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Lazard Capital Allocator Series Capital Market Viewpoints 1Q17 Outlook The Lazard Capital Allocator Series Investment Team (“Investment Team”) has taken recent economic and global developments into consideration in constructing what it believes to be an optimal asset allocation for the first quarter of 2017. The Investment Team’s methodology remains “top down” by nature. Historical relationships combined with information contained in the futures markets are used to develop a forward-looking worldview that endeavors to anticipate major turning points in various asset-return cycles. The process tends to be gradual and directional in terms of specific asset allocation recommendations. A range of factors—from legislative changes to geopolitical events—are analyzed in the process of identifying and anticipating secular and cyclical adjustments in the relative performance of assets both domestically and across countries. This information is applied to the Investment Team’s rules for determining how and when to choose a style, location, and/ or size of an investment, and whether to do so in a passive or active mode. RD12102 Major Reallocation Changes in LCAS Portfolios for the First Quarter 2017: • Increased equity exposure, particularly to US small and mid cap equities • Significantly decreased fixed income exposure • Increased exposure to nontraditional investments to allow for tactical engagement A Brave New Investment World It is a new world. Global asset allocators woke up in different market environments after the 23 June Brexit vote and the 8 November US presidential election—events that called into question assumptions about economic growth, fiscal and monetary stimulus, and geopolitics. The stark rejection of Italian voters to a referendum in December was the exclamation point for a year when populist rage surprised, then shocked, and finally overwhelmed elites. James Carville distilled Bill Clinton’s 1992 presidential election campaign in a single, memorable phrase, “It’s the economy, stupid.” A variation for ballot-driven markets in 2016 could be: “It’s the politics, stupid.” Each upheaval was dreaded by markets, and yet each sell-off was swiftly erased by investors (Exhibit 1). The impact of Brexit lingered for a few weeks; the US presidential election was absorbed in days; the Italian referendum was shaken off in hours. Animal spirits, long dormant, stirred. After Donald Trump’s election, the markets anticipated that the federal government might break its deadlock and cut taxes, lower regulation, and increase infrastructure spending. At the same time, investors appeared to downplay (or in some cases ignore) Trump’s previous statements on trade, immigration, and foreign policy. Investor enthusiasm gained momentum on evidence that the global economy—and the US economy in particular—was strengthening. US GDP grew at an annual rate of 3.5% in the third quarter, up from anemic levels in the first half of 2016 and the strongest pace in two years. In light of this data, the US Federal Reserve’s decision to raise the fed funds rate in December—only the second rate hike in the past decade—was taken as a sign of confidence. US equities jumped while emerging markets, under pressure from a surging US dollar, dropped. Japanese equities also declined sharply after the US presidential election. European equities slid as economic and political uncertainty continued to undermine investor confidence. In the old investing world, deflation was the major concern, in the new world, it’s inflation. Before, monetary policy was the tool to support economic growth, now the tool appears to be fiscal stimulus. Six months ago, investors were desperate as yields hovered at historic lows and even entered negative territory. Today, upward pressure on interest rates is growing. We have entered a new paradigm. Fiscal policy is taking over from monetary policy, which should create more “normal” market conditions. These conditions will likely be more volatile and characterized by higher interest rates compared to the previous environment. For global investors, opportunity and uncertainty beckon. As we explain below, the events of the past several months have shifted our perspective on asset classes, even as we remain highly sensitive to potential risks to our outlook. We have implemented three major reallocation changes: • Increased equity exposure, particularly to US small and mid cap equities • Significantly decreased fixed income exposure • Increased exposure to nontraditional investments to allow for tactical engagement We believe that global economic growth is resilient and that, over time, equities will continue to offer more opportunities for returns than bonds will. In fact, one of the perplexing questions is what constitutes a “safe” asset in the current environment. We believe fixed income is vulnerable as interest rates continue to normalize to a higher level. This is especially true for the US Treasury market, which has been a safe haven trade for quite some time. We remain vigilant, as volatility can meaningfully impact markets over the short run. However, we also believe economic or political trends will produce both economic winners and losers, which skillful investment managers can seek to exploit. Exhibit 1 UK Equities Surged after Brexit; US Equities Jumped after the Presidential Election FTSE 100 Index S&P 500 Index 7,000 2,275 