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INVESTMENT STRATEGY
AND PORTFOLIO MANAGEMENT
October 2013
Contents
Executive Summary……. 1
Economic Outlook. …… 2
Market Outlook ….……. 3
Edward Campbell, Portfolio Manager
Ed Keon, Portfolio Manager
Joel Kallman, Portfolio Manager
Marcus Perl, Portfolio Manager
Rory Cummings, Associate
Executive Summary
Economic Outlook
• Global growth should continue to strengthen through the end of this year and into
2014.
• U.S. growth has been sluggish but resilient in the face of strong fiscal headwinds. As
the fiscal drag fades, we expect U.S. growth to pick up nicely, driven by pent-up
demand in consumer durables and stronger capital spending.
• The international growth picture is also brightening, with clear signs of a cyclical
economic recovery in the Euro-zone and faster growth in Japan and the U.K.
• Tentative signs that the emerging markets growth slowdown may have run its course
may mean a synchronized global upturn.
• Downside risks remain, as evidenced by recent market volatility surrounding the
U.S. government shutdown.
• If the shutdown is resolved reasonably quickly, it should have a limited impact on
global growth prospects. However, if this escalates into a showdown on the debt
ceiling and raises serious fear of default, the situation becomes more dangerous.
Market Outlook
• Our investment strategy of overweighting risky assets, including global stocks and
high yield bonds, and underweighting government bonds has paid off so far in 2013.
However, in light of the risks posed by the fluid situation in Washington, we have
reduced our equity overweight on a tactical basis.
• We have brought our EAFE and U.S. equity overweights in line by reducing U.S.
and raising EAFE exposure, given EAFE’s better relative valuations, an upturn in
Euro-zone leading economic indicators, and continued strength in Japan.
• Despite strong equity performance this year, along with higher yields, equities are
still attractive relative to government bonds on a valuation basis.
• The trend in bond yields has been down since early September, and this may
continue as political and fiscal risks dominate the headlines over the coming weeks,
but our long term view has not changed, as we believe a slow Fed exit from
quantitative easing, along with accelerating economic growth, will drive yields higher.
• Within fixed income, we prefer high yield credit to Treasuries or investment grade,
given reasonable valuation, low default rates, and equity-like characteristics.
Confidential — Not For Further Distribution
ECONOMIC AND MARKET OUTLOOK
ECONOMIC AND MARKET OUTLOOK
2
October 2013
Economic Outlook
Overall, global growth will likely continue to strengthen through the end of this
year and into 2014. A more synchronized global recovery appears to be in place,
with a strengthening U.S. economy, a faster recovery in the Euro-zone, growth
normalization in Japan, and economic stabilization in China. OECD Leading
Indicators (chart 1) now suggest that the global, U.S., Japanese, Euro-zone, and
U.K. economies are all in an expansionary environment. This runs parallel with
our expectations that global growth will strengthen, moving into the new year,
given supportive financial conditions, continued monetary expansion, and a lack of
inflationary pressures in the developed world (chart 2).
U.S. growth has continued its sluggish pace, largely due to fiscal headwinds. These
headwinds should diminish next year, as federal spending cuts and tax rate hikes
will continue to slow. Recent data in the U.S. is mixed, with PMI surveys and auto
sales strengthening while job gains have not impressed and housing momentum
has slowed. Concerns with the latter seem to have factored into the Fed’s
unexpected decision to hold off on the tapering of their QE program in
September. With initial jobless claims reaching lows last seen in 2007, we expect
an improvement in job gains over the coming months; which may prompt the Fed
to begin tapering. The uncertainty of the Fed’s timetable may present some
downside risk, as financial conditions may tighten in response to an increase in
tapering rhetoric – a negative for housing and autos. Short-term risks of a
government shutdown and failure to raise the debt ceiling will also serve as
headwinds, though the impact on growth prospects should be marginal. With an
improving labor market backdrop, lower gas prices helping consumers, indications
of strengthening business investment, and the September manufacturing PMI
hitting a 29-month high, we maintain our view that U.S. growth should pick-up
momentum heading into 2014.
In Europe, compelling evidence is forming that suggests their economies have
emerged from recession. This recovery has been driven by fiscal, financial, and
policy headwinds slowing, rather than positive demand shocks. There are signs of
fundamental improvement with the latest Euro-zone PMI and consumer
confidence numbers reaching two year highs. Also, the ECB has opened the door
to looser monetary policy, expanding the LTRO lending facilities. We don’t expect
a particularly vigorous recovery in Europe, given continued fiscal tightening and
financial deleveraging, though the current recovery looks sustainable, with scope
for acceleration into 2014.
