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2018 Capital Market Projections

Capital Markets Research Group

January 2018

12018 Capital Market ProjectionsKnowledge. Experience. Integrity.

Agenda

● Process Overview– Why does Callan create capital market projections?

● 2018 Projections– What are our projections and how did we develop them?– Economic outlook– Asset class outlook

– Equity– Fixed Income– Alternative Investments

● Detailed 2018 Projections and Resulting Portfolio Returns

Process Overview


Why Make Capital Market Projections?

● Cornerstone of a prudent process is a long-term strategic investment plan

● Capital market projections are key elements — set reasonable return and risk projections for the appropriate time horizon

● Projections represent our best thinking regarding the long-term (10-year) outlook, recognizing our median projections represent the midpoint of a range, rather than a specific number

● Develop results that are readily defensible both for individual asset classes and for total portfolios

● Be conscious of the level of change suggested in strategic allocations for long-term investors: DB plan sponsors, foundations, endowments, trusts, DC participants, families and individuals

● Reflect common sense and recent market developments, within reason– Callan’s forecasts are informed by current market conditions, but are not built directly from them

● Balance recent, immediate performance and valuation against long-term equilibrium projections

Guiding Objectives and Process


Why Make Capital Market Projections?

● Underlying beliefs guide the development of the projections:– An initial bias toward long-run averages– A conservative bias– An awareness of risk premiums– A presumption that markets ultimately clear and are rational.

● Reflect our beliefs that long-term equilibrium relationships between the capital markets and lasting trends in global economic growth are key drivers to setting capital market projections

● Long-term compensated risk premiums represent “beta”—exposure to each broad market, whether traditional or “exotic,” with limited dependence on successful realization of alpha

● The projection process is built around several key building blocks:– Advanced modeling at the individual asset class level (for example, a detailed bond model, an equity model)– A path for interest rates and inflation– A cohesive economic outlook– A framework that encompasses Callan beliefs about the long-term operation and efficiencies of the capital

markets.

Guiding Objectives and Process


How are Capital Market Projections Constructed?

● Projections consist of return and two measures that contribute to portfolio volatility: standard deviation and correlation

● Cover most broad asset classes and inflation– Broad Domestic Equity

– Large Cap– Small/mid Cap

– International Equity– Developed Markets– Emerging Markets

– Domestic Fixed Income– Short Duration– Broad Market– TIPS– High Yield– Long Duration

– International Fixed Income– Real Estate– Alternative Investments– Cash– Inflation


The Capital Markets at January 2018

● Stock and bond markets enjoyed a solid year around the world, with particularly strong results in emerging markets equity. Underlying economic data remain positive, and tell a story of persistent growth in the U.S. and continued modest recovery in Europe.

● Five-year US equity returns through 2017 are very strong.Ten-year returns no longer include the robust 2003-05 results. Fifteen-year equity returns are now close to long-run averages, and are above those of fixed income, as 2000-2002 downturn has rolled off the calculation.

U.S. and Global Capital Markets Rallied After Mid-Year Investor Uncertainty

Average Annual Returnsfor periods ended 12.31.2017

2012 2013 2014 2015 2016 2017 5 Years 10 Years 15 YearsBroad U.S. Stock MarketRussell 3000 16.42 33.55 12.56 0.48 12.74 21.13 15.58 8.60 10.25Large Cap U.S. StocksS&P 500 16.00 32.39 13.69 1.38 11.96 21.83 15.79 8.50 9.92Small Cap U.S. StocksRussell 2000 16.35 38.82 4.89 -4.41 21.31 14.65 14.12 8.71 11.17Non-U.S. Stock MarketsMSCI EAFE US$ 17.32 22.78 -4.90 -0.81 1.00 25.03 7.90 1.94 8.11MSCI Emerging Markets 18.63 -2.27 -1.82 -14.60 11.60 37.75 4.73 2.02 12.68Fixed IncomeBarclays Aggregate 4.21 -2.02 5.97 0.55 2.65 3.54 2.10 4.01 4.15Barclays Glbl Agg ex USD 4.09 -3.08 -3.09 -6.02 1.49 10.51 -0.20 2.40 4.25Barclays Long Gov/Credit 8.78 -8.83 19.31 -3.30 6.67 10.71 4.43 7.26 6.77Real EstateNCREIF 10.54 10.98 11.82 13.33 7.97 6.85 10.16 6.07 9.01Hedge FundsCS Hedge Fund Index 7.67 9.73 4.13 -0.71 1.25 7.12 4.23 3.24 6.01Private EquityCambridge Private Equity* 13.54 21.02 11.80 8.66 9.26 15.76* 13.45* 8.85* 12.63*CommoditiesBloomberg Commodity -1.06 -9.52 -17.01 -24.66 11.77 1.70 -8.45 -6.83 -0.27Cash Market90-Day T-Bill 0.11 0.07 0.03 0.05 0.33 0.86 0.27 0.39 1.28InflationCPI-U 1.74 1.50 0.76 0.73 2.07 2.11 1.43 1.61 2.08

• Private equity data is time-weighted return series for 1, 5, 10 and 15-year periods ended 6.30.2017 rather than 12.31.2017 in select columns due to a reporting lag.