6,700 2,225 6,400 2,175 6,100 2,125 5,800 Mar 2016 Apr 2016 As of 31 December 2016 Source: Bloomberg May 2016 Jun 2016 Jul 2016 Aug 2016 Sep 2016 2,075 Jun 2016 Jul 2016 Aug 2016 Sep 2016 Oct 2016 Nov 2016 Dec 2016 Exhibit 2 US Consumer Confidence Has Risen to a Decade High Exhibit 3 Interest Rates Rose Sharply After the US Presidential Election University of Michigan Consumer Confidence Index US Treasury Yield (%) 115 3 95 2 Average 75 1993 1996 1999 Yield curve as of 30 September 2016 1 55 1990 Yield curve as of 31 December 2016 2002 2005 2008 2011 2014 2017 0 0.5 2 5 10 As of 31 December 2016 As of 31 December 2016 Source: Bloomberg Source: Bloomberg “Trumpflation” or Stagflation? The election of Donald Trump to the presidency, while the Republican party retained control of both houses of Congress, has changed market sentiment in the United States. Expectations have risen that the federal government can break the legislative gridlock of the past several years. A number of important initiatives now seem not only possible but plausible, such as infrastructure spending, tax reform, and a lighter regulatory regime. Fiscal stimulus may take over from monetary policy. The era of “Trumpflation” has arrived. US economic growth appeared to be accelerating. GDP expanded at a 3.5% annualized rate in the third quarter, the highest in two years. November’s job numbers came in strong, and the unemployment rate dipped to 4.6 percent, the lowest since August 2007. Consumer confidence in December rose to a decade high (Exhibit 2), partly reflecting the fact that median US household income, adjusted for inflation, grew at its fastest rate since the survey was started in 1968. In addition, the US housing market continues to improve, and the S&P/ Case-Shiller Home Price Index shows that home prices have nearly recovered their losses from the global financial crisis. Equity markets appeared, at times, exuberant. The S&P 500 Index gained nearly 5% in the weeks after the election, betting on pro-growth 30 initiatives from Washington, D.C. The mood in the bond markets was different, where additional debt expectations and rising inflationary pressures caused a sell-off. The yield on the benchmark 10-Year Treasury rose sharply by about 70 basis points (bps) (Exhibit 3). The decline in bonds was partly driven by rising inflationary expectations as well as the likelihood the Fed would raise interest rates, which occurred at the December meeting. The new rate, 0.50%–0.75%, is still low in historical terms, but the Fed indicated that three more hikes were likely in 2017. This was higher than the one or two hikes Fed officials had forecast in September—an example of how Trump’s election has seemingly changed expectations. In this environment, equities with exposure to the US economy and infrastructure have benefited. Financials, energy, and industrials sectors have outperformed since the election. On the other hand, more defensive sectors, such as health care and consumer staples, have lagged. The prospect of higher interest rates and stronger growth boosted the US dollar (Exhibit 4). Ironically, we believe this makes Trump’s pledge to increase US manufacturing jobs more difficult as the rising US dollar will make US-based corporations and manufacturers less competitive. In addition, the Fed’s campaign could be too aggressive, threatening to choke off growth. Exhibit 4 The US Dollar and Commodities Prices Increased Due Partly to Stronger US Economic Growth Prospects DXY US Dollar Currency Indexa CRB Raw Industrials Indexb 104 500 100 480 96 460 92 Dec 2015 440 Mar 2016 Jun 2016 Sep 2016 Dec 2016 Jun 2016 Aug 2016 Oct 2016 Dec 2016 As of 31 December 2016 a DXY Index is a measure of the US dollar’s value relative to a basket of select foreign currencies that represent the United States’ major trading partners. b CRB Raw Industrials Spot Market Price Index is a measure of price movements of 22 sensitive basic commodities whose markets are presumed to be among the first to be influenced by changes in economic conditions. Source: Bloomberg One of the most important questions facing investors in 2017 is determining whether rising interest rates are: “good,” i.e., representing healthy economic growth and a normalization of rates; or “bad,” reflecting inflationary pressures from structural imbalances in the economy. One driver of inflation comes from commodities prices, which have been rising in 2016 after hitting lows early in the year. Surprisingly, this trend continued as the US dollar strengthened (Exhibit 4), an unusual development given that commodities are priced in US dollars and thus usually decline when the US dollar gains purchasing power. While this would likely contribute to inflationary pressures, years of investment in commodities production during the boom years before the global financial crisis has left meaningful capacity. Another important issue is the rise of populist, anti-globalization views in developed markets. Given the importance of exports to emerging markets economic growth, a threat such as trade barriers can have an outsized impact on emerging markets. We find it notable that protectionist sentiment—note Trump’s slogan: “America First”—has risen steadily over the past several years. Another potential source of inflation is wages, which have been rising. The US unemployment rate is about 4.6, a low, which implies that the labor market is near full employment—thus giving workers