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Wells Capital Management 2017 Investment and risk outlook EverKey Global Equity January 2017 Venkateshwar “Venk” Lal Director of Investment Risk & Strategy, EverKey Global Equity Executive summary We remain excited about the opportunities we are identifying given extraordinary short-term, medium-term, and long-term cyclical swings in market assessments of intrinsic value as we approach our tenth anniversary at EverKey Global shepherding investments across global public equity markets. Vast divergences in company fortunes, sector and industry developments, global economies, public policies, and capital markets provide us a solid foundation to continue delivering differentiated performance by leveraging our core investment philosophy—a disciplined approach to search for non-consensus fundamentally under-valued equities with patience and care in the face of persistent bouts of macroeconomic and political uncertainty. Last year and this year ahead appear to exemplify the power of cycles driving market valuations inherent in all asset classes. Investors begin 2017 pointing to a global reflationary window opening—optimism reinforced by signs of synchronized worldwide recoveries after almost a decade of healing since the global financial crisis (GFC), the comforting fading into rear view of early-2016’s disruptive deflationary scare, and any pernicious prospective inflation still far out of sight. At the same time, official government policies are pivoting increasingly towards thrusts from fiscal stimulus and structural reform and away from reliance on diminishing returns from loose monetary policies. Expectations for central bank policy rates are now turning positive, rising from zero, if not negative real rates, and ostensibly onceunfettered mechanics of free-markets are gradually falling under the influence, or command (but debatable, if actually control), of greater state capitalism, in developed (DM) and emerging markets (EM) alike. We look forward to capitalizing on what we expect will be evolving market volatility to season our portfolios, as stocks which are capable of normalizing their earnings much higher in coming years are periodically misjudged by powerful waves of short-term reactive investor sentiment. No doubt, 2017 will provide its fair share of market rotations, if not reversals. What began as volatility within the weakest links in credit markets one decade ago and quickly caught fire across equity markets during the depths of the GFC unleashed unprecedented global policy accommodation rescues in the immediately forthcoming years. However, the shifting tectonic plates of policy divergences from competing economic and political responses to the crisis since then triggered volatility first across currency and then commodity markets. Now we believe that cross asset class volatility has also spread to sovereign interest rate markets, best evidenced by last quarter’s U.S. Treasury bond sell-off, rising yield curve, and groundswell of populism polarizing disaffected and disgruntled electorates worldwide. Only time will tell if a tipping point has been passed contradicting the multi-decade asset allocation mantra of bonds out-performing stocks, or the last 10 years’ investing playbook of U.S. stocks out-running foreign stocks, or even the post-quantitative easing (QE)-fueled environment of passive growth and momentum equity investing out-pacing active value equity investing. Shifting performance since last summer suggests a long-awaited normalizing reversal may indeed finally be under way. Nevertheless, we remain disciplined in exercising our investment and risk management process marrying fundamental stock and fundamental macro research. Our positioning favoring individual stocks in Europe and Japan (as well as in North America and certain EMs) is predicated on what we believe are the most attractive three to five year total returns with limited near-term downside—under-valued, under-earning, underappreciated equities benefiting from self-help restructuring, targeted reform and reflationary public policy backdrop in macro resilient markets. While we sense improving prospects for a stimulus-enhanced U.S. recovery, we appreciate that some companies in Europe (Germany, U.K., Switzerland, Netherlands, as well as Norway, Denmark, Italy, and France), Japan and select EMs (such as Hong Kong, South Korea, Russia, Brazil, as opposed to other EM value traps with intractable imbalances) exhibit greater operational leverage to accelerating U.S. and global growth given higher fixed costs and sensitivity to revenue and profitability enhancement. In fact, these international markets, especially Europe and Japan (1) trade at historically steep valuation discounts (-20-40% versus the U.S. S&P 500), (2) harness significant relative earnings power (MSCI World ex-U.S. earnings per share (EPS) 50% below 2007 peak versus MSCI U.S. EPS 20% above 2007 peak) and (3) benefit from more supportive government policy mixes (active European Central Bank (ECB) and Bank of Japan (BOJ) easing with expanding fiscal support and targeted structural reforms versus a normalizing Federal Reserve); on the other hand, rising domestic wages, interest rates and exchange rates weigh on U.S. corporate earnings and stock multiples. Notable undervalued sector exposures include segments in industrials (restructuring and portfolio reshaping stories), financials (capital-rich insurance, brokers and asset managers, as opposed to banks with capital and regulatory burdens), energy (integrated oils with encouraging commodity supply-demand balances, as opposed to base and industrial metals) and telecoms (high yield beneficiaries of rising consumer demand, especially EM), mindful of avoiding popular “expensive defensive” DM consumer staple equities that we expect will de-rate as deteriorating fundamentals dampen euphoric aspirations. Given imbalances in anticipated relative sovereign rates, capital flows, balance of payments and monetary policies, our portfolios are still currently partially hedged back to the U.S. dollar. 2017 Investment and risk outlook | January 2017 2016: A tale of two halves 2016 exhibited unusual asymmetries, if not contradictions, between perceived and actual outcomes as markets grappled to understand potential turning points in what have become long-established economic and political cycles and underlying presumptions. Last year was book-ended by sentiment extremes—creating a tale of two halves, commencing 2016 in a deflationary scare pounding multiple asset classes during Q1/Q2 and concluding the year with reflationary zeal picking up speed in Q3/Q4, propelling the MSCI All Country World Index (ACWI) to register all-time highs in the first days of 2017. Confounding most market participants, neither advancement in “artificial intelligence” (however “robo,” big data, or smart sensor-driven) nor proliferation of “fake news” (however overt, covert, or clandestine) adequately prepared consensus expectations for 2016’s milestone events. First half: Deflationary scare Right out of the gates, 2016 displayed un-nerving confluence of international cross-asset class volatility last witnessed during the GFC. Deflationary angst and risk aversion momentum was widespread: (1) commodity markets started the year with the CRB Index down 25% from 2014 highs (Brent futures marking their bottom in January, 65% off of 2014 highs), (2) China hard landing fears sent the Shanghai Composite down 30%+ in January (forcing it 50% below its June 2016 A-share peak), (3) credit and solvency fears surrounding European banks pummeled the Stoxx 600 Bank Index down 35% by the end of Q2 (with illiquidity and “CoCo” complexity marring bank credit instrument price discovery), and (4) currency trading was roiled by concurrent risk-off carry trade unwinds and central bank credibility assaults (as the yen spiked 20% and the Nikkei sank 20% after the BOJ faced scrutiny for its controversial adoption of a negative interest rate policy (NIRP), crimping domestic bank net interest margins and derailing an Abe-nomics reflation transmission mechanism). Adding insult to injury, improperly positioned investors were caught off-sides by the U.K.’s Brexit referendum in late-Q2, sending the EU Stoxx Index down 15% intra-quarter and the British pound plumbing past 30-year depths. The rush to safety drove 10-year U.S. Treasury yields to all-time lows during the week of July 4, further fueling investors’ search for yield and lower volatility surrogates. 