THINKING DIFFERENTLY - SSGA...THINKING DIFFERENTLY Ideas for a Low-Growth World MASTERING VOLATILITY KEYS TO IGNITION EUROPE OUTPERFORMS CREDIT WHERE IT’S DUE TOO EARLY TO CALL TIME

THINKING DIFFERENTLYIdeas for a Low-Growth World

MASTERING VOLATILITY

KEYS TO IGNITION

EUROPE OUTPERFORMS

CREDIT WHERE IT’S DUE

TOO EARLY TO CALL TIME

Volatility will be here for a while yet. What happens next?

A trio of factors hold the key to success in Emerging Markets.

Conditions are good for European growth. How can you profit from it?

Investment grade and high yield hold promise for 2016.

US earnings appear to have stalled but there’s still room for growth.

MORE FROM YOUR COREHow to shape your portfolio for the world ahead.

OUTLOOKWhat does 2016 hold for the world’s economies and markets?

04THE OUTLOOK FOR THE MAJOR ADVANCED ECONOMIES10THE OUTLOOK FOR EMERGING MARKETS14THE OUTLOOK FOR CHINA16MARKET OUTLOOK

Today’s low-growth world brings new challenges for all investors.To succeed, investors will need to act and think differently.State Street Global Advisors brings you the themes that matter in 2016.

Outlook

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MORE FROM YOUR CORE 20

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01 Portfolio Construction

04 US Earnings & Equities

A Third WayFactorizing the Total PortfolioThe Global Factor Outlook 2016Putting It All Together

What Next for US Earnings?Some Headwinds are TemporaryWhile Others are More Persistent

21222425

353637

39404041

26MASTERING VOLATILITY02 Equity Market Risk

What to DoWhat Might Cause Volatility in 2016?

2728

KEYS TO IGNITION05 Emerging Markets

A Waiting GameKey EM Growth CatalystsIs It Different Now? It Might BeReforms to Watch

42CREDIT WHERE IT’S DUE06 Fixed Income

Uncertainty and FragmentationEmerging Market DebtTaking Credit in 2016

434545

30EUROPE OUTPERFORMS03 European Equities

Where’s Europe Now?How to HarvestConvinced but Cautious?

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Ideas for a Low-Growth World

03State Street Global Advisors

For a year that was supposed to be characterized by accelerating growth in the world economy, 2015 was slow to get out of the starting blocks. So instead of the global economy growing by half a percentage point more than in 2014, the outcome has been largely the same. This disappointing result partly reflects another poor first-half performance in the US, but a deterioration in the emerging markets large enough to damage the broader global environment was the principal driver.

There’s a cold draft blowing from the emerging markets, holding back growth and complicating policymaking in the advanced economies.

Ɇ Slower emerging market growth has put downward pressure on oil prices, hitting employment and investment in the energy sectors of oil-producers like Canada and the US. Indeed, the effect was large enough to push the former into a brief recession.

Ɇ The slowdown has reduced the demand for developed market exports, dampening output in manufacturing sectors around the G7.

Ɇ Capital has flowed out of the emerging markets, boosting the exchange rates of the advanced economies, in turn reducing their competitiveness and exacerbating the problems in manufacturing.

Ɇ Balancing the impact of domestic strength against the influence of weakness in other economies has complicated policymaking. This was particularly so in the US, where the Federal Reserve has been eager but until now “afraid” to move administered interest rates off the zero lower bound.

Rick Lacaille Chief Investment Officer

Weak Cycles, Bad Trends

THE OUTLOOK FOR THE MAJOR ADVANCED ECONOMIES

Low and SlowUnfortunately, conditions are unlikely to change much in 2016. The weakness of manufacturing in the major economies would seem to limit the upside, while the strength of other more domestically focused sectors would appear to limit the downside. It’s a scenario that leads us to project more of the same: lackluster growth, low inflation and limited policy tightening. Moreover, we continue to see the risks as skewed to the downside, likely fueling bouts of investor uncertainty and market volatility.

The US Economy in Decent HealthIn the US, growth accelerated to 3.9% (annualized rate) in Q2, with retail sales, vehicle sales and housing starts rebounding robustly. Business investment picked up, while trade made a positive contribution to growth. The unemployment rate moved down towards 5%.

Growth slowed sharply in the third quarter because of lower inventory accumulation and will likely struggle to regain momentum as the effects of a stronger dollar on exports and manufacturing are felt.

Lower oil prices have implications for energy exploration, while the still-elevated level of business inventories indicates that sales are not keeping pace with company expectations. Moreover, given the twin-speed nature of the economy (robust services, anemic manufacturing) there are few grounds for assuming much will be different in 2016.

We continue to see the risks as skewed to the downside, likely fueling bouts of investor uncertainty and market volatility.

Global US

Growth Forecasts

3.2% 2.5%3.3% 2.5%

2015 20152016 2016

The US — A Twin-Speed Economy

Source: Institute for Supply Management, as of 31 October 2015.

Jan 2013 Sept 2013 Jan 2014 Sept 2014 Jan 2015 Sept 2015

US Non-Manufacturing Purchasing Managers’ IndexUS Manufacturing Purchasing Managers’ Index

62

64 Diffusion Index

60

58

56

54

52

50

Inflation Benign Despite Falling Unemployment

Source: US BEA, Federal Reserve, as of September 2015.*Personal Consumption Expenditures. **Excluding Food & Energy.

2010 2011 2012 2013 2014 2015

US Core** PCE Price Index, % chg y/yUS PCE* Price Index, % chg y/y

2.5

3.0

3.5

2.0

1.5

1.0

0.5

Fed Target

Percent


A Cautious FedThe Fed is eager to lift interest rates. After all, zero interest rates were entirely appropriate when the economy was contracting and unemployment heading to 10%, but not now, when the economy is expanding and unemployment is 5%. However, liftoff was initially delayed because the weak first quarter posed questions about the economy.

The expected September liftoff then failed to materialize because, according to the Fed, “recent global economic and financial developments … [might] restrain economic activity somewhat and … put further downward pressure on inflation in the near term.”

While it would have been nice to get the federal funds target rate moving higher, it was not absolutely necessary to do so in September. Inflation pressures are virtually absent, so the risks of undermining growth, contributing to financial market volatility, or having to reverse direction in short order were simply not worth taking.

However, given the unexpectedly strong October employment report, we expect the Fed to lift off with a 25 basis point hike in December, and follow that with four more increases next year.

SIGNAL FOR THE FED: STRONG JOB CREATION

Source: US Bureau of Labor Statistics, as of 31 October 2015 The numbers above reflect the month-to-month changes for non-farm payrolls.

201266

119187

260245

223153

137271

Jan 2015

Thousands

Feb 2015

Mar 2015

Apr 2015

May 2015

Jun 2015

Jul 2015

Aug 2015

Sept 2015

Oct 2015

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Global Market Outlook 2016

The eurozone recovery has gained some traction. GDP has risen by 0.4-0.5% in three of the last four quarters, helped by a near-20% fall in the euro against the US dollar and an oil price decline of almost 60% since the middle of 2014. Immediate concerns surrounding the European banking system were eased by the Asset Quality Review, while the European Central Bank’s (ECB) €1.1 trillion asset purchase program has helped headline money supply (M3) grow at its 5% reference rate.

Euro consumers begin to spendThe latest acceleration has largely reflected a pickup in household consumption and an improvement in net exports. Retail sales surged to multi-year highs and international trade finally contributed to growth in Q2 after being largely neutral over the previous year.

The contribution from capital investment has been more mixed. Most importantly, however, the quality of growth has been good, with inventories remaining well behaved. We expect GDP to expand 1.6% in 2016, up from 1.4% in 2015 (see chart below).

Structural flaws revolving around relative competitiveness may preclude a protracted period of robust growth. In a monetary union like the eurozone, maintaining competitiveness against other members is crucial because there are no exchange rates to adjust for any loss, leaving uncompetitive countries to underperform. In the absence of fiscal transfers between nations within the union to compensate for the problem, such underperformance tends to persist.

Higher interest rates not on the horizonThe ECB has reacted to dangerously low inflation, slow money growth and the ongoing contraction of private sector credit with rate cuts (with the deposit rate going negative), targeted long-term refinancing operations, and asset purchase programs for covered bonds and asset-backed securities.

In early 2015, it introduced its Quantitative Easing (QE) program. If the downside risks to global growth materialize, the ECB may even increase the size and/or duration of the program beyond the September 2016 time frame.

3%

0.5%

2%

1.6%

0.9% 1.6%1.4%

FORECAST

-4.5%

-0.8% -0.5%

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

EUROZONE GROWTH TO TREND SLOWLY HIGHER

Source: SSGA Economics Team, Oxford Economics, as of 31 October 2015.

Eurozone Gains Traction


Japan — More Work to DoJapan’s recent economic past has been heavily affected by consumption taxes. The three percentage point increase in April 2014 to 8% was followed by two quarters of economic contraction and a suspension of plans to increase it to 10%. The economy grew 1.1% in the first quarter of 2015, but the quality of growth was poor. Inventories accounted for a good proportion of the gain, causing some payback in Q2 when GDP slipped 0.3%.

More recent data have been mixed, with the labor market remaining tight and retail sales recovering. But manufacturing lacks any real momentum, partly because exports have suffered from the slowdown in China. Hence, while we expect growth to re-accelerate, it is likely to reach only 0.8% in 2015 before picking up to 1.2% in 2016.

Because of the lack of progress toward the Bank of Japan’s (BoJ) 2% inflation target (the target variable — national core consumer price inflation — is currently running at -0.1% year over year), we expect it either to increase the size of monthly purchases, and/or adopt a new target, which eliminates the effect of lower oil prices on the inflation calculation.

Stubborn Absence of Inflation to Trigger More QE?

Source: US BLS, as of September 2015.

2010 2011 2012 2013 2014 2015

Japan CPI, % change y/y

Japan CPI, excluding fresh food (core) % change y/yJapan CPI, excluding food & energy % change y/y

Percent

-1.0

0.0

1.0

2.0

3.0

4.0

-2.0

Official Target

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Back in the late 1990s, economists — excited by the technological revolution they saw around them — spoke about a “new US economy” that could perhaps grow 4% a year on a sustained basis. While we never quite bought in to that, it was widely accepted that the US economy’s trend (or potential) growth rate had accelerated to somewhere in excess of 3%.

Now the Fed seems to think it is no more than 2%, and recent data on productivity and employment suggest it could be even lower. Indeed, by some estimates, potential growth has dropped to zero.

Some slowdown in potential was to be expected given the aging of the baby-boom generation, but that appears to have been accentuated by an unexplained reduction in labor force participation among prime-age adults. (Underinvestment in capital equipment may also be contributing.) In any event, the economy has grown by almost 39% since 1999, an average of just 2.2%, compared to 3.5% between 1947 and 1999.