Source: Callan Associates

Economic Outlook


Economic Outlook

● Real Gross Domestic Product (GDP) Growth and Consumer Price Inflation (CPI) are forecast

● Callan forecasts are based on forecasts provided by governmental and non-governmental agencies as well as private sources such as– Federal Reserve– Bureau of Economic Analysis (BEA)– International Monetary Fund (IMF)– European Central Bank (ECB)– Bank for International Settlements (BIS)– National statistics offices– IHS Markit

● Forecasts are intertwined – GDP and inflation tend to rise and fall together

● Forecasts form a starting point for projections– GDP forecasts provide a very rough estimate of future earnings growth– Inflation forecasts provide an approximate path for short-term yields– Inflation is added to the real return forecasts for equity and fixed income

Role of Economic Variables


Economic Outlook

● Real GDP grew in excess of 3% for the middle two quarters of 2017– Well above 10-year average of 1.4%– Higher than 50-year average of 2.8%

● Some sectors grew more strongly than others– Real gross private domestic investment grew well above trend with a Q3 YoY growth rate of 4.5%– Real personal consumption expenditures grew in the 2.5% to 3% range– Real government expenditures were flat

Historical US Real Gross Domestic Product (GDP) Growth

Source: U.S. Bureau of Economic Analysis, Callan LLC


Economic Outlook

● Fed real GDP growth projections from 12/13/17 meeting

● Fed is not optimistic that current real growth levels can be maintained– Median estimate is at 2% or above through 2020– Median estimate falls below 2% over the longer run

● Part of the Fed’s pessimism may be due to the length of the current expansion– Current expansion at 34 quarters vs. median of 24 quarters over the last 50 years

Forecast US Real Gross Domestic Product (GDP) Growth

Source: Board of Governors of the Federal Reserve System, Callan LLC


Economic Outlook

● Personal consumption expenditures (PCE) account for almost 70% of US economic activity– Current economic growth is limited unless consumers are spending

● Size of gross private domestic investment now comparable to government spending– Domestic investment has a large impact on future economic growth

● Government expenditures as percentage of GDP continue to fall after GFC stimulus

US Real Gross Domestic Product (GDP) Shares



Economic Outlook

● The services component of real personal consumption expenditures (PCE) is key to current economic growth– Services make up almost

70% of PCE– Growth improved

significantly since the end of the GFC but has been trending down over recent periods

● Growth in spending on durable goods has been strong– Rebounded quickly after

GFC to longer term average– Durable goods spending

continues to grow almost twice as fast as GDP as a whole

Personal Consumption Expenditures



Economic Outlook

● Real gross private domestic investment growth has turned positive again– In mid 2016 it was falling at a 2.5% to 3% annual rate– In Q3 2017 it grew at 4.5%, above the long-term average of 3.9%

● Although investment only accounts for about 15% of current GDP it is key to future GDP growth– Residential construction leads to follow on consumption– Productivity grows when firms purchase new equipment and technologies

US Real Gross Private Domestic Investment



Economic Outlook

● Residential fixed investment has struggled in recent periods– Residential fixed investment

represents about 20% of total private investment

– Recovered after the GFC– Modestly positive in 2017 but

below average– Increasing mortgage rates

could restrain future growth

● Non-residential fixed investment has rebounded– Non-residential fixed

investment represents about 80% of total private investment

– Modestly negative through much of 2016

– Appears to indicate optimism for future demand

US Real Gross Private Domestic Investment



Economic Outlook

● Intellectual property products are a large part of non-residential fixed investment– Account for 30% to 35% – Second largest component

behind equipment

● Composition of intellectual property products – Software– Research and development– Entertainment, literary and

artistic originals

● Growth in intellectual property products is high but erratic

US Real Gross Private Domestic Investment: Intellectual Property Products



Economic Outlook

● US Real GDP Forecast to Grow at 2% to 2.5%

● Forecast stakes out a middle ground– Lower than recent growth– Higher than Fed’s longer run growth estimate

● Factors which could lead to the higher end of the forecast– Consumer spending on services rebounds to levels at or above its historical average– Tax and regulatory environment spur further increases in business investment as well as consumer spending