2016’s EM bond fund flows were the highest since 2012, allowing EM equities and exchange rates, especially high yielding ones, to compress risk spreads, starting to heal from 2015’s strains and delivering the best U.S. dollar performance since 2010. Second half: Reflationary rebound Market performance revitalized beginning mid-2016 into year-end: (1) supportive public policy muscles flexed, stabilizing monetary credibility (BOJ JGB yield curve control with quantitative and qualitative easing (QQE) intact diffused earlier NIRP concerns and round-tripped the yen, and together with ECB QE extensions, offset the Fed’s U.S. rate normalization stance) and passing the stimulus baton to fiscal authorities (Japan launched its largest fiscal stimulus under Abe-nomics, China rolled-out infrastructure spend, and the European Union’s (E.U.) benign neglect let fiscal austerity relax), (2) commodities regained composure (Brent climbed 60%+ by year-end aided by OPEC’s first production curtailment since GFC, and CRB reclaimed half of its post2014 drop), and (3) leading economic indicators rebounded globally (forceful 52-55+ composite Purchasing Managers’ Index (PMI) lift-offs from the U.S., E.U., Japan, China, and EM, up-ticks in producer/consumer inflation gauges, and the Global Citi Economic Surprise Index flirted with 2010’s highs by mid-January). Ironically, these inflections unfolded during widespread obsession with Trans-Atlantic electoral volatility (reminiscent of grinding preoccupations over Y2K at the turn of the century), encouraging defensive market positioning (high cash and passive allocations, with ETFs exceeding $3 trillion in AUM) and coiling the spring for a forceful catalyst-driven pro-cyclical bounce. Enter November 8’s Trump takeover with hopes (euphoric in some cases) of executive stimulus turbo-charging post-July’s reflationary confidence, rising inflation expectations, ascending yield curve, strengthening U.S. dollar and visible rotation into value stocks from momentum and growth stocks after almost a decade-long underperformance cycle. Widening political-economic fault-lines push this game into overtime 2016’s sharp V-shaped trajectory revealed not only powerful forces underpinning capital markets’ decade-long struggle to escape deflationary pull with reflationary velocity, but also complex political-economic fault-lines likely to prompt reappraisals of historical investment assumptions and influence future performance results. Last year reinforced a steady trend in expanding nationalism worldwide, in some cases widening social divisions, often at the expense of traditional multilateral arrangements, and almost always with concentration of activist leadership. Figure 1 International stock valuation discounts vs. U.S.: (Cyclically-Adj P/E, Trailing P/E, Forward P/E, P/Sales, P/Cash, P/BV) U.S. stock valuation percentile relative to foreign country valuation range 110% Sources: BCA, Thomson, MSC, Star Capital. Valuation metrics average of six factors indexed with U.S. set at 100%. U.S. in orange, DMs in green, EMs in blue. | 2 | Trailing P/E Indonesia India Spain Australia U.S. U.K. Netherlands Sweden Switzerland Canada Mexico China Brazil France Germany Japan S. Africa Italy S. Korea Russia 50% P/Book Value 60% P/Cash 70% P/Sales 80% Forward P/E 90% CAPE 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 100% 2017 Investment and risk outlook | January 2017 Figure 2 International vs. U.S. EPS vs. Late-07 peak EPS 120% 70% Favorable divergences in public policy support: U.S. vs. international regions Policy/Region U.S. Europe Monetary QE expiring, rising rates hurt EPS QE extended Fiscal Stimulus hopes Deficits still consolidating Stimulus in action Structural reform Potential energy, financials deregulation Self-help restructuring Targeted corporate governance reforms FX Rising U.S. dollar, rates, wages hurt EPS Weak euro and pound buy time for political compromises Weak yen reflationary 20% -30% 12/31/2015 12/31/2014 12/31/2013 12/31/2012 12/31/2011 12/31/2010 12/31/2009 12/31/2008 12/31/2007 12/31/2006 -80% International EPS vs Peak Japan Emerging markets (Value) (Value trap) QE / Yield Flexible easing curve control Improving deficits, fiscal efficiency Industrial reforms w/political aircover Resilient balance of payments No flexibility Unsustainable twin deficits Inefficient, corrupt bureaucracies Flight capital risk, low FX reserves U.S. EPS vs Peak Spread of Int'l-U.S. EPS vs Peak EPS Sources: MSCI, Bloomberg U.S. (MXUS) and International (MXWOU) trailing last 12-months’ EPS, indexed to 10/31/07 EPS peak. This sea change has manifested itself in a variety of forms—from transformative and consolidating power among leaders in Japan (Abe), China (Xi), Russia (Putin), India (Modi), Turkey (Erdogan), Philippines (Duterte) and Venezuela (Maduro) over the last three years— to more inward-looking movements of “power-to-the-people,” just evidenced in the U.K. (vote to extricate from E.U.) and U.S. (TrumpGOP landslide). Defying gloomy prognostications, at least in the near-term, these two most recent transitions ushered in sharp post-event risk equity market appreciation, with the U.K. FTSE index outperforming G7 peers (in local currency terms) and U.S. Dow Jones just crossing the 20K threshold; both cases illustrate the power of non-consensus investing. cross-currents to determine if cyclical inflections favor one investment asset class and style or another. We expect this see-saw effect to be compounded by growing political tensions that may further splinter or harmonize global interests and cooperation. These strains are already apparent, challenging traditional assumptions regarding free movement of capital, labor and trade, with gyrating sovereign interest rate and foreign exchange markets that are now serving as escape valves allowing the release of steam when most necessary. Combining fundamental stock and macro research guides us to favor compelling micro investments with macro resilience and judiciously sized currency hedges based upon conditions that support the U.S. dollar over the longer-term, albeit during a period of heightened foreseeable volatility. By the end of 2016, the broad international equity benchmark (ACWI ex-U.S., showing negligible major DM country divergences) delivered less than half the return of stocks in the U.S. and EM (MSCI EM, displaying acute inter-country divergences), providing little relief from the post-GFC trend of lagging foreign stock market performance—now amounting to more than 100% in cumulative return underperformance versus domestic stocks (see Appendix). We expect the periodic waves of volatility witnessed in recent quarters to persist, providing opportunities to find individual stocks with compelling prospects from value re-rating, earnings growth and yield, as well as resilience from unrelenting whims of macro and political tensions. “Make America great again” Well-aware of ubiquitous popular media, market participants face a perplexing dilemma in assessing implications of the new American presidency: how can rhetoric imbued with an anti-establishment and polarizing ethos that delivered local electoral legitimacy galvanize sufficient broad-reaching domestic and international collaboration to affect grand and lasting action? While it is at this stage far too early to judge the ultimate efficacy of the business of the newly inaugurated POTUS, we are generally constructive on pro-cyclical fiscal and structural reform priorities articulated to-date, balancing contractionary forces from tightening domestic monetary conditions and potentially aggravating international relations sensitive to “go-it-alone protectionism.” We ascribe a strong probability for collective U.S. policymaking to navigate forward (albeit in a choppy ride not for the faint-hearted) to achieve common missions, given clear vision for spurring nominal growth, forceful CEO leadership, and a pragmatic and seasoned nominated senior management team leveraging America’s solid foundation for recovery, inherent institutional self-correcting checks and balances, and unquestionably deep and long-established global competitive advantages and leadership position. Outlook We begin 2017 with a constructive investment and risk outlook for our positioning across Europe, Asia, and the