Japan has been the fastest growing developed economy this year, with real GDP
rising nearly 4%, annualized, through the second quarter, driven by monetary and
fiscal policy easing and a weaker yen. Today, the effects from demand-enhancing
structural policies specific to Abe’s “Third Arrow” remain unknown, but will likely
offset the prospective dampening brought on from the recent consumption tax
hike. Along with the tax hike, a rapid surge in energy prices should weaken
consumer spending. Going forward, strong corporate cash flow, upcoming tax
incentives for capex, and privately financed infrastructure projects should be a
major boost to business spending, serving as a major tailwind for growth. The
latest PMI and Tankan surveys further emphasize improving business sentiment.
The risk of slower growth within emerging economies remains elevated. In China,
the September PMI was recently revised lower, though still above 50. Consumer
confidence remains at record lows, suggesting that a consumption-driven rebalance
has yet to take place. Tightening labor costs and declining EM currencies continue
to create inflationary pressures, while volatile commodity prices impact growth for
producing nations. Notably; manufacturing PMIs for India, Russia, and Brazil all
remain below the 50-mark, while Asian economies that are more synchronized to
the global recovery continue to decouple on improving growth prospects (chart 3).
Downside risks remain, as evidenced by recent U.S. market volatility surrounding
the government shutdown. If short-lived, these risks should have a limited impact
on global growth prospects as global inflationary pressures remain in check and a
synchronized manufacturing recovery takes form. This should be especially
beneficial for the U.S. and other developed economies going forward.
98.5
99.0
99.5
100.0
100.5
101.0
101.5
102.0 OECD Leading Economic Indicators
As of 7/15/13
Euro-zone Global Japan
United States United Kingdom
Chart 1: Global Growth: Set To Accelerate?
Source: QMA
Ind
ex
Chart 3: Emerging Markets PMI
Capital Economics BRIC & Non-BRIC PMIs
Source: Capital Economics
Chart 2: Global Inflation Rates
ECONOMIC AND MARKET OUTLOOK
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October 2013
Market Outlook
Equities continued higher in the third quarter, as the market, for the most part,
shrugged off lackluster top line growth, as well as rising geopolitical tensions as
the S&P 500 provided a total return of 5.24%. The quarter was characterized by
renewed hope for accelerating domestic and global growth, as well as
speculation of a bottom in emerging markets. This drove risk assets higher
through mid-September. During the second half of September, sentiment
shifted as the Fed surprised the market by not tapering its QE purchases. This,
along with heightened concerns over a government shutdown and the potential
for default, have driven the VIX higher, while putting pressure on equities and
bond yields.
Despite the noise introduced by the volatility in Washington, our outlook for
the economy remains positive. Economic indicators are pointing to renewed
global growth, as improving labor markets, expectations for increased
corporate spending, and at least a partial waning of global fiscal drags appear to
be paving the way for a strong 2014. While we believe that external concerns,
such as those posed by Washington, could drive near-term volatility, ultimately
the market should look through this and focus on underlying private sector
fundamentals. However, though we remain overweight in risk assets, we have
trimmed these positions on a tactical basis, as the situation in Washington
remains fluid.
Our view of above-consensus economic growth for 2014, along with
reasonable, though rising, valuations, has kept us overweight equities despite
the increased volatility. What has changed, however, is our positioning in U.S.
equities relative to EAFE. As shown in chart 4, during the first half of 2013, the
U.S. enjoyed strong outperformance relative to both its developed and
emerging market counterparts, with an excess return of 10% compared to the
MSCI® EAFE Index. We maintained our overweight position in the U.S.
during that time, amid a backdrop of declining tail risks, low volatility,
improved expectations for U.S. economic growth, and recessionary conditions
throughout developed Europe. During the third quarter, this dynamic changed,
as European leading indicators turned up and the valuation skew began to more
heavily favor EAFE countries (chart 5). This, combined with continued
strength in Japan, drove EAFE outperformance from July through September.
Our most recent country analysis is in line with the markets’ view of the relative
prospects between the U.S. and Europe (and Japan), as we believe near-term
returns will likely favor the latter.
Emerging markets have been the subject of much controversy among market
pundits over the past several months. While emerging market equities
undoubtedly had a strong third quarter, questions remain as to whether the
underlying economic fundamentals have truly bottomed (chart 6). With China
as the largest emerging market economy, as well a significant importer of
emerging market goods, much of the focus centers around its economic
outlook. While Chinese economic readings have been marginally positive over
the past several weeks, we maintain our view that the transition to a
consumption-driven economy will likely be a bumpy one. We are currently
taking a cautious approach to EM, despite its recent strength, while continuing
to closely monitor the economic data.
