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  Investment Strategy Update, February 2018

Positioning for Value

Global equity markets and risky assets alike surged higher in 2017 as earnings recovered, realized and implied market volatility tumbled to near-historic lows, and momentum and positive sentiment continue to propel valuations higher. Markets are very enthusiastic about the new U.S. administration’s execution on tax reform, which may help extend the rally in risk assets even further, provided that monetary conditions do not tighten too quickly. Therefore, our analysis continues to focus on the fundamentals of the macroeconomic landscape while considering how fundamentals may change in response to the recent policy actions.

We maintained an overweight to government bond exposure through the second half of 2017 to offset additional equity risk in our portfolios. We have also been largely overweight to non-U.S. equities, benefiting from cheaper valuations and economic momentum abroad, along with a significantly weaker U.S. dollar which served as a tailwind for foreign equity exposure.

In order to adapt to evolving market conditions, the Wilshire Funds Management Investment Strategy Committee meets at least quarterly to assess a variety of factors, including but not limited to economic, fundamental, technical, and risk indicators. This quarter, we are continuing to maintain our overweight to foreign equities and government bonds. We believe that the current economic landscape warrants a gradual tightening in monetary conditions and lower expected returns across asset classes. We remain consistent in our slightly cautious risk posture, and are now choosing to implement this view through an overweight to value equities. Although our views are directly reflected in our portfolios, we have also included a broad review of the changes in our views since October, with a summary of our rationale and supporting exhibits in the proceeding sections. We will continue to keep you apprised of our market perspectives and positioning.

Asset Class October Change January
Fixed Income vs. Equity Neutral Neutral
Alternatives vs. Equity Overweight Neutral
Alternatives vs. Fixed Income Neutral Neutral
Duration vs. Bloomberg Barclays Cap Agg. Bond Index Underweight Underweight
Credit vs. Government Underweight Underweight
Investment Grade vs. High Yield Neutral Neutral
High Yield vs. Bank Loans Underweight Underweight
Non-U.S. vs. U.S. Fixed Income Underweight Underweight
Large Cap vs. Small Cap Equities Neutral Neutral
Growth vs. Value Equities Neutral Underweight
Global ex-U.S. vs. U.S. Equities Large Overweight Large Overweight
Emerging Markets vs. Developed Equities Overweight Overweight
Global REITS vs. Global Equities Underweight Underweight
Commodities vs. Global Equities Underweight Underweight

 

Asset Class Change View Summary of Rationale
Fixed Income vs. Equity

Neutral

We acknowledge that valuations are high in both equities and fixed income, and we see no economic or relative valuation basis to spend our risk budget in favor of either asset class. 

Alternatives vs. Equity

Neutral

We have moved to a neutral posture in alternatives. This will result in a very small increase in equity beta, as we seek to implement this shift through an allocation to long-short equity strategies with more beta exposure to facilitate alpha-oriented opportunities that can benefit from the additional breadth of short positions.  

Altnernatives vs. Fixed Income

Neutral

We continue to believe that interest rates will be low for longer, given modest levels of inflation and economic growth on a global basis. We believe that fixed income will continue to serve as one of the best sources of diversification to equity risk.

Duration vs. Bloomberg Barclays Capital Aggregate Bond Index

Underweight   

Our decision to remain underweight duration is in response to rising duration exposure in the benchmark, and we have decided to be only slightly shorter than the benchmark as we still find duration exposure to be complementary to our equity risk exposure.

Credit vs. Government

Underweight

Given the dramatic narrowing of corporate bond spreads over Treasuries, we see limited upside in corporate bonds today, and are now favoring government bonds. This decision is also meant to serve as a ballast to our equity risk and non-U.S. equity exposure.

Investment Grade vs. High Yield

Neutral

Cross-sectional valuations do not warrant a deviation from neutral posture. 

High Yield vs. Bank Loans

Underweight

Bank loans offer similar yield spreads relative to high yield, with significantly less volatility.

Large Cap vs. Small Cap Equities

Neutral

We no longer see a valuation case for being overweight large caps and find that small cap exposure provides a diversification benefit to our portfolios, particularly given our large overweight to international equities, as large cap performance may be more correlated to foreign economic growth given their significant exposure to overseas earnings.

Growth vs. Value Equities

Underweight

We observe that the prices of growth stocks imply a high level of excess optimism, and after the extreme outperformance of growth vs. value in 2017, we are positioning for mean reversion in favor of value equities. We also believe that the recent tax reform will be favorable for value equities, and will serve as a near-term catalyst for a cyclical rally. 

Global ex-U.S. vs. U.S. Equities

Large Overweight

We are witnessing economic momentum in foreign economies relative to the U.S., and foreign equities remain more attractive on a valuation basis. The U.S. dollar remains overvalued relative to the euro, yen, and pound, which may create an additional tailwind for foreign returns in dollar.