more bargaining power for higher pay. However, labor participation in the United States has also declined since 2007, implying slack still exists in the job market. Europe: Political Uncertainty Ahead The question of “‘Trumpflation’ or stagflation?” cannot be answered with certainty yet. So far, the markets appear to be pricing in an optimal scenario for Trump’s administration—prospects of an effective federal government while downplaying Trump’s statements on immigration, trade, and international alliances. It is also important to note that, while Trump is working with a Republican-controlled legislature, there is no guarantee that his proposals will actually be implemented as the potentially significant increases to the federal deficit may cause concern. However, we believe the 10-year Treasury yield low in July after the Brexit vote likely marked the end of the secular stagnation. Emerging Markets: Caught between Higher Growth and Higher Rates The uncertainty around a Trump presidency and his proposed policies had a direct impact on emerging markets equities, which tumbled in November after Trump’s election. The decline erased their yearto-date outperformance compared to US equities, though emerging markets equities finished 2016 up strongly. This result was notable, considering that the MSCI Emerging Markets Index had posted three calendar years of negative returns prior to 2016. Going forward, emerging markets investors face a number of questions. One concern is the potential impact of accelerating US economic growth, which should be a boon for emerging markets exporters. Another is a strong US dollar, which can make emerging markets companies more competitive while at the same time making it more difficult to repay US dollar–denominated debt. Finally, commodities prices continue to have significant influence on emerging markets equities, even though emerging markets are diverse economically. The bottoming of commodities prices in the first quarter provided vital support to the emerging markets rally in 2016. Further stability or inflation in commodities prices would benefit the asset class, in our view. This near-term uncertainty overshadows the improvements in emerging markets fundamentals as well as the asset class’s long-term positive outlook. We believe that 2016’s performance is not—potentially yet—an inflection point that signals a rotation out of developed markets into emerging markets. Many investors are growing optimistic about Europe as it enters 2017, even though equity performance mostly lagged in 2016. The global economy is accelerating, US prospects have risen, and European manufacturing activity and economic sentiment have reached levels last seen in 2011. The European labor market appears healthier, and a weaker euro versus the US dollar has made European exporters more competitive. At the European Central Bank (ECB), monetary policy remains accommodative. Europe does face a number of political challenges as the Brexit negotiations play out and populist, euro-sceptic arguments dominate upcoming elections in a number of countries, including France (in April/May) and Germany (October). If populist-driven figures take power in a major European government, the euro and the structure of the European Union (EU) could be called into even greater question. However, we believe the likelihood of this is low. Investment Insights Market conditions have changed dramatically since the US elections, and we are adjusting our portfolios accordingly. We believe the new administration, working with Congress, could deliver significant regulatory and tax reforms, along with an infrastructure package, that would be stimulative to the US economy. In our view, this would have two likely outcomes—equity assets with exposure to US growth will be supported, while interest rates would experience upward pressure. The implications are significant for investors in US fixed income, which have been bid up over the past several years as central banks pushed down rates and investors, desperate for yield, turned to lower quality securities. We see potential for significant downside if US economic growth climbs to its historical range of 2%–3% (it has been below 2% for most of the past six years) and inflation hits 2%. The benchmark 10-year Treasury, in our view, could rise well above the 2.6%–3.0% threshold established by consensus. If rates continue to normalize, it would not be unreasonable to see the 10-year Treasury bond yield in the 4%–5% range. Duration-sensitive investment across both the equity and fixed income markets would be especially vulnerable. However, we do not believe that the recent rise in interest rates is due to inflationary pressures. Supply and demand in commodities appear to be still in balance. We are also watching wage pressures in the US labor market closely, but we believe that the low rate of labor participation implies more slack than is apparent in the current unemployment rate. demand for emerging markets products. At the same time, despite strong performance this year, we believe emerging markets equities remain relatively inexpensive. In Europe, we continue to have ongoing concerns about political uncertainty, especially the challenges posed by the Brexit process as well as the number of important elections scheduled for 2017. We note that the European economy is recovering and that the ECB has maintained loose monetary policy. However, the labor market