● Factors which could lead to the lower end of the forecast– Consumers cut their spending on durable goods– Higher mortgage rates limit private domestic residential investment– Lower consumer spending causes businesses to curtail their investment spending

US Real GDP Growth Forecasts


Economic Outlook

● IMF expects foreign developed economic growth to be tepid over the next 5 years– International Monetary Fund, World Economic Outlook Database, October 2017

● France and Canada lead with expected growth rates of about 1.8%

● Japan is expected to experience the lowest level of growth at about 0.6%

● The IMF expectation for US growth is 1.7%

Developed Markets GDP Growth

Source: International Monetary Fund World Economic Outlook Database, Callan LLC


Economic Outlook

● Growth should be underpinned by increasing employment

● Italian unemployment is expected to fall into the single digits

● Unemployment in France should dip under 8% for the first time since the GFC

● Japanese unemployment is expected to be steady at just under 3%

Developed Markets Unemployment



Economic Outlook

● 1.5% to 2.0% for Developed Non-US Markets– Real growth rates improved through 2017– Employment picture is brightening– Threat of political instability has subsided

● Factors which could lead to the higher end of the forecast– More consumer and governmental spending in Germany– Clearer path to Brexit

● Factors which could lead to the lower end of the forecast– ECB tightening– Stubbornly high unemployment

Non-US Developed Markets Real GDP Growth Forecasts


Economic Outlook

● IMF forecasts a wide range of growth rates for emerging markets economies

● India leads the way with an 8% growth rate

● China’s growth rate is expected to decline but only to the 6% level at the end of the forecast

● Resource driven economies are anticipated to have slow growth although this could change if commodity prices such as oil continue to rise

Emerging Markets GDP Growth



Economic Outlook

● High levels of employment should keep growth healthy

● Brazilian employment is rebounding after a severe downturn

● Labor markets in Korea, Taiwan and Mexico are tight

● South Africa (not shown) will wrestle with unemployment on the order of 25% to 30%

Emerging Markets Unemployment



Economic Outlook

● 4% to 5% for Emerging Markets– Actual growth rate depends heavily on performance of China and India– Smaller economies need to grow at least at the rates of developed markets

● Factors which could lead to the higher end of the forecast– Demand for exports of consumer products and natural resources remains high– Unemployment falls at a faster rate than forecast

● Factors which could lead to the lower end of the forecast– Political uncertainty– Difficulties in the private borrowing markets– Global growth fades

Emerging Markets Real GDP Growth Forecasts


Economic Outlook

● Consumer price inflation has averaged in the low to mid 2% range over the most recent 30 years

● Inflation rebounded in 2011 but subsequently fell back to near zero

● Headline inflation currently exceeds core– Headline inflation has fluctuated significantly around core primarily due to transient impacts of energy prices

● CPI has average about 45 bps above PCE over 30 years but the gap has been narrower in many recent periods

Historical US Consumer Price Inflation Measures

Source: U.S. Bureau of Labor Statistics, Callan LLC


Economic Outlook

● Fed forecasts the Personal Consumption Expenditure (PCE) measure of inflation

● Longer term forecast of 2% implies CPI near 2.45%– 2% forecast is consistent with the Fed’s policy benchmark but may be above actual expectations– Fed has had trouble meeting this benchmark until recently– By presenting a 2% longer run forecast the Fed may be trying to anchor expectations there

Fed Inflation Forecasts

Source: Board of Governors of the Federal Reserve System, Callan LLC


Economic Outlook

● Crude oil prices are on an upward trend– Brent rose above $60 in Q4

● Demand for oil is expected to strengthen with worldwide uptick in economic growth

● Supply is a wildcard– Political factors– Alternative sources of petroleum products and alternative energy

Crude Oil

Source: Federal Reserve Bank of St. Louis , Callan LLC


Economic Outlook

● Compensation growth is a “stickier” driver of inflation– Expectations tend to be anchored at relatively stable levels over long periods

● Real wage and salary growth is modestly above 30-year average

● Compensation trend has been going down over the most recent 3 years

Real Employment Compensation

Source: U.S. Bureau of Labor Statistics , Callan LLC


Economic Outlook

● 2% to 2.5% CPI Growth– Headline CPI-U growth accelerated in 2016 but drifted down to near 2% in 2017– Core CPI dropped below 2% early in 2017 and has remained there– PCE growth touched 2% but subsided as the year progressed– Oil prices could have a transient impact if they rise moderately– Real employment compensation growth appears anchored at low levels

● Factors which could lead to significant deviations from the forecast– Sustained changes in energy prices that pass through to prices of finished goods– Variations in employment compensation expectations– Significant changes in the value of the dollar

