[GREETING] Thank you for joining me today. Over the next half hour or so, I’ll offer AB’s assessment of the

global economic and capital markets landscape. I’ll also offer our insights on the opportunities and risks we see globally.

As we introduced last year, our current theme in the CMO is “After the Beta Trade.” For years, investors have enjoyed strong returns across capital market sectors. Simply having market exposure, or beta, was very effective, with market returns generally accompanied by low volatility and dispersion.

But we think the great beta wave has subsided, and investors need to consider new ways to enhance expected lower market returns, with higher volatility and more return dispersion. We think active management and the right positioning are key.

First, let’s run through the big picture.

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We continue to see modest global growth and low inflation, with the support of still-accommodative monetary policies. The US economy continues to expand, although the Federal Reserve has pushed back additional rate hikes over concerns about the pace of global growth.

Collectively, major developed economies are on relatively solid footing. Emerging economies in aggregate are still growing faster than the developed world, but growth has decelerated and the growth gap between the two groups has narrowed.

Our After the Beta Trade theme seems to be playing out, with higher volatility and muted market returns. Key recent volatility drivers include concerns about low oil prices, slower growth in China and general concerns over global growth. This is a far cry from the multi-year beta trade driven by easy money policies and well-below-normal volatility. The days of autopilot investing are over.

Investors should focus on strategies to add alpha to enhance lower market returns. They should also consider downside protection to insulate against a potential setback.

In equities, we expect modest returns, but there are opportunities for high-conviction active investors.

In bonds, we see a compelling opportunity in credit, even after recent strength in USHY, however using a selective approach is key; we also wouldn’t abandon interest rate exposure – but we would globalize it; finally for clients that pay taxes, we continue to see attractive opportunities in municipal bonds.

With alternatives, current asset valuations support using alternative strategies to incorporate downside protection combined with security-selection opportunities.

Let’s take a closer look at what’s been going on in the capital markets, which reinforces why we think investors need a new approach to building portfolios.

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Market returns in the first quarter of 2016 remained volatile, particularly in the first month and a half of the year.

In a pattern reflecting the second half of last year, markets were highly volatile, with a significant sell-off in the first half of the quarter followed by a very strong recovery in market performance in the latter half. In the end, developed market equity market returns were mixed, with emerging market stocks generating strong returns on the back of (to confirm: lower rates/a dovish Fed, higher energy prices, etc) …. Falling yields and compressed spreads drove nearly across the board strength in bonds; however, despite the performance strength US HY spreads essentially ended up where they finished at the end of 2015.

When all was said and done, investors have gotten only minimal gains from growth-driven risk assets since the “end” of the beta trade. And many are worried that an earnings slump will extend the difficult times.

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At the heart of the concern is a prolonged slump in earnings growth, which has was negative for the S&P 500 in all four quarters of 2015. You can see that in the last four green bars on the left display.

That streak represents an equity earnings recession. It’s modest compared to other earnings recessions historically, although the first quarter of 2016 is shaping up to be particularly disappointing. Some investors worry that a disappointing equity market is upon us. It seems intuitive, given the markets heavy focus on earnings results. Additionally, throughout the quarter there were questions of whether difficult markets foretold of difficult economic conditions

But the historical data counters the notion that a bad earnings stretch means a poor economy or a bad market. In the left display, we show quarterly earnings growth for the S&P 500 Index since 1990 (the green bars). The diagonal shading represents earnings recessions that coincided with economic recessions: market returns, shown by the diamonds, were substantially negative in both periods.

The gray shaded regions represent the earnings recessions that didn’t coincide with economic recessions. In total, there have been 11 earnings recessions since 1990, including the current slump. But only four of those periods saw an equity market decline—and two of those down markets were during economic recessions.

And if we do a little math in the table on the right, we find that the median market return across all earnings recessions is positive 5.5%. And it’s nearly 8% if we exclude the Global Financial Crisis, which is certainly shaping up to be a historical outlier. So it isn’t a sure thing that a bad earnings stretch will translate into a bad market stretch.

The global macro backdrop remains largely supportive, although concern has been mounting about a softening of global growth.

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Business surveys have not shown much strength so far this year. The Purchasing Managers’ Indices in the left-hand-display are based on five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment. The emerging-markets PMI has slowed lately, although it and the developed-market reading are still above 50, indicating expansion.

One bright spot is that the continuing fall in inventories indicates that firms are operating with thin positions; any pickup in demand would trigger a fast and positive response in orders and production. Still, the lackluster growth and inflation environment (we show inflation in the middle display) is likely to keep central banks broadly in a highly accommodative mode.