What makes this trend so alarming is that the two other major advanced economies are not picking up the slack. The eurozone matched the US between 1999 and early 2008 (although part of the increase in eurozone GDP reflected the inclusion of new members, most notably Greece in 2001). But the region’s GDP has only recently returned to its 2008 peak and is only 26% higher than in 1999.

Japan has fared even worse, having suffered through numerous recessions including two since the global financial crisis (the first because of the earthquake in March 2011 and the second because of the VAT hike in April 2014.)

Hence, while US growth has slowed, its economy has still expanded by 50% more than the eurozone and 200% more than Japan over the last 16 years.

LOWER AND SLOWER FOR LONGER

A NEW NORMAL?The International Monetary Fund seems to be caught in a loop of predicting that growth “next year” will increase by 0.5%. In its October 2015 World Economic Outlook, it forecasted that the world economy will grow by 3.1% in 2015 and 3.6% in 2016. In October 2014, it had predicted growth of 3.3% in 2014 and 3.8% in 2015.

Interestingly, it is projecting that in 2016 growth will accelerate faster in emerging markets (from 4.0% to 4.5%) than in the advanced economies (2.0% to 2.2%).

The downside risks to growth are seen as emanating primarily from the emerging markets, so the anticipated improvement there is far from guaranteed. Indeed, we are quite skeptical. Chinese growth could easily fall short of IMF expectations.

Even if the IMF forecast proves correct this time, 2016 will become the fifth consecutive year of below-average global growth. This would be the first time that has happened since the early 1990s, when the world was rocked by the first Gulf War.

There has been a debate about whether this sluggishness reflects temporary headwinds that will eventually dissipate and allow growth to return to more normal levels, or whether low growth is the new normal. The final verdict may not be in, but the longer this goes on, the more likely the latter becomes.

1.4

1.5 Index Q1 1999 = 1.1

US GDP Extends Its Lead

Source: US BEA; Eurostat; Japan ESRI, as of Q3 2015.

1.3

1.2

1.1

1.0

‘99 ‘01 ‘03 ‘05 ‘07 ‘09 ‘11 ‘13 ‘15

US JapanEurozone


Modest Growth Acceleration But Downside RiskThe Emerging Markets (EM) are expected to grow by 4.3% in 2016, modestly up from the estimated 4.2% growth in 2015. Risks, however, are to the downside.

The prospect of a greater-than-anticipated slowdown in China and several geopolitical risks including the widening conflict in Syria and political turmoil in places like Brazil and Malaysia contribute to the uncertainty.

As it is, Brazil and Russia, both of which are currently in recession, account for the bulk of the anticipated pickup in EM activity in 2016.

Wide DispersionProspects are highly differentiated by region and by country, with emerging countries exhibiting, as in the developed world, decoupled monetary policy cycles.

In the fourth quarter of 2015, the spread between emerging market and developed market growth rates was at the lowest level in 15 years.

Several factors — the continued slow expansion in the US, the cumulative positive impact of lower oil prices and the easy monetary policies in Europe and Japan — should all be supportive of emerging markets in 2016. Yet, these developing economies face cyclical and secular headwinds.

CYCLICAL FACTORS Ɇ Deceleration in China. Ɇ Gradual tightening of financial conditions as

the Fed normalizes interest rate policy. Ɇ Commodity price weakness. Ɇ Capital outflows and country-specific

currency depreciation. Ɇ Debt deleveraging and tepid domestic demand.

SECULAR FACTORS Ɇ Slower trend growth in China. Ɇ World trade growth down from around 7% per

annum pre-crisis to around 4% post-crisis. Ɇ Reforms that could increase potential output

have stagnated in some countries. Ɇ New technologies may reduce EM

cost advantage.

THE OUTLOOK FOR EMERGING MARKETS

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Growing Share of World EconomyEconomists generally use two methods to measure the size of the world economy: the Nominal Exchange Rate method and the Purchasing Power Parity (PPP) method. The former measures total global output at current exchange rates (or average annual exchange rates) and translates everything back to dollars. The latter adjusts for domestic price levels.

On this basis, if the dollar appreciates 20% against the euro, does that mean the eurozone economy is 20% smaller? By one metric yes, by another metric no. Many consumer purchases, for example rent and haircuts, are not tradable in international markets. And haircuts may be cheaper in the eurozone than in the US. Thus, PPP calculates relative welfare.

For this and other reasons, the IMF calculates the relative size of the global economies on the PPP basis. By this metric, Emerging Markets represent 54% of global output. Under the Nominal Exchange Rate method, which perhaps is a better metric of the relative impact on global aggregate demand of various economies, the IMF values 2014 world output at $78 trillion. By this method, emerging markets represent 38% of the world economy. Whatever method is used, the share of emerging markets in the world economy continues to grow.

Many Moving PartsThe upward move in official US interest rates through 2016 also raises concerns that this development might feed a vicious circle by increasing capital outflows from emerging markets. That would prompt more EM currency weakness, accelerate inflation and promote further interest rate hikes. This in turn could lead to slower growth and corporate debt servicing problems, particularly given the sharp rise in debt levels in recent years.

Some emerging currencies have fallen very sharply in recent months. For example, for the 12 months to the end of October 2015, the South African rand fell 20%, the Turkish lira 24%, the Russian ruble 33% and the Brazilian real 35% against the US dollar.

An estimated 18% of emerging market corporate debt is in hard currencies, and net capital flows (a record approximate $500 billion outflow in 2015) are again expected to be negative in 2016. Those countries with small or non-existent fiscal and current account deficits (“twin deficits”) and robust policy frameworks are best positioned to deal with financial market volatility.

A Delicate Balance Our core scenario for EM in 2016 is:

Ɇ No sharp growth deceleration in China. Ɇ No commodity bust and no overshoot of the

US dollar’s value beyond current market expectations.

Ɇ A very gradual and well-modulated liftoff in US interest rates.

A negative surprise in any of these areas could lead to financial market volatility, which could reduce EM growth in 2016. Slower medium-term trend growth in emerging markets is already impacting developed markets. And speculation surrounding the pace of firming of US Federal Reserve policy in 2016 has led to major uncertainty.


MEXICOCurrent Backdrop

� Accelerating retail sales and wage growth � US recovery is beneficial � GDP growth of 2.2% in 2015

What to look for in 2016 � Will benefit from any upside economic

surprise in US � Trans-Pacific Partnership trade agreement

to aid Mexico � GDP growth of 2.8%

BRAZILCurrent Backdrop

� Economy hurt by collapse of commodity prices � High inflation and real interest rates � Capital outflows and currency weakness � Inadequate infrastructure � Weak consumer and business confidence,

given corruption scandal � GDP growth of -2.5% in 2015

What to look for in 2016 � Lower inflation and interest rates � Political uncertainty, including possible

impeachment of President Rousseff, could delay much-needed fiscal adjustment

� Economic contraction will be more modest � GDP growth of -1.9%

Emerging AsiaGrowth in Asia ex China/India is expected to accelerate from 2.8% in 2015 to 3.1% in 2016. In the ASEAN (Association of South East Asian Nations) countries, all of which are negatively impacted by slower trend growth in China, the Philippines is the main positive performer.

Latin AmericaThe Brazilian economy, Latin America’s largest, will still be in recession in 2016, with output falling 1.9%. By contrast, Mexican growth is expected to accelerate in 2016, reaching 2.8%. Growth is expected to fall from 2.8% to 2.2% in Colombia, an oil exporter, but accelerate modestly in Chile and Peru. With the exception of Brazil, most Latin American countries are expected to raise interest rates in 2016.

Europe, Middle East and Africa Emerging Europe’s prospects are distorted by geopolitics, from Russia’s entrenchment in Ukraine to Turkey’s proximity to Syria. The Russian economy will rebound in 2016, but growth will be anemic. The Ukraine and refugee crises could dampen growth in the Czech Republic, Hungary, and Poland. Weaker capital inflows could hurt South African growth.

EMERGING MARKETS SNAPSHOT 2016

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RUSSIACurrent Backdrop

� Economy hurt by oil price drop and sanctions � Weak ruble has hit imports as import prices have risen � Annual inflation currently around 15% � GDP growth of -3.9% in 2015

What to look for in 2016 � Inflation to fall to 7% � Oil price stability would be a positive � Medium-term growth prospects limited by: sanctions on borrowing;

poor business climate; state intervention; risks from Syria � GDP growth to improve to 0%

SOUTH KOREACurrent Backdrop

� Large current account surplus � Foreign exchange reserves at $360bn

(from $200bn in 2009) � Supportive fiscal policy � GDP growth of 2.6% in 2015

What to look for in 2016 � GDP growth of 3.2%

PHILIPPINESCurrent Backdrop

� Prudent macroeconomic policies � Resilient worker remittances � Ongoing business processing

outsourcing in global services sector � GDP growth of 5.0% in 2015


INDONESIACurrent Backdrop

� Economy exposed to commodities � Supply-side bottlenecks � Relatively little success at reducing fiscal

and monetary deficits � GDP growth of 4.4% in 2015

What to look for in 2016 � GDP growth of 4%

MALAYSIACurrent Backdrop

� Economy heavily exposed to global trade and commodity prices

� GDP growth of 4.4% in 2015

What to look for in 2016 � Risk from ongoing political crisis � GDP growth of 3.3%INDIA

Current Backdrop � Beneficiary of lower oil prices � Credible central bank policy � Inflation down to about 5.0% � Prime Minister Modi pushing reforms � GDP growth of 7.5% in 2015

What to look for in 2016 � Continuation of reforms to improve supply restraints

and attract foreign direct investment � Progress expected on land reform and Goods & Services tax � GDP growth of 7.7%

SOUTH AFRICACurrent Backdrop

� Commodity price weakness � GDP growth of 1.4% in 2015


TURKEYCurrent Backdrop

� High reliance on foreign capital flows

� Inflation at 7.8% � GDP growth of 3.3% in 2015

What to look for in 2016 � Continued violence in Syria � Inflation to fall to 6.2% � Unexpected capital outflows and

currency weakness could hit inflation and growth estimates

� GDP growth of 2.8%

Source: SSGA, Oxford Economics, as of 31 October 2015.


Slowing GrowthThe IMF projects China will grow 6.3% in 2016, and Bloomberg consensus forecasts predict growth of 6.5%. These estimates contrast with our view that growth will slow from 6.5% in 2015 to 6.0%, and that risks are to the downside. Our caution is prompted by the persistence of many structural problems in the Chinese economy, including:

Ɇ Excess manufacturing capacity. Ɇ Persistent deflation. Ɇ High total debt in the economy. Ɇ Property market overhang estimated at roughly 18

months of unsold inventory. Ɇ Distorted cost of capital. Ɇ Declining marginal productivity of capital. Ɇ Large contingent guarantees throughout the

Chinese financial system and a lack of transparency as to who the ultimate creditor is.

THE OUTLOOK FOR CHINA

WHAT IF? A HARD LANDING FOR CHINAOur baseline scenario is for Chinese growth to decelerate to 6.0% in 2016. However, we recognize the risks are skewed to the downside, and here we explore the effects of a much sharper growth decline, to just 3.0%.