Americas focused on individual stocks that we believe offer compelling appreciation potential due to their under-valuation with combinations of self-help and cyclical catalysts, franchise earnings growth, and sustainable dividends. We believe that public equity market valuation margins of safety, corporate operating leverage and earnings normalization potential, and mix of public policy favor certain stocks in Continental Europe and U.K., Japan, and select EMs—non-U.S. stocks with favorable gearing to the improving trajectory of U.S. and global growth profiles. We also recognize that the deflation-reflation pendulum mood swings on display last year are far from over as markets interpret complex Trump’s pro-business agenda to support jobs and manufacturing Preliminary indications suggest the incoming administration has solid prospects to reinforce a pro-business reflationary agenda with a host of measures promoting American jobs and manufacturing, including: (1) decisive streamlining of regulations with efforts to slash the Gordian | 3 | 2017 Investment and risk outlook | January 2017 Figure 3 Rotation or reversal: Rising PMIs, inflation expectations, interest rates and global equity value versus growth performance spread Marrying micro and macro: Framework for balancing risk and opportunity 2.6 6.0 5.0 4.0 3.0 2.0 1.0 (1.0) (2.0) 2.4 2.2 Cons: “Wall of worry” Pros: Climbing the “wall of worry” Profitability peaking Self-help restructuring/catalysts 2.0 1.8 Few value margins of safety vs. Value versus value traps 1.6 1.4 Hard deleveragings (sovereign risk) Soft debt extensions/jubilees Political polarization (Brexit, EMU) Reflationary policies (CB, fiscal) Globalization stalling (protectionism) Risk repatriation (banks, capital) Geopolitics/nationalism volatility Policy colllaboration/coordination 1.2 12/1/2016 11/1/2016 9/1/2016 10/1/2016 8/1/2016 7/1/2016 6/1/2016 5/1/2016 4/1/2016 3/1/2016 2/1/2016 1/1/2016 12/1/2015 11/1/2015 10/1/2015 1.0 MSCI World Value-Growth Equity Index Cumulative Return Spread (Left axis) JPM Global Composite PMI (Points Above 50 Baseline, Left axis) Fed 5Yr-5Yr Fwd Inflation B/e (Right axis) 10-Yr U.S. Treasury Rates (Right axis) Source: Bloomberg. knot of Washington D.C. bureaucracy (reducing burdens on small- and medium-sized businesses, softening enforcement by the Consumer Financial Protection Bureau and SEC, eventually simplifying financial services regulation), (2) comprehensive tax relief (reducing individual and corporate taxes—the latter realistically moving midway between 35% current and 15% proposed, eliminating interest deduction and state and local income tax deductions from federal taxes, potentially ushering in some form of Border Adjustment Tax (BAT) and one-time 10% offshore corporate earnings repatriation tax holiday to help pay for added spending), (3) structural reforms and fiscal infrastructure stimulus ($1 trillion over 10 years, adding incentives for national resource production to lower energy costs and for targeted corporate innovation, promoting public-private partnerships with direct labor participation improvement), and (4) re-striking of international trade deals (improving U.S. corporate access abroad and defending homeland employment, correcting perceived unfair practices—already pulling out from the Trans Pacific Partnership (TPP) with imminent talks to update the North American Free Trade Agreement (NAFTA) and Trans-Atlantic Trade and Investment Partnership (TTIP), tightening immigration to deter lower wage offshoring H-1B Visas), intending to keep counter-productive protectionist retaliation at bay. The Trump economic team has cited aerospace, chemicals, electronics, energy, motor vehicles, pharmaceuticals, railways, and robotics, among other sectors, for targeted 2017 investment. Stock markets anticipate economic trends—what about rising wages, rates and currency? Importantly, our constructive U.S. economic outlook does not automatically translate to an analogous stance on the general U.S. stock market if market expectations for new policy stimulus have already run ahead of underlying fundamentals. While we believe many of the pro-cyclical elements cited above will bear fruit over several quarters, their practical design and implementation will take time to sequence and steer properly. The swift post-election U.S. equity market rally into early-2017, led by a powerful 20% surge from the smaller capitalization Russell 2000 Index, suggests cautious optimism ahead mindful of overheating expectations compared to realistic timetables to translate campaign proposals into tangible earnings and economic uplift. Challenges include relatively low market valuation support (with the cyclically-adjusted U.S. price-to-earnings ratio today at the highest levels since the early-2000s) and peak corporate margins (aided by debt-financed share buybacks scaling new heights ($3 trillion) leaving negligible cash spend for capital expenditure and R&D, doubling corporate debt since 2007 and elevating median S&P Debt/Book Values to 2000 peaks). We expect U.S. margins to be pressured by rising wages (across all segments, especially given recent Fed-cited limited U.S. employment slack), rising interest rates (weighing on small and medium-sized borrowers more reliant on floating-rate debt), and rising U.S. dollar (impacting large multinationals, more than one-third of S&P 500 earnings come from overseas even with exports at only 13% of U.S. GDP), with uneven help from potential corporate tax rate reductions (as effective marginal tax rates for large firms are now at multi-decade lows). Striving for the Goldilocks balance Put simply, the U.S. executive and legislative branch, in conjunction with Treasury and trade officials, have to achieve a Goldilocks balance: sufficient nominal growth fast enough to offset the dampening effects of a tightening monetary policy trajectory, yet not so heavy-handed as to trigger a riot from an alert Federal Reserve (poised to raise rates at least thrice in the coming year to satisfy dot-plot projections), a touchy bond market (licking its wounds from last year), or wary international partners (fearful that an America First doctrine unfairly diminishes them). Trump’s first 100 days will indeed be eventful, with early bilateral negotiations commencing with the U.K., Japan, and Mexico, a looming mid-March Congressional debt ceiling deadline debate centered on not aggravating America’s twin deficits with fiscal stimulus leverage, and a host of executive actions in the works. It is notable that the current U.S. expansion is already into its 90th month, drawing parallels with comparable duration past expansions: in the 1980’s (the Reagan Revolution from November 1982 until Gulf War I, 92 months), in the 1960’s (Johnson’s Great Society, 106 months), and even in the 1990’s (roaring economic boom until the TMT bubble, 120 months). While inspiring to invoke these great periods of economic | 4 | 2017 Investment and risk outlook | January 2017 recovery and useful to appreciate investment-led productivity surges take many years to realize, investors must recognize the starting point of today’s dramatically different investing context: historically high corporate leverage and equity market multiples, generational lows in policy rates, and a paradigm-shifting conclusion to a long QE cycle that had artificially suppressed term risk premium, stock-bond correlations, and cross-asset class volatility. prime money market funds (a leading source of overnight U.S. dollar liquidity), and by Basel III-constrained bank lending that has tightened globally available U.S. dollar liquidity. Trumpeted tweets: Discern the forest from the trees We expect ongoing U.S. political turbulence, made all the more unstable by the increasingly publicized nature of policy debate at home and the inevitably unpredictable tests to confront the new administration from abroad. Consensus observations point to a paradoxical presidential governance and communication style that simultaneously leaves no room for nuance yet obfuscates. The recent dizzying use of the digital bully pulpit to blitzkrieg messages leaves many to their own devices to decipher and distinguish official priorities along the broadest of spectrums—from innocuous and well-intentioned rallying slogans designed to motivate or allay a base electorate, to assertive negotiating tactics and posturing aimed to exact concession, to