In some cases, central banks have continued to push the boundaries of unconventional monetary policy and are experimenting with negative interest rates. The European Central Bank has pushed rates deeper into negative territory, and we expect the Bank of Japan to do so as well. In our view, negative rates are untested and may not prove effective. As a result, they may have undesirable and unpredictable economic and financial consequences.

Overall, we think the macro backdrop paves the way for moderate global economic growth to continue in 2016, accelerating slightly.

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We expect real global GDP to increase by 2.6% in 2016, largely in line with the 2.5% increase in 2015. Emerging economies are still growing at a faster pace than developed economies, but the gap is shrinking as emerging growth decelerates and developed growth gains. In 2016, we expect developed economies to expand by 1.9% and emerging economies by 3.6%.

The US growth cycle seems firmly in place. Solid gains in consumer spending and housing leave the US economy poised to grow somewhat faster this year. We expect US GDP growth to pick up from 2.4% to 2.7% in 2016.

Despite strong consumer data, the recovery in the euro area has slowed. Inflation is turning negative again and core inflation is soft, which spurred the ECB to provide additional quantitative easing in March. For 2016, we project euro area GDP growth at 1.3%, with the UK checking in at 1.9% growth. In Japan, the door is open for more policy easing—economic data are mixed but generally biased to the downside.

If you scan the columns showing our inflation forecasts 2016, you’ll see a relatively benign environment accompanying moderate global growth. This gives policymakers plenty of room to continue accommodative monetary policies.

One of the bigger sources of debate and worry from the standpoint of global growth patterns is the economic trajectory of China. We don’t expect China to endure a hard economic landing, but there are some open questions.

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China is still growing fast, but by its previous standards it has hit a softer patch. We’re forecasting that China’s GDP growth will decline to 6.3% in 2016 from 6.9% in 2015. Many investors believe that China is already in a growth recession, but Chinese policymakers seem to think slower growth is part of a structural transition to a more sustainable growth model.

One factor in these opposing views may be the changing mix of growth drivers in the Chinese economy. In the past, the more tradable sectors like industrial and construction played a greater role. Today, the non-tradable services sector is growing more important, as we show on the left. Our view is that the Chinese economy is transitioning to being more services-led.

The housing sector has some upside potential in 2016, although demand tapered late in 2015 and new-housing starts are still depressed. China is tightening housing policy in Tier One cities while trying to boost demand in lower tier cities. We don’t know if this mixed policy will work or if the tightening in big cities will spill over to smaller cities and reduce the appetite for housing purchases. A “major” housing recovery scenario is NOT our base case expectation—we expect more of a marginal improvement, with the downside risk of a broad housing correction.

Then we have the currency question. As China implements an ongoing reform of its currency and capital account, volatility from the renminbi—particularly versus the US dollar, puts the plan under threat, because capital outflows intensify and foreign reserves dwindle. Forging ahead with the reform and taking a pause to let the market settle down both have pros and cons.

Our base-case scenario is that Beijing will continue to walk a fine line, keeping the renminbistable against a basket of key currencies. On the right, you can see that even though the renminbi has fallen against the dollar, it has stayed relatively stable against the CFETS (China Foreign Exchange Trading System) basket.

Turning to the US, there has been much discussion of the risk of an economic recession, but we don’t expect that to occur. Economic growth remains relatively well established, global growth patterns considered.

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The severe drop in equity prices raised concerns of recession risks in the US. However, our assessment of today’s key economic variables suggests that the economic growth cycle remains on track—although continued financial market disorder would pose a risk to the expansion at some point.

In fact, our research has found that three leading economic indicators—the ISM New Orders Index, building permits and jobless claims—stand out for their consistency in highlighting inflection points in the US business cycle.

The New Orders Index, which we show in the left-hand display, has recently been added to The Conference Board’s index of leadingeconomic indicators. The new orders index suggests continued moderate economic growth. If recession risk were relatively high, New Orders would already be well below the all-important threshold of 50 for several months, and the eventual drop would be substantial.

Jobs growth has been a big part of the US economic story, and that has continued. Jobless claims sit near forty year lows. Here, we are showing the path of the unemployment rate. However, while job gains have been a fairly consistent positive, wage gains have been less clear. A common indicator for wage gains is found in the average hourly earnings reported by the BLS.

However, in our opinion average hourly earnings data is of poor quality---it’s not a direct measure of wages/the proportion of companies that report aggregates wages is less than half that provide jobs and hours; and it excludes some forms of compensation.