US Inflation Forecasts


Economic Outlook

● IMF expects non-US developed consumer price inflation to be well controlled over the next 5 years– Germany is expected to have the highest level of inflation at about 2.5%– Japan and Italy are expected to have the lowest levels at about 1.5%

● The European Central Bank (ECB) has a target of 2%– It has been unsuccessful in reaching that target in spite of its loose monetary policies– The ECB has announced that its policies will tighten going forward

Developed Markets Consumer Price Index (CPI) Inflation

Source: International Monetary Fund World Economic Outlook Database , Callan LLC


Economic Outlook

● IMF expects emerging markets consumer price inflation to reach moderate levels over 5 years– South Africa is expected to have the highest level of inflation at about 5.5%– Taiwan and Korea are expected to have developed market levels of about 2%

● External economic factors and internal political issues could lead to very different outcomes

Emerging Markets Consumer Price Index (CPI) Inflation

Source: International Monetary Fund World Economic Outlook Database , Callan LLC


Economic Outlook

● 1.75% to 2.25% for Developed Non-US Markets– Inflation is starting to tick up but is very low in the largest economies– Factors which could lead to upper end of forecast

– The ECB or the BoJ raise interest rates too slowly– Increases in energy prices– Improving labor markets lead to wage inflation

– Factors which could lead to lower end of forecast– High levels of government debt constrain necessary fiscal stimulus– Unemployment does not improve as expected

● 2.5% to 3.5% for Emerging Markets– Future inflation is uncertain– Path of prices depends on government policies, relative currency strength, trade policies, the balance of

internal supply and demand, and commodity prices

Inflation Forecasts


Economic Outlook

● The US Treasury yield curve flattened between the end of 2016 and the end of 2017

● The short end rose in concert with increases in the Fed Funds rate

● Yields on the long end declined with the 30 year yield falling from about 3.1% to just over 2.75%

Interest Rates, Historical US Treasury Yield Curves

Source: U.S. Department of the Treasury, Callan LLC


Economic Outlook

● Developed markets government rates have given a hint of turning up– A similar pattern was observed in 2013

● The US Treasury 10-year rate is the highest among major markets as it rose above 2% at the end of Q3 and is now above 2.5%– Rates have risen before only to fall back

● Rates in Japan (5 bps) and Germany (40 bps) are still very low

Interest Rates, Historical Developed Market 10-Year Treasury Rates

Source: Organization for Economic Co-operation and Development, Callan LLC


Economic Outlook

● Fed Governors and Presidents see rising Fed Funds rate but at different paces

● Fed Funds should peak in 3 years

● “Longer run” Fed Funds rate at 3% or below

Interest Rates, Fed “Dot Plot”

5.04.875

4.750

4.625

4.54.375

4.250

4.125

4.03.875

3.750

3.625

3.5

3.375

3.250

3.125

3.0

2.875

2.750

2.625

2.5

2.375

2.250

2.125

2.01.875

1.750

1.625

1.51.375

1.250

1.125

1.00.875

0.750

0.625

0.50.375

0.250

0.125

0.02017 2018 2019 2020 Longer run

Source: Board of Governors of the Federal Reserve System,Callan LLC


Economic Outlook

● Option-adjusted spreads (OAS) for the Bloomberg Barclays US Aggregate Index have continued the narrowing that began in 2016

● Since the end of the GFC spreads have cycled in a fairly narrow range– From 2012 to 2014 spreads narrowed from 91 bps to 40 bps before widening back to 64 bps over the next 2

years

Interest Rates, Bloomberg Barclays US Aggregate Index Option-Adjusted Spreads

Source: Bloomberg Barclays, Callan LLC

Asset Class Outlook


Equity Forecasts

● Fundamental Relationship

● Forecast capital appreciation depends on projected future earnings– Long-term earnings tend to correspond to long-term GDP growth

– Weak short-term relationship– Relationship more robust in developed than emerging markets economies

– Investors will pay more for stocks with better future earnings potential– Prices don’t depend on historical or current earnings

● Forecast income also depends on projected future earnings– Income is related to earnings via the payout ratio– Income also influenced by

– Prospects for future corporate investments– Interest rates

● Valuations have limited impact on forecasts– Average P/Es over different market cycles differ markedly

– Oil Boycott– Tech Bubble– Global Financial Crisis

– Capital market projections only impacted when markets reach extreme valuations

Overview

Equity Return = Capital Appreciation + Income


Equity Forecasts

● The S&P 500 P/E as of 9/30/17 was 23.5

● This P/E is well within norms for the most recent 29 years– The 90th percentile (highest 10%) P/E is 29.5– The median P/E is 20.8– The P/E as of 12/30/16 was 23.7 so it has been relatively stable for the last year

