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  Investment Strategy Update, February 2019

Discipline Outperforms Emotion

Global investor sentiment deteriorated in the fourth quarter of 2018, and the trend lower in risk assets escalated during the month of December as restrictive monetary policy began to weigh on sentiment and risk. Over the past two years, the Federal Reserve has been gradually and judiciously implementing a path to raising interest rates as the economy has demonstrated signs of stable economic growth. In 2018, the U.S. economy largely benefited from sizable tax cuts, predominantly in corporate taxes, which not only boosted corporate earnings but facilitated strong economic growth. It has yet to be seen, however, if the benefit of lower taxes will persist into 2019 and beyond, particularly in the face of tighter monetary policy.

Ultimately, global securities markets (stocks, bonds, and commodities) began to price in slower expectations of growth and inflation late in the fourth quarter, and the decision to raise interest rates in December was met with concern that the Fed may stall the already uncertain future of economic growth. Very recently, the Fed has moderated its tone which has been supportive of risk assets. Separating the volatility from the fundamentals, we spend considerable time focused on the macroeconomic landscape, how economic growth and inflation are evolving, how the interest rate environment is adapting, and how security valuations are reflecting all of the available information, while also closely monitoring technicals, sentiment, and risk as these factors will continue to impact investor behavior. This quarter we are remaining overweight to foreign equities and emerging markets. We are consistent in our slightly cautious risk posture, favoring government bonds in our fixed income allocations and value in our equity allocations. We have 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 Neutral Neutral
Alternatives vs. Fixed Income Neutral Neutral
Duration vs. 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 Neutral
Non-U.S. vs. U.S. Fixed Income Underweight Neutral
Large Cap vs. Small Cap Equities Underweight Underweight
Growth vs. Value Equities Underweight Underweight
Global ex-U.S. vs. U.S. Equities Overweight Overweight
Emerging Markets vs. Developed Equities Large Overweight Large Overweight
Global REITS vs. Global Equities Underweight Neutral
Commodities vs. Global Equities Neutral Neutral

 

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

Neutral   

While valuations are more attractive in equities today, we believe it’s important to maintain a balanced portfolio given the rise in volatility and heightened economic uncertainty.

Alternatives vs. Equity

Neutral   

We remain in a neutral posture in alternatives, but we continue to allocate to long-short equity strategies with more beta exposure in lieu of market neutral/equity hedge 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, and we believe that fixed income will continue to serve as one of the best sources of diversification to equity risk.

Duration vs. Barclays Cap Agg. Bond Index

Underweight   

With the 10-Year/2-Year spread under 20 basis points, investors are not sufficiently compensated for duration risk in longer bonds. As a result, we remain shorter in duration exposure in portfolios.

Credit vs. Government

Underweight   

Despite the recent widening of credit spreads, we see limited upside in corporate bonds today and continue to favor 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

Neutral   

We no longer need the interest rate protection as we expect a more dovish Fed going forward. We are also no longer sufficiently compensated given the deterioration in underwriting standards.

Large Cap vs. Small Cap Equities

Underweight   

We see a modest valuation case for favoring small caps, but also see less risk to small cap earnings given their domestic orientation relative to large caps, which have significant international revenue exposure that makes earnings more susceptible to recent dollar strength and geopolitical risk.

Growth vs. Value Equities

Underweight   

While growth stocks are exhibiting less optimism after tumbling in Q4, we believe that the technical rotation out of growth stocks and into value will be a longer-term trend, as valuations are still very compelling in value stocks versus growth.

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

Overweight   

While we continue to see declining economic momentum in foreign economies relative to the U.S., foreign equities are very attractive on a relative valuation basis. Given a more dovish Federal Reserve in 2019, we expect a weaker dollar to serve as a tailwind to foreign equities in the future.

Emerging Markets vs. Developed Equities

Large Overweight   

Valuations are very compelling on a relative basis, and emerging market currencies and equities have substantially priced in the existing geopolitical risks.

Global REITS vs. Global Equities

Neutral   

We have moved to a neutral position with the goal of adding defensive yield exposure.

Commodities vs. Global Equities

Neutral   

We see no fundamental or technical rationale to deviate from neutral.

 

Macroeconomic Outlook: Growth

  • Our assessment of the macroeconomic landscape indicates slowing economic growth on a global basis, as shown in Exhibits A through D.
  • U.S. growth outpaced major foreign developed markets in 2018 (Exhibit A), as we have seen economic activity continue to deteriorate in Europe and Japan. While emerging markets growth (Exhibit B) has slowed over the past several years, economic growth remains higher than that of developed markets.
  • Leading Economic Indicators (Exhibit C) have been trending lower, and more recently economic indicators appear to be rolling over in the U.S. (Exhibit D) highlights the Economy Weighted Manufacturing and Non-Manufacturing ISM Index, which serves as a strong indication of U.S. economic growth. The most recent print of this index indicates a deterioration in growth in the U.S.