A pure measure of wage growth is seen in the quarterly report on employer costs for employee compensation. This series is reported by the companies and there is no adjustment for occupation or industry shifts (ie, capturing if workers are moving to higher paying occupations and industries that is being captured). As you can see, this measure of wage growth tracks job growth quite closely, and paints a more positive picture of earnings growth.

Lastly, key housing market data is also signaling continued moderate economic growth. The US Census Bureau series on buildingpermits in the right display captures the ups and downs of one of the most important cyclically sensitive sectors—residential construction. Building permits tend to decline long before the economy does—sometimes a year or more before. Instead, in the fourth quarter of 2015, building permits reached their second highest level since 2007.

Along with building permits, we are showing house prices, which among other things relates to the “wealth effect”, which includes financial as well as durable assets (such as housing) . Significant equity declines have often preceded negative economic outcomes, but they’ve also happened when no economic fallout occurred. And household ownership of stocks is much less widespread than home ownership. When asset cycles unwind abruptly, like housing did in 208, it can trigger big adjustments in the economy.

But 2016 isn’t 2008. Back then, both home values and equity prices tanked—and there was a lot more leverage in household balancesheets to unwind. Today’s real estate values aren’t as inflated as those in 2008, and house prices are rising roughly 5% nationally. Household financial obligations are also near lows of the past 35 years—compared to a record high of 18% in 2007, in part reflecting the lower interest cost of things like home purchase and/or refis.

All of this suggests that the wealth and cash positions and psychological outlook of the average household will not be jarred anywhere near as badly as happened in 2008. And while there might be some temporary pullback on consumer spending from high-end consumers, we expect the impact to be short lived and relatively small, unless the equity spiral continues downward.

But investors shouldn’t expect a capital market experience that resembles the multi-year rally that extended through most of the post-Global Financial Crisis period.

After years of strong market returns, we think this “great beta trade” has likely concluded. And based on our return outlook, most asset classes will produce below-average returns in the years ahead.

On the left, we compare the expected returns for major capital-market segments, including equities and bonds. For bonds, we compare currently available yields—generally a good proxy of forward returns over a few years—to their average annualized returns over the past five years. Municipal and investment-grade bond yields are lower today, and so are expected returns. High-yield bond yields offer a higher expected return, although below their five-year average returns.

We also show expected returns for both US and non-US developed market stocks, which are likewise substantially lower than their experience of the last several years. We’ve also included last quarter’s expected returns, too, so you can get a visual sense of how the market selloff has bumped up expected returns pretty much across the board. But returns ae still likely to be well below recent experience.

What happens when we plug our expected returns into a classic balanced portfolio allocation of 60% stocks/40% bonds? We end up with an expected return of between 4-5%. That’s a pretty sobering expectation. Volatility is a big question mark, but it will most likely be higher—as recent experience has brought home.

The bottom line is that investors face a very different beta world as we move forward, and they’ll need to adopt strategies and active approaches that can enhance portfolio returns. Let’s start with fixed income.

Thursday, April 07, 2016

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Here, we’re showing a broad spectrum of the credit markets. We’re comparing the current yield spreads (represented by the diamonds) to the high and low end of the yield spread over the past three years. At these levels, which are still above the 3-year average in many sectors, we see attractive opportunities. But because we’re late in the credit cycle, we view the opportunity in credit not as an “all-in” play, but as a selective buying opportunity in diversified strategies.

For example, as you see in the first few columns, US high yield corporate bonds are attractive, even excluding the energy sector, where the distress has been most severe. In high yield, we continue to favor higher-quality bonds over the CCC-rated segment. CCC-rated high yield does offer attractive spreads, but since we’re late in the credit cycle, defaults are a meaningful risk factor in this segment. Moving to the right, US investment grade corporates look moderately attractive—with spreads around the average of the past 3 years.

Securitized assets look even more compelling in our view. Fundamentals in the space strong as the real estate markets in the US continue to recover. And spreads remain above average, as the high yield selloff spilled over to these markets.

We also see select opportunities in the emerging market space. For instance, valuations in EM local bonds became more compelling after the recent selloff. EM corporates are also attractive; however, we recommend that investors focus on companies which are less vulnerable to currency volatility (such as exporters). Being very selective in both EM sectors is critical.

Valuations in many sectors ended the quarter close to the levels where they began it. But that masks the volatility we saw, because valuations widened dramatically in January and early February, only to rebound in late February and March as sentiment improved. But the rebound hasn’t removed the opportunity, as we show on the next slide.

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On the left, we address a big question many investors are asking after the recent high yield rebound: did they miss a good entry point into additional high yield exposure?