Emerging Markets vs. Developed Equities

Overweight

Valuations remain more compelling on a relative basis.

Global REITS vs. Global Equities

Underweight

We are reducing our exposure to REITs on valuation concerns.

Commodities vs. Global Equities

Underweight

Inflation remains below target, and energy prices are facing resistance in the face of rising production.

 

Macroeconomic Outlook

  • Our assessment of the macroeconomic landscape indicates improving moderating growth and inflation on a global basis, as shown in Exhibits A and B
  • Foreign developed markets are demonstrating stronger growth relative to the U.S. on a normalized basis, and while we are still seeing below average growth in emerging markets, these economies are growing at a faster pace than developed markets. 
  • While global growth and inflation remain moderate, there are signs of improving economic conditions and rising inflationary pressures in the U.S., which will be supportive of tighter monetary policy, but we believe this is already being priced into market expectations.

Exhibit A: Country GDP Growth (Normalized, 15 years)

Exhibit A: Country GDP Growth

Source: Bloomberg

Exhibit B: Country CPI Growth (Normalized, 15 years)

Exhibit B: Country CPI Growth

Source: Bloomberg

  • On a forward looking basis, when we look at the Purchasing Manager Index (PMI), which is an indicator of economic health in the manufacturing sector of a country or a region, we continue to witness positive economic momentum in the foreign economies of both Eurozone and Japan relative to the U.S. (Exhibits C & D). Preliminary data suggests that euro area year-on-year GDP growth expanded at the fastest pace in as decade. Japan factory output also surged in December, pushing output to the highest level since the global financial crisis

Exhibit C: PMI Surveys – Eurozone (Orange) vs. U.S. (Blue)

Exhibit C: PMI Surveys

Exhibit D: PMI Surveys – Japan (Gray) vs. U.S. (Blue)

Exhibit D: U.S. GDP

Source: Bloomberg

  • Within the U.S., we are witnessing signs of improving Leading Economic Indicators (“LEI”) (Exhibit E) and Improving CEO and Consumer Confidence (Exhibit F). The latest spike in LEI was widespread, with the strongest growth in new orders for manufacturing, improving financial conditions, and a positive consumer and stock market outlook. The recent tax reform is also expected to lead to a further hike in LEI.

Exhibit E: Pickup in Leading Economic Indicators (12 month moving average in blue)

Exhibit E: Inflation Measures

Exhibit F: Improving Confidence – CEO Confidence (Orange) & Consumer Confidence (Blue)

Exhibit F: Improving Confidence

Source: Bloomberg

  • Investor portfolios are becoming ever more bullish, as measured by the TD Ameritrade Investor Movement Index® (IMX), which measures sentiment based on observed information such as investor holdings and trading activity (Exhibit G). This positive sentiment on behalf of retail investors can further extend the rally in equities and other risk assets, but is often viewed as a sign of an overheating equity market.

Exhibit G: Investor Movement Index (Green) vs. S&P 500 Index (Gray)

Exhibit G: Investor Movement Index

Source: TD Ameritrade Inc.

  • As shown in Exhibit H, the recent rise in headline inflation (CPI YOY Index) was primarily due to a rise in gasoline prices and a surprise move higher in core inflation (CPI XYOY Index), resulting from stronger home prices.
  • When looking beneath the primary components of core inflation, we are still witnessing price deflation across most core commodities and services aside from owners’ equivalent rents (home prices), which has continued to offset weaker prices elsewhere. We believe that the underlying price weakness is due in part to the “Amazon effect,” or the deflationary impact of eCommerce, which we see as a prolonged secular trend. As a result, home prices will be essential to support core inflation going forward, which may face downward pressure if monetary conditions (interest rates) tighten too quickly.
  • U.S. personal consumption expenditures remain below the Fed’s 2% target. This represents one of the Fed’s most favored measures of inflation, and based on this indicator, we still expect the Fed to be cautious with its tightening of monetary policy so as not to stymie economic growth and modest inflationary pressure.

Exhibit H: Inflation Measures are Heating Up
CPI YoY (Green), Core CPI YoY (Orange), Personal Consumption Expenditures (Blue), Fed’s Five Year Forward Breakeven Inflation Rate (Gray)