S&P 500 Price/Earnings Ratio

Source: S&P Dow Jones Indices, Callan LLC


Equity Forecasts

● S&P 500 earnings have been growing rapidly since Q4 2016

● For the year ended Q3 2017, reported earnings grew by just over 20%

● Capital appreciation for the S&P 500 in 2017 was 19.42% which is why the P/E is essentially unchanged

S&P 500 Earnings



Equity Forecasts

● Quotes from Robert Shiller’s Op-Ed in the New York Times, March 31, 2017– “In years when CAPE was lower than that [15], subsequent 10-year returns for the stock market tended to be

good. In years when it was higher, the 10-year returns tended to be bad.”– “The current level of CAPE suggests a dim outlook for the American stock market over the next 10 years or so,

but it does not tell us for sure nor does it say when to expect a decline.”– “But my bottom line is that the high pricing of the market — and the public perception that the market is indeed

highly priced — are the most important factors for the current market outlook. And those factors are negative.”– “We don’t know where the market will go this month or this year.”

Cyclically Adjusted Price-Earnings Ratio (CAPE)

Source: http://www.econ.yale.edu/~shiller/data.htm, Callan LLC


Equity Forecasts

● Over 50% of earnings comes from 3 sectors– Information technology (22.3%)– Financials (16.8%)– Healthcare (14%)

● Changes in earnings growth rates in any of these sectors would have a substantial impact on overall index earnings – These sectors are seen as generally benefiting from tax law changes

S&P 500 Contributions to Earnings



Equity Forecasts

● Dividends were growing at a rapid rate but slowed in 2017– Double digit growth from

2011 through 2015– Mid single digits since 2016

which is close to the long-term median

● Dividend yields are still within historical norms– Q3 yield was 1.95%– Median since 1988 is 2.04%– 10th percentile (lowest 10%

of dividend yields) is 1.38%

S&P 500 Dividend Yield



Equity Forecasts

● The Russell 2500 nominal earnings growth has been declining but remains close to 10%

● Compound earnings growth has been substantially smaller than double digits due to the volatility of earnings

Russell 2500 Earnings Growth

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

0.0

2.5

5.0

7.5

10.0

12.5

15.0

17.5

20.0

22.5

Nom

inal

Gro

wth

in E

arni

ngs

US Eq R2500 US Eq R2500 Average

9.8410.84

Source: FTSE Russell, Callan LLC


Equity Forecasts

● The Russell 2500 appreciated by about 15% in 2017

● Appreciation exceeded even the high earnings growth rate

● The price-earnings ratio is above its average but not near historical peaks

Russell 2500 Price-Earnings Ratio

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

10

15

20

25

30

35

40

Pric

e/Ea

rnin

gs R

atio

(exc

neg

)


25.8

21.9



Equity Forecasts

● The Russell 2500 appreciated by about 15%

● The price return was higher than the growth in dividends causing the dividend yield to fall

● The current dividend yield is near its long-term average

Russell 2500 Dividend Yield

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

1.00

1.25

1.50

1.75

2.00

2.25

Div

iden

d Yi

eld


1.441.43



Equity Forecasts

● Return = 6.85%, Risk = 18.25%

● Broad US equity is represented by the Russell 3000 index

● Earnings growth must continue to keep pace with returns– Short-term measures of valuations are above average but not at extremes

– Strong earnings growth in excess of returns could reduce valuations without a significant market correction– Longer-term valuation measure provides imprecise forecasts– Large cap earnings growth anticipated to modestly outpace GDP growth– Small cap earnings growth should grow faster than large cap– US consumers have to continue to buy in the face of limited wage growth– Firms need to continue to invest to improve productivity and profits

● Dividend yield consistent with recent history– Growth in dividends likely to continue near current pace while returns moderate leading to modestly higher

yields– Dividend growth may suffer if firms focus on investment but additional investment will improve expected capital

appreciation– Yields have been stable for 20 years in the face of changing interest rates so higher rates are unlikely to have

a large impact

● Inflation is added to earnings growth and dividend yield to get the nominal return

Broad US Equity


Equity Forecasts

● The World ex USA nominal earnings have shown modest growth since 2014

● Continued improvements in GDP growth are likely to support future earnings growth

MSCI World ex USA Earnings Growth

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

(10)

(5)

0

5

10

15

20

25

30

Nom

inal

Gro

wth

in E

arni

ngs

NUS Eq MSCI World ex USA NUS Eq MSCI World ex USA Average

5.08

7.87

Source: MSCI, Callan LLC


Equity Forecasts

● Capital appreciation for the World ex USA in 2017 was 21%

● Just as in the US, earnings growth has not kept pace with returns leading to increases in valuations