remains relatively inflexible and the debt overhang is formidable. In politics, officials must contend with euro-sceptic contenders, though we believe scenarios of a breakup of the EU or a dissolution of the euro remain extreme. We believe large cap US equities, on the other hand, appear more fully valued, which has partly driven our decision to lower our allocation. However, a stimulus from the federal government should benefit the US economy and assets with the most exposure to US growth—such as small and mid-cap stocks, which are more domestically sensitive. Small businesses, in particular, would benefit from lower regulation as they typically do not have the scale to efficiently address government requirements. We have raised our allocation to these asset classes. We are much less confident in prospects for US fixed income, especially high quality bonds. As a result, we have decided to reduce our allocation and now have a significant underweight to the asset class. We have maintained our allocation to emerging markets equities. This reflects the growing fundamental strength in emerging markets, despite the pressures caused by the US dollar and more hawkish Fed interest rate policy. We believe that a growing US economy will raise The “relative” nature of returns is a central concept in our assetallocation process. In this changing and uncertain environment, and as always, we remain confident that our versatile framework will reward risk-takers who stay the course with attractive relative returns over time. Lazard’s 2017Q1 Asset Class Viewpoints Attractive EQUITY Fair Valued United States Emerging Markets Cap Small Cap Mid Cap Large Cap Style Value Non-Traditional Cash Non-Traditional Credit Region FIXED INCOME For illustrative purposes only and, along with allocations and security selection, are subject to change. Unattractive Japan Europe Asia Pacific ex-Japan Growth US Treasury Lazard Capital Allocator Series Capital Market Viewpoints This content represents the views of the author(s), and its conclusions may vary from those held elsewhere within Lazard Asset Management. Lazard is committed to giving our investment professionals the autonomy to develop their own investment views, which are informed by a robust exchange of ideas throughout the firm. Important Information Published on 20 January 2017. The information and opinions presented have been obtained or derived from sources believed by Lazard to be reliable. Lazard makes no representation as to their accuracy or completeness. All opinions expressed herein are as of 31 December 2016, unless otherwise specified, and are subject to change. Allocations and security selection are subject to change. The securities and funds identified are not necessarily held by Lazard Asset Management for all client portfolios and should not be considered a recommendation or solicitation to purchase or sell any security or fund. It should not be assumed that any investment in these securities or funds was, or will be, profitable or that the investment decisions we make in the future will be profitable or equal to the investment performance of the securities or funds referenced herein. There is no assurance that any security or fund referenced herein is currently held in the account’s portfolio or that any security or fund sold has not been repurchased. The securities or funds discussed may not represent the account’s entire portfolio. Certain information included herein is derived by Lazard in part from an MSCI index or indices (the “Index Data”). However, MSCI has not reviewed this product or report, and does not endorse or express any opinion regarding this product or report or any analysis or other information contained herein or the author or source of any such information or analysis. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any Index Data or data derived therefrom. Equity securities will fluctuate in price; the value of your investment will thus fluctuate, and this may result in a loss. Securities in certain non-domestic countries may be less liquid, more volatile, and less subject to governmental supervision than in one’s home market. The values of these securities may be affected by changes in currency rates, application of a country’s specific tax laws, changes in government administration, and economic and monetary policy. Small- and mid-capitalization stocks may be subject to higher degrees of risk, their earnings may be less predictable, their prices more volatile, and their liquidity less than that of large-capitalization or more established companies’ securities. Emerging markets securities carry special risks, such as less developed or less efficient trading markets, a lack of company information, and differing auditing and legal standards. The securities markets of emerging markets countries can be extremely volatile; performance can also be influenced by political, social, and economic factors affecting companies in emerging markets countries. Equity securities will fluctuate in price; the value of your investment will thus fluctuate, and this may result in a loss. Investments in Japan are subject to certain risks, such as the risks associated with the economy of Japan generally. A portfolio of securities concentrated in one country or geographic region may be subject to greater volatility than a more diversified portfolio. An investment in bonds carries risk. If interest rates rise, bond prices usually