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Fourth Quarter 2017 Capital Markets outlook The Economy 6 North Park Drive | Suite 208 Hunt Valley, MD 21030 Tel 410-528-8282 | Fax 410-528-8305 [email protected] www.assetstrategyconsultants.com n Baltimore n Boston n Charleston n Harrisburg n Raleigh/Durham For a quarter-century, Asset Strategy Consultants has been providing investment management consulting to fiduciaries of endowments, foundations and retirement plans. We are dedicated to: developing and implementing customized solutions for each client portfolio; achieving superior investment performance; reducing risks; controlling expenses; and providing an exceptional level of client service. Capital Markets Outlook is published quarterly by Asset Strategy Consultants. Disclaimer and Sources: The material contained in Capital Markets Outlook is based upon consensus information published by the following sources and does not represent any specific recommendation: Callan, Morningstar, JP Morgan, T Rowe Price, Lazard, Russell, John Hancock, Prudential, HFR, Pointer, Weatherlow, Lighthouse, Preqin, Pitchbook, PCCP and Perennial. T he theme for 2017 is global growth. The “advance” estimate for U.S. real GDP growth was an encouraging 3.0% in the third quarter. The U.S. is now in its eighth year of expansion, and now almost all major economies are partaking. Manufacturing indicators are hot all over the world. The trend of low growth domestically is not expected to change much: the consensus forecast for GDP growth (from the Wall Street Journal’s monthly survey of sixty economists) has the US at around 2.4% in 2018. The most-significant (if not market-moving) news out of the most-recent FOMC meeting was the announcement that balance sheet normalization would commence in October. The Fed has previously made its plans for unwinding the balance sheet clear. The current balance of Treasuries and mortgage-backed securities stands at 4.5 trillion dollars. And while not all assets will be removed, this will still be a multi-year process. Expectations for significant policy change in Washington has waned. With the tax reform proposal under consideration now, the last chance to effect some stimulus in 2017 is quickly approaching. Consumer University of Michigan Index of Consumer Sentiment is at 101.1 in October. This metric has trended upward since the financial crisis, reaching levels of the mid-1990s and mid- 2000s. The Case-Shiller 20-City Composite Home Price Index marched up to 200.29 in August, approaching an April 2006 high of 206.65. Debt payments are only about 10% of disposable income – very low compared to a fourth-quarter-2007 high of 13.2%. This all bodes well for growth moving forward as consumer spending makes up about 70% of GDP. Currencies The dollar has trended downward since the start of the year relative to a trade-weighted basket of currencies, but is still expensive relative to its Change in Real GDP Source: U.S. Federal Reserve Bank

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  • First

    Fourth Quarter 2017

    Capital Markets

    outlookThe Economy

    6 North Park Drive | Suite 208 Hunt Valley, MD 21030

    Tel 410-528-8282 | Fax 410-528-8305

    [email protected] www.assetstrategyconsultants.com

    n Baltimore n Boston n Charleston n Harrisburg n Raleigh/Durham

    For a quarter-century, Asset Strategy Consultants has been providing investment

    management consulting to fiduciaries of endowments,

    foundations and retirement plans.

    We are dedicated to: developing and implementing customized

    solutions for each client portfolio; achieving superior investment

    performance; reducing risks; controlling expenses;

    and providing an exceptional level of client service.

    Capital Markets Outlook is published quarterly by Asset Strategy Consultants.

    Disclaimer and Sources: The material contained in Capital Markets Outlook is based upon consensus information published by the following sources and does not represent any specific recommendation: Callan, Morningstar, JP Morgan, T Rowe Price, Lazard, Russell, John Hancock, Prudential, HFR, Pointer, Weatherlow,

    Lighthouse, Preqin, Pitchbook, PCCP and Perennial.

    The theme for 2017 is global growth. The advance estimate for U.S. real GDP growth was an encouraging 3.0% in the third quarter. The U.S. is now in its eighth year of expansion, and now almost all major economies are partaking. Manufacturing indicators are hot all over the world.

    The trend of low growth domestically is not expected to change much: the consensus forecast for GDP growth (from the Wall Street Journals monthly survey of sixty economists) has the US at around 2.4% in 2018. The most-significant (if not market-moving) news out of the most-recent FOMC meeting was the announcement that balance sheet normalization would commence in October. The Fed has previously made its plans for unwinding the balance sheet clear. The current balance of Treasuries and mortgage-backed securities stands at 4.5 trillion dollars. And while not all assets will be removed, this will still be a multi-year process. Expectations for significant policy change in Washington has waned. With the tax reform proposal under consideration now, the last chance to effect some stimulus in 2017 is quickly approaching.

    ConsumerUniversity of Michigan Index of Consumer

    Sentiment is at 101.1 in October. This metric

    has trended upward since the financial crisis,

    reaching levels of the mid-1990s and mid-

    2000s. The Case-Shiller 20-City Composite

    Home Price Index marched up to 200.29 in

    August, approaching an April 2006 high of

    206.65. Debt payments are only about 10%

    of disposable income very low compared to a fourth-quarter-2007 high of 13.2%. This all bodes well for growth moving forward as consumer spending makes up about 70% of GDP.