● The World ex USA P/E is moderately above its average since 2004

MSCI World ex USA Price-Earnings Ratios

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

7.5

10.0

12.5

15.0

17.5

20.0

22.5

25.0

Pric

e/Ea

rnin

gs R

atio

(exc

neg

)


17.9

15.7



Equity Forecasts

● World ex USA dividend yields fell over the course of 2017

● Dividends grew but not as quickly as the index appreciated

● The dividend yield is now below its average since 2004

MSCI World ex USA Dividend Yield

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

Div

iden

d Yi

eld


2.903.07



Equity Forecasts

● Earnings growth in emerging markets fell from 2014 into 2017

● Recent earnings growth rates have been below the average of the last 11 years but are trending up

● Future earnings growth will be supported by continued GDP growth

MSCI Emerging Markets Earnings Growth

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

5

10

15

20

25

30

Nom

inal

Gro

wth

in E

arni

ngs

NUS Eq MSCI Emg Mkts NUS Eq MSCI Emg Mkts Average

9.91

14.65



Equity Forecasts

● Capital appreciation for the Emerging Markets Index in 2017 was over 34%

● A relatively high rate of earnings growth has kept valuations in check

● P/E is only modestly above its average since 2004

MSCI Emerging Markets Price-Earnings Ratios

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

7.5

10.0

12.5

15.0

17.5

20.0

Pric

e/Ea

rnin

gs R

atio

(exc

neg

)


14.9

13.4



Equity Forecasts

● Dividends grew in emerging markets but were not able to keep pace with the high level of capital appreciation forcing yields lower

● Yields are expected to rise as the relative growth of prices and dividends moves back to normal

MSCI Emerging Markets Dividend Yield

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

1.5

2.0

2.5

3.0

3.5

4.0

4.5

Div

iden

d Yi

eld


2.17

2.58



Equity Forecasts

● Return = 7.00%, Risk = 21.00%

● Global ex US equity is represented by the MSCI All-Country World ex USA index

● Earnings growth likely to be moderate– Earnings expected to be at the top end of GDP growth for developed markets– Emerging markets earnings growth is expected to modestly lag GDP growth consistent with history– Improving projections for GDP growth support earnings in developed markets

– ECB and BoJ likely to err on the side of maintaining looser monetary policy which will support economic growth and earnings – Valuations above average but not substantially so in both developed and emerging markets– Moderate uncertainty remains for future political and economic policies

● Relatively high dividend yields will support returns– Developed markets yields are expected to recover to average levels of ~3%– Dividend yields for emerging markets expected to at least move toward historical average of about 2.5%

Global ex US Equity


Fixed Income Forecasts

● Fundamental Relationship

● Forecast capital appreciation depends on projected future interest rates– Inflation– Central bank policy– Credit conditions

● Income = yield

● Roll return reflects capital appreciation from declines in yields as bonds move toward maturity with upward sloping yield curves

Overview

Bond Return = Capital Appreciation + Income + Roll Return



● End of year yields for the Aggregate Index have been remarkably stable for the last 3 years– 12/31/15 = 2.59%– 12/30/16 = 2.61%– 12/29/17 = 2.71%

● Yields last peaked at 5.67% in Q3 2008

Bloomberg Barclays Aggregate Index Yield to Worst




● Spreads have cycled over the most recent four years– 0.47 is the average spread since 1990

● Spreads were near current levels in 2014 and 2015 before peaking in 2016 and falling back to current values which are similar to those of earlier years

Bloomberg Barclays Aggregate Index Option-Adjusted Spreads




● Return = 3.00%, Risk = 3.75%

● Broad US fixed income is represented by the Bloomberg Barclays Aggregate index

● Higher starting yields for intermediate fixed income offset by a small negative from changing credit spreads leaves forecasted returns unchanged from last year

● Interest rates expected to rise– Yield to worst has been stable for 3 years maintaining the starting point for the forecast– Most of the increase is expected over the next 3 years – Our path is consistent with that forecast by the Fed

● Capital losses expected as yields increase in early years– Losses consistent with moderate duration

– Historically about 5 but currently closer to 6

● Higher yields expected to be earned over most of the forecast horizon

Broad US Fixed Income


Alternative Investment Forecasts

● Return = 5.05%, Risk = 9.15%

● Hedge funds are represented by the Callan Hedge Fund of Funds database

● Hedge fund returns will be supported by increasing interest rates– Hedge fund returns consist of cash plus a spread– 2.25% cash forecast

● Hedge funds overall tend to have an equity beta– Beta tends to be about 0.4– Return expected between that of stocks and bonds; benefit to hedge fund investing derives from potential for

diversification to stocks and bonds

● Hedge funds earn risk premia– Exotic beta– Illiquidity

● Forecast does not include a net active management premium beyond beta and illiquidity– Broad spectrum of possible returns– Represents an average expectation for return across the universe– Skillful managers expected to earn net excess returns