fundamentally contentious disruptions to upend long-held assumptions of order, shaking what has been the country’s core inter-generational foreign economic policy orthodoxy and risking unintended self-inflicted consequences. Carefully and coherently characterizing these political impulses will remain a critical ingredient for investors to judge when politicallyinduced whirlwinds, and importantly their impacts on securities prices across capital markets, are structural with sustained investment repercussions versus when they are just noisy distraction creating ephemeral trading opportunity. The case for the U.S: dollar: Long-term strength but short-term volatility This challenge of discerning the forest from the trees is no more evident than in the more abstract realm of exchange rates, home to macroeconomics’ most severe zero-sum trade-offs made ever-more precarious by elevated volatility in sovereign interest rates, capital flows, trade policy, and verbal intervention. We continue to believe that we are in the early innings of a long cycle of persistent exchange rate volatility—an important consideration from both a stock-picking and portfolio management perspective.1 While we believe that the new American administration will find it difficult to resist the short-term temptations to promote a weak U.S. currency for its export-enhancing benefits, especially after the eye-catching technically-overbought 15% rise in the DXY U.S. dollar index from the Q2 2016 lows into year-end (one-third of which occurred after the U.S. election), macro fundamentals point to longer-term U.S. dollar strength. Researching currency cross-currents helps inform our evaluation of domestic-consumption versus export-oriented international stocks, as well as portfolio currency hedges. Changes in official exchange rate policies, real interest rate differentials, capital flows, balance of payments, and major public policy shifts account for the lion’s share of fluctuations in exchange rates. With an ongoing U.S. recovery and tightening Federal Reserve relative to an accommodating ECB, Bank of England (BOE), and BOJ, real yield differentials favor the dollar as short-term portfolio flows flock to higher dollar-denominated rates. From a capital flows perspective, medium-term demand for the dollar is underpinned by $10 trillion in short U.S. dollar positions from institutional corporate and sovereign borrowers (per the Bank of International Settlements, with EMs holding a third), by recent higher Libor spreads from regulation of U.S. Positive U.S. dollar capital flows and balance of payments are reinforced by the potential for a U.S. corporate offshore earnings repatriation tax holiday and very preliminary discussions regarding what still remains a complex BAT debate. The former tax amnesty could generate close to $2.5-3 trillion in overseas capital earmarked for re-investment destined to return back home to the U.S., effectively adding to demand for U.S. currency: an estimated 60% share not held in cash or securities offshore is currently reinvested in European businesses (typically first converted into euros, for example, for use in Belgian, Dutch, and Irish affiliated corporate jurisdictions, but would result in absent euro demand under a repatriation scenario), and the 40% balance held in U.S. dollar cash and securities sits in E.U. banks (for their overnight U.S. dollar funding use and would be missed and need to be replaced with U.S. dollar repurchases in the event of a repatriation holiday). We suspect that 2015’s U.S. dollar strength following enactment of the 2014 Homeland Investment Act’s tax holiday provides useful lessons regarding encouraging U.S. dollar repatriation. From a balance of payments perspective, proposals surrounding a current account-enhancing BAT (or “destination-based cash flow tax”) induce trade volatility. This type of measure would tax U.S. imports and subsidize U.S. exports to encourage domestic industry. Hot corporate lobbying pitting industrial and technology interests against retail, is likely to impact the design and applicability of final rules, possibly exempting crude oil/refined products and apparel yet applying to base/industrial metals and agriculture. In theory, the dollar should appreciate sufficiently to offset the tax paid by importers and tax advantage gained by exporters, keeping a steady trade balance and after-tax distribution of corporate profits. Over time, this would likely support the U.S. current account and inflationary impulses (depressing imports and encouraging exports), affording America a stronger currency; conversely, legislative delays could have inverse impact. In essence, an “America First” policy associated with a balance of payments surplus is tantamount to a U.S. dollar first policy, for only a country with durable current account strength and associated economic benefits can tolerate currency strength in the longer-run. Early signs from the White House point to temperamental foreign exchange volatility. It remains unclear if the new administration has yet established a consistent currency policy that speaks with one voice. Official statements remain cacophonous, evidenced by conflicting remarks made days ago by National Trade Council Head Navarro (calling the euro “grossly under-valued”) and the designated Ambassador to the E.U. Malloch (calling to “short the euro”). While we do not underestimate the propensity of politicians to talk down a home currency for domestic pyrrhic victories, we recognize that a strengthening dollar can enhance America’s ultimate negotiation leverage, especially with China, who has actually been intervening to avoid a reputationdamaging devaluation and prop up its yuan (managed to track a U.S. dollar-heavy currency basket). We would not be surprised to see U.S. officials embracing the value of the dollar’s reserve status and associated “exorbitant privilege” as realities of foreign exchange dynamics become evident and as the world inflects away from deflationary danger. Maximum U.S. trade negotiation advantage may yet be gained from a position of dollar strength, as threat of substantial subsequent dollar depreciation could materially impair a trading counterpart’s balance of payments if it chose not to make concessions to the U.S.—perhaps a consideration for the Trump team trying to stabilize the dollar’s rise. | 5 | 2017 Investment and risk outlook | January 2017 E.U. Economic and Monetary Union (EMU) or Dis-union? Compared to high expectations for U.S. equities, investors view markets in America’s largest trading partner, the E.U., with continued skepticism and pessimism. The E.U. remains engaged in its own delicate balancing act of deleveraging and entering a reflationary sweet-spot while still struggling with dependency on the ECB’s monetary largesse to buy time to consolidate greater fiscal union for a more durable currency union that can withstand forces of political fragmentation. Critics of EMU point to failed “establishment” plebiscites as harbingers of an inevitable retrenchment back to a “multi-speed” currency union, even harking back to French President De Gualle’s famous 1969 failed constitutional referendum and resignation that accelerated declines in the franc and breakdown of the Bretton Woods fixed exchange rate system. These challenges have propelled equities to significant global valuation discounts leaving ample opportunity for some firms to outperform depressed macro expectations by (1) taking advantage of self-help restructuring and portfolio reshaping, (2) leveraging micro operating leverage to better U.S. and global growth and (3) monetizing benefits from declines in home exchange rates driven by a more accommodative ECB and BOE relative to the Fed. In order to tuck in unwanted risk, our portfolios retain partial hedges on the euro (initiated in 2014) and pound (implemented prior to June 2016’s Brexit vote). Brexit casts a long shadow E.U. developments have been overshadowed by the upcoming U.K. invocation of the Lisbon Treaty’s Article 50, starting the two-year clock for negotiating terms for an exit from the single market and customs union. Our base case assessment suggests that the U.K. referendum reflects popular disaffection along economic and political lines: the need to find economic relief from a weaker currency that can arrest a spiraling current account deficit (which had grown to be the biggest in the developed world) and frustrations about an ossified 28-country administrative edifice perceived to be incapable of swift problem solving without resorting to lowest common denominators (i.e. migration crisis border security). Given that the U.K. has been at its core a trading nation well aware and protective of commercial interests, we interpret the current state-of-play as neither an outright rejection of globalization nor an act of desperation triggering another “1976 sterling crisis.” Rather, based on vested U.K.