    CurrenciesThe dollar has trended downward since the start of the year relative to a trade-weighted basket of currencies, but is still expensive relative to its

    Change in Real GDP

    Source: U.S. Federal Reserve Bank

  • Asset Strategy Consultants

    Capital Markets Outlook Fourth Quarter 2017

    2

    Capital Markets

    Domestic EquitiesDomestic equities posted positive returns for the third quarter of 2017 as the S&P 500 gained 4.5%, and has now gained 14.2% for the year. The growth style continued outperforming value in all market caps. Small cap stocks outperformed large cap stocks for the first time this year, however, still trail in YTD returns. Technology led all sectors with an 8.6% return in the third quarter and leads all sectors with a 27.4% return for the year. Consumer Staples was the lone sector with a negative return for the quarter, returning -1.3%. Stronger global growth has added a new source of revenue for U.S. companies across the economy, resulting in an earnings growth rebound. In addition, market support is transitioning from the Fed to fundamentals. Seven of the ten composite index leading indicators were positive as the economy strengthened. The impacts of Hurricanes Harvey and Irma did not weigh heavily on 3rd quarter growth, however, spending on rebuilding may bring supporting growth by the 4th quarter. Looking ahead, earnings growth in the third quarter is trending well. Early reports indicate that approximately 75% of the S&P500 companies reporting had beaten estimates. However, starting valuations for equities remain elevated as shown by the S&P 500 12-month forward looking P/E ratio at 17.7x which is ahead of the 25 year average of 16.0x. The S&P 500 is expected to end the year around 2600.

    Developed EquitiesDeveloped Markets posted another period of strong gains in the third quarter. Various positive factors aided the equity markets, including improving economic growth, improving manufacturing data, strong corporate earnings, and an increase in oil prices. Both the European Central Bank (ECB) and the Bank of England made no changes to interest rates. The ECB is also expected to slowly start tapering its asset purchases in 2018. The United Kingdom still faces uncertainly due to the ongoing Brexit negotiations, affecting business spending decisions and delaying contracts; but the improving trend in the global economy, especially in developing markets, provide some tailwinds. Looking ahead, despite the recent appreciation in the Euro, the Eurozones outlook remains very positive; economic sentiments are rising, inflation forecasts remain subdued, industrial production is increasing, and the unemployment rate is sliding down to a multi-year low. The ECB increased its economic growth forecast to 2.2% for 2017 and 1.8% for 2018. Japanese equities rallied in the third quarter, beating market expectations and outpacing most developed economies. The two biggest contributors to this rally were wage gains and consumption. The Bank of Japan (BOJ) still remains highly

    Wage growth increased 2.5% at the most-recent reading. Economic theory would suggest that a falling

    unemployment reflects a tightening labor market and that wage growth would subsequently follow, but

    wages have remained stubbornly low.

    10-year average. If other central banks do not keep pace with US tightening, global interest rates could diverge further, making the dollar more attractive and subsequently strengthening versus other currencies. A stronger dollar would make imports cheaper and undercut inflation but also potentially dampen export demand growth.

    EmploymentLabor market is tight in the U.S. The October measurement stood at 4.1%. Most unemployment is likely due to industry reorganization or people voluntarily looking for better jobs. As a benchmark, the Fed considers 4.7% the natural rate. Concerns about low wage growth that have characterized this expansion have not dissipated. Wage growth increased 2.5% at the most-recent reading. Economic theory would suggest that a falling unemployment reflects a tightening labor market and that wage growth would subsequently follow, but wages have remained stubbornly low. Part of this may be because of prime-age (25-54) workers returning to the labor force in the past two years. This could explain jobs growth without wage growth.

    Interest RatesThe Fed raised rates in June, but the path forward will be very gradual. At the September meeting, 12 out of 16 participants anticipated a third rate hike this year. As has been the case this cycle, the market (represented by Fed Fund futures) is more tepid about the pace of hikes than the Fed. The Fed is aware of lofty U.S. equity valuations, but is unlikely to intentionally use the funds rate to bring them down. Quantitative easing is ending, with the U.S. at the vanguard. The European Central Bank and Bank of Japan are expected to slow the pace of their asset purchases. The market consensus is that the end of QE will not be detrimental. These central bank moves are not coming as a surprise.

    InflationInflation has remained stubbornly muted, especially here in the U.S. Core PCE is at 1.8% year-over-year. This is below the Feds understood target of 2%. Wage growth and inflation have historically had a positive relationship, meaning as inflation increases, so does wage growth. The period since the Financial Crisis though has been characterized by stubbornly-low wage growth relative to historically-low inflation. v

  • Capital Markets Outlook Fourth Quarter 2017

    3Asset Strategy Consultants

    Alternative Investments

    Hedge FundsHedge fund assets hit a new peak of $3.2 trillion at the end of the third quarter. While inflows slowed from 2Q17, they were a big improvement over the net outflows seen in 3Q2016. If this trend continues, 2017 could prove to end the year with net positive inflows. A resurgence in performance also is a positive for the hedge fund industry. As performance has improved in 2017, so has investor sentiment. Long/Short Equity strategies appear to be the most prevalent strategies used by investors, although there have been a number of multi-strategy funds launched in 2017 as well. Over the next twelve months, investors say they plan to allocate more to Relative Value and Macro strategies according to Preqin. HFR president Kenneth Heinz indicated that institutions are looking for ways to insulate their portfolios from potential market corrections. The S&P 500 is closing in on one of the longest periods since 1928 without a 5% correction. The longer the markets go on without a correction could make for an unpleasant reappearance when it comes.

    Private EquityA total of 181 funds closed in 3Q17 a decrease of 75 from the second quarter. While the number of funds closed in 3Q17 is 22% lower than 3Q16 the total capital raised rose by 43% to $95B. Investors continue