Turning to bonds, the 10-year treasury rate rose from a low of 2.5% to a high
of 2.97% before declining back to the 2.6% range post the Fed announcement
that they would delay tapering. While we see the potential for a continued
pullback in yields as political and fiscal risks dominate the headlines over the
coming weeks, our long-term view remains unchanged, as we believe a slow
Fed exit from quantitative easing, along with accelerating economic growth will
drive yields higher.
Chart 4: Recent EAFE Outperformance
Chart 5: Rising Confidence in Developed Economies
Chart 6: BRICS LEIs Continue to Look Weak
ECONOMIC AND MARKET OUTLOOK
4
October 2013
Please see page 5 for index definitions.
Source: FactSet Research Systems.
Source of sector classification: S&P/MSCI.
Performance Summary as of 9/30/13 ---------------Annualized---------------
Quarter YTD 1 Year 3 Year 5 Year 10 Year Equity S&P 500 Index 5.24% 19.79% 19.34% 16.27% 10.02% 7.57%
Consumer Staples 0.80% 16.08% 14.05% 15.86% 10.87% 9.89% Consumer Discretionary 7.79% 29.12% 31.84% 24.13% 18.77% 9.79% Energy 5.15% 15.42% 12.25% 15.38% 6.60% 14.15% Financials 2.87% 22.93% 30.20% 13.58% 1.72% -0.12% Health Care 6.82% 28.45% 28.55% 20.95% 13.07% 8.18% Industrials 8.91% 23.92% 28.50% 16.69% 10.62% 8.71% Information Technology 6.62% 13.39% 6.91% 13.70% 12.03% 7.13% Materials 10.30% 13.50% 16.55% 11.92% 8.16% 9.41% Telecommunications Services -4.40% 5.69% -0.68% 12.56% 11.17% 8.93% Utilities 0.19% 10.14% 6.99% 10.58% 7.06% 9.76%
Russell 1000® Index 6.02% 20.76% 20.91% 16.64% 10.53% 7.98% Russell 1000® Growth 8.11% 20.87% 19.27% 16.94% 12.07% 7.82% Russell 1000® Value 3.94% 20.47% 22.30% 16.25% 8.86% 7.99%
Russell 2000® Index 10.21% 27.69% 30.06% 18.29% 11.15% 9.64% Russell 2000® Growth 12.80% 32.47% 33.07% 19.96% 13.17% 9.85% Russell 2000® Value 7.59% 23.07% 27.04% 16.57% 9.13% 9.29%
Russell 3000® Index 6.35% 21.30% 21.60% 16.76% 10.58% 8.11% Russell 3000® Growth 8.48% 21.75% 20.30% 17.18% 12.16% 7.99% Russell 3000® Value 4.23% 20.68% 22.67% 16.27% 8.89% 8.09%
Wilshire 5000℠ 6.03% 20.85% 20.96% 16.48% 10.43% 8.19%
MSCI EAFE® in Local Currency 7.50% 19.34% 28.31% 9.11% 5.54% 6.28% MSCI EAFE® in US$ 11.56% 16.14% 23.77% 8.47% 6.35% 8.01%
MSCI EAFE® Growth in U.S.$ 10.50% 16.54% 23.27% 8.88% 6.79% 8.00% MSCI EAFE® Value in U.S.$ 12.63% 15.71% 24.27% 7.99% 5.86% 7.94%
MSCI® EM in Local Currency 5.63% 0.47% 5.82% 2.74% 8.18% 12.49% MSCI® EM in US$ 5.77% -4.35% 0.98% -0.33% 7.22% 12.80%
MSCI® World 8.18% 17.29% 20.21% 11.82% 7.84% 7.58% Fixed Income Barclays Capital Aggregate 0.57% -1.89% -1.68% 2.86% 5.41% 4.59% Citi BIG 3 Mo T-bill 0.01% 0.04% 0.07% 0.08% 0.15% 1.61%
Barclays High Yield 2.28% 3.73% 7.14% 9.19% 13.53% 8.86% Barclays TIPS 0.70% -6.74% -6.10% 4.02% 5.31% 5.23% Barclays Government 0.12% -1.92% -1.98% 2.13% 4.00% 4.17% Barclays Credit 0.72% -2.91% -1.90% 4.13% 8.54% 5.19%
Citi Non U.S. Gov't ($ hedged) 1.01% 0.98% 2.19% 2.79% 4.18% 4.21% Citi Non U.S. Gov't (unhedged) 4.06% -3.37% -5.65% 0.55% 4.27% 4.91%
JPM EMBI+ 0.51% -8.89% -5.94% 4.69% 9.51% 8.74% Other DJAIG Commodities 2.13% -8.56% -14.35% -3.16% -5.29% 2.14% DJ Wilshire REIT -3.04% 2.71% 5.26% 12.48% 5.55% 9.42%
ECONOMIC AND MARKET OUTLOOK
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October 2013
Explanation of Indices
Citigroup (formerly Salomon Smith Barney) Non-U.S. World Government Bond Index—Unhedged. This Index is based on the Citigroup
formerly Salomon Brothers) World Bond Index, and excludes issues denominated in U.S. dollars. The Index measures the total return of
government securities in major sectors of the international bond market.