Hedge Funds



● Return = 5.75%, Risk = 16.35%

● Real estate is represented by the Callan Real Estate database

● Real estate returns reflect decreases in cap rates– Cap rates continued to declined in 2017– Spread between cap rates and bonds has compressed making real estate relatively less attractive– Demand remains high as equity gains rebalanced into real estate

● Overall real estate tends to have an equity beta– Stylized beta tends to be about 0.75– Reduced equity projections weigh on real estate return

● Risk reflects economic realities rather than volatility observed under normal conditions– Observed volatility is generally less than 5% in normal markets– Our forecast volatility better represents the risk of loss

– Assuming a 3% standard deviation would imply that the real estate loss experienced during the financial crisis was a 10+ standard deviation event

Real Estate



● Return = 7.35%, Risk = 32.90%

● Private equity is represented by the Cambridge Private Equity index

● Private equity forecasts related to public equity forecasts– Both returns driven by similar economic factors

– Risk premia for both should rise and fall together– Public equity markets are often the exit strategy for private equity investments

– Less attractive public markets reduce the outlook for private equity– The compound return reflects heightened risk

– In any single period the private equity forecast has a 4.15% spread over the US public equity forecast

● Wide range of results across implementations– The best managers far outperform the worst managers in any given period– Superior managers could substantially outperform our projected return

● Risk reflects economic realities rather than volatility observed under normal conditions– Observed volatility is generally less than that of the S&P 500– Variations in investment values can’t be observed since private equity is not frequently priced in public markets– Our forecast volatility puts private equity on the security market line

Private Equity


2018 Capital Market Projections—Return and RiskSummary of Callan’s Long-Term Capital Market Projections (2018 – 2027)

Source: Callan LLC

PROJECTED RETURN PROJECTED RISK

Asset Class Index1-Year

Arithmetic10-Year

Geometric* RealStandard Deviation

Projected Yield

EquitiesBroad Domestic Equity Russell 3000 8.30% 6.85% 4.60% 18.25% 2.00%Large Cap S&P 500 8.05% 6.75% 4.50% 17.40% 2.10%Small/Mid Cap Russell 2500 9.30% 7.00% 4.75% 22.60% 1.55%Global ex-US Equity MSCI ACWI ex USA 8.95% 7.00% 4.75% 21.00% 3.10%International Equity MSCI World ex USA 8.45% 6.75% 4.50% 19.70% 3.25%Emerging Markets Equity MSCI Emerging Markets 10.50% 7.00% 4.75% 27.45% 2.65%

Fixed IncomeShort Duration Bloomberg Barclays 1-3 Yr G/C 2.60% 2.60% 0.35% 2.10% 2.85%Domestic Fixed Bloomberg Barclays Aggregate 3.05% 3.00% 0.75% 3.75% 3.50%Long Duration Bloomberg Barclays Long G/C 3.50% 3.00% 0.75% 10.95% 4.45%TIPS Bloomberg Barclays TIPS 3.10% 3.00% 0.75% 5.25% 3.35%High Yield Bloomberg Barclays High Yield 5.20% 4.75% 2.50% 10.35% 7.75%Non-US Fixed Bloomberg Barclays Glbl Agg xUSD 1.80% 1.40% -0.85% 9.20% 2.50%Emerging Market Debt EMBI Global Diversified 4.85% 4.50% 2.25% 9.60% 5.75%

OtherReal Estate Callan Real Estate Database 6.90% 5.75% 3.50% 16.35% 4.75%Private Equity TR Post Venture Capital 12.45% 7.35% 5.10% 32.90% 0.00%Hedge Funds Callan Hedge FoF Database 5.35% 5.05% 2.80% 9.15% 2.25%Commodities Bloomberg Commodity 4.25% 2.65% 0.40% 18.30% 2.25%Cash Equivalents 90-Day T-Bill 2.25% 2.25% 0.00% 0.90% 2.25%

Inflation CPI-U 2.25% 1.50%

* Geometric returns are derived from arithmetic returns and the associated risk (standard deviation).