Exhibit H: Inflation Measures are Heating Up

Source: Bloomberg

Fixed Income Outlook

  • We remain neutral in our exposure to fixed income relative to equities, as we see no valuation case for favoring one asset class over the other.
  • Given ultra-low foreign developed market bond yields, we favor domestic fixed income over global fixed income. However, we recognize that further weakness in the U.S. dollar would serve to benefit foreign fixed income.
  • From an interest rate risk perspective, we maintain a slightly shorter duration exposure relative to each portfolio’s benchmark exposure, as the benchmark’s duration has been gradually rising. While we expect monetary conditions to tighten somewhat, we believe that these expectations are currently priced into markets, and interest rate sensitivity may still provide a diversification benefit, although more limited, in the event that we see a meaningful correction in risk assets.
  • Exhibit I shows that the market is now pricing in an 87% probability of a rate hike by March (1.5-1.75), 58% for an additional hike in June (1.75-2.00), and 36% for a third hike in December (2.00-2.25), indicating that the market is pricing in approximately two to three rate hikes in 2018. We see this as gradual, but believe that a more aggressive tightening cycle would be detrimental to economic growth, inflation, and the valuations of risk assets.
  • With respect to credit markets, given the further narrowing of corporate bond yield spreads over Treasuries, we remain even less favorable on credit and are still underweight credit and overweight government bonds.
  • Our decision to overweight government bonds continues to be reflective of our belief that inflation is still not supportive of an aggressive cycle of interest rate hikes. We acknowledge that expected returns are low and/or limited in government bonds today, but we maintain this exposure because we see it as the only form of true long-volatility (risk management) in the event of a correction in risk assets, and it is specifically meant to serve as a ballast to our equity exposure.

Exhibit I: Futures Implied % Probability for Fed Funds Rate – Pricing in Two to Three Rate Hikes in 2018

Exhibit I: Futures Implied % Probability for Fed Funds Rate

As of 1/30/2018, the current Fed Funds is between 1.25 – 1.50%.
Source: Bloomberg data

Equity Outlook

  • Our proprietary equity heat map, which expresses positive and negative valuation signals through green and red indicators, respectively, continues to indicate that equities are trading well above historical average valuations.
  • On a cross-sectional basis, we observe that U.S. equities remain significantly more expensive relative to their non-U.S. developed market counterparts. Exhibit J shows the dramatic P/E multiple expansion that has occurred in U.S. equities relative to Non-U.S.
  • As noted earlier, we are also witnessing economic momentum in Europe and Japan relative to the U.S. Given that we have already seen material U.S. dollar weakness in 2017, we may observe some near-term support for the greenback. That said, we continue to find the U.S. dollar to be slightly overvalued against major developed market currencies (but meaningfully expensive relative to the Japanese yen), which may lead to continued performance tailwinds for foreign equity allocations. Given the continued positive alignment for foreign equities across valuations, economic momentum, and currency valuations, we believe that remaining in a large overweight posture to foreign equities versus U.S. equities will provide the best opportunity to outperform on a relative basis.
  • We see a tremendous amount of earnings optimism in 2018, most notably through significant earnings growth in the Information Technology sector. We believe that this is indicative of the excessive optimism priced into growth stocks today, which is supportive of a decision to underweight growth vs. value equities.
  • We expect an improving economic growth environment in the intermediate-term, which we believe will be beneficial for cyclical sectors, albeit in the face of rich equity valuations. As a result, we are shifting client portfolios to favor value-oriented equities, which are more largely represented by cyclical sectors. This is being funded by our alternatives allocations. As a result, we expect a very slight increase in equity exposure, which we forecast will benefit to a greater degree in a cyclical economic rally, while also providing greater margin of safety in an equity market correction due to cheaper valuations.
  • We will continue to adapt our portfolios to market conditions and promote diversification to dampen the volatility of our client portfolios with the goal of achieving long-term financial objectives for our clients.

Exhibit J: U.S. vs. Non-U.S. Forward P/E

Exhibit J: U.S. vs. Non-U.S. Forward P/E

Source: Bloomberg data

Important Information
Wilshire Funds Management (“WFM”) is a business unit of Wilshire Associates Incorporated (“Wilshire®”).

This material contains confidential and proprietary information of Wilshire. It may not be disclosed, reproduced or redistributed, in whole or in part, to any other person or entity without prior written permission from Wilshire Funds Management.

This material is intended for informational purposes only and should not be construed as legal, accounting, tax, investment, or other professional advice. Past performance is not indicative of future results. This material may include estimates, projections and other “forward-looking statements.” Due to numerous factors, actual events may differ substantially from those presented.

This material represents the current opinion of Wilshire based on sources believed to be reliable. Wilshire assumes no duty to update any such opinions. Wilshire gives no representations or warranties as to the accuracy of such information, and accepts no responsibility or liability (including for indirect, consequential or incidental damages) for any error, omission or inaccuracy in such information and for results obtained from its use. Information and opinions are as of the date indicated, and are subject to change without notice.

Wilshire is a registered service mark of Wilshire Associates Incorporated, Santa Monica, California. All other trade names, trademarks, and/or service marks are the property of their respective holders.

Copyright© 2018 Wilshire Associates Incorporated. All rights reserved.

180202 WAS E0518

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