Citi Non-US Government Hedged is an international fixed-income fund.
Citi BIG T-Bill (3-month) is the 3-month Treasury bill subsector of the Broad Investment Grade (BIG) index.
Dow Jones - AIG Commodity Index is a diversified benchmark for the commodity futures market. It is composed of futures contracts on 19
physical commodities traded on U.S. exchanges, with the exception of aluminum, nickel and zinc, which trade on the London Metal Exchange
(LME).
Dow Jones Wilshire REIT Index. Measures U.S. publicly traded Real Estate Investment Trusts. The index is a subset of the Dow Jones Wilshire
Real Estate Securities Index (WRESI). The indexes are weighted by both full market capitalization and float-adjusted market capitalization.
JP Morgan Emerging Markets Bond Index Plus. The JP Morgan Emerging Markets Bond Index Plus is a market capitalization-weighted total
return index of U.S. dollar and other external currency denominated Brady bonds, loans, eurobonds, and local market debt instruments traded in
emerging markets.
Barclays Capital Aggregate. Composed of U.S. investment-grade fixed-rate bond market, including government and credit securities, agency
mortgage pass-through securities, asset-backed securities, and commercial mortgage-based securities.
Barclays US Corporate High Yield Index. Covers the universe of high-yield corporate bonds.
Barclays Capital US TIPS Index. An unmanaged index that represents securities that protect against adverse inflation and provide a minimum level
of real return. To be included in this index, bonds must have cash flows linked to an inflation index, be sovereign issues denominated in U.S.
currency, and have more than one year to maturity, and, as a portion of the index, total a minimum amount outstanding of $100 million U.S.
dollars.
Market Volatility Index of the Chicago Board Options Exchange. A measure of market expectations of near-term volatility conveyed by S&P 500
stock index option prices.
Morgan Stanley Capital International (MSCI®) Europe, Australasia, and Far East (EAFE) Equity Index. MSCI® EAFE acts as a benchmark for 24
developed-market stock portfolios. MSCI® Japan Equity Index is a subset of MSCI® EAFE.
Morgan Stanley Capital International (MSCI®) Emerging Markets Equity Index. MSCI® EM acts as a benchmark for 27 emerging-market stock
portfolios.
MSCI® World Index. A free-float weighted equity index that includes developed world markets but not emerging markets.
Russell 3000®, 2000®, & 1000®. The Russell 3000® is composed of 3,000 large U.S. companies representing approximately 98% of the U.S. equity
market. The Russell 1000® represents the largest 1,000 companies in the Russell 3000®, and the Russell 2000® represents the 2,000 smallest
companies. The Russell 1000® Growth includes those Russell 1000® companies with higher price-to-book ratios and higher forecast growth
values. The Russell 1000® Value includes those Russell 1000® companies with lower price-to-book ratios and lower expected growth values. The
Russell 2000® Growth includes those Russell 2000® companies with higher price-to-book ratios and higher forecast growth values. The Russell
2000® Value includes those Russell 2000® companies with lower price-to-book ratios and lower forecast growth values. The indexes are value-
weighted. The Russell indices are trademarks/service marks of the Russell Investments. Russell is a trademark of the Russell Investments.
Wilshire 5000 Total Market IndexSM represents the broadest index for the US equity market, measuring the performance of all US equity securities
with readily available price data. A number of securities are over-the-counter and small companies. Wilshire®, the Wilshire IndexesSM and the
Wilshire 5000 Total Market IndexSM are service marks of Wilshire Associates Incorporated (“Wilshire”) and have been licensed for use by
QMA. All content of the Wilshire IndexesSM and Wilshire 5000 Total Market IndexSM is © 2010 Wilshire Associates Incorporated, all rights
reserved.
S&P 500 Index. Covers 500 industrial, utility, transportation, and financial companies of the U.S. markets. The value-weighted index represents
about 75% of the NYSE market capitalization and 30% of the NYSE issues.
Emerging market countries may have unstable governments and/or economies that are subject to sudden change. These changes may be
magnified by the countries’ emergent financial markets, resulting in significant volatility to investments in these countries.
Gold returns represent the performance of the price of gold bullion per the spot price of one ounce of London fixing. The spot price is valued in
USD.
These indices are all unmanaged. Investors cannot invest directly in an index.
ECONOMIC AND MARKET OUTLOOK
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October 2013
IMPORTANT INFORMATION
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QMA-20131004-128