We don’t think so. In fact, even though spreads have come in quite a bit from their recent peaks, they were still at about 650 basis points at the end of the first quarter. That’s about the same as they were at year end—and we were calling them attractive back then.

At current spread levels, high yield bonds have historically translated into attractive returns. In the middle display, we’re looking at the average subsequent six-month and 12-month returns for US high yield from various spread starting points. When spreads were between 600 and 800 basis points (which is the case now), high yield returned an average of 0.65% over six months and 6% over 12 months. Those numbers far outpace the returns of the S&P 500—a proxy for a passive equities.

If spreads widen again, the return could be even more attractive—when spreads are above 800 basis points, high yield has historically produced an average of more than 17% over six months and more than 30% over 12 months.

High-yield investors who are focused on the longer horizon can take comfort in this fact: historically, the current yield to worst is a good indicator of the type of returns investors can expect over the following five years. Today, that yield is around 8%.

Furthermore, high yield has been a pretty resilient asset class over the years. In fact, 2015 was only the fifth year in over 20 years that the high yield market posted a negative total return. And high yield typically rebounds swiftly from down years, with strong returns.

Of course, there are challenges in today’s high-yield market, although we’ve found them to be concentrated in specific sectors.

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While ”risk on” sentiment returned recently and high yield delivered solid returns in the second half of the quarter, volatility is likely to stay. However, we don’t expect a sustained broad market selloff. Instead, we think volatility will be concentrated in the commodity-related sectors, much like it was last year.

In 2015, the US high-yield market was down, but the impact came largely from energy and other commodity-related sectors such as Metals and Mining, which fall under Basic Industry in the left display. Other sectors posted positive returns for theyear.

This is a very different from 2008, where the massive selloff was very broad-based, with every major high yield industry down well into double digits. 2015 was actually a lot more like 2002, with a couple of struggling sectors pulling down the overall market. In 2002, it was communications—largely a telecom issue—and transportation, driven by an airline selloff after 9/11. Utilities also posted very weak returns, mostly due to company-specific events.

As we moved into 2016, volatility in high yield was again driven largely by energy, which we show in the middle display. Both the early selloff and the subsequent recovery were led by energy issues. The balance of the high-yield market saw much less severe swings.

Defaults in 2015 were likewise concentrated in the energy sector, just as they were concentrated in telecom in 2001 and 2002. Going forward, we expect defaults to remain concentrated in the energy sector. In fact, we think that over the next twoyears, approximately 20% of energy companies could default each year. Much of that, however, has been already priced into the market. Outside of the energy sector, default rates are expected to remain below their historical average.

There are some valid investor concerns over corporate fundamentals—such as the upward trend in gross leverage. But in our view, even though credit is in the late stages of the cycle, market excesses are mostly limited—the most recent increase in leverage has been less about companies levering up to engage in risky leveraged buyouts. Instead, the leverage increase has been more organic—CEOs are finding projects with attractive ROIs and taking advantage of cheap financing to fund them. Also, the issuance of riskier CCC-rated paper remains well below its 2007 peak.

So, there are opportunities across high yield for active managers able to do their credit homework on individual issuers—because not all lower-rated securities are created equal.

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The left display shows one of the reasons we see better value in higher-quality credits than in lower-quality issues. Prices are cheaper for lower quality bonds—CCC bonds now trade at around 76 cents on the dollar as a group. But cheaper prices still don’t compensate for their historically high default rates. The historical cumulative five-year default rate for B-rated bonds is about 22%, but it’s 36% for CCC and lower-rated bonds.

We think there are more attractive opportunities in other parts of the market, such as mortgage-backed securities (MBS). Unlike many corporates, real estate in the US is at an earlier part of its cycle. Borrower fundamentals are strong, with high credit scores. Default rates, which had spiked during the crisis, have come down significantly. You can see this from the blue line in the middle display. Also in the middle display, we show steadily rising home prices; higher home values provide another big incentive for homeowners to stay current on their payments.

MBS also provide a less volatile source of diversification. Not only do they have low correlation to other fixed income sectors, but to equity as well. We can see an illustration of this if we look at the right hand display, which shows option-adjusted yield spreads for high-yield corporate bonds and high-yield residential mortgage-backed securities—in this case credit risk transfer securities.

Late last year, when Third Avenue Management’s Focused Credit Fund collapsed, high credit spreads across sectors widened in response. Spreads in the high yield corporate market widened from the lower to mid-600s to nearly 700 basis points. High yield MBS, on the other hand, widened by less: from about 465 to 485. By the same token, when high-yield spreads compressed significantly in the second half of the quarter, mortgage spreads compressed less.