2018 Capital Market Projections—Correlation Coefficient MatrixKey to Constructing Efficient Portfolios

Correlation Matrix 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 191 Broad Domestic Equity 1.002 Large Cap 1.00 1.003 Small/Mid Cap 0.97 0.94 1.004 Global ex-US Equity 0.87 0.87 0.84 1.005 International Equity 0.84 0.84 0.80 0.99 1.006 Emerging Markets Equity 0.87 0.86 0.85 0.94 0.87 1.007 Short Duration -0.25 -0.24 -0.27 -0.27 -0.25 -0.29 1.008 Domestic Fixed -0.11 -0.10 -0.14 -0.13 -0.11 -0.16 0.87 1.009 Long Duration 0.11 0.11 0.10 0.08 0.09 0.04 0.74 0.93 1.0010 TIPS -0.05 -0.05 -0.08 -0.05 -0.03 -0.09 0.53 0.60 0.53 1.0011 High Yield 0.64 0.64 0.61 0.63 0.61 0.62 -0.14 0.02 0.19 0.06 1.0012 Non-US Fixed 0.01 0.05 -0.10 0.01 0.06 -0.09 0.48 0.51 0.54 0.34 0.12 1.0013 EMD 0.57 0.57 0.56 0.58 0.55 0.58 -0.04 0.10 0.14 0.18 0.60 0.01 1.0014 Real Estate 0.73 0.73 0.71 0.68 0.66 0.65 -0.17 -0.03 0.17 0.00 0.56 -0.05 0.44 1.0015 Private Equity 0.95 0.95 0.92 0.93 0.90 0.91 -0.26 -0.20 0.00 -0.11 0.64 -0.06 0.57 0.72 1.0016 Hedge Funds 0.80 0.80 0.77 0.76 0.73 0.76 -0.13 0.08 0.29 0.08 0.57 -0.08 0.54 0.61 0.78 1.0017 Commodities 0.15 0.15 0.15 0.16 0.16 0.16 -0.22 -0.10 -0.04 0.12 0.10 0.05 0.19 0.20 0.18 0.21 1.0018 Cash Equivalents -0.04 -0.03 -0.08 -0.04 -0.01 -0.10 0.30 0.10 -0.04 0.07 -0.11 -0.09 -0.07 -0.06 0.00 -0.07 0.07 1.0019 Inflation -0.01 -0.02 0.02 0.01 0.00 0.03 -0.20 -0.28 -0.29 0.18 0.07 -0.15 0.00 0.10 0.06 0.20 0.40 0.00 1.00

Source: Callan LLC


2018 Capital Market Projections – Efficient Mixes

● A portfolio with 35% fixed income is expected to earn only 6% over the next ten years

● The fixed income allocation has to fall below 20% to earn 6.5%

● Total alternatives allocations in excess of 20% are common for diversified asset mixes

Subdued Returns Even for Risky Portfolios

Source: Callan LLC


2018 Capital Market ProjectionsRange of Returns

Mix 1 Mix 2 Mix 3 Mix 4 Mix 5 Mix 6(30%)

(20%)

(10%)

0%

10%

20%

30%

40%

50%

1 Year

Annu

al R

ates

of R

etur

n (%

)

Average

5th Percentile25th PercentileMedian75th Percentile95th Percentile

4.5%

14.5%8.4%4.5%0.7%

(4.3%)

5.1%

18.3%10.2%5.0%0.1%

(6.4%)

5.6%

22.7%12.2%5.5%

(0.9%)(9.1%)

6.2%

27.9%14.6%6.1%

(1.9%)(12.1%)

6.7%

34.0%17.3%6.7%

(3.2%)(15.6%)

7.4%

42.6%20.6%7.3%

(5.0%)(20.2%)

Mix 1 Mix 2 Mix 3 Mix 4 Mix 5 Mix 6(5%)

0%

5%

10%

15%

20%

10 Years

Annu

al R

ates

of R

etur

n (%

)

Average

5th Percentile25th PercentileMedian75th Percentile95th Percentile

4.5%

7.5%5.7%4.5%3.3%1.6%

5.0%

8.9%6.6%5.0%3.4%1.2%

5.5%

10.6%7.6%5.5%3.5%0.6%

6.0%

12.5%8.6%6.0%3.4%

(0.1%)

6.5%

14.7%9.7%6.5%3.3%

(1.1%)

7.0%

17.2%11.1%6.9%3.0%

(2.4%)Source: Callan LLC


Disclaimers

This report is for informational purposes only and should not be construed as legal or tax advice on any matter. Any decision you make on the basis of this content is your sole responsibility. You should consult with legal and tax advisers before applying any of this information to your particular situation.

This report may consist of statements of opinion, which are made as of the date they are expressed and are not statements of fact.

Reference to or inclusion in this report of any product, service or entity should not be construed as a recommendation, approval, affiliation or endorsement of such product, service or entity by Callan.

Past performance is no guarantee of future results.

The statements made herein may include forward-looking statements regarding future results. The forward-looking statements herein: (i) are best estimations consistent with the information available as of the date hereof and (ii) involve known and unknown risks and uncertainties such that actual results may differ materially from these statements. There is no obligation to update or alter any forward-looking statement, whether as a result of new information, future events or otherwise. Undue reliance should not be placed on forward-looking statements.

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