We accentuate the fallout caused by direct trade linkages by assuming a moderate reduction of business and consumer confidence in Europe and North America, as well as more marked erosions in Asia-Pacific.

It appears a reduction in Chinese growth of this magnitude would be enough to tip the world into recession (which is defined as growth of under 2.5%.)

3.0% 2.3%

If China’s growth slowed to:

World growth would decrease by 1% to:

Source: SSGA, as of 31 October 2015.

Currency InterventionChinese policymakers will strengthen measures to curb capital outflow and have stated their intention to stabilize the Chinese currency, following weakness that followed the move to a de facto managed floating-exchange-rate regime in August 2015.

A weak currency that benefits exporters must be weighed against the contractionary impact for unhedged Chinese borrowers in dollars. We do not anticipate a sharp fall in the currency’s value in 2016.

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Facilitating GrowthChina has announced structural policies like State-Owned Enterprise (SOE) reform and smaller down payments for first-time homebuyers. The People’s Bank of China reduced interest rates several times in 2015, and further monetary policy easing measures can be expected in the next 12 months.

However, the bank has multiple objectives, encompassing price, exchange rate and financial stability, as well as full employment, economic growth and social stability. It is not an “independent” central bank. It must be careful to avoid policy mistakes, such as inadequate supervision of the shadow banking system or an overly rapid cut in interest rates, that could accelerate capital outflows.

The IMF is “cautiously optimistic” about China. It argues that China’s debt is largely held by domestic residents. It also notes that China has both the monetary policy flexibility and fiscal capacity to stimulate the economy and/or add bad debts to the sovereign’s balance sheet if necessary.

But risks continue to be to the downside and potential negative spillovers to Asia are large.

1.5% 0.4%

0.3% 0.4% 0.3% 0.9% 0.6%

Growth forecasts for Developing Economies would decrease by:

Growth forecasts for Developed Economies would decrease by:

US Eurozone UK Japan Australia

0.4% if RBA cut rate to 0.50%.

How Fast is the Economy Growing?With nominal GDP growth at a 30-year low, the challenge for China is to maintain the reform impetus while avoiding a sharp decline in output.

While not having much impact on GDP growth, the collapse of China’s stock market in mid-2015 intensified the debate among policymakers about making the market the “decisive factor” in the economy.

While the Chinese government says current growth is about 6.9%, some analysts say it could be as low as 4%. There has also been a shift in growth patterns. The service sector is now larger than the manufacturing sector and is growing in excess of 8% per annum.


MARKET OUTLOOK Ɇ We remain positive on risk assets, mainly

equities, over the course of 2016.

Ɇ Anemic economic growth, impacts on profitability, changing policy backdrops, and geopolitical events are concerns as we start the year.

Ɇ Japanese and European equities will likely be among the best performers.

Ɇ Global government bonds likely to fare worst.

Ɇ Volatility will remain highly unpredictable.

Ɇ Commodity- and interest-rate-exposed sectors and asset classes are positioned to underperform.

Ɇ Consumer-related sectors and asset classes with a reasonable risk-adjusted yield may outperform.

Ɇ Transparent series of Fed rate rises underway by early 2016.

Ɇ Various QE programs will stay in place and probably expand at the margins.

Ɇ UK interest rates are likely to follow the Fed higher during 2016.

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Rather than focusing on economic data alone to discern market direction, investors have been dealing with central bank policy adjustments as the first order issue for their decisions, with traditional data as the second order — and central bank policy will likely continue to be a dominant influence on investment decision-making in 2016.

However, trying to predict how central bank policy will be managed is often a fool’s errand, and we believe that investors should always stay focused on the expected returns that assets will generate.

Developed World Equities

Emerging Market Equities

2016

2016

10-Year

10-Year

Return Forecasts

4.4%

3.9%

6.3%

7.1%



1-Year 10-YearUS Large Stocks 1.8% 6.1%Europe 5.4% 6.3%UK 4.8% 6.3%Japan 7.5% 6.5%

US EquitiesThe significantly lower expected return for US equities reflects the absence of topline growth across most US companies due to the scarcity of genuine organic growth. A lot of the recent US market performance has been due to price/earnings expansion, lower interest rates and cost reductions rather than from a rise in demand for the goods and services that companies provide.

Manufacturers of capital goods have seen demand from clients largely confined to orders for replacement and maintenance rather than for expansion. The energy and mining industries have slashed spending on the capital goods that support exploration and production amid lower oil and mineral prices.

Currency ImpactWhile a stronger US dollar does reduce the costs of imports, that benefit has a much slower impact than the ability to export. Major capital items (such as aircraft, equipment, vehicles, machinery and electronics) are now over 15% more expensive than their global competitors. The options for US exporters are to cut their margins or lose sales, both of which are negative for earnings.

Tentative ConsumerThe US consumer and housing sectors have not yet fully picked up the slack to help drive topline growth. It seems that the US consumer is still selective, and while we expect increased contributions from the consumer side to earnings, it remains docile compared to previous cycles.

Identifying Growth Low rates dampen the earnings of financial companies that rely on interest rate margins, while US households that rely on income from interest-bearing instruments find their ability to spend is constrained. Meanwhile, IT and Healthcare earnings have benefited from the desire of US consumers and businesses to restrict additional marginal spending to items that are seen as a “must have.”

US consumer confidence is approaching more-normal levels though, which should see spending get closer to a 4% growth rate while the saving rate falls. This means that consumer activity could put a floor under the US economy, and if our US equity forecast is wrong it is likely to be because consumer spending proves to be more robust than expected.

European and Japanese EquitiesEuropean equities are showing signs of life, particularly Europe-focused names as opposed to those reliant on exports. Pan-European trade is picking up and German business sentiment surveys point to a solid upswing in cyclical growth. Europe is a large net importer of commodities, and these lower input costs will improve European corporate profits.

Our lower forecast return for UK equities is partly due to previous relative outperformance versus European peers, but also because the UK market has a higher exposure to energy stocks, which are experiencing significant pressure on earnings amid lower oil prices.

Credit growth in the G7 is also expanding, which should help improve European financials’ earnings. Borrowing by European corporates has been solid.

In Japan, the Abenomics fiscal and reform programs appear to be finally generating a pickup in growth and inflation.

The higher ex-US developed market returns reflect the lower base from which these stocks are growing and the already elevated level of US equities, which are well priced by comparison. The mantle for best-performing market should move to other parts of the developed world, although we think the US market will relatively underperform as opposed to generating negative returns.

Emerging Markets EquitiesThe EM equity forecast is lower than its DM equivalent, highlighting the massive profitability losses caused by the huge deterioration in global trade. EM profits are largely drawn from export-oriented activities split between commodities and manufactured goods.

Not only has global trade slumped but the margin component of revenues from key EM industries is faced with massive over-supply or capacity, leaving companies with little pricing power. Moreover, the US dollar’s strength means higher borrowing costs, with a negative impact on earnings, for many EM companies.

The profit and loss statements of EM stocks are deteriorating on both sides of the ledger.

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Fixed IncomeWith few exceptions, the overall returns from bonds will be low due to yield-curve normalization as the Fed begins to raise US rates. Global bonds also have a very low forecast return due to the QE programs in place and the eventual return of higher interest rates.

Since we expect official US rates to rise 25 bps on the initial move in December and then by four further 25 bps hikes during 2016, that will push official rates to the 1.25–1.50% bound by December. This will cause capital losses for many holders of US-linked paper.

Regardless of central bank policy, government bonds simply have an asymmetric return profile; yields have so little extra room to fall that the return outlook is poor.


Credit and High YieldThe still-low absolute level of rates in the next year reinforces the relative attractiveness of credit and high yield. The excess spread on offer in both asset classes is likely to prove irresistible versus the paltry-to-negative returns from sovereigns. Our forecast for inflation-linked bonds has also become more positive and a total return above 2.5% looks attractive. Even if any rise in inflation is small, the change in perception for inflation is likely to give these bonds a positive outlook for 2016.

PREPARING FOR 2016A consistent theme in our recent asset allocation studies for clients has been the falling forecasted returns from balanced portfolios.

While it remains to be seen what the “new normal” economic growth rate is, and hence the equity earnings rate, the low forecasted returns for bonds seem unavoidable.

Interest rates are likely to be much lower than long-term rates in 2016, but they will be higher than in 2015.

Global Government Bonds Return Forecasts

Emerging Bonds

1-Year

1-Year

10-Year

10-Year

0.3%

3.0%

2.0%

6.4%


MORE FROM YOUR CORE

01 Portfolio Construction

ADD A NEW DIMENSION TO STRATEGIC ALLOCATIONDirectly target macro factors such as equity beta, fixed income duration, leverage and liquidity.

INCLUDE ASSET AND FACTOR CLASSESFor example, beyond low beta, consider value, size and quality factors within equity.

TRACK THE VALUATIONMove away from a factor if it appears expensive.

In a low and slow world, investors are looking for options. We believe that putting aside the traditional 60/40 approach and instead targeting factors that you believe in is a viable alternative to going active or lowering return expectations.

Investment Ideas

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The Problem with Low and SlowThe reality of a “low and slow” growth outlook is starting to sink in with investors. Financial markets ultimately reflect underlying economic conditions, and with global growth slowing in recent years, many investors now face something of an existential crisis.

For example, after several years of double-digit returns, Callan Associates reported that the largest US pension funds posted an average return of just 3.4% for the 2015 fiscal year ended 30 June. This compares to returns of 12.5% in 2013 and 17.3% in 2014. And that drop preceded the significant slide in stock prices that gripped global markets in late August 2015.1

Institutions outside the US have reported similar results. For example, coverage ratios fell below 100% for four-of-the-five largest Dutch pension funds in the third quarter, with a sharp drop in interest rates and weak equity returns that hurt asset balances.

Coping StrategiesGiven the average institutional investor’s traditional return assumptions of 6 or 7%, there is no longer any obvious answer to how they get there. This has left many investors heading down one of two distinctly different paths.

At least among large institutions, some are doubling down on active management, focusing in particular on high-growth strategies such as private equity and real estate, both of which continue to post double-digit gains.2

Others have gone in the opposite direction, lowering their return targets and their overall volatility profiles. One major public retirement plan for state employees announced in 2015 that it would cut its allocation to riskier investments, such as stocks, and increase exposure to bonds and other less volatile asset classes to reduce losses in down markets, even though that would likely mean sacrificing returns.

There is a third option, however, which we believe has been relatively overlooked.

This third way reconceives the whole asset management framework, making every asset class decision work harder for the capital invested.

The answer doesn’t have to be to (a) go for broke or (b) throw in the towel, but (c) a new approach that is more intentional, more efficient and more precise about the assets one invests in and how they all fit together.

A THIRD WAY


Time for a New Approach?Historically, many portfolio managers have used the cap-weighted market as the center of gravity for their investment policy.