Let’s turn the focus now to interest rate exposure, where we think policy divergence between the US and other countries makes a strong argument for going global.

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First, a reminder of why interest-rate risk is important to a well-balanced bond strategy. It helps reduce the correlation of a bond portfolio to equities, making it an effective counterbalance. So, you need some duration in your bonds.

But despite a decidedly dovish stance lately, the US Federal Reserve is still likely to make additional rate hikes this year. With US rates likely headed upward, albeit slowly, we think it makes sense to diversify your interest-rate risk away from exposure to only the US bond market.

In the left display, we show the various expected official interest rate paths globally. Many central banks are expected to stay stable or cut official rates, including Australia, the Euro Area, Japan, Norway, Sweden, Canada and the UK. The US, on the other hand, has begun raising rates. We’ve also seen hikes in Brazil and Mexico.

This type of divergence in monetary policies means that (currency hedged) global bonds provide a better upside / downside capture than single country bonds. This is illustrated in the middle display.. Hedged global bonds have captured most of the upside from rising US bond markets while reducing the downside in selloffs. Going back to 1990, the average return for the Barclays US Aggregate Index in positive quarters has been 2.3%; during the same time period, global bonds (hedged to USD) nearly match that with a return of 2.2%. The average return for the US Aggregate in down quarters has been –0.9%; global bonds (hedged to USD) have declined by only –0.7%. The improved downside of a global portfolio is a key today, with official rate increases expected to continue in the US.

But when investing in global bonds as an equity-risk-reducing strategy, it’s important to hedge out non-US currency exposure. Currency adds a lot of volatility to global bond returns without adding return over the long run. We think it’s better to hedge nearly all foreign currency exposure to US dollars (or another home currency) and take very select currency positions backed by strong conviction and research. Adding such a hedged global bond strategy to a fixed-income portfolio creates a more attractive risk/return patterns for investors.

But why should US investors diversify their exposure globally when many yields outside the US are lower than those offered by US Treasuries, as you see in the right display? This chart looks at various 10-year government bond yields and their US dollar hedged yields. Many investors consider 10-year US Treasury yields low, but yields in other countries such as Germany or Japan are even lower. However, the impact of currency hedging impacts the yields investors actually realize.

Here’s how. Currency hedging involves selling the cash rate of the currency you’re hedging from and buying the cash rate of the currency you’re hedging to. Depending on where relative short-term interest rates are, hedging can either raise or lower a country’s bond yield. For low-yielding countries, it can make yields more attractive. You can see that in German yields, which rise from 15 basis points to 126 basis points, and in Spanish yields, which rise from 143 basis points to 254 basis points. In countries like New Zealand and Australia where cash yields are higher, the result of currency hedging is to lower the realized yield.

Now, let’s take a look at the landscape on the tax-exempt fixed income side, with a closer look at the fundamentals in municipal bonds.

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There’s been a lot of hand wringing and headlines about the few trouble spots in the muni world, including Chicago and Puerto Rico. But we see those as outliers, and munis have pretty much been a “Steady Eddie” sector.

One potential source of concern for municipal bond investors is too much supply potentially pushing prices down. There’s a substantial amount of gross issuance in the muni market, but a sizable amount of the issuance is related to bond issues being refinanced to take advantage of relatively low interest rates today.

If we look at the change in net new issuance after refinancing has been accounted for in the left display, it’s actually been negative for five years in a row. And muni demand remains strong, as you can see in the middle display, which shows the fairly steady flows into municipal bond funds over the past couple of years.

And muni credit fundamentals continue to show strength, as we show on the right with the steady growth in federal and state tax revenues since the global recession. As US GDP has recovered and the economy has continued to expand, more jobs and more income translate into increased revenue, which bolsters state and municipal finances.

So, there’s a lot of opportunity for solid risk-adjusted returns in the municipal space, but we think active management is critical in navigating the market. For one thing, transaction costs are higher, so it makes sense to work with a professional investor who can trade most efficiently. Also, it can be difficult to source bonds, since the market tends to be fragmented. This takes legwork and relationships. What’s our assessment of muni opportunities today?

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Munis remain attractive today on pound-for-pound basis versus most taxable bonds. But positioning along the muni yield curve can make a big difference in return potential, because the areas with the most value vary along the maturity spectrum.

