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  Investment Strategy Update, July 2016

Investment Strategy—Positioning for Uncertainty

Despite a turbulent start to 2016, global securities markets have shrugged off geopolitical concerns, slower economic growth, and a deterioration in earnings, delivering compelling returns for investors. Our analysis of the macroeconomic landscape continues to indicate slower economic growth and limited inflation, and we foresee potential economic headwinds resulting from “Brexit,” the vote by the U.K. to leave the European Union.

We foresee a slow growth environment in the foreseeable future and continue to believe that the current economic landscape warrants lower interest rates and lower expected returns across asset classes. In order to adapt to evolving conditions, the Wilshire Funds Management Investment Strategy Committee meets monthly to reassess a variety of factors, including but not limited to economic, fundamental, technical, and risk indicators. Our most recent assessment of global market conditions has resulted in meaningful changes in our portfolios, as we have adjusted our risk budget to a more cautious positioning, most specifically through a reduction in equity risk in favor of credit risk, and by restructuring our equity exposure. Although our views are directly reflected in our portfolios, we have also included a broad summary of the changes in our views since April, with a discussion of our rationale in the following sections.

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

Macroeconomic Outlook

Our assessment of the macroeconomic landscape continues to indicate slower economic growth and limited 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. We are also witnessing low levels of inflation on a global basis. With the exception of a handful of countries, inflation is below average and declining. The challenge today is that global sovereign yields already sit well below historical averages on a normalized basis, leaving central banks with limited ammunition to combat slow economic growth and deflationary pressures.

On a forward looking basis, we are concerned about the economic headwinds resulting from “Brexit,” the vote by the U.K. to leave the European Union. While the strong recovery of global markets shortly after the initial risk-off response is calming for many, it’s important to recognize the global economic implications of this, especially at a time when the global economy is already very fragile. There is a considerable probability that the U.K. will enter a recession, and the largest European economies will not be immune to the spill-over effects. According to Bloomberg’s most recent survey of economists, Eurozone GDP growth estimates have been revised down by -0.4% for 2017, which is nearly in line with the -0.3% reduction in the IMF’s most recent forecast. Deterioration in European economic growth may have more global implications as China, for example, may be negatively impacted by slowing European growth, given its substantial exports to Europe.

Exhibit A1: Country GDP Growth (Normalized, 15 years)

Exhibit B1: Country CPI Growth (Normalized, 15 years)

While the U.S. appears to be more immune to the implications of Brexit, the residual effects are still hard to quantify, but may result in a negative impact to U.S. earnings due to a stronger dollar (causing higher export prices) and lower interest rates (pressuring margins on a variety of financial institutions). We already see signs of slowing growth in the U.S., but we do not yet observe signs of a recession on the horizon. Exhibit C shows the Conference Board US Leading Index, which shows that although leading economic indicators are on a downward trend, we are not yet at levels that have been consistent with the past two recessions (as denoted by the red shaded areas). Recent readings of U.S. Industrial Production are also disappointing, but we continue to see healthy job growth, as we have consistently observed the average 12-month change of US Nonfarm Payrolls rise by more than 200,000/month.

Exhibit C1: Conference Board U.S. Leading Index MoM

Exhibit D1: U.S. Industrial Production MoM

Exhibit E1: U.S. Employees on Nonfarm Payrolls Total MoM

Commodity prices have put significant downward pressure on U.S. inflation measures, and we continue to monitor readings of core inflation (which strips out volatile fuel & food costs) for signs of a recovery in inflationary pressure, which has risen to 2.3% year-on-year. While the rebound in core inflation is noteworthy, we’ve seen breakeven levels of inflation move closer to the lows of earlier this year, as the Fed’s Five-Year Forward Breakeven Inflation Rate is well below the targeted 2% objective (Exhibit F). US Personal Consumption Expenditures, although rising, also continues to sit well below the Fed’s 2% target (Exhibit G). This, in combination with the uncertainty regarding the implications of Brexit, likely warrant a more dovish approach by the Fed in the intermediate time horizon. It is also challenging to envision a material rise in interest rates in the U.S. given the very low-to-negative bond yields that we are witnessing in developed Europe and Japan (supporting continued global demand for dollars). We foresee a slow 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 adjusted our risk budget to a more cautious positioning, most specifically in our equity allocations, which we will discuss in the following sections.