-E.U. interests as each other’s largest trading partner, and prospects for enhanced U.S.-U.K. relations with benefits for being front in queue at precedentsetting trade deals, we would not be surprised to see efforts move towards better-than-expected Free Trade Agreements (FTA). In the meantime, we remain wary of more domestic-facing firms exposed to economic disruption, instead owning non-consensus and cheap exporters with earnings resilience. Beware the moral hazards of ECB largesse and rear view reflation Cries of “referendum-contagion” and hard-to-shake-off bank solvency concerns have pushed down stock valuations despite 2016’s E.U. real GDP growth estimated to have exceeded U.S. growth for the first time since the GFC. Inflation metrics have set five-year highs thanks to steady manufacturing pick-up, services rebound, reversal of energy deflation, and shelved Maastricht Treaty fiscal austerity. This reversal of fortune speaks volumes for work orchestrated by primarily ECB officials: ring-fencing, recapitalizing and repatriating peripheral bank risk (still more to do), establishing a common bank supervisory and resolution mechanism (the latter untested, awaiting deposit insurance and risk-sharing compromise) and greasing liquidity wheels (extended QE, targeted long-term refinancing operations (T-LTRO), and negative deposit rates yet to spur private lending) with euro depreciation and competitiveness improvement effects. Two challenges dictate EMU’s future: (1) can recovery self-sustain long enough to ensure orderly deleveraging but not fast enough to prompt ECB tapering and/or sovereign yield escalation, and (2) can policymakers march forward forging greater political and fiscal union without monetary stimulus “moral hazard” lulling officials into a false sense of complacency before the next financial, social, or political flashpoints can derail the E.U. integration project. Continental Europe’s mounting electoral event risks Multiple 2017 elections will reflexively test commitments for a tighter European union. Populist anti-E.U. parties have prominent voices in each race: (1) mid-March in the Dutch parliament (Wilders’ Freedom Party polling a distant 3rd), (2) April-May for the French presidency and parliament (Le Pen’s National Front picking up speed versus Macron and an embattled Fillon but with momentum potentially buffered by a two-stage national electoral process), (3) perhaps June for an early Italian interim government replacement (still needing a stable coalition to flex real muscle, Grillo’s 5-Star Movement now rivals Renzi’s Democratic Party after December’s failed constitutional plebiscite and resignation) and (4) late-September for the German federal coalition test following Merkel’s hosting the G20 in July (her Christian Democratic-led bloc still the favorite deflecting a euro-skeptic Alternative for Germany (AfD) likely to be the first right-wing party to enter the Bundestag since 1945). Political observers remain acutely aware of populist dominoes falling with center-left parties in disarray and pollsters burnt by 2016’s failures to predict Brexit and Trump’s ascendancy. Surveying the event risk landscape suggests great variability in outcomes, ranging from (1) any one or more populist parties either winning, or eventually gaining, sufficient leverage to force E.U. existential referenda at home (i.e. Le Pen has already called for a return to a “two-speed” EMU, with a core set of states that have relinquished sufficient political sovereignty sharing a currency and other members revolving around the core until prepared to join in), (2) a muddle-through where satisfactory status quo compromises bide time in hopes that incremental steps of political coordination can address the crises du jour, and (3) upside surprises, perhaps through sequencing of self-reinforcing positives, starting with a Macro or Fillon win ushering in long-needed French structural reforms, followed by Merkel loosening fiscal grip and reevaluating immigration stance, mindful of how reinvigorating Franco-German mutual interests and alliances, in keeping with the E.U.’s history of centripetal evolution spurred on by its “core” members, can inspire deeper integration by others. Regardless of the scenario interplay, some companies continue to engage in profitability-enhancing initiatives, often with new management teams and required reform air-cover from home policymakers, ready to significantly outperform as improving micro fundamentals outperform macro despondency. Japanese reflation back on track Turning to Japan, where similar skepticism and pessimism pervades the consensus investment view, Prime Minister Abe continues to drive ahead with his agenda to break the back of deflation that has inhibited animal spirits for decades. To his advantage, he is inhibited by neither complexity of having to corral competing national interests as in the E.U., nor concerns of coordinating divided branches of government with questionable popular legitimacy as in the U.S. Abe must instead promote a radical cultural transformation to ultimately deliver intended reflationary achievement with peak popular ratings entering his fifth year in office (his term likely to extend to 2021, making him the longest-serving post-WWII Japanese prime minister) and with clear alignment across the multiple arms of governance. Leading | 6 | 2017 Investment and risk outlook | January 2017 Japanese economic and inflation indicators inflecting upwards in late-2016 suggest the deflationary scare from 2014-2015’s commodity collapse had masked some of his administration’s early wins—fears that may still spook, or at least stagger, shy foreign equity investors from returning to Japan with the same magnitude as during their 2013-2015’s risk-taking. Sporting among the cheapest DM stock valuations globally (P/BV and P/Cash at 30% and 50% discounts to U.S., respectively) in a country carefully complementing years of aggressive monetary stimulus (QQE began in 2013) with newly-enhanced fiscal stimulus and targeted reforms, Japan provides appetizing hunting ground for non-consensus value equities with substantial upside potential. Our notable Japanese exposures date back to 2013 and have evolved from initially including a number of export beneficiaries as the “rising tide” of BOJ-led Abe-nomics pressured the yen 40% and “lifted all boats” from 2013 to mid-2015, to reflation-oriented stock beneficiaries, and now to more under-owned idiosyncratic corporate governance and shareholder-sensitive equities restructuring, reforming, and realizing high global operating leverage with innovation (“new” versus “old” Japan). While we have hedged a portion of our bottom-up yen risks for years (starting in early 2013), these positions were closed last year as NIRP raised concerns over monetary policy efficacy. We would not be surprised to see hedges re-implemented in the future based on evolving currency fundamentals and portfolio exposures. Handing over stimulus baton from ongoing monetary to fiscal and structural reform engines We believe that several considerations bode well for a reflationary backdrop as many companies reporting earnings this year have topped 2007 highs: (1) transition to forceful fiscal stimulus (largest package since the GFC: $275 billion in infrastructure spending and targeted low interest loans and projects to improve transportation, communication, energy, technology, and defense pre-2020 Tokyo Olympics), (2) adaptive and aggressive BOJ stimulus (QQE and capping of JGB yields out 10 years pressures the yen; whereas U.S. corporates have become the largest buyers of U.S. shares, in Japan, the BOJ holds that throne), (3) quasi-public sector stimulus (pensions/insurers continued equity allocations and January’s Government Pension Investment Fund (GPIF) announcement of plans to buy U.S. corporate debt to finance U.S. infrastructure, joint R&D projects/trade