In this display, we look at muni strategies to consider, with the combination of yield and roll at different maturity ranges grouped into short, intermediate and long-term. We’ve talked about the power of roll for some time. It’s the natural price gain a bond experiences as it moves closer to maturity, assuming interest rates don’t change. Roll varies considerably based on where you are on the curve.

We think credit exposure makes sense at longer maturities, simply because investors essentially have to take on longer-term bonds to access much of the available credit supply. By dipping down in credit quality in long bonds, investors get not only modest yield pickup, but lower interest rate sensitivity versus higher quality bonds.

From a high-grade perspective though, we still see the “sweet spot” of the yield curve as intermediate maturities, in terms of combined yield and roll potential. For a 10-year A-rated muni bond, the combined potential of yield and roll amounts to about 3.4%.

Using roll may enhance returns, but there are risks associated with investing in bonds for a longer period of time, including interest-rate risk. Again, that’s why we focus on the “smart” part of the curve in munis. For instance, yield plus roll is about the same for a 10-year bond as a 30-year bond, which carries significantly more interest rate risk and volatility!

At the short end of the municipal bond yield curve, there are challenges with a lack of municipal supply and resulting low bond yields. At this range, investors’ tax brackets come into play, and in some cases taxable bonds may be a better—or at least equal—choice.

Now, let’s turn to equity markets. One of the most immediate concerns for investors is the likely modest level of returns from equity market exposure. We think active management can help.

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As you see in the left-hand display, the sources of equity returns vary over time. From June 2009 through June 2012, earnings growth was the predominant return driver. On average, dividends provided a modest contribution, and valuations contracted, which cost a little over four percentage points on an annualized basis for the period.

The composition of returns was very different from mid-2012 through the end of 2014. Valuations rose considerably, providing much more return contribution than both dividends and earnings growth combined. So, where does that leave us going forward?

We think earnings growth will be the main driver of equity returns as we move forward. Our quantitative team’s analysis for the next five-year period suggests that the total return for stocks will be relatively muted at 5.9% annualized. So, investors will need to look toward active management to enhance returns that are no longer going to be in the double digits. Of course, active has been out of favor and somewhat challenged recently, but the display on the right puts that difficult stretch into context and provides optimism about its future potential.

We’re looking at the relative performance of active US large-cap equity strategies in different return and valuation environments. As you can see, active managers have historically underperformed when markets are rising rapidly on the back of multiple expansion—precisely the environment we have experienced in recent years.

Add to this that many managers typically carry a bit of cash and international stocks, and typically maintain a small-cap bias, all recent performance drags, and you start to see why the past few years have been so challenging for active management. Based on our left-hand chart, it’s not likely that this scenario will be extended going forward. As we’ve been saying, return expectations are more muted, and earnings—not multiple expansion—will be the key to returns.

So, we’ve just seen a cycle in which the deck was stacked against active managers. If historical patterns play out again, the hand for active management should be better as we move forward.

But investors need to be prepared to navigate bouts of volatility. As we show in the left display, equity markets saw big moves during 2015—there were 25 days in which the equity market moved by 1.5% or more. And 2016 looks like it picked up where 2015 left off, with 15 “big move” days in just the first quarter.

In addition to volatility at the broad equity market level, we’ve also seen it in equity sector return patterns, which we show in the right display. So far in 2016, defensive sectors have been in favor, with telecom and utilities snapping back after lagging during 2015.

Perhaps in response to the volatile period in equity markets, investors have gravitated toward perceived safety stocks.

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As a result, safety is expensive while profitability isn’t. You can see that illustrated in the left display: safety stock valuations (using the MSCI Minimum Volatility Index as a proxy for low-beta stocks), in terms of price/earnings ratios, are in the 81st percentile in historical terms—so “low beta” stocks are quite expensive. Contrast that with profitability stocks, as represented by cash return on assets, which are in the 35th percentile historically.

In the right display, you can see clearly that dividend growth is quite cheap relative to dividend yield. Essentially, investors are paying up for companies offering high current yields over firms that have the ability to grow dividends over time. It’s a “now” focus we’re seeing in equity markets. We don’t think investors should allow themselves to be romanced by dividend yielders. Right now, the equity landscape favors profitability and growth.

Of course, given the environment, it’s pretty challenging for companies to find growth today.

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Considering the moderate pace of the global economy, where profit margins aren’t likely to continue expanding and valuation multiples don’t have a ton of room to expand further, growth is slowing. It’s getting progressively harder for companies to find growth.

As we show on the left, the trend in S&P 500 revenue growth has been slowing recently. With less ability for top-line sales growth as a driver, firms will be significantly challenged in trying to deliver sustainable earnings growth.