decline. The longer a bond’s maturity, the greater the impact a change in interest rates can have on its price. If you do not hold a bond until maturity, you may experience a gain or loss when you sell. Bonds also carry the risk of default, which is the risk that the issuer is unable to make further income and principal payments. Other risks, including inflation risk, call risk, and pre-payment risk, also apply. High yield securities (also referred to as “junk bonds”) inherently have a higher degree of market risk, default risk, and credit risk. Investments in closed-end funds are non-redeemable and are subject to the same risks as other publicly-traded equity securities. Sometimes, however, there may be no public market for units of closed-end funds. The shares of closed-end funds, and exchange-traded funds (“ETFs”) may trade at prices at, below, or above their most recent net asset value. There is no guarantee that a fund’s discount will ever be narrowed or eliminated. Additionally, the performance of an ETF pursuing a passive index-based strategy may diverge from the performance of the index. Exchange traded notes (“ETNs”) may not trade in the secondary market, but typically are redeemable by the issuer. Unlike ETFs and closed-end funds, ETNs are not registered investment companies and thus are not regulated under the 1940 Act. In addition, as debt securities, ETNs are subject to the additional risk of the creditworthiness of the issuer. ETNs typically do not make periodic interest payments. An investment in these types of instruments is indirectly subject to all the risks associated with the investments made by the closed-end fund, ETF, or ETN. This material is provided by Lazard Asset Management LLC or its affiliates (“Lazard”). There is no guarantee that any projection, forecast, or opinion in this material will be realized. Past performance does not guarantee future results. This document is for informational purposes only and does not constitute an investment agreement or investment advice. References to specific strategies or securities are provided solely in the context of this document and are not to be considered recommendations by Lazard. Investments in securities and derivatives involve risk, will fluctuate in price, and may result in losses. Certain securities and derivatives in Lazard’s investment strategies, and alternative strategies in particular, can include high degrees of risk and volatility, when compared to other securities or strategies. Similarly, certain securities in Lazard’s investment portfolios may trade in less liquid or efficient markets, which can affect investment performance. Australia: FOR WHOLESALE INVESTORS ONLY. Issued by Lazard Asset Management Pacific Co., ABN 13 064 523 619, AFS License 238432, Level 39 Gateway, 1 Macquarie Place, Sydney NSW 2000. Dubai: Issued and approved by Lazard Gulf Limited, Gate Village 1, Level 2, Dubai International Financial Centre, PO Box 506644, Dubai, United Arab Emirates. Registered in Dubai International Financial Centre 0467. Authorised and regulated by the Dubai Financial Services Authority to deal with Professional Clients only. Germany: Issued by Lazard Asset Management (Deutschland) GmbH, Neue Mainzer Strasse 75, D-60311 Frankfurt am Main. Hong Kong: Issued by Lazard Asset Management (Hong Kong) Limited (AQZ743), Unit 29, Level 8, Two Exchange Square, 8 Connaught Place, Central, Hong Kong. Lazard Asset Management (Hong Kong) Limited is a corporation licensed by the Hong Kong Securities and Futures Commission to conduct Type 1 (dealing in securities) and Type 4 (advising on securities) regulated activities. This document is only for “professional investors” as defined under the Hong Kong Securities and Futures Ordinance (Cap. 571 of the Laws of Hong Kong) and its subsidiary legislation and may not be distributed or otherwise made available to any other person. Japan: Issued by Lazard Japan Asset Management K.K., ATT Annex 7th Floor, 2-11-7 Akasaka, Minato-ku, Tokyo 107-0052. Korea: Issued by Lazard Korea Asset Management Co. Ltd., 10F Seoul Finance Center, 136 Sejong-daero, Jung-gu, Seoul, 04520. People’s Republic of China: Issued by Lazard Asset Management. Lazard Asset Management does not carry out business in the P.R.C. and is not a licensed investment adviser with the China Securities Regulatory Commission or the China Banking Regulatory Commission. This document is for reference only and for intended recipients only. The information in this document does not constitute any specific investment advice on China capital markets or an offer of securities or investment, tax, legal, or other advice or recommendation or, an offer to sell or an invitation to apply for any product or service of Lazard Asset Management. Singapore: Issued by Lazard Asset Management (Singapore) Pte. Ltd., 1 Raffles Place, #15-02 One Raffles Place Tower 1, Singapore 048616. Company Registration Number 201135005W. This document is for “institutional investors” or “accredited investors” as defined under the Securities and Futures Act, Chapter 289 of Singapore and may not be distributed to any other person. United Kingdom: FOR PROFESSIONAL INVESTORS ONLY. Issued by Lazard Asset Management Ltd., 50 Stratton Street, London W1J 8LL. Registered in England Number 525667. Authorised and regulated by the Financial Conduct Authority (FCA). United States: Issued by Lazard Asset Management LLC, 30 Rockefeller Plaza, New York, NY 10112.