and employment— perhaps a quid pro quo template for further bilateral collaboration as Japan supplants China as the largest holder of U.S. Treasuries), and (4) ongoing industrial reforms (Stewardship and Corporate Governance Code enforcement, now with 80% of firms having two or more independent directors, 30% annual rise in corporate share repurchases, rising dividend payout ratios, and inklings of corporate cross-holdings starting to unwind). Japan’s eventual path to deleveraging and sustainable recovery rests on balancing the falling role of monetary with rising use of fiscal, structural and industrial reforms in an environment of added trade and bond market tension. While the early U.S. scrapping of the TPP raises protectionist flags, Japan does benefit from some trade volatility insulation: exports represent less than 15% of Japan’s GDP, and the country sells 45% of its offshore production in the U.S. In addition, as sovereign bond markets appear to become less liquid with dwindling inventories for central banks to buy, it remains worthwhile keeping a keen eye on signals of undesirable swings in JGB yields, amounting to market tests of central bank credibility and ultimately pressures on the BOJ to follow the Fed in tapering. China balancing national strengths with external uncertainties into the 19th National People’s Congress (NPC) Global equity investors need not look any further than China to appreciate feverish extremes in risk appetite, assessments of fundamental worth, and ability to influence cross-asset class volatility. Starting the year with one of the worst annual performances of any major international equity market, Chinese shares have lagged other EMs in performance (under-owned by dedicated EM funds) and valuation (mainland and Hong Kong P/BVs among the lowest in the world) given complex super-cycle deleveraging and macro imbalances. Smoothly transitioning to a consumption-led efficient economy this year will have to leverage key national advantages—reflationary momentum (no longer a deflation exporter), centralized policymaking power (to be magnified by President Xi at October’s 19th NPC generational leadership reshuffle), and rich savings ($3 trillion in reserves, albeit down a trillion since 2014)—to overcome heightened uncertainties—currency volatility (as a “managed peg,” the yuan is not yet permitted to float freely) and protectionism (rhetoric and reality). Our stock picks include under-valued domestic-oriented firms (primarily H-shares) benefiting from consumer growth and specific corporate/regulatory reform, rather than debt-burdened banks or industrials vulnerable to external trade friction. Juggling fiscal expansion and targeted reforms with tightening (but still flexible) monetary policy We expect China’s policymakers to remain generally accommodative this year to safeguard an ongoing recovery aided by debt-fueled stimulus recharged in the wake of mid-2015’s A-share market collapse, targeting a smooth period for NPC transition, and standing ready to offset negative shocks from abroad. Signs of China’s reflationary pivot abound: last month’s PPI figures hit five-year highs, and the Li Keqiang index of freight, electricity consumption, and bank lending metrics grew at its fastest pace since 2009, providing relief for private and state-owned enterprise (SOE) profits, bank NPLs and a housing sector adjusting to October’s Politburo clamp-down. While China skeptics argue policy activism induces binge stimuluscontraction cycles (inflating-deflating cycles in Macau gaming, real estate, A-shares, and commodity futures in years past), we expect policy flexibility offers latitude in maneuvering around near-term obstacles to satisfy 6.5%+ growth expectations. Fiscal expansion has become a powerful growth engine: (1) tailwinds from $1 trillion in infrastructure public-private partnerships (PPP) recently deployed (mid-2015-2016, fueled a 15% annual investment spend increase), (2) over $350 billion to develop the energy sector (renewable power to amount to half of new electricity generation by 2021), and (3) $1.75 trillion in infrastructure PPPs likely to be announced in Q1, focused on urbanization and transportation, linking Beijing-Tianjin-Hebei). Structural reforms have varied: financial services and technology reforms have moved apace (Shenzhen-Hong Kong Stock Connect, productivity-enhancing robotics-cloud initiatives), but others have lagged (capital misallocation-prone SOEs with few changes to local government financing vehicle debt extensions and social safety nets). Monetary policy remains flexible, but with a tightening bias for foreign exchange controls, money market, and lending rates (1) to curb domestic capital flight (and its pressures on the yuan) and (2) to reign in speculative excesses perhaps spurred by 2015’s increase in system leverage (futures on steel/iron doubled and copper spiked 40% since early-2016, China’s 70 major city housing price index has alarmingly spiked to early-2010 and late-2013 cyclical peaks). | 7 | 2017 Investment and risk outlook | January 2017 Keeping China’s currency and trade policy in perspective China’s yuan and trade policy require scrutiny to better understand 2017’s investment and risk outlook. Government priority for maintaining stability points to gradual yuan depreciation as the path of least resistance, with associated delays in capital account liberalization. While China’s trade sensitivity has declined since it joined the World Trade Organization (WTO) in 2001, halving its GDP export share to 22%, top officials consider yuan stability paramount. The PBOC remains intent on squeezing domestic capital exodus and watching key currency crosses, recalling that its A-share bubble popped in the summer of 2015, when the yuan surprisingly devalued days after the yen hit its multi-decade trough aggravating Sino-Japanese trade competition. China exhibits relative dependency on the U.S., as exports to the U.S. are close to 4% of Chinese GDP, but U.S. exports to China are less than 1% of U.S. GDP. However, China and the U.S. share strong bilateral inter-dependency, as it is in neither country’s interests to see the value of U.S. Treasuries sink in a “Clash of the Titans” trade war pitting Chinese heavy industry interests against America’s transportation equipment and agriculture exporters. and macro fundamentals. Our current positioning is steered towards under-valued firms benefiting from domestic consumption and investment with combinations of exceptional franchises, sustainable earnings leverage and attractive yields supported by responsible and determined reform mandates and public policy backdrops; we seek to avoid perceived value traps where stock-picking can be overwhelmed by dodgy corporate governance in markets with untenable twin deficits, stagflation, intractable structural problems, and over-dependence on foreign capital and trade. China’s international standing looks likely to elevate with the recent U.S. withdrawal from the TPP (that excluded China), making the proposed Regional Comprehensive Economic Partnership FTA the most interesting multilateral trade alternative in town (its 16 members account for 30% of world GDP). In May, President Xi will host a summit for its One Belt One Road (OBOR) “Silk Road,” linking China, Eurasia, South Asia, Oceania, and North Africa investment collaboration and chair deliberations for the new Asian Infrastructure Investment Bank (57 countries and growing). Favorable prospects for advancing international arrangements (whether imperial in intent or practical bridges for sustainable development) provide China cushion against rising protectionist impulses. On the margin, energy foundations more stable than metals We marginally favor energy equities with oil more stabilized than unsettled metals markets given cross-currents from (1) China’s restricting trading excesses, (2) reflationary tilts from the world’s largest economies, (3) supportive U.S. dollar fundamentals despite countervailing short-term pressures (and traditionally negative U.S dollar-CRB correlations), and (4) supply-demand dynamics.2 Oil supply discipline (capital expenditure cuts of 60% by U.S. shale and 40% from international oil companies in 2014-2016), in conjunction with U.S. and DM demand strength (amounting to 50% of global oil consumption), appears to allow incremental demand to eat into overstocked crude inventories, placing