Exhibit F1: Fed’s Five Year Forward Breakeven Inflation Rate

Exhibit G1: U.S. Personal Consumption Expenditures

Fixed Income Outlook

We have moved to an overweight in fixed income relative to equities, specifically by replacing equity risk with credit risk. We began increasing our exposure to fixed income in the fourth quarter of 2015 (moving from an underweight to neutral). This move served to offset market volatility earlier in the year, with the fixed income allocation also benefiting from a notable decline in U.S. Treasury yields. We favor domestic fixed income over global fixed income, given ultra-low foreign developed market bond yields, and we are concerned that further dollar strength will serve as a headwind for global bonds.

From an interest rate risk perspective, we remain duration neutral relative to the Barclays Capital Aggregate Bond Index. We have continued to reiterate our belief that rates will be lower for longer and interest rate sensitivity may still provide a diversification benefit, although more limited, in the event that economic growth and inflation continue to surprise to the downside. We recognize that valuations in fixed income are rich relative to history, but we see lower yields persisting for longer and we observe that the implied probability of another rate hike in 2016 still sits below 50%, with a probability of approximately 25% in September (Exhibit H). We continue to believe that the economic data is broadly inconsistent with a material rise in interest rates, and we expect any move by the Fed to raise rates in this environment will likely be met with a negative response in risk assets and a potential decline in bond yields as a result.

Exhibit H1: Futures Implied % Probability for 07/20/16 (Fed Funds Ranges Expressed in 25 Basis Point Increments From 0.0–1.75%)

With respect to credit markets, we acknowledge that liquidity remains low, despite the rally in prices since February. Specifically, we continue to see consistently wide spreads between CDX and cash bonds for both investment grade and high yield (Exhibits I and J), an indication that liquidity is still an area of risk in fixed income. That being said, we believe that allocating to credit as a replacement to equities is prudent, primarily with the goal of reducing equity risk while “getting paid to wait” in what we expect to be a lower return environment.

Exhibit I1: CDX () vs. Inv. Grade Cash Bond Spreads () (Basis Points)

Exhibit J1: CDX () vs. High Yield Cash Bond Spreads ()

Equity Outlook

As we discussed in the previous segment, we moved to an underweight in equities relative to fixed income. We have also reduced our overweight in non-U.S. equities to neutral relative to U.S. equities. In our analysis of the equity market we consider a variety of factors. Our equity research measures the state of the equity market through an assessment of valuations, yield, growth, trend, and volatility. Our equity heat map expresses positive and negative signals through green and red indicators, respectively. On a broad basis, equities continue to exhibit higher than normal valuations on a forward earnings basis, below average earnings growth, and negative trend. On a cross-sectional basis (Exhibits K and L), we recognize that U.S. equities are richly valued relative to their non-U.S. developed market counterparts (1.27 standard deviations above the 15 year average). U.S. equities are also exhibiting much higher levels of forward earnings growth (2.18 standard deviations above the 15 year average). Ultimately, investors have been paying up for growth in the U.S. relative to foreign developed market equities. We have referenced our valuation argument in favor of foreign equities for some time now, but given the heightened uncertainty for a number of foreign economies due to Brexit concerns—most notably Europe, our thesis has changed. We do not believe that European equities are pricing in the economic headwinds that Brexit may cause; moreover, we expect further currency headwinds due to this event and acknowledge the difficulty in forecasting the implications of this outcome. As a result, we believe that moving to a neutral posture between foreign and U.S. equities is prudent.

Exhibit K1: Cross-Sectional Equity Valuations (forward P/E, 15 years, normalized)

Exhibit L1: Cross-Sectional Earnings Growth (forward EPS, 15 years, normalized)


Specific to our decision to reduce equity risk, our observation of the trend in both estimated and actual earnings growth remains negative, as we are now witnessing the fifth straight quarter of negative earnings growth. When measuring the forward P/E of the S&P 500 Index relative to forward earnings, we can clearly see that valuations have moved considerably past earnings, which topped out late in 2014 (Exhibit M). This, in combination with an ultra-low level of implied volatility, as measured by the VIX Index, is symptomatic of complacency. The market’s ability to shrug of geopolitical concerns, slower economic growth, and a deterioration in earnings is encouraging from a technical perspective, and concerning from a fundamental perspective. Given our emphasis on fundamentals and acknowledgement of the technicals, we believe that taking some equity risk off the table while still seeking to harvest returns through our allocation to credit risk is prudent. 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 M1: S&P 500 Forward P/E (Normalized) vs. Forward Earnings

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. Wilshire Funds Management delivers Wilshire Advisor Solutions, which include models designed to provide a broad range of outcome-oriented investment portfolios 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 does not guarantee future returns. 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.

Copyright ©2016 Wilshire Associates Incorporated. All rights reserved.

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