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  Investment Strategy Update, October 2017

Staying on Course    

Global equity markets and risky assets alike have surged higher year-to-date 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 once again pricing some additional enthusiasm about the new U.S. administration’s ability to execute on its policy agenda of lighter regulation and looser fiscal policy, however there remains significant uncertainty regarding actual policy implementation.

Therefore, our analysis continues to focus on the fundamentals of the macroeconomic landscape while considering how such fundamentals may change in response to policy actions.  As a result, last quarter we shifted portfolios away from a credit-bias relative to equities and moved to increase government bond exposure to offset the additional equity risk. We also increased our already overweight exposure to non-U.S. equity, seeking to benefit from cheaper valuations and economic momentum abroad, along with our expectations of a weaker U.S. dollar which serves 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 continue to believe that the current economic landscape warrants lower interest rates and lower expected returns across asset classes.  We remain consistent in our slightly cautious risk posture, most specifically expressed through an underweight in equity risk in favor of alternative investments. Although our views are directly reflected in our portfolios, we have also included a broad review of the changes in our views since July, 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 July Change October
Fixed Income vs. Equity Neutral Neutral
Alternatives vs. Equity Overweight Overweight
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 Overweight Neutral
Growth vs. Value Equities Neutral Neutral
Global ex-U.S. vs. U.S. Equities Large Overweight Large Overweight
Emerging Markets vs. Developed Equities Overweight Overweight
Global REITS vs. Global Equities Neutral 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 Overweight
  • We maintain our overweight in alternatives, which is specifically implemented through equity hedge strategies. This continues to serve the objective of reducing equity beta and introducing more alpha-oriented strategies 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 caps performance may be more correlated to foreign economic growth given their significant exposure to overseas earnings.
Growth vs. Value Equities Neutral
  • The current valuation dispersion between growth and value has continued to widen, but not materially enough relative to the long-term history of this measure. The performance of value vs. growth is largely dependent on the outcome of government policy which is too uncertain for our risk budget. 
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 moderating economic growth and inflation on a global basis, as shown in Exhibits A and B
  • Developed markets remain relatively stable in terms of GDP growth on a normalized basis, and we are still seeing below average growth in emerging markets, albeit at a faster pace than in developed markets. 
  • 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. (Exhibit C). 
  • On a global basis, measures of inflation are mostly in-line with or slightly below historic averages. 
  • Given that global growth and inflation remain moderate, we believe that global central banks will be slower to tighten monetary policy relative to 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

Exhibit C: PMI Surveys – Eurozone & Japan vs. U.S.

Exhibit C: PMI Surveys

Source: Bloomberg

Exhibit D: U.S. GDP – Big Q2 Recovery, Primarily Driven by Goods

Exhibit D: U.S. GDP

Source: Bloomberg

Exhibit E: Inflation Measures

Exhibit E: Inflation Measures

Source: Bloomberg

  • As shown in Exhibit D, U.S. economic growth has recovered recently, primarily due to a significant rise in the Goods segment (PCRGPCGD Index), but the Services segment of GDP (GDPCSRV% Index), which represents nearly half of the GDP measure, continues to exhibit modest growth figures since late 2014.
  • As shown in Exhibit E, the recent rise in headline inflation (CPI YOY Index) was primarily due to a rise in gasoline prices as a result of the recent hurricanes, while both core inflation (CPI XYOY Index) and personal consumption expenditures (PCE DEFY Index) have not risen.
  • When looking beneath the primary components of core inflation, we are witnessing price deflation across most core commodities and services aside from owners’ equivalent rents, which we also believe has more limited upside going forward. 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.
  • U.S. personal consumption expenditures now sit meaningfully below the Fed’s 2% target, at 1.4%. This represents one of the Fed’s most favored measures of inflation, and based on this indicator, we expect the Fed to be cautious with its tightening of monetary policy so as not to stymie economic growth and inflationary pressure.
  • We maintain our view that given the very low bond yields in developed European countries and Japan, which continue to support global demand for U.S. dollars, it is challenging to envision a material rise in interest rates in the U.S.
  • We continue to expect a moderating economic growth environment in the foreseeable future, and therefore we continue to believe that the current economic landscape warrants lower interest rates and lower expected returns across asset classes. As a result, we have maintained our more cautious positioning, most specifically in our equity allocations, where we remain underweight in portfolios where we have the ability to allocate to alternative investments

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. We have continued to reiterate our belief that rates will remain low and interest rate sensitivity may still provide a diversification benefit, although more limited, in the event that the economy and inflation continue to grow at a moderate pace.
  • We continue to believe that the economic data is broadly inconsistent with restrictive monetary policy. The market is pricing in a very high probability that the Fed will raise interest rates again in 2017, and given the recent significant move higher in yields off of the August lows of near 2.0% on the U.S. 10 Year Treasury Bond, we believe this expectation is already reflected in the bond market. Exhibit F shows that the market is now pricing in a probability of 87.5% of one additional rate hike by December.
  • Investors have noted concerns that the Fed’s decision to gradually shrink its balance sheet introduces additional risk to U.S. Treasury bonds, as this reduction in demand/increase in supply may introduce additional risk of a significant rise in yields. While we acknowledge this risk, we believe that it is important to recognize the recent recovery in foreign demand for U.S. Treasury bonds following the net selling activity in 2016. As we note in Exhibit G, the Fed may be stepping away, but foreign buyers have returned.
  • With respect to credit markets, given the further narrowing of corporate bond yield spreads over Treasuries, we remain less favorable on credit and are still underweight credit and overweight government bonds.
  • The decision to overweight government bonds is reflective of our belief that inflation will remain low, and is also meant to serve as a ballast to our equity exposure.

Exhibit F: Futures Implied % Probability for One Rate Hike

Exhibit F: Futures Implied % Probability for One Rate Hike

As of 10/31/2017, the current Fed Funds is between 1.00 and 1.25%.
Source: Bloomberg data

Exhibit G: Foreign Holdings of US Treasury Securities ($B) – The Fed is Stepping Away, but Foreign Buyers Have Returned

Exhibit G: Foreign Holdings of US Treasury Securities

Source: Bloomberg

Equity Outlook

  • Our equity heat map, which expresses positive and negative 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 H 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. Although we have already witnessed material U.S. dollar weakness in the second and third quarter, we continue to find the U.S. dollar to be overvalued against major developed market currencies (particularly relative to the Japanese yen), which may lead to continued performance tailwinds for foreign equity allocations if we see weakness in the U.S. dollar. 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 have moved past an earnings recession, and earnings forecasts for 2017 and 2018 remain optimistic—now approximately 9.0% earnings growth for the S&P 500 Index, although down from earlier estimates of 13%.  As we’ve discussed in the past, these expectations are largely driven by margin expansion, a continued improvement in earnings in the Energy sector, and significant earnings growth in the Technology sector. 
  • While we are encouraged by the market’s ability to shrug of geopolitical concerns and moderating economic growth, we believe that ultra-low levels of implied volatility, as measured by the VIX Index, remain symptomatic of complacency, particularly in the face of high valuations.
  • We believe that increasing government bond exposure to help offset our equity risk is prudent given current valuations. We will continue to adapt our portfolios to market conditions and promote diversification to dampen the volatility of our client portfolios with the objective of achieving long-term financial objectives.

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

Exhibit H: 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®”).

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© 2017 Wilshire Associates Incorporated. All rights reserved. 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.

© 2017 Wilshire Associates Incorporated. All rights reserved.

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