In fact, as we show on the right, a good portion of S&P 500 companies have been reporting negative revenue growth. Based on 457 of 502 companies reporting 4Q 2015 earnings through early March 2016, 56% of reporting companies checked in with negative revenue growth. That’s over half the index! Also note that 21% of companies managed to post 10%-plus revenue growth.

So consistent and sustainable growth isn’t impossible to achieve—and it can be very rewarding for those who do achieve it. Such a binary growth backdrop can establish fertile ground for active managers, whose sound research can identify attractive stocks for their investors.

On the left, we’re looking at the top 1,000 companies in market cap over the last 35 years or so. How many maintained high annualized earnings growth rates of 10% or above annually?

Over one year periods, a fair number of companies did it: 350 of the 1,000 companies we looked at. And those companies collectively outperformed the S&P 500 Index by about 1% annualized. Sustaining growth over a three-year period gets a lot harder: only 77 companies did it, but they beat the S&P 500 by 1.2% annualized. And over a five-year period, only 22 companies were able to do it, but they beat the S&P by a whopping 2.7% annualized.

And the market is pricing these companies very attractively right now, making persistent growth fairly cheap. On the right, we show the relative price/forward earnings ratio of high-persistent-return-growth stocks versus the market. Historically, these stocks sell at about a 15% premium to the market. Right now, they’re priced well below this historical average. We think this is a great opportunity to pick up quality, profitable companies at cheap levels.

The key, of course, is using active management to identify and capitalize on good companies, while avoiding trouble spots.

One place where we’re seeing substantial opportunities with good companies is in the small-cap space, where valuations are more attractive today.

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Smaller US stocks were hit harder than their large-cap peers over the last nine months, and especially so during the January sell-off. We think the harsh treatment is unwarranted and a strong recovery could be in the cards when risk appetite returns.

Sharp downturns in equity markets are never kind to smaller-cap stocks. As we show in the left display, since July of 2015, the Russell 2000 Index of smaller-cap stocks has fallen by 10.1%. The Russell 1000 Index of larger-cap stocks has actually risen by the small amount of 0.4% over the same period. The slump wiped out the strong performance gains that small-caps had been enjoying over large-caps since the financial crisis in 2008.

We show the after-effects of that selloff in the right display. After the correction, valuations look attractive, in our view. When compared with large-caps on several metrics, the relative valuation of smaller stocks hasn’t been this low since the end of 2003.

But investors are still wary. Smaller names are still seen as much riskier. Do all smaller-cap stocks really deserve such a bad reputation? We don’t think so. Although US smaller-caps are risk assets that will be vulnerable in market drawdowns, if you choose the right companies, with solid fundamentals, they aren’t necessarily as dicey over the long term as many investors believe.

When choosing smaller stocks, bottom-up research into the sources of a company’s business advantages and earnings potential should be the focus, even when markets are fixated on economic trends. That principle is perhaps even more valid today. By focusing on a small slice of the market with much stronger fundamentals, active managers can scoop up stocks with more resilient characteristics and better return potential at attractive valuations.

If investors focus on high-conviction, active approaches to equity investing, we think it can make a big difference to their experience over the long run.

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On the left, we’ve focused on five specific equity investing strategies geared to different factors: dividend yield, value, quality, low beta and momentum. As you can see from the light green bar, passive index strategies targeting these factors for the most part outperformed the S&P 5000 Index over the last decade or so.

We focused on managers who reported holdings for at least three years and were in the top 20% of our high-conviction metric in each of these categories at least 60% of the time. Then, we identified skill by extracting managers who delivered above-median returns for the period in which they reported. In some years, that top-half manager didn’t beat the benchmark, but was still included in our universe.

To those who say, “why not just invest in a passive factor strategy?”, I highlight the darker bars, which show the excess returns of those skilled managers. Over this time period, skilled, high-conviction managers on average produced returns that could have reasonably outperformed their fees: 1.6% for value managers and 2.4% for low-beta managers, for example.

In an environment of relatively muted equity returns, the ability to find an active manager that can outperform becomes much more important to meeting long-term goals. Even modest alpha can go a long way, which we illustrate on the right.

An investor who put $100 in the market would receive a substantially different return by generating more than the expected equity forecast each year. The dark green line shows the hypothetical growth of a dollar from equities returning 6% annually—similar to what we expect going forward. A portfolio that beats the market by 2% and produces 8% returns per year would increase the ending wealth accumulation by 21%. And if 3% alpha raised the return to 9%, the ending wealth would be 32% higher than it would be at a 6% return rate.