For example, investors would use a 60/40 framework of index funds split between equities and fixed income, and spend their time seeking active managers capable of outperforming the cap-weighted benchmarks.

Where they could find promising sources of alpha, they would complement the cap-weighted core with active satellite exposures. The overall 60/40 mix, though, remained fixed, with little thought given to changing it.

In a recent article “The New Policy ‘Policy,’” we highlighted some of the ways this approach is showing its age, particularly in a lower-return environment. As investors have come under more pressure, many have added to their rosters of active managers.

However, as active managers are added, they have the potential to cancel out each other’s bets without canceling out each other’s fees. This can leave an investor with the functional equivalent of a very expensive index fund.

We’ve found this can occur even in programs where the underlying managers are concentrated stock selectors. Take the case of the large asset owner who allocates extra capital to small-cap managers in order to benefit from the perceived alpha opportunities down the cap spectrum.

The plan will gain an overweight to the small-cap risk factor, with little stock-specific risk. This is because the union of all the small-cap managers’ portfolios ultimately ends up being a well-diversified portfolio holding nearly as many names as the broad benchmark.

Unintended Factor RiskThe investor started with the objective of increasing stock-specific risk but instead winds up with factor risk — and not necessarily even the type of factor risk they would have consciously chosen.

In this respect, at least the second path investors are taking is more intentional. When institutions take down their exposure to riskier assets, at some level they are identifying “low volatility” as the factor most in line with their objectives and prioritizing a smoother, less volatile return stream even if it means lower growth.

Go a Step FurtherHowever, we’re inviting investors to go a step further. Why not reconceive the entire 60/40 framework in terms of all the factors they want — and don’t want — exposure to?

In our approach, factor-based asset allocation has two parts:

In both cases, the investor ultimately still invests in asset classes, but now crafts their exposures so they’re tilted in the direction of the most desirable factors.

The focus moves from picking external managers, whose mission is to add value over a cap-weighted index, towards directly picking the factors that reduce risk and increase returns.

FACTORIZING THE TOTAL PORTFOLIO

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Identify unwanted factor risks and invest in asset classes that neutralize those risks.

Identify factor risk premiums in the market and invest in asset classes that harvest those premiums.

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How it WorksThe impact this approach can have is best demonstrated with an illustration. To keep things simple, we focus on two key factors that operate at the aggregate level — equity beta, or a measure of the risk arising from general market movements, and fixed income duration, capturing the sensitivity of a bond’s price (calculated in years) to a change in interest rates.

Consider the two portfolios below. The Old Portfolio builds its allocations around the cap-weighted index, while the New Portfolio directly targets equity beta and duration. The Old Portfolio uses the Barclays Global Aggregate Bond Index for its fixed income benchmark, which had an effective duration of 5.4 as of 30 September 2015. Given the portfolio’s 25% allocation to fixed income, the portfolio duration is 1.35. Its portfolio equity beta is 0.5, which is simply the equity allocation percentage multiplied by a beta of 1, from buying the full spectrum of equity risk in the market.

The ResultsThe New Portfolio extends duration in order to take advantage of the still relatively healthy yields offered at the longest end of the US yield curve and the fact that the long end is not expected to move up nearly as fast as short-term rates when rates do begin to rise.

The portfolio can do this by moving out of the Global Aggregate and into long-term Treasury bonds, “strips” (bonds with the coupons and principal stripped out and sold separately, usually at a discount, and typically maturing at par) and long-duration, high-quality corporates.

However, in order to keep the total duration constant, the fixed income allocation is cut in half. The extra capital is rolled into a minimum-volatility equity strategy, along with some additional shifts out of the cap-weighted index. The result is a new, lower market equity beta of 0.8. Since the equity allocation has increased, the portfolio equity beta stays constant at 0.5.

Efficiency and ControlThe New Portfolio is structured in a much more capital-efficient manner. It has the same total duration and beta as before, but it now has more capital allocated to growth assets and less to hedge assets. This means that the expected return on the portfolio increases over the long run, even though the expected risk remains constant.

Additionally, the fixed income portion has less sensitivity to interest rates, due to its positioning farther out on the curve. Likewise, the equity portfolio is now centered on lower-beta stocks, which have historically performed better than the equity market.3

Which of the two portfolios would you prefer?

1 Randy Diamond, “High Return Era Ends for Many Big Public Pension Funds,” Pensions and Investments, August 10, 2015. 2 See for example, Robert Styer, “Cornell endowment returns,” Pensions and Investments, October 8, 2015. 3 Fischer Black, Michael Jensen, and Myron Scholes, “The Capital Asset Pricing Model: Some Empirical Tests,” 1972.

Source: SSGA, as of 31 October 2015. For illustrative purposes only. Not intended to represent an actual product.

Equity (a)

Fixed Income (b)

Alternatives

Total Portfolio

Equity Beta (c)

Total Portfolio Asset Beta (a*c)

Fixed Duration (d)

Total Portfolio Duration (b*d)

Return

Risk

Efficiency Ratio

50%

25%

25%

100%

1.000.505.401.356.15%

12.07%

0.51

62.5%

12.5%

25%

100%

0.800.50

10.801.35

6.62%

12.31%

0.54

Old Portfolio

New Portfolio


In the example overleaf, we moved assets to a low-volatility equity portfolio, treating equity beta as a key factor. But how can we be sure that investing in low beta is attractive going forward and there aren’t other factors that should take precedence? Each month, our Investment Solutions Group sorts stocks in the MSCI World based on one of four factors — Value, Quality, Size and Volatility.

After a strong showing in Q3, Low-Volatility stocks (bottom right) have become more expensive going into year end. Conversely, Value looks more attractive after having performed poorly during the bulk of 2015.

As global growth has slowed, investors appear to have discounted in a risk premium for Value stocks.

Hence, even if the slowdown continues as expected, valuation-based stocks could do well, as some of this expectation is now “in the price.” Investors with a portfolio currently tilted toward low volatility may thus consider shifting some of that capital to a value-based approach, particularly if they have a longer time horizon.

THE GLOBAL FACTOR OUTLOOK 2016

Value

Size

Quality

Low Volatility

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2.0 0.00

1.5-0.20

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Median Book-Value-to-Price Spreads

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0.80

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0.60

0.40

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-0.60

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We then look at the book-value-to-price (B/P) spread between the top and bottom quintile of each factor-sorted universe. A high B/P ratio indicates that the factor is cheap, while a low ratio suggests the opposite. Below we plot the valuation of each of these smart beta factors over time.

Spread Average Spread 1 Std Dev Above 1 Std Dev Below

Base = 0 Base = 0

Base = 0Base = 0

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Bring a new dimension to strategic allocation.

The strategic allocation setup is possibly the most important decision. However, the decision needs to extend beyond how much to allocate between equity, fixed income, real estate and private equity. It should directly target macro factors such as equity beta, fixed income duration, leverage and liquidity. The plan will still invest in asset classes, not factors, but the asset classes will carry factor exposures and these should be consciously targeted.

Do not over-diversify. Beyond a certain point, active managers cancel each other out. Adding too many active managers forces the investment team to spend more time analyzing an active program that increasingly carries less active risk. Hire fewer active managers, but allocate greater capital to each in order to make a meaningful impact.

Use capital-efficient allocations.

Particularly where yield curves are positive and upward sloping. Extend the fixed income duration, which is effectively a form of leverage without the borrowing. Simultaneously reduce the fixed income allocation and roll the extra capital into low-beta equities, various multi-asset class strategies or other low-beta growth substitutes. Moving to the back end of the yield curve is consistent with our outlook. If global growth continues to slow as expected, inflationary expectations should remain subdued, keeping a lid on longer-term rates.

Consider asset and factor classes for additional returns.

Both asset and factor classes play a vital role in your investment outcomes, so making sure your portfolio has accurately targeted your intended exposures is critical. Within equities, integral factor classes include Value, Quality, Size and Low Beta. Beyond equity, factor classes can include currency carry, currency valuation, fixed income slope, commodity curve, volatility and momentum, among others.

Structuring factor classes so that they are insensitive to the economic environment can be beneficial. For example, Value tends to work best in a strengthening environment, so balancing this factor with a modest dose of Low Beta can help if growth continues to soften.

Track the factor portfolio valuation.

Look to move away from a factor if it appears expensive. Crowding can occur in any asset or factor class, and knowing the price of these classes is the first step in forming a long-term view.

Today, the game has shifted. Returns may not be easy going forward. Investors will be well-served by adopting a more holistic mindset. We advocate targeting the aggregate factors to control risk, and factorizing the underlying asset classes to harvest return. These shifts can have a meaningful impact on the total portfolio, even in a low and slow environment.

PUTTING IT ALL TOGETHER

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Investors are facing the challenge of hitting their return objectives, despite diminished return expectations on major asset classes. Those designing investment portfolios have two main choices: They can look to active managers as a means to boost returns, or they can spend more time thinking about asset and factor allocation.

Particularly for large portfolios afflicted with the problem of over-diversification, we think the factor path is the more elegant and ultimately more effective solution.

Five-step approach for those in charge of designing investment portfolios


After rising strongly in late 2015, volatility appeared to stall. However, geopolitical and structural factors mean that volatility is here to stay for a while yet. Investors should consider strategies that limit downside but allow them to participate in upside.

02 Equity Market Risk

Investment Ideas

MASTERING VOLATILITY

MANAGED OR LOW VOLATILITY STRATEGIESTarget lower volatility and smaller drawdowns.

TARGET VOLATILITY TRIGGERSProvide a stable volatility level in the portfolio.

MARKET-REGIME AWARE INVESTINGVia Flexible Asset Allocation strategies.

LIQUID ALTERNATIVESConsider Global Macro or Managed Futures approaches.

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Maintain ExposureVolatility looks set to remain but most investors require some level of exposure to growth assets. How do you achieve this while protecting against further spikes in volatility?

One approach is to use managed volatility strategies. These strategies target lower volatility and smaller drawdowns by investing in lower beta stocks. Active approaches here could be beneficial, with better return potential and lower interest rate sensitivity than passive alternatives. Interest rate sensitivity could be an important consideration, given the potential for rates to increase. Active strategies may be better able to balance their exposures, helping to offset their large allocations to rate-sensitive sectors such as utilities.

Target Specific Volatility LevelsStrategies targeting some predefined level of volatility are also a viable option. These strategies target a maximum level of forecast volatility and reduce exposure to equity (or other growth assets) when the target volatility ceiling is breached. These elegant solutions can be very effective.

Target the Right Asset MixMulti-asset class solutions can be used to dynamically shift allocations between growth-seeking and more conservative positioning by predicting the level of risk sentiment in the market. Market risk barometers, such as SSGA’s Market Regime Indicator, can be used in tactical solutions that are designed to provide cover in down-markets as well as allow participation in up-markets. These kinds of solutions can be a transparent, cost-effective way of providing downside protection and capital preservation.