Exhibit A: Developed Markets
Real GDP Growth

Exhibit A: Developed Markets Real GDP Growth

Source: Bloomberg

Exhibit B: Emerging Markets
Real GDP Growth

Exhibit B: Emerging Markets Real GDP Growth

Source: Bloomberg


 

Exhibit C: Developed Markets Leading Economic Indicators
 

Exhibit C: Developed Markets Leading Economic Indicators

Source: Bloomberg

Exhibit D: Manufact. & Non-Manufact. ISM (Blue), GDP Core YoY (Orange)

Exhibit D: Manufact. & Non-Manufact. ISM (Blue), GDP Core YoY (Orange)

Source: Bloomberg


 

Macroeconomic Outlook: Inflation

  • The recent move higher in Average Hourly Earnings (Exhibit E) has fueled short-term inflation expectations, while rising U.S. Producer Prices (Exhibit F)) have heightened concerns that higher production costs would flow through to higher consumer prices. These expectations have not come to fruition.
  • Tighter interest rate policy on behalf of the Fed effectively dampened shorter-term and longer-term growth and inflation expectations, as reflected in the large decline in breakeven inflation rates (Exhibit G). It’s worth noting that the massive decline in oil prices and risk assets during the fourth quarter also likely had an impact on breakeven expectations.
  • In the U.S. we have seen inflation measures roll-over, albeit not as dramatically as breakeven rates. We have repeatedly communicated our expectations that the housing market would soften and the deflationary effect of e-commerce will weigh on inflation. Consistent with our views, Exhibit H shows the decline in headline CPI from nearly 3% to under 2% on a year-on-year basis. Core CPI sits at just 2.1%, while Personal Consumption Expenditures have fallen below 2%.

Exhibit E: Avg Hourly Earnings YoY% (Blue) vs. Six Mnth Moving Avg (Green)

Exhibit E: Avg Hourly Earnings YoY% (Blue) vs. Six Mnth Moving Avg (Green)

Source: Bloomberg

Exhibit F: U.S. Producer Price Index YoY

Exhibit F: U.S. Producer Price Index YoY

Source: Bloomberg


 

Exhibit G: Breakeven Inflation Rates Tumbled Since the End of Q3

Exhibit G: Breakeven Inflation Rates Tumbled Since the End of Q3

Source: Bloomberg

Exhibit H: Exhibit H: Diversified Measures of Inflation

Exhibit H: Diversified Measures of Inflation

Source: Bloomberg


 

Valuations: Fixed Income & Currency

  • Given the rally in the 10 year Treasury yield in the face of rising short-term rates, the yield curve has nearly flattened, as exhibited in the 10yr-2yr spread (Exhibit I). There is minimal term premium that investors receive for accepting duration risk in longer maturity bonds, and therefore, there is limited risk-adjusted excess return opportunities in long-duration bonds today. As a result, we believe that it’s prudent to remain short in duration, thereby reducing interest rate sensitivity.
  • Credit spreads widened considerably from the lows of 2018, as shown in Exhibit J. While investors receive higher yield compensation today relative to six months ago, current option-adjusted spreads do not yet represent a value opportunity, and we remain underweight in credit as a result.
  • The U.S. dollar (USD) staged a magnificent rally since the spring of 2018 on the heels of tighter monetary policy in the U.S., which resulted in an attractive interest rate spread relative to many foreign economies. As we know, the pendulum often swings too far, and the USD has been no exception, as it is now expensive relative to major developed market currencies (Japanese yen, euro, and British pound) and most emerging market currencies (Exhibit K and L). Given the relative richness of the USD, and a higher probability of the Fed pausing in its path towards higher interest rates, we believe that remaining underweight USD is prudent, and this view is embedded in our overweight in foreign equities.

Exhibit I: 10-2 Yr Treasury Yield Spread
– The Curve is Nearly Flat


 

Exhibit I: 10-2 Yr Treasury Yield Spread – The Curve is Nearly Flat

Source: Bloomberg

Exhibit J: Credit Spreads Are Wider, But Not Indicative of Value Opportunity Invest. Grade (Blue), Emerging Mkts (brown), High Yield (Red)

Exhibit J: Credit Spreads Are Wider, But Not Indicative of Value Opportunity
Invest. Grade (Blue), Emerging Mkts (brown), High Yield (Red)

Source: Bloomberg


 

Exhibit K: Developed Markets Currency Valuation – Purchasing Power Parity
 

Exhibit K: Developed Markets Currency Valuation – Purchasing Power Parity

Source: Bloomberg

Exhibit L: Emerging Markets Currency Valuation – Purchasing Power Parity

Exhibit L: Emerging Markets Currency Valuation – Purchasing Power Parity

Source: Bloomberg


 

