, while longer-maturity yields are
have exhibited faster dividend growth, essentially being pulled lower largely by the term premium in
15Back to Normal: 2018 Outlook Part II
light of global concerns and ongoing central bank
Chart 26
easing. We think inflation expectations will rise 3-Month LIBOR
as survey-based measures used by the Fed have Daily, 1/1/10 through 12/15/17
remained relatively flat, commodity prices have
1.8
stabilized, and wages have trended higher as the
United States moves closer to full employment. 1.6
1.4
TIPS can be a favorable alternative to conventional
Treasuries; TIPS provide both a comparable yield 1.2
Percent
and the credit quality of Treasury notes, while 1.0
also furnishing protection against the risk of
0.8
higher inflation. In addition, since TIPS return the
greater of the face value or the inflation-adjusted 0.6
principal at maturity, these securities would 0.4
increase in real value even during a deflationary 0.2
period. With commodity prices finally finding some 2010 2011 2012 2013 2014 2015 2016 2017
footing following a volatile period recently, TIPS are Source: British Bankers’ Association, Bloomberg L.P., PNC
indirect beneficiaries due to the CPI adjustment.
While not our base case in the near term, we This allocation could be characterized as lowering
think TIPS are likely the best defense against the portfolios’ interest-rate risk while raising their
stagflation because high inflation coupled with low credit risk and correlation with equities. We believe
growth provide the optimal environment for TIPS it accomplishes this without a large impact on
performance. portfolio income. In our opinion, this correlation
From both a valuation and goal-based methodology, with equities, which we have noted since
TIPS are likely a good addition to many portfolios. In recommending the allocation, has become more
particular, tax-deferred and tax-exempt accounts apparent in the recent stock market downturn,
are likely beneficiaries of TIPS allocations. In our allowing investors an attractive entry point.
opinion, TIPS provide some measure of insurance
against the risk of inflation and reduced real Allocation to Absolute-Return-Oriented
purchasing power, while protecting against severe Fixed Income within Bonds4
deflation. This seems especially true for investors We believe an allocation to an absolute-return-
holding excess cash or nominal Treasuries. oriented fixedincome strategy within the bond
portion of a portfolio has several benefits,
Allocation to Leveraged Loans within Bonds3 including:
We believe an allocation to leveraged loans within defending against higher interest rates;
the bond portion of a portfolio should help defend further expanding the opportunity set for fixed
against higher interest rates. Since leveraged income; and
loans are adjustablerate instruments tied to
increasing exposure to credit.
short-term interest rates (typically the 3-month
LIBOR), we believe holders should benefit from Given our belief that the economy will continue
rising rates (Chart 26). If longer-term interest to improve, strategies that help protect against
rates rise, we expect the shorter duration of the risk of rising rates will become increasingly
leveraged loans should result in much better important. While we do not believe interest rates
performance relative to longer-duration fixed will necessarily move markedly higher in the near
income, such as the Barclays U.S. Aggregate term, rate volatility has certainly increased, and we
Bond Index. expect that the downside risk to holding excessive
3
The March 2010 Investment Outlook, Shakespeare for Primates, provides details about leveraged loans.
4
The July 2013 Investment Outlook, Breaking the Bonds, provides details about absolute-return-oriented fixed income.
16Back to Normal: 2018 Outlook Part II
duration will increase the longer rates remain low.
Chart 27
We believe it makes sense to further hedge against Barclays Capital Global Aggregate by Country
this risk while maintaining the ability to participate As of 11/24/17
in upside credit potential. This is also consistent
with our current tactical allocations to global bonds 38.5% United States
16.9% Japan
and leveraged loans. 8.3% Other
6.1% France
We believe the Fed will continue to support the 5.6% United Kingdom
economy as necessary until the economy can 5.3% Germany
grow and function without additional monetary 4.1% Italy
3.3% Canada
policy accommodation. This should lend itself to
2.7% Spain
further credit spread tightening over the short to 2.3% Supranational
intermediate term. Even with spreads at relatively 1.7% Netherlands
attractive levels compared with historical standards, 1.7% Australia
1.4% South Korea
we admit the absolute low level of yields increases 1.2% Belgium
the difficulty of adding alpha within spread sectors. 0.9% Switzerland
This is one aspect in which we believe an absolute- Source: Barclays Capital, PNC
return long-short approach can add value. Absolute-
return strategies have the ability to exploit mispricing
via both long and short positions and also expand the investors may have the opportunity to reap the
opportunity set of strategies typically not accessible benefits of tightening global credit spreads relative
to traditional long-only managers. Typical trading to the United States. More importantly, currently
strategies include, but are not limited to, capital investors can take advantage of higher interest
structure arbitrage, convertible arbitrage, event rates abroad to gain higher yields. The addition of
driven, and pairs trading. the currency exposure that comes with an unhedged
global bond can act to help lower the correlation
Allocation to Global Bonds within Bonds with U.S. bond returns (Chart 29, page18).