Consider Alternatives Using wider levels of discretion and incorporating leverage, global macro funds can also play a role by seeking to generate absolute returns while managing total portfolio risk. Liquid alternatives and derivatives overlay strategies are also tools for investors to consider as they look for ways to weather this uncertain environment.

Watch for the Right SignsWhat signals should trigger re-risking? Any improvement in the global situation — economic, geopolitical or otherwise — that reduces uncertainty may present opportunistic re-entry points for some investors, especially if one believes uncertainty is already priced in.

More clarity surrounding China’s growth path would be helpful. Even if evidence confirms a gradual slowdown, investors may well breathe easier with evidence of, for example, further growth in the service sector or an improvement in consumption.

Similarly, more clarity surrounding the trajectory of the US economy, improvements in the Middle East and better growth globally are all things that might indicate a re-risking opportunity.

The problem is that right now many of these sound a little Utopian.

Consider EquitiesHowever, with equity valuations currently looking fairly reasonable in some places and the ECB and BoJ remaining accommodative, equities may have some support. And, if data in the US continues to be soft and Fed rate rises slow to materialize, US equities may also rally.

Think Longer TermInvestors should weigh the opportunities against the risk, and their own level of risk aversion and we would advocate taking a longer view.

While there is uncertainty — given that valuations are not stretched and that central banks are easing — it might be prudent to make an allocation toward growth assets with an eye on the long term.

WHAT TO DO


Slowing ChinaChina continues to be the scapegoat for everything from recent market angst to poor earnings. The risk of a hard landing does pose, perhaps, the most serious risk to the global economy. Credit Suisse points to what it calls the “three bubbles” of credit, investment and housing.1 They suggest private debt is approximately 196% of GDP and some 40% above trend. What’s more, housing as a share of GDP is three times the US at the peak.

As China continues to slow, shifting from an investment-driven economy to a service-driven one, these hefty burdens could intensify instability.

Additionally, on 11 August, the renminbi declined 1.9% versus the dollar following a revision to the quotation method of central parity. If investors fear further declines and capital begins to flow out, a new risk and source of volatility presents itself.

There are some positives, which include a stabilizing housing market, strong GDP growth in the service sector and ample policy flexibility. One thing is sure, however — all eyes will be on China in 2016.

WHAT MIGHT CAUSE VOLATILITY IN 2016?

Source: SSGA, as of 31 October 2015. For illustrative purposes only.

Just what are the factors that lead us to believe that volatility will rise? And, why do we think it makes sense for investors to adopt volatility management measures?

In the late autumn of 2014, just after the bout of excitement that saw the VIX spike from a low of just over 10 to a high of over 26, we forecast that volatility might be a cause for concern for investors in 2015. Fast forward a year, and after seeing the VIX spike ever higher, we think that it may be more of the same as we consider 2016.

Similar to a year ago, there’s much to be concerned about. China is a favorite to cause further unease in 2016, as are the machinations of the Fed, the situation in Europe and various geopolitical consternations.

Here are some of the reasons why investors might be prudent to prepare for a choppy ride in 2016.

April June August

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Geopolitical EventsFrom conflict in the Middle East to instability in Europe, geopolitical events play their part to increase uncertainty and, through that, volatility.

The situation in Syria and subsequent humanitarian disaster has grabbed headlines and may yet be the cause of more instability.

In Europe, terrorist incidents have added to investor anxiety. And, while the Greek issue seems to have calmed down somewhat, the innate structural challenges to the euro have not truly gone away. Fears of a “Brexit,” where the United Kingdom further distances itself from Europe, may gain attention and serve as yet another reminder of the potential instability there.

Finally, the situation in the US could present challenges. The political environment could be a potential culprit as we head into a presidential election year and gridlock in Washington raises the specter of a possible government shutdown.

What’s more, lackluster growth and continued mixed economic data could cause investors to wonder about the risks of a recession. If investors perceive this risk to be increasing (whether it is or not) and think the Fed is out of ammunition, they could become spooked.

1 Global Equity Strategy — The Critical Issue: China and China Plays, July 2015, Credit Suisse.2 For more on this topic see: Restriking the Fed Put — Implications for Vol and Liquidity, September 2015, Morgan Stanley.

Fed (In)ActionA year ago many thought the Fed liftoff could be a potential source of angst either because market participants would disagree with the timing or because of a communication misstep. This potential remains today.

Some think the Fed is so eager to move away from zero interest rates that it could move too soon. There’s also a great deal of sensitivity around the communication.

When the Fed decided not to raise rates in September, investors were initially relieved but later confused by Fed comments around global growth concerns. Ultimately, this episode highlights the level of delicacy that is needed.

We think the Fed is likely to move this December, followed by four hikes next year, in March, June, September and December. Given this view, we think the yield curve will flatten, with the long end of the curve remaining anchored given the muted growth, outlook for inflation and institutional demand.

Over to equities, where many suggest this scenario is priced in and the markets will be fine. But, the economy has historically been more robust preceding Fed increases than it is today. Concerns roiling other areas, such as emerging markets, could make for an interesting ride.

If the Fed were to unexpectedly quicken the pace of their liftoff —because of unanticipated inflation, for example — market volatility could spike as both equities and longer-duration bonds could come under pressure.

October

VIX IN 2015

Structural ChallengesLiquidity issues could also impact volatility. Natural liquidity, which many describe as the ability for buyers and sellers to transact with each other efficiently, is on the decline due to investor consolidation, increases in passive management and regulatory changes.

An increase in passive investing and institutional stock ownership has and will continue to pressure this natural liquidity as the holdings concentration increases and turnover decreases.2

In addition, regulatory changes such as the Volcker rule have made it more difficult and less profitable for market makers to warehouse risk. The curtailing of this mechanism limits the ability to transfer risk between buyers and sellers and could lead to a mismatch during market sell-offs as investors who wish to reduce or hedge exposures find few takers on the other side.

In addition, as the Fed pulls back on the monetary stimulus throttle, the mechanism that has compressed volatility in recent times is reduced. Couple this with elusive growth and volatility could well be coaxed higher.


Europe has the potential to be a key investment area in 2016. Conditions there are looking very promising for equities. A favorable environment for growth means that domestically focused companies should do well.

03 European Equities

Investment Ideas

EUROPE OUTPERFORMS

OVERWEIGHT EUROPEFor exposure to the region’s growth potential.

CONSIDER SECTORSDomestic cyclicals have promise.

EUROPEAN SMALL CAPSHave characteristics that will benefit from European growth.

MANAGED VOLATILITY STRATEGIESCan give participation in the region’s growth story coupled with volatility management in case of a reversal.

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Where’s Europe Now?Europe took center stage again for investors in 2015, and this time not only because of crises such as the ongoing Greek situation but also because some of the investment opportunities that we hinted at in our 2015 Global Market Outlook came to fruition.

Indeed, for the first three quarters of the year, the MSCI Europe index was 1% better than the World index and slightly better that than its US counterpart.

But what’s in store for 2016? Will the success story continue? And, will the European small-cap premium, which was over 12% versus the MSCI Europe index in the first three quarters of 2015, be sustained? Could the eurozone offer a shelter against more troubled environments elsewhere?

A Return of SortsLagging the Fed by fully six years, the ECB announced on 22 January 2015 the final details of its quantitative easing program. On 22 October it followed up with an announcement of further expansion of the program, coupled with a potential rate decrease.

At the same time, gradual rate increases by the Fed have been alluded to but have taken time to materialize due to general concerns over the economy and this summer’s Chinese stock market crash.

All this happened in a context where the economic situation in Europe is looking better, leading indicators are improving and the unemployment rate is smoothly slowing down.

What Matters in EuropeWith European large-cap equities having a substantial 16% sales exposure to the US and 15% to emerging markets, the economic dynamics in those regions should not be ignored.

The recent decoupling in the economic momentum of the three regions (slowdown in Emerging markets, stabilization in the US and improvement in Europe) will continue to contribute volatility in the coming quarters.

As a matter of fact, in recent months the economic decoupling between the three regions has somewhat accelerated. The reading in the eurozone looks more favorable with positive manufacturing indicators and upward-trending earnings.

Following the global financial crisis, and after a five-year period where European equities were off of most investors’ radar, the first signs of renewed interest appeared with the “whatever it takes” speech from Mario Draghi in mid 2012. Between then and mid 2014, European equities rallied sharply. Since the beginning of 2015, the picture has looked encouraging, with flows coming back to European equities.

It is probably too early to assess the long-term effects of European QE on the real economy in Europe. The long-term challenge for the eurozone is to raise its growth potential, significantly reduce structurally high unemployment and shift public finances to a more sustainable path.

Ideal for GrowthPart of the answer has to do with the ability of European governments to succeed in implementing their reform agendas (labor market, private-sector liberalization and competitiveness, education etc.) in a difficult context.

With that disclaimer in mind, over the short term, the eurozone economy is underpinned by strong market conditions.

All create a very favorable environment for European growth.

The vast majority of European countries are expected to grow at a faster pace over the next two years. Economic leading indicators that coincide with stronger economic growth also rebounded, notably in Germany, one of Europe’s key countries.

Overall, there is a very positive outlook for Europe. But how best to harvest it? Which industries should be targeted and which avoided? And how does large cap and small cap differ in Europe? Let’s look at these questions in more detail now.

A WEAKER EURO

LOW INTEREST RATES

LOW RAW MATERIAL PRICES

LOW ENERGY PRICES


Choose the Right IndustryHow should investors position their portfolios to benefit from this decoupling environment? In order to tackle this question, we begin by classifying European industry groups into 4 clusters according to whether they are cyclical/defensive in one dimension, or global/domestic (depending on their sales exposure breakdown) in the other dimension. We’re looking for the industry group that looks best placed to benefit from the European growth story.

We then check where the different industry groups are positioned with respect to their own business cycle over both the short term (earnings revisions over the last 3 months) and the longer term (EPS distance to previous 2007 peak).

If more analysts revise their earnings expectations upwards than downwards, this is a positive since it indicates return potential within this industry. The graph below shows this on the horizontal axis, and this represents our short-term view.

The second dimension, representing our long-term view, on the vertical axis, looks at each industry in terms of earnings per share (EPS) and how the current EPS value is relative to the EPS peak in 2007 right before the Global Financial Crisis. If an industry currently shows a lower value EPS than in 2007, this should indicate that there is still potential in terms of earnings growth (and return, as a result).

The overall European market is a mixed bag, with earnings still lagging their previous cyclical peak and suffering from negative earnings revisions. But clearly, most of the industries in the lower-right quadrant are green — they are both domestic and cyclical, and it is industries with these characteristics that are our recommendation.

In general, industries with positive earnings revisions also trade below their last cyclical peaks while industries above their last peak are almost always negatively revised. This suggests some diverging sector dynamics within the market.

Globally exposed industry groups (both cyclicals and defensives) all exhibit negative earnings trends, while the picture is more mixed for domestic industry groups.

Domestic industries (both cyclical and defensive) are all below previous peak levels while only a few global industries (e.g. Energy, Materials) share this characteristic.