In today’s environment, we also think there’s more value in return sources that differ from those of traditional stock and bond patterns. This takes us into the realm of alternative investments, and how investors can deploy them to improve their upside/downside balance.

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If we look at the performance of the Multi-alternative manager universe in the left display versus the S&P 500 in different periods of second half underperformance, we see a pretty effective job of downside protection.

If we look at 2015’s max drawdown, for example, the S&P was down 8.4% and multi-alternative managers a little more than half that amount. So, alternative strategies generally did provide the downside protection many investors are looking for, and they did it with lower volatility than traditional assets.

One place we see higher numbers in alternatives is return dispersion—the size of the differences among managers’ returns. The higher the dispersion, the more variability in return experiences within a category. Alternatives’ dispersion has been wider than that of traditional categories over the trailing three-year period, as we show on the right. Large-cap blend dispersion, for example, was 5.7% while long/short equity was 7.8%. However, that was largely during the beta trade.

That dispersion jumped up substantially—in absolute and relative terms—over the last half of 2015 and into the first quarter of this year: large-cap blend dispersion was 12.8% while long/short equity was 19.4%. The broad lesson from this is that the large number of investment choices/approaches that alternatives use (often in lieu of market risk) creates enormous return dispersion amongst offerings. Investors need to do a fair bit of legwork to understand a manager and its strategy—and to determine which performance profile makes the most sense for your specific portfolio.

If investors do that homework, there are a lot of potential opportunities for alternative strategies, as the market environment is becoming more supportive of the relative value (long/short) that many of these strategies seek to exploit.

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We see one example on the left that highlights opportunities in the credit space. The distributions of returns in 2015 for high-yield corporate bonds, investment-grade US credit and global credit universes are substantial. This illustrates that in addition to the market risk, or “beta” opportunities in US credit, there are also meaningful relative value opportunities across credits.

And on the right, you can see the increase in the volume of M&A deals has risen substantially since 2013. The reason is macroeconomic fundamentals—low oil prices, low funding costs and robust corporate balance sheets.

With revenue growth otherwise challenged in a low-growth economic environment, corporate deals continue to offer potentially compelling solutions for companies. As a result, corporate activity remains at near-record highs across a variety of areas, including spinoffs and merger activity.

However, two factors: 1) greatly reduced proprietary capital following the financial crisis, and 2) heightened regulatory scrutiny of M&A deals given politically charged concerns of “tax inversion deals”, led merger, or risk, arbitrage strategies to struggle in 2015. However, the continued increase in deal volume, as well as the extremely high spreads available entering the year (approximately 12%) have led to increased investment and strong performance in the first quarter as spreads compressed by approximately 400 bps –and yet there is still significant “room to run” relative to history.

So, how do we tie all of this asset-class-specific advice together into a broader portfolio context?

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Within equities, the buzzword is “be active.” We expect muted market returns over the next couple years, so the real value is in the ability to differentiate between winners and losers as divergences happen.

For us, that means focusing on high-conviction, more-concentrated strategies. In addition, we’d suggest pursuing stable and consistent return sources as we’ve described—by their nature, these provide downside protection. And we think an overweight to developed markets makes sense.

On the fixed income side, the buzzword is “be balanced.” We continue to suggest a balance between risk-reducing high-grade interest-rate risk—global and US core strategies—and return-seeking credit-based risk, with a global, multi-sector approach.

Within high-grade, the focus should be on which country yield curves and where on those curves to invest, but the currency exposure should be hedged to reduce volatility, which can be considerable—as seen in the divergent currency returns earlier.

Within credit, our best idea remains diversification, including avoiding stretching for yield in areas such as energy debt and CCC-rated corporate bonds. And finally, it’s important to manage liquidity risk—the changing cost of security transactions across markets.

This idea of downside protection is why we see value in including alternatives over the coming years. But we think the exposures should focus on relative value strategies and strong up/down capture structures and approaches.

Of course, this suggested approach is based on our expectation of moderate global growth and largely benign inflation. What if we’re wrong? What type of position would you take (or use as a hedge) if you thought there was a possibility that we’d see resurgence in growth and inflation? That’s what we’re showing in our “contrarian corner.”

If the economy grows faster than expected, equity exposure would favor a more cyclical approach, such as value, as well as lower quality sectors like financials and energy. In fixed income, we’d suggest a tilt toward a bit more credit risk, but still avoid stretching for yield.

If the economy grows slower than expected, equities should emphasize income and quality attributes, while fixed income should tilt more toward interest-rate exposure and remain global.

Thank you. I’d be happy to take your questions now.

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