Valuations: Equities

  • The correction in equities during the fourth quarter of 2018 created valuation opportunities that we hadn’t witnessed in years. Exhibit M shows the increase in the equity risk premiums (earnings yield – 10 year U.S. Treasury yield) for U.S., foreign developed, and emerging markets. While opportunities were presented across the spectrum of equities, valuations in foreign equities, particularly in emerging markets, remain most compelling. As a result, we are maintaining our overweight to foreign equities, and large overweight to emerging markets.
  • Our global equity heat map (Exhibit N), confirms the attractiveness of equity valuations, as U.S., foreign developed, and emerging market equities are all trading at more than one standard deviation below their average valuations (price/forward earnings) over the past five years.
  • Exhibit O shows the ratio of the large cap growth vs. large cap value forward P/E, which clearly demonstrates the outsized expansion of earnings multiples in growth vs. value stocks. Despite the strong rally in value vs. growth equities during the fourth quarter, the contraction in relative earnings multiples has only started to retrace, and we still see significant opportunities in value equities relative to their growth counterparts.
  • Exhibit P shows the same analysis as Exhibit O, but applied to large caps vs. small caps. Large caps have experienced significantly higher expansion of earnings multiples since the lows of 2009. In addition to attractive relative valuations, the domestic orientation of small caps is likely to be in favor given the recent trend away from globalization.

Exhibit M: Equity Risk Premiums: Foreign (orange), Emerging (green)
U.S. (blue)

Exhibit M: Equity Risk Premiums: Foreign (orange), Emerging (green), U.S. (blue)

Source: Bloomberg

Exhibit N: Wilshire Global Equity Heat Map (as of 12/31/18)*

Exhibit N: Wilshire Global Equity Heat Map (as of 12/31/18)

*Data reflects longest available time period when 15 years is not available


 

Exhibit O: U.S. Large Cap Growth/Large Cap Value Forward P/E

Exhibit O: U.S. Large Cap Growth/Large Cap Value Forward P/E

Source: Bloomberg

Exhibit P: U.S. Large Caps/Small Caps Forward P/E Ratio

Exhibit P: U.S. Large Caps/Small Caps Forward P/E Ratio

Source: Bloomberg


 

Sentiment, Technicals, and Risk

  • Given the dramatic sell-off in equities, credit, and commodities, heightened geopolitical risks, the government shutdown in the U.S., and recent concerns of a recession, we have started to see sentiment wane. Specifically, Consumer and CEO Confidence have fallen from very high levels (Exhibit Q), and U.S. investors have flocked to the exits.
  • Exhibit R shows the magnitude of weekly outflows from U.S. mutual funds and ETFs in December, outflows not seen since the 2008 financial crisis, and certainly indicative of panic. As we shared in our article titled “Volatility Creates Opportunity” on December 26th, 2018, the technical panic that ensued in late December created significant return opportunities for investors heading into 2019.
  • In light of the deterioration in confidence and investor sentiment, along with the backdrop of slower growth and inflation, it’s likely that monetary policy becomes less restrictive in 2019. This may be supportive of asset valuations, but likely to the detriment of the U.S. dollar. Exhibit S shows the Net Non-Commercial Futures positions in the USD, which demonstrates potential crowding in long U.S. dollar positions. This only heightens the risk of a correction in the USD, and would serve as a tailwind to foreign investment exposure (supportive of our decision to be overweight foreign equities/emerging markets).
  • We have seen repeated spikes in volatility over the past year, and implied volatility remains high (Exhibit T). We expect risk and volatility to remain elevated over the ensuing year, and we promote diversification to dampen the volatility of our client portfolios with the goal of achieving long-term financial objectives for our clients.

Exhibit Q: Consumer Confidence (Blue) vs. CEO Confidence (Orange)

Exhibit Q: Consumer Confidence (Blue) vs. CEO Confidence (Orange)

Source: Bloomberg

Exhibit R: Estimated Weekly Outflows $B (Mutual Funds & ETFs)

Exhibit R: Estimated Weekly Outflows $B (Mutual Funds & ETFs)

Source: Bloomberg


 

Exhibit S: USD CFTC Net Non-Commercial Futures (bars) vs. USD Index (line)

Exhibit S: USD CFTC Net Non-Commercial Futures (bars) vs. USD Index (line)

Source: Bloomberg

Exhibit T: CBOE S&P 500 Volatility Index (VIX) Index

Exhibit T: CBOE S&P 500 Volatility Index (VIX) Index

Source: Bloomberg


 

Important Information
Wilshire Funds Management (“WFM”) is a business unit of Wilshire Associates Incorporated (“Wilshire®”). WFM delivers WIlshire Advisor Solutions, which include models designed to provide a broad range of outcome oriented investment solutions for advisors to use with their clients.

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. Forward-looking statements speak only as of the date on which they are made and are subject to addition, change or deletion without notice; we undertake no obligation to update or revise any forward-looking statements.

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.

©2019 Wilshire Associates Incorporated. All rights reserved.

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