a medium-term floor on price. We expect it would still take several quarters before any Trump renaissance from the Texan Permian Basin to North Dakota’s Bakken Formation, combined with likely cartel cheating, could tilt “swing producer” status back to the U.S. and materially depress prices. On the other hand, iron and copper output continues to grow with large Chinese inventories unlikely to be shaken even by rising DM fiscal infrastructure stimulus demand. The U.S. contributes to only 8% and 4% of global copper and iron demand, respectively; Japanese demand has largely been sourced through long-term contracts; and EM demand prospects remain highly uneven due to China carefully tracking metals market speculation and high variability in EM fiscal programs given their limited ability to ignite spending until debt burdens shrink. Prefer domestic-focused EM firms to externally-facing manufacturing exporters We believe that EM equities will continue to deliver among the most differentiated performances globally given vast divergences in micro Generally, EM equities may very well be in a bottoming-out stage of what has lasted as more than a six-year cycle of underperformance versus DM stocks. EM equities are under-owned and globally cheap, some having benefited from positive political and economic reforms in a “virtuous cycle” climate of (1) compressing credit debt spreads (J.P. Morgan EMBI Global Spread just reaching 2008’s lows thanks to yield-seeking foreigners’ EM bond fund purchases), (2) stabilizing local currencies (at least from 2014-2015’s U.S. dollar acceleration), improved current account balances (especially in Asia), and (3) constructive commodity signals (recovering from 2014-2015’s fallout). However, the mixed country records of growth and productivity, fiscal and political responsibility, and sensitivity to rising U.S. dollar and protectionist waves warrant caution from EMs that may be the source of future deflationary shocks. Discriminating between EM values versus value traps In today’s volatile world, discriminating EM equities and countries along the spectrum of values and value traps remains a particularly fluid challenge. We expect that many EMs are well on their way to buying time to sustainably extend recoveries with thoughtful reforms, but others will be forced to adjust through currency depreciation. Put simply, some EM local currencies are likely to sweat profusely to allow adjustment, while others may just perspire lightly as the gravitational pull of falling real yields versus the U.S. dollar exerts itself. We find a favorable backdrop for selected equities in Hong Kong-China (scheduled to replace an unpopular chief executive this March), South Korea (sustainable balance of payments surplus accompanied with a December presidential election potentially ushering in fresh governance and reform), Russia (improving oil-based fundamentals and potential boost from U.S. sanctions lifting) and Brazil (ongoing long-awaited political transition and steps to address corruption, selected reforms, declining inflationary pressures), among others. Less cheap equity markets may also offer opportunity tomorrow, including India (last November’s “shock and awe” demonetization set growth backwards in the short-term for improved long-term prospects given other fiscal and structural reforms leveraging digital banking and strong demographics) and Mexico (past structural reforms have paid-off but immediate outlook remains in cross-hairs of protectionist backlash). Most vulnerable markets remain Malaysia (high foreign capital dependency, twin deficits and low political legitimacy), South Africa (high twin deficits and stagflation, rising political volatility, exposed to further material currency depreciation), and especially Turkey (perhaps mired in the most difficult-to-escape vicious cycle that can precipitate either currency crisis or debilitating capital controls). Turkey suffers from a compromised central bank caught in the middle of stagflation and topping credit cycle, 20%+ foreign funding requirements as a percent of GDP with dwindling U.S. dollar reserves to satisfy untenable short-term external liabilities, and shattering confidence from international observers in the face of autocratic and intransigent leadership tightening grip after mid-2016’s failed coup, effectively shunning traditional IMF-E.U.-Russian-Gulf or other “white knight” rescues in case of a future funding emergency. | 8 | 2017 Investment and risk outlook | January 2017 Any sharp rise in the U.S. dollar hurting the largest EM U.S. dollar borrowers (such as Turkey, Indonesia, Chile) or U.S. bilateral trade bluster (East Asia most directly vulnerable, in particular Taiwan, where investors have flocked seeking safe haven) could precipitate further EM equity volatility cycles in quarters to come; conversely, any pauses in reflationary, U.S. rate and dollar recovery could further encourage EM carry trades extending the runway for continued self-reinforcing positive EM adjustments. We intend to deploy our disciplined non-consensus investment philosophy marrying stock and macro fundamental research to find what we expect will be more idiosyncratic EM investment ideas as sentiment and fundamentals swing from one cyclical extreme to another. Concluding remarks: Cycles, risks and opportunities We believe that ongoing swings in long-term investment cycles favor disciplined fundamental global equity investors who are ready and capable of sifting through periodic sharp short-term volatility to season portfolios with long-term under-appreciated values. The last six months’ worth of reflationary signals around the world, coupled with a healthy pace of rising sovereign rates, begs the question of whether the best days of the 35-year U.S. bond bull run are over and if equity value investing is finally distinguishing itself against the momentum growth-oriented investment styles in vogue since herculean central bank stimulus was unleashed almost a decade ago. While we are currently in the camp favoring an improving environment for fundamental stock selection mindful of macro considerations, we recognize that growing political extremism today aggravates the ability of long-established cycles to turn easily. Determined corporate managements leveraging self-help restructuring and targeted reforms to boost earnings and valuations in markets with resilient, adaptive, and flexible public policy frameworks remain bestplaced to deliver outstanding investment results. We recognize that corporate and government policymakers must remain vigilant, not taking for granted recent signs of improved global economic performance. Deflationary risks lie around a number of corners in DMs and EMs alike. For example, fiscal stimulus hopes can be disappointed by unexpected legislative and implementation delays without requisite popular support to catalyze reform, or bond markets may re-test monetary policy credibility by negatively reappraising sovereign risk faster than officials can react. Unchecked extreme populism can damage international relations to a point where its participants believe that the rules of the game have been suspended, precipitating rapid disintegration of global institutional architecture and igniting systemic risk. On this note, lacerating rhetoric of mercantilist ultimatums can easily make world players sleep-walk into a financial and economic trade war, and reactive nationalism can splinter alliances into unstable geopolitical spheres of influence ever more combustible in an era of cyber insecurity fueling a visceral public sense that decades-long globalization has only fostered wider and unsustainable inequality. Moves away from traditional globalization—already in force since the GFC after which financial and trade flows began to recede—can sow the seeds of inflation: control of immigration from lower-wage domiciles and national industrial policies can raise the cost of labor, capital controls can tighten financial conditions and the cost of capital, and protectionism can raise the costs of tradable goods and services. Geopolitical volatility itself can elevate cross-asset class risk premiums. As such, we believe it is worth watching out for well-intended promotions of nominal growth to eventually be beset with creeping inflation—not at first so visible, but eventually recognizable and translating into lower real economic growth. Policymakers, companies, and