Healthcare Equipment

Software & Services

Domestic CyclicalsDomestic DefensiveGlobal CyclicalsGlobal Defensive

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Telecommunications Services

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MSCI Europe TransportationInsurance

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Capital Goods

Commercial & Professional Services

Consumer Durables

HOW TO HARVEST

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EPS Distance to Previous 2007 Peak

Source: SSGA, as of 31 October 2015. For illustrative purposes only.

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Choose the Right CapitalizationEuropean small-cap companies are more domestically focused than their large-cap counterparts and also offer a more cyclical exposure. European small-cap stocks have on average more cyclical exposure than large-cap stocks. European small-cap stocks are also more domestic than large caps.*

But how have European small-cap stocks done in the recent past? The graphic below shows that the small-cap premium remains strong. In 2015 especially, it was a very good year for small-cap investors in Europe.

The asset class offers a purer leverage to the domestic European economy than large-cap companies. With these characteristics, we think investing in European small-cap companies is another good way to play the economic decoupling within Europe.

The European Small-Cap Premium

Go Active? A number of factors make the current market environment favorable for active quant equity managers:

Heightened Market VolatilityMore volatility offers an opportunity for skilled active management to separate good stocks from bad stocks.

Range of Return DispersionHigher dispersion among factors can be preferable since it gives opportunities for managers to express their views on factor premia.

Lower CorrelationsCorrelations have been decreasing since their peak at the end of 2011, a positive sign for active managers. Lower correlations can improve active returns for skilled managers and present opportunities for adding value.

Active management primarily makes sense when an asset manager is managing a complex strategy that invests in less-widely researched areas such as small-cap equities or emerging markets.

The more efficient the market, the more difficult it is to generate excess returns through active management. However, with superior research, and an “information edge,” successful active management in more efficient markets is indeed possible.

Convinced but Cautious?There are still many unresolved issues that may yet throw some volatility into the European mix. The rest of the world continues to slow down, especially Emerging Markets. Although Europe has a large internal market, it is not insulated from slowdowns elsewhere, as recent decreases in German exports shows. And, the impact of the recent influx of refugees has yet to be fully quantified. The first casualty has been Chancellor Merkel’s approval rating, leaving her less able to maneuver politically. The recent Volkswagen emissions affair has also cast a cloud over the powerful “Made in Germany” brand.

Investors may want to retain exposure to Europe but with added downside protection in case of a reversal. One way of achieving this is via managed volatility strategies. These target a 20-30% reduction in overall volatility relative to the broad equity market while remaining fully exposed to equities. The long-term investment case for managed volatility strategies is strong, and they really come into their own in times of uncertainty.

*More on this analysis can be found in Chatron, Ekambi and Schulmerich, “European View on Equities: Q4-2015”. SSGA IQ Insights, October 2015.

Last 10 Years Last 5 Years 2015 (YTD)

Source: SSGA. MSCI Europe Small Cap Index minus the MSCI Europe Large Cap Index return (in EUR). As of 30 September 2015.

4.34% 5.89% 12.47%


While US earnings appear to have peaked in early 2015, we believe it is still too early to call time on the current earnings cycle. Growth is likely to be slower, but pockets of opportunity still exist.

04 US Earnings & Equities

Investment Ideas


MORE HEADROOM IN THE USAlthough US equities will not be the top performer, there’s still plenty of room for returns.

LOOK AT SECTORSWith lower oil prices and more money in consumer pockets, Consumer Discretionary has promise.

CONSIDER SMART BETATo help protect portfolios in the case of downside risk, consider Managed Volatility strategies.

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The recent reversal in US earnings appears reminiscent of downdrafts that preceded the last two recessions.

This raises the question: Is this the end of the earnings cycle, the current business cycle or both? We believe such forecasts are premature.

After growing consistently on an annual basis in line with the US economic expansion since 2010, earnings on the S&P 500 peaked in the fourth quarter of 2014 and have been on a downward slide throughout 2015.

As the third-quarter earnings season got underway in October, the consensus among security analysts was that the 500 largest US-based companies in the S&P 500 index would average decisively negative year-over-year results for 2015. Against these substantially lowered expectations, most companies were actually able to beat their Q3 forecasts.

The tone, however, remained muted, with concerns about global growth and a recent equity market correction injecting considerable uncertainty into the outlook for Q4 and beyond.

In the end, the earnings and business cycles are tightly linked. Our base case for 2016 is a continuation of US economic growth at a modest pace, consistent with that of 2015. So, if this forecast holds, earnings growth should turn positive again in 2016.

Probably the biggest risk to the US economic outlook and earnings is the external impact of a broader global growth slowdown emanating from emerging markets. This is what happened the last time earnings saw a mid-cycle pullback in 1998.

Now, as then, we expect recent policy moves to prevent a global recession. With US earnings already well along in their life cycle, expectations for a second wind this time around should remain fairly subdued. As with our overall economic forecast, “low and slow” remains the mantra of the day.

For investors looking to navigate this period, we advocate a focus on sectors that still have room to grow in this business cycle.

These include the Consumer Discretionary sector, where reasonably healthy household balance sheets combined with the savings from lower energy prices should be supportive.

Housing is another potential growth area, given the late start it got participating in this business cycle and the relative underinvestment in the industry since the housing bubble burst in 2009.

Finally, Banking should see some lift as the Fed begins normalizing interest rates, earning the sector more revenue on its cash holdings.

The End of Growth? Or Merely a Blip?

Jan 1996 Jan 2000 Jan 2004 Jan 2008 Jan 2012 Jan 2015

Base = 100 Trailing 1-Year S&P 500 Earnings Per Share


300

400

500

200

100

< Recession Periods >

WHAT NEXT FOR US EARNINGS?


SOME HEADWINDS ARE TEMPORARYIt’s too early to pronounce this earnings cycle dead just yet. The parallels to the past two pre-recessionary periods aside, there are plenty of historical instances when earnings took a breather mid-business cycle.

As recently as 1998, falling oil prices and emerging market turbulence combined for a couple of down quarters before another positive run started in Q1 1999. We see a similar pattern developing now, and the three factors currently weighing most on earnings should all prove temporary.

The Strength of the US Dollar With a full third of S&P 500 revenues now derived overseas, the 12% surge in the dollar over the past year has weighed heavily on many companies’ profits. October 2015 earnings reports brought a fresh round of disappointing results from firms with large international operations.

IBM, Kimberly Clark and Johnson & Johnson were among those specifically calling out the strong dollar as a factor in their quarterly declines.

As with oil, though, the worst may be behind us. When the dollar peaked in April, markets were still pricing in a Fed rate hike this year and a higher level of monetary divergence between the US and other developed and emerging market economies. With the Fed now seemingly moving more cautiously, additional gains in the dollar should be limited, reducing the drag on earnings for companies with substantial international exposure.

The Collapse of Oil Prices From a 2014 peak of $107 a barrel, the price of oil fell to as low as $38 per barrel in August 2015. This sharp decline has been devastating for energy companies. Earnings in the sector tumbled 56% from Q2 2014 to Q2 2015.

As energy constitutes 7% of the S&P 500, a huge portion of the decline across the index can be attributed to this fact alone. Energy’s outsized impact is seen clearly in the chart below. When that sector is removed, earnings would have actually shown steady gains over the past year.

Eventually, oil prices will bottom out (if they haven’t already), and energy company earnings will slowly recover. In the meantime, the benefits of cheaper gas, utilities and materials costs, have created a silver lining for the airline and automobile industries as well as the broader consumer-led economy.

Ultra-Low Inflation Related to the decline in energy prices, inflation has been nonexistent for most of 2015. This acts as a barrier on the ability of companies to raise prices and grow nominal earnings.

Recent YoY inflation as measured by the Consumer Price Index (CPI) for urban consumers is barely above zero (see chart below), which is well below the levels for a typical expansion.

However, the foundation for modest price increases has at least been laid. With the biggest drop in oil prices occurring at the end of 2014 into early 2015, the effect of oil on overall inflation should be muted as we head into 2016. Prices of services, meanwhile, have been ticking up (+2.3% YoY ).

The one perplexing laggard has been wage inflation, but with the labor market continuing to tighten, wage pressures should be starting to build.

Percent

‘02 ‘06 ‘10 ‘15


Inflation Very LowS&P Earnings Fall Mainly Caused by EnergyBase = 100

‘10 ‘11 ‘12 ‘15‘14‘13


6.0

2.0

4.0

0.0

-2.0

300

200

150

250

100

50

Change in US CPI Urban Consumers YoYS&P 500 Ex-Energy Real EPSEnergy S&P 500 Component Real EPS

36 ssga.com


...WHILE OTHERS ARE MORE PERSISTENTWhile we anticipate that earnings should climb back into positive territory by Q1 2016, we do not expect S&P 500 earnings to come anywhere close to their growth rates from earlier in the cycle.

At 75 months, the current business cycle is already the 5th longest on record. There are good reasons for its durability — it started from a lower place, was slower to get started and has been supported by more policy interventions than any other cycle of the past 80 years.

Cheap Financing is OverEarnings growth benefited early in the economic recovery from rock-bottom interest rates that allowed companies to reduce debt servicing through refinancing. As credit spreads narrowed through the middle of 2014 and rates overall remained low, corporate financing costs continued to decline, further enhancing the ability of companies to improve their bottom line. But, at this point, rates are unlikely to fall further. Indeed, they are more likely to rise, with the markets now pricing in a 55% chance for a first Fed rate hike in December. And credit spreads have recently begun widening. The result is that financing costs are likely to produce a modest drag on earnings going forward.

Wage Growth Unusually Restrained The current economic expansion has been notable for very low wage growth, allowing corporations to pay out a smaller share of growing revenues to their employees than in previous cycles.

As noted above, though, wage pressures will likely start to build as the unemployment rate continues to decline, meaning corporations will have to start paying out a larger share of revenues to maintain their labor force.

Unsustainable Ratios of Profits to GDP Based on the National Income and Product Accounts, corporate profits as a share of GDP have been well above historical norms during this cycle. But, in recent quarters that ratio has shrunk, falling from a peak of 10% at the end of 2011 to about 8.5% through Q2 2015. Given that the baseline forecast from our economics team is for GDP to remain in the 2–2.5% range for the foreseeable future, earnings wouldn’t seem to have much room to run.

Percent 5.0

4.0

3.0

2.0

‘02 ‘06 ‘10 ‘15


High Profits to GDPWage Growth Restrained

‘60 ‘66 ‘72 ‘78 ‘84 ‘90 ‘96 ‘14‘02 ‘08

Ratio

9

6

12


As cycles age, certain trends that fanned growth in earlier phases inevitably start to shift and blow in the other direction. In no case do we see these gusts as being strong enough to push earnings back into the red, at least not in 2016, but they will likely present enough resistance to keep earnings well below their 2014 growth levels.