The strategic rationale for including global bonds In general, we suggest that active management
in the portfolio rests on expanding the opportunity makes the most sense in this allocation. Global
set within the investible bond universe. The bond index construction usually focuses on
Barclays Capital Global Aggregate Index, our proxy allocating more assets to countries with more
for highquality global bonds, contains less than
40% U.S. issues (Chart 27). (For further details Chart 28
of our view on global bonds, see the July 2011 Barclays Capital Global Aggregate Excluding United
Investment Outlook, Pulling the Fourth Lever.) We States, Unhedged, Correlation with Dollar
believe investors who decline to look outside the Monthly, 1/29/93 through 11/30/17
United States may be missing opportunities for 1.2
diversification and enhanced returns.
0.8
36-Month Rolling Correlations
A primary motivation for allocating to global bonds
is to introduce currency exposure to a portfolio. 0.4
Although currency adds another level of volatility
to a portfolio’s fixed-income allocation, it provides 0.0
for investors a natural hedge against devaluation of
-0.4
the dollar, which traditional domestic fixed-income
asset classes cannot offer (Chart 28). -0.8
The prospect of higher global economic growth
outside the United States is another motive -1.2
1993 1996 1999 2002 2005 2008 2011 2014 2017
for allocating fixed income globally. As world
Source: Bloomberg L.P., Barclays Capital, PNC
economies grow more quickly, international bond
17Back to Normal: 2018 Outlook Part II
Chart 29 Chart 30
Barclays Capital Global Aggregate Excluding United 10-Year Treasury Yields
States, Correlation with U.S. Aggregate Daily, 1/3/11 through 12/15/17
Monthly, 1/29/93 through 11/30/17 4.0
1.2
3.5
0.8
36-Month Rolling Correlations
3.0
0.4
Percent
2.5
0.0
2.0
-0.4
Unhedged 1.5
-0.8
Hedged
1.0
-1.2
1993 1996 1999 2002 2005 2008 2011 2014 2017 2011 2012 2013 2014 2015 2016 2017
Source: Bloomberg L.P., Barclays Capital, PNC Source: Bloomberg L.P., PNC
outstanding debt. This may or may not be a good and our view that yields will rise over time as the
thing. Larger and more stable economies are current economic soft patch and the flight to safety
likely to be able to support higher debt levels, but fade (Chart 30). We also see this as an opportunity
some fundamental analysis is likely helpful. We to benefit from higher bond yields elsewhere in
also believe that the current state of the global the world.
economy, with the large dichotomy between most
developed and emerging economies, provides Allocation to Alternative Investments
a possible opportunity for active managers for We also believe alternative asset classes should
exposure to credit and foreign exchange. be considered for qualified investors because they
In our opinion, it is likely that many managers’ may provide an effective risk management tool for
allocations will differ greatly from the index. This portfolios. Our argument is that if alternative and
also affects risk metrics, typically to the upside traditional investments are put on even footing with
in terms of volatility, index tracking error, and regard to expected returns, then solely by virtue
historical drawdowns. This was explicitly taken of the two investments being different, the risk of
into consideration by the PNC IPC when it sized the the overall portfolio is reduced without altering
recommended allocation to global bonds. the portfolio’s expected return. The risks may not
be less, but they are in some ways different, so we
Given the concerns regarding how the United
believe this diversification may help manage overall
States will handle upcoming monetary and
portfolio risk.
fiscal policy decisions, as well as what effects
those decisions might have on the value of Every action (or inaction) involves risk, and we believe
the dollar, we believe an allocation outside investors should think about risk when they consider
traditional fixed-income bond sectors is prudent. alternative investments. However, our research
We believe the advantage of higher global growth suggests that adding carefully selected alternative
and diversification benefits, along with the ability investments to a diversified portfolio of traditional
to benefit from currency exposure outside the investments may reduce the overall risk (as defined
dollar, make investing in the global bond sector by the volatility of returns) of that portfolio without
a viable complement to traditional dollar-based affecting expected returns. We believe that, for
fixed-income assets. This allocation can be seen as qualified investors, alternative investments should be
adding to PNC’s defensive posture on U.S. interest considered as a tool for managing portfolio risk, not
rates, with 10-year Treasury rates now above 2% for adding risk to increase returns.
18You can also read