investors will need to adapt accordingly. We are cautiously optimistic that there are also opportunities for developments to outperform expectations. Surprise bilateral (or multilateral) arrangements fortifying obvious common vested interests or modernizing outdated existing relationships inspiring others to follow remain far from consensus investor views but are not improbable possibilities in quarters to come (i.e. what if, when the first mutually positive U.S. bilateral deal gets struck, and/or a revised NAFTA?). Resolutions to what are assumed to be intractable dilemmas can pave a way forward with alacrity rather than the sluggish muddle-along base case of most market prognosticators (i.e. could a multi-speed EMU eventually facilitate a more orderly E.U. recovery adjustment; could continuing Japanese reflation ease a transition to an inter-generational domestic wealth transfer diffusing Japan’s debt predicament?). What if more stable equilibriums can be negotiated in markets at the sharper end of the geo-political-economic volatility stick, even if only for a few quarters at a time (i.e. what if leaders from major economies, or just the U.S. and China, recognizing mutual benefits from lower currency volatility, meet to stabilize exchange rates for some time, perhaps satisfying ambitions of those hoping to ink a landmark deal at another New York hotel down the block from where the famed Plaza Accord was struck?). We appreciate that unforeseen transitions to sustain global recoveries are ultimately critical to build bridges for the wider and more resilient prosperity needed to spur a positive re-embrace of globalization spirit. Regardless of directional swings in sentiment and fundamental rebalancing of macro risk and opportunity, we will continue to deploy our time-tested investment and risk management approach to season your portfolios in the years ahead. Thank you for your trust and support. | 9 | 2017 Investment and risk outlook | January 2017 Appendix: Global equity markets overview Global equity market capitalizations ($bn) with returns YTD & since March 2009 lows (local currency & USD) 2016 YTD Since 3/09 Low Mkt 2016 YTD Since 3/09 Low North Mkt America Cap % w/FX % w/FX Europe Cap % w/FX % $25,338 10% 10% 231% 231% U.K. (W) $3,092 14% -4% 102% $1,996 18% 21% 102% 95% France (W) $1,940 5% 2% 93% $27,335 10% 10% 219% 218% Germany (W) U.S. (W) Canada (W) Total % of World Latin 41% % YTD % w/FX Mkt America 2016 YTD Since 3/09 Low Cap % w/FX % 39% 69% 64% Venezuela $483 117% 37% N.M Mexico (EM) $310 6% -11% 169% % 80% Russia (EM) $586 27% 52% 224% 89% Japan (W) 61% Turkey (EM) $165 9% -10% 239% 74% % of World 2016 YTD Since 3/09 Low Cap % w/FX % w/FX $5,084 -2% 1% 114% 81% 8% % YTD % w/FX % PTD % w/FX 105% 3% 211% 159% Poland (EM) $139 11% 4% 128% 91% 117% Czech. (EM) $24 -4% -7% 44% 22% Non-Japan Mkt Sweden (W) $672 5% -3% 146% 148% Croatia $21 18% 15% 58% 29% Asia Cap % w/FX % w/FX Spain (W) $645 -2% -5% 37% $21 34% 31% 219% 167% China (EM) $6,463 -12% -18% 46% 44% $528 -10% -13% 52% $486 9% 6% 142% w/FX Italy (W) 20% Neths. (W) 14% Hungary (EM) 27% Romania 102% Total 94% % of World N.M Belgium (W) $408 -3% -5% 132% 101% Denmark (W) $356 -13% -15% 312% 245% 175% Middle East 13% 19% 75% 60% Norway (W) $247 15% 17% 234% 18% 25% 32% 12% Finland (W) $218 4% 0% 115% $63 45% 18% 1676% 306% Ireland (W) $106 -4% -7% 240% 100% Austria (W) 80% & Africa 184% Saudi Arabia 2016 YTD Since 3/09 Low $16 1% -3% 261% 185% HK (W) $3,977 0% 0% 94% 94% $972 20% 25% 203% 86% India (EM) $1,550 2% -1% 226% 149% 1% % YTD % w/FX % PTD Mkt 2016 YTD % w/FX S. Korea (EM) $1,214 3% 1% 89% 142% Australia (W) $1,167 7% 6% 80% 105% Since 3/09 Low $951 11% 13% 100% 115% Cap % w/FX % w/FX Singapore (W) Taiwan (EM) $465 0% -2% 98% 112% $448 4% 4% 75% 75% Indonesia (EM) $422 15% 18% 312% 265% 278% $103 9% 6% 85% $423 0% 13% 179% 115% Thailand (EM) $411 20% 21% 275% 47% Portugal (W) $58 -12% -15% -19% -32% U.A.E. (EM) $223 12% 12% 131% 131% Malaysia (EM) $354 -3% -7% 91% 58% % PTD % w/FX Greece (EM) $36 2% -1% -56% -63% Israel (W) $154 -2% -1% 123% 146% Philips. (EM) $235 -2% -7% 262% 254% $12,224 4% -3% 113% 89% Qatar (EM) $153 0% 0% 118% 118% Pakistan $96 46% 46% 744% 552% -15% Vietnam $85 15% 13% 168% 106% -10% N. Zealand (W) $73 9% 10% 179% 292% $17,461 -3% -6% 99% 97% $74 58% 60% 94% $1,951 41% 32% 112% 3% % YTD % w/FX Mkt w/FX Japan w/FX -9% $206 % of World Since 3/09 Low % 7% $104 Peru (EM) 2016 YTD Cap -7% Chile (EM) Total Mkt $1,861 Colombia (EM) Argentina Frontier w/FX Europe $1,468 % PTD % w/FX Switz. (W) $711 Brazil (EM) Developed Total % of World Index Returns 2016 YTD Since 3/09 Low S&P 500: 10% 231% World: 8% 200% 55% S. Africa (EM) 18% % YTD % w/FX % PTD % w/FX Kuwait $79 2% 2% -12% $57 32% 29% 5% Egypt (EM) $35 76% -24% 244% Nigeria $29 -6% -41% 35% $1,602 4% 5% 108% 77% 2% % YTD % w/FX % PTD % w/FX Morocco ACWI: 8% 189% Total ACWI ex-US: 4% 127% % of World EM: 11% 115% Index Returns 2016 YTD Since 3/09 Low S&P 500: 10% 231% World: 8% 200% ACWI: 8% 189% ACWI ex-US: 4% 127% EM: 11% 115% Period-to-date (PDT) returns from March 9, 2009 GFC lows. Source: Bloomberg and FactSet for selected MSCI ACWI (ACWI) markets. Country equity indices from Bloomberg STAT Market Caps function. (W) MSCI World Index (MXWO) member. (EM) MSCI Emerging Markets Index (MXEF) member. | 10 | 6% Total -37% % of World 26% % YTD % w/FX % PTD % w/FX 2017 Investment and risk outlook | January 2017 Venkateshwar “Venk” Lal Director of Investment Risk & Strategy, EverKey Global Equity Venkateshwar Lal is the director of investment risk & strategy for the EverKey Global Equity team at Wells Capital Management. He joined WellsCap in 2012 from EverKey Global Partners where he served as a founding partner and head of risk and trading since 2007. Since 2013, Venk has also served on Wells Fargo Asset Management’s WealthBuilder Investment Committee. Prior to joining EverKey, Venk served as an executive director in the Consolidated Equities Division at Morgan Stanley, advising hedge funds and other investment management firms on implementing and managing risk exposures in global equity markets. In addition, he previously advised and structured capital markets solutions for corporate clients seeking to issue or repurchase capital in the equity, convertible, and fixed-income markets. Venk joined Morgan Stanley as a sales and trading associate and previously served as a financial analyst for Goldman Sachs & Co. He has been in the investment industry since 1991. Venk earned a bachelor’s degree from the Woodrow Wilson School of Public and International Affairs at Princeton University, where he graduated summa cum laude, and a master’s degree in business administration from Harvard Business School. He has served as a term member of the Council on Foreign Relations. 1 Currency risks for U.S. dollar-based global equity investors are discussed further in our October 2014 review, Currency Volatility Revisited, an update to a global equity risk discussion we published for clients in February 2013. 2 Cross-asset class commodity considerations for global equity investors are detailed in Spotlight on Global Currencies and Commodities, published for clients in February 2015. CFA® and Chartered Financial Analyst® are trademarks owned by CFA Institute. Wells Fargo Asset Management (WFAM) is a trade name used by the asset management businesses of Wells Fargo & Company. 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WFBNA DIFC branch only deals with Professional Clients as defined by the DFSA. ©2016 Wells Fargo Bank NA. All Rights Reserved. Wells Capital Management (WellsCap) is a registered investment adviser and a wholly owned subsidiary of Wells Fargo Bank, N.A. WellsCap provides investment management services for a variety of institutions. The views expressed are those of the author at the time of writing and are subject to change. This material has been distributed for educational/informational purposes only, and should not be considered as investment advice or a recommendation for any particular security, strategy or investment product. The material is based upon information we consider reliable, but its accuracy and completeness cannot be guaranteed. Past performance is not a guarantee of future returns. As with any investment vehicle, there is a potential for profit as well as the possibility of loss. 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