Corporate Profits as a Share of GDPChange in US Employment Cost Index YoY


Investment Ideas

Emerging markets have lost their luster of yesteryear. Returns on equity are now less than for developed markets. We believe that a trio of key factors hold the key to reigniting the EM growth story.

05 Emerging Markets

KEYS TO IGNITION

CAUTION WARRANTEDWatch for key signs of a potential turnaround in fortunes.

QUALITY AND VALUEMatter most… until there are clear signs of reform, then cyclical themes become important.

CONSIDER SMALL CAPSThese now appear to have good longer-term potential.

38 ssga.com

A Waiting GamePatience is a virtue. And that couldn’t be more true for Emerging Market (EM) investors than at present. There can be little doubt the gloss on the sector has worn thin over the past couple of years, with growth rates struggling to reach anywhere near previous highs. The sector has a sizable hangover following a period of stellar growth fueled primarily by strong commodity prices, seemingly insatiable Chinese demand and a favorable global growth backdrop.

It is the reversal of fortune of those very factors that is weighing on emerging market performance today. Asset allocation remains underweight for many investors, who are keenly looking for signals that the time is right to fully invest again.

What’s neededWhile the challenges are indeed significant for many EM countries, much of the negative sentiment is already priced in to asset prices. Attention has turned to the potential catalysts for a rally — either in the short term, or something more sustained. In 2016, we believe investors should be watching a trio of factors with the potential to reignite the fortunes of EM — namely, China and associated commodity trends, foreign exchange and local debt dynamics, and the pace of reform programs.

A primary condition, in our view, for EM assets to rally is the expectation of better growth relative to developed markets in terms of both GDP and earnings. Right now, as shown in the chart below, the GDP differential has narrowed to its lowest level in a decade. As EM growth struggles, developed markets have staged a slow — even if at times unsteady — recovery since the global financial crisis.

Returns challengedReturn-on-equity (ROE) data, a key metric for assessing shareholder value, also highlight the challenges confronting EM. ROE in EM is now lower than developed markets for the first time in 13 years. Strong leverage growth has buffered the rate of decline; however, it is hard to argue that this is desirable with EM leverage at all-time highs, having soared relative to GDP since 2008. In the immediate aftermath of the financial crisis, consumption was a driver for EM, but more traditional factors such as commodity prices and the forward path of the US dollar now dominate the growth trajectory.

‘91 ‘93 ‘95 ‘97 ‘99 ‘01 ‘03 ‘05 ‘07 ‘09 ‘11 ‘13 ‘15

MSCI EMMSCI World

10 Percent

8

6

4

2

-4

0

EM and DM Growth and Spread

Source: SSGA, Haver, UBS, as of 31 October 2015.

‘95 ‘97 ‘99 ‘01 ‘02 ‘03 ‘05 ‘07 ‘09 ‘11 ‘13 ‘15

%, YoY growth Spread (EM–DM)EMDM

10

8

6

4

2

-4

0

-2

-2

The collapse in EM ROE is linked to a drop in margins, primarily due to rising labor costs and falling productivity. Productivity growth in EM has slipped markedly over the past decade, while wage growth has far outstripped developed markets. This has reduced the competitive advantage that lower labor costs once offered.

While EM equities are not especially cheap in a historical sense (particularly in light of pressures from an anticipated interest rate rise in the US and ongoing weakness in commodities), they are cheap relative to their developed market peers (see chart above). EM offers the lowest discount seen over the last 10 years compared to the MSCI World Index.

While that may offer some immediate encouragement for EM investors, any prospect of a rally or sustained growth will be guided by other market and structural factors.


EM ROE Now Lower Than DM


Key 1

Stabilization Expectations in China and CommoditiesCommodity-linked markets have been among the poorest performing in EM. The supply-side challenges for commodities are well known and increasingly priced in. However, uncertainty persists on the demand side; a recovery in commodities will be intricately linked to Chinese growth. Any sign of stabilization there has the potential to quickly change the direction of sentiment.

Government reforms to state-owned enterprises and other growth measures have the potential to support a modest recovery in EM assets. A reduction in housing inventory could generate commodity demand, while rising fiscal spending on rail, power and water infrastructure — already in evidence (see chart below) — would also be positive.

Infrastructure spending in Asia ex-China, with annual growth estimated at 13% over the next 5 years,* could provide further stimulus.

Overall, we believe that in the medium term China’s growth deceleration will extend over several quarters but will include both cyclical bounces and slumps.

Key 2

Foreign Exchange and Local Debt DynamicsOne of the most significant trends in EM in the wake of the global financial crisis has been a substantial rise in debt. While debt has been important for arresting the extent of decline in ROE, it has conversely acted as a restraint on growth. Corporates have had to service those debts at relatively high interest rates, resulting in poor balance sheets. Any signs of a peak in levels of debt expansion or reduction in servicing costs would therefore be positive for EM.

Foreign exchange (FX) dynamics can be crucial here. A significant proportion of EM sovereign and corporate debt is owned by foreigners, particularly in Israel, Indonesia, Brazil, South Africa and Mexico. FX depreciation, while potentially good for exports, can increase the debt burden. A vicious cycle evolves if significant outflows add further downward pressure on FX. While most of the recent outflows have been in equity markets, a sell-off in local currency debt could feedback into equities, given the high correlation between FX and bonds/equities.

IS IT DIFFERENT NOW? IT MIGHT BE

Real rates are positive in most EM countries so there is room for further easing as long as real rates stay positive.

Reforms in the banking sector could help control lending to higher-risk corporates.

FX valuations are supportive. The undervaluation of FX is at levels last seen in 2008, and global macroeconomic conditions are arguably much improved.

KEY EM GROWTH CATALYSTS

*Source: CLSA, September 2015.


Fiscal Spending Recently Accelerated

‘10 ‘11 ‘12 ‘13 ‘14 ‘15

RMB Billion Chinese Government Total Fiscal Spending(Seasonally Adjusted)

1600

1200

800

40 ssga.com


Key 3

The Pace of Structural ReformWe have argued for some time that reform opportunities in many EM countries will be vital to help overcome the structural limitations to growth and support any sustained rally.

The precise policy prescriptions to address these trends vary significantly by country. In general, however, an acceleration in privatization of state-owned enterprises, expanding tax bases, reforms to land and labor laws and improvements in the overall business climate to attract foreign investment can all help boost growth and structural capital inflows.

At a company level, improving corporate governance, a stronger focus on costs and positive free cash flows would be beneficial. To some extent, efforts to reduce costs are already being seen in many emerging market firms; however, this has been countered by weak topline growth.

In the near term, wage growth in developed markets is showing signs of accelerating, which could help slow or reverse the narrowing differential with EM. Labor market reforms that make hiring and firing more flexible can also help contain wage growth. Additionally, privatization can contribute to a more competitive labor market, attract foreign investment and benefit overall productivity.

REFORMS TO WATCHBrazilEntitlement reform: Efforts to contain Brazil’s ballooning welfare expenditures and earmarked revenues will be essential for a sustainable fiscal adjustment.

ChinaState-Owned Enterprises: Progress is being made on moves toward mixed ownership, securitization and employee shareholding — particularly in market competitive sectors (as opposed to those deemed “national interest”).

IndiaTaxation: Plans are afoot to replace existing overlapping central and state taxes with a single sales tax, a major step toward consolidating a single internal common market and bolstering overall GDP growth.

MexicoRegulation: A range of measures including tax reform, regulatory framework changes to promote competition in the financial and telecom sectors, and reforms for the railway industry have been approved. Energy reforms and anti-corruption measures are ongoing.

IndonesiaInvestment: While progress has been slow, streamlined licensing requirements for Foreign Direct Investment (FDI) are planned, as are tax incentives for FDI labor-intensive infrastructure projects.

RussiaPrivatization: While plans to privatize a range of state-controlled companies have been made, only 5% of the target has so far been reached.

Inflation: Progress toward a credible inflation targeting regime remains stalled as lower oil prices, Western sanctions and the Ukraine crisis take priority.


EM Wage Growth Higher Than DM

Emerging Markets wage growth since 2009

Developed Markets wage growth since 2009

Down in 2012 Down in 2014Down in 20130.3% 0.5% 0.7%EM Productivity Growth Slipping

7.4% 2.0%


Investment Ideas

In 2015 we saw many elements of the credit sector underperform, providing what we believe are the right conditions for both investment grade and high yield debt to reward investors in 2016.

06 Fixed Income

CREDIT WHERE IT’S DUE

CREDIT FUNDAMENTALS ARE SUPPORTIVEEarnings remain solid, balance sheets are strong and there is little in the way of refinancing pressure.

CONSIDER HIGH YIELD & INVESTMENT GRADEFundamentals and QE underpin Investment Grade and High Yield debt.

BE CAUTIOUS ON EMERGING MARKETSWhile EM now looks more attractive, investors should remain cautious in this space.

42 ssga.com

Uncertainty and FragmentationA feature for much of the past two years has been the rise in uncertainty. Uncertainty around China, uncertainty around commodities and uncertainty around central bank interest rates.

This has driven a recent fragmentation of the risk-asset rally that has lifted markets far above the crisis levels of 2009.

There are many reasons why investors might presume that the credit cycle has already run its course. Principal among them are concerns around the impact of the slowdown in China on global growth and the timing and pace at which the Federal Reserve raises interest rates. There is a perception, largely unwarranted, that credit simply does not do well in a rate-tightening environment.

Be SelectiveNotwithstanding the uncertain backdrop, we believe that selective exposure to credit is a strategy worth pursuing because of accommodative global monetary policy and the continuing influence of quantitative easing (QE) in particular. The correlation between QE and lower interest rates is clearly evident in the trajectory of government bond yields since the onset of the Global Financial Crisis, as illustrated below.

That Déjà Vu Feeling?Lower government bond yields for extended periods present investors with a dilemma: How do you balance the security of a government bond with the need for reasonable returns? This can push investors further up the risk spectrum into credit sectors including investment grade corporate bonds, high yield and maybe even emerging market debt. The push toward riskier assets has been supported by central bank monetary policies in this instance, but it’s not the first time that we’ve seen yields pushed lower by such a demand shock.

In the mid-2000s, demand for investment grade credit and high yield debt was fueled by the structured credit boom. This fueled demand for credit in general and helped power leveraged buyouts to record levels. The impact on credit markets was particularly noticeable. Following the dotcom bubble and the corporate scandals of the early part of the millennium, credit spreads rallied to historically tight levels in both the investment grade space and high yield markets.

Source: SSGA, Bloomberg, as at 31 October 2015.

Investment Grade Credit Spreads

High Yield Credit Spreads

Source: Bloomberg, BAML Option-Adjusted Spreads, as at 31 October 2015.

Source: Bloomberg, BAML Option-Adjusted Spreads, as at 31 October 2015.

2003

2003

2000

2000

2006

2006

2009

2009

2012

2012

2015

2015

Basis Points

Basis Points

US Credit

US Credit

Euro Credit

Euro Credit

500

400

700

600

300

100

200

2,500

2,000

1,500

500

1,000

Government Bond Yields Near All-Time Lows

US 10 Year

German 10 Year

UK 10 Year

Japanese 10 Year

2.12%

0.62%

1.86%

0.32%


No Silver BulletWhat is particularly notable about the highlighted periods in the charts is just how stable credit markets were, with low levels of volatility in both markets.

However, while QE has bolstered credit markets since 2009, it hasn’t prevented a sell-off this time. General market volatility and the fallout from low oil prices on energy-sector debt is largely responsible for the recent jump in US high yield credit spreads above their long-term average. Meanwhile, investment grade markets are closer to what we would consider fair value.

More QE The argument that central bank actions will continue to support investment grade and high yield credit markets is persuasive, provided there are no dramatic shifts in policy.

The ECB’s QE program runs through September 2016 and consists, at a minimum, of buying €60 billion of government and non-sovereign bonds each month. However, there is a growing belief that this program could be extended and the Bank of Japan also seems to be open to an increase in its QE program.

Rising Rates Are a Positive SignalWhile the market expects the Bank of England to start raising interest rates by mid-2016 and the Fed to embark on that journey before then, both have been slow to follow through on previous expectations.

Inflationary pressures have failed to materialize. And, more recently, the Fed has expressed concerns about global economic and financial developments that have the potential to restrain economic activity. It should be noted, however, that a Fed move to raise interest rates would constitute a vote of confidence in both the domestic and global outlook. That should, in turn, imply a positive outlook for corporates, consumers and, by association, credit markets. History supports this view as credit spreads typically perform well after the Fed commences a tightening cycle.

Credit Fundamentals Broadly Healthy …The investment case is also underpinned by the fundamentals:

Ɇ Corporate earnings are strong in the US and showing signs of improvement in Europe.

Ɇ While the credit cycle is now quite mature, balance sheets are not particularly extended.

Ɇ A greater proportion of M&A activity in this cycle has been funded by equity rather than by leveraged buyouts.

Ɇ Cash balances in general remain high. Ɇ Low yields in recent years have enabled issuers to

term-out their debt, reducing refinancing risks as rates rise over the coming years.

… Although Not EverywhereNotwithstanding the broad support from credit fundamentals, the impact of slumping oil prices on the energy sector (particularly in the US, where the index exposure is heavier) is indicative that areas of concern exist, as they always do. But then again, the correction we have witnessed this year suggests a lot of the bad news is already priced in.

This is best illustrated by an example: Distressed bonds trade at significant discounts to their par value to reflect their high probability of default and potential recovery value. There is currently $54.5 billion (face value) of the US high yield market trading with a price below $0.50, representing 4.1% of the index (again based on face value).

The energy sector accounts for nearly 60% of this total. The average price of this debt is just under $0.31, so if all of this debt was to default with 0% recovery then the impact on the index would be -1.3%. For an index currently yielding 7.75%, these potential losses are clearly bearable.

44 ssga.com


Emerging Market DebtEmerging market debt is more vulnerable to exogenous shocks, as we witnessed during the Mexican debt crisis in 1994, the Asian debt crisis and, more recently, in Russia, Ukraine and Brazil. Emerging markets have been facing significant headwinds of late in the form of weakening growth, concerns around China and the softening in commodity prices.

EM currencies in aggregate (based on the JP Morgan Emerging Markets Currency Index) are down over 30% versus the US dollar over the last four years, while yields on both local-currency and hard-currency debt have increased by about 2% from their lows in mid-2013 (see graph below). Markets have re-priced EM risks and the question is whether they now represent good value.

Following the sell-off in both emerging market currencies and bonds there may now be some potential for EM debt, especially if it shows some stability if, and when, the Fed starts to raise rates. But concerns remain and investors should seek more certainty around the outlook for emerging markets before committing to an asset class that has struggled over the last couple of years.

EM Debt — Hard and Local Currencies

Source: SSGA, Bloomberg, JP Morgan, as at 31 October 2015.

2010 2011 2012 2013 2014 2015

Percent JP Morgan EM (Local Currency)JP Morgan EM (Hard Currency)

8

7

5

6

The argument that monetary policy/QE is supportive of credit investment is persuasive. Investors considering credit can also take comfort in the strong fundamentals underpinning much of the sector.

Furthermore, investment grade and high yield have re-priced in 2015 to take into account the evolving macroeconomic situation and drop in oil prices.

Quantitative easing in Japan and the eurozone is far from being exhausted and is supportive of credit prospects in 2016. The upside potential for high yield credit is arguably more compelling than investment grade credit, but investors must weigh their own requirements in terms of risk, return and duration when balancing allocations. Investment grade credit typically has longer duration than high yield.

Understandably, investors may be concerned about exogenous shocks and the impact these could have on credit markets but history supports the argument that investment grade and high yield markets are typically resilient to exogenous shocks.

Whether you’re talking about the 1997 Asian financial crisis, the 1998 Russian default or the more recent European sovereign debt crisis, credit markets have proven robust.

TAKING CREDIT IN 2016


For more on how we can help you navigate the current low and slow environment or to discuss any of the investment themes in this outlook, please contact your relationship manager or visit us at ssga.com

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For institutional use only. Not for use with the public. State Street Global Advisors Worldwide EntitiesAustralia: State Street Global Advisors, Australia, Limited (ABN 42 003 914 225) is the holder of an Australian Financial Services Licence (AFSL Number 238276). Registered Office: Level 17, 420 George Street, Sydney, NSW 2000, Australia. T: +612 9240 7600. F: +612 9240 7611.Belgium: State Street Global Advisors Belgium, Chausse de La Hulpe 120, 1000 Brussels, Belgium. T: +32 2 663 2036, F: +32 2 672 2077. SSGA Belgium is a branch office of State Street Global Advisors Limited. State Street Global Advisors Limited is authorized and regulated by the Financial Conduct Authority in the United Kingdom.Canada: State Street Global Advisors, Ltd., 770 Sherbrooke Street West, Suite 1200 Montreal, Quebec, H3A 1G1, T: +514 282 2400 and 30 Adelaide Street East Suite 500, Toronto, Ontario M5C 3G6. T: +647 775 5900.Dubai: State Street Bank and Trust Company (Representative Office), Boulevard Plaza 1, 17th Floor, Office 1703 Near Dubai Mall & Burj Khalifa, P.O Box 26838, Dubai, United Arab Emirates. T: +971 (0)4 4372800. F: +971 (0)4 4372818.France: State Street Global Advisors France. Authorized and regulated by the Autorité des Marchés Financiers. Registered with the Register of Commerce and Companies of Nanterre under the number: 412 052 680. Registered Office: Immeuble Défense Plaza, 23-25 rue Delarivière-Lefoullon, 92064 Paris La Défense Cedex, France. T: +33 1 44 45 40 00. F: +33 1 44 45 41 92.Germany: State Street Global Advisors GmbH, Brienner Strasse 59, D-80333 Munich. T: +49 (0)89 55878 100. F: +49 (0)89 55878 440.Hong Kong: State Street Global Advisors Asia Limited, 68/F, Two International Finance Centre, 8 Finance Street, Central, Hong Kong. T: +852 2103 0288. F: +852 2103 0200.Ireland: State Street Global Advisors Ireland Limited is regulated by the Central Bank of Ireland. Incorporated and registered in Ireland at Two Park Place, Upper Hatch Street, Dublin 2. Registered Number: 145221. Member of the Irish Association of Investment Managers. T: +353 (0)1 776 3000. F: +353 (0)1 776 3300.Italy: State Street Global Advisors Limited, Milan Branch (Sede Secondaria di Milano) is a branch of State Street Global Advisors Limited, a company registered in the UK, authorized and regulated by the Financial Conduct Authority (FCA ), with a capital of GBP 71’650’000.00, and whose registered office is at 20 Churchill Place, London E14 5HJ. State Street Global Advisors Limited, Milan Branch (Sede Secondaria di Milano), is registered in Italy with company number 06353340968 - R.E.A. 1887090 and VAT number 06353340968 and whose office is at Via dei Bossi, 4 - 20121 Milano, Italy. T: +39 02 32066 100. F: +39 02 32066 155.Japan: State Street Global Advisors (Japan) Co., Ltd., Japan, Toranomon Hills Mori Tower 25F, 1-23-1 Toranomon, Minato-ku, Tokyo, 105-6325. T: +81 (0)3 4530 7380 Financial Instruments Business Operator, Kanto Local Financial Bureau (Kinsho #345) Membership: Japan Investment Advisers Association, The Investment Trust Association, Japan, Japan Securities Dealers’ Association.

Netherlands: State Street Global Advisors Netherlands, Adam Smith Building, Thomas Malthusstraat 1-3, 1066 JR Amsterdam, Netherlands. T: +31 (0)20 7181701. State Street Global Advisors Netherlands is a branch office of State Street Global Advisors Limited. State Street Global Advisors Limited is authorized and regulated by the Financial Conduct Authority in the United Kingdom.Singapore: State Street Global Advisors Singapore Limited, 168 Robinson Road, #33-01 Capital Tower, Singapore 068912 (Company Registered Number: 200002719D). T: +65 6826 7500. F: +65 6826 7501.Switzerland: State Street Global Advisors AG, Beethovenstrasse. 19, Postfach, CH-8027 Zurich. T: +41 (0)44 245 70 00. F: +41 (0)44 245 70 16.United Kingdom: State Street Global Advisors Limited. Authorized and regulated by the Financial Conduct Authority. Registered in England. Registered Number: 2509928. VAT Number: 5776591 81. Registered Office: 20 Churchill Place, Canary Wharf, London, E14 5HJ. T: +020 3395 6000. F: +020 3395 6350.United States: State Street Global Advisors, One Lincoln Street, Boston, MA 02111-2900. T: +1 617 664 7727.Investing involves risk including the risk of loss of principal. The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA’s express written consent. The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor. All material has been obtained from sources believed to be reliable. There is no representation or warranty as to the accuracy of the information and State Street shall have no liability for decisions based on such information. The views expressed in this material are the views of SSGA as of 30 November 2015 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.Risk associated with equity investing include stock values which may fluctuate in response to the activities of individual companies and general market and economic conditions. The views expressed in this material are the views of SSGA as of 1 November 2015 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.This document provides summary information regarding the Strategy. This document should be read in conjunction with the Strategy’s Disclosure Document, which is available from SSGA. The Strategy Disclosure Document contains important information about the Strategy, including a description of a number of risks.

About UsFor nearly four decades, State Street Global Advisors has been committed to helping our clients, and the millions who rely on them, achieve financial security. We partner with many of the world’s largest, most sophisticated investors and financial intermediaries to help them reach their goals through a rigorous, research-driven investment process spanning both indexing and active disciplines. With trillions* in assets, our scale and global reach offer clients unrivaled access to markets, geographies and asset classes, and allow us to deliver thoughtful insights and innovative solutions.

State Street Global Advisors is the investment management arm of State Street Corporation.

*Assets under management were $2.2 trillion as of 30 September 2015.

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