the retro normal - bernstein€¦ · for many years, investors could rely on a few key principles...

JANUARY 2017

THE RETRO NORMALInvesting in the Changing Landscape

2

OLD, NEW, AND RETRO NORMALFor many years, investors could rely on a few key principles of

investing to steer a course. Maintaining a globally diversified

portfolio of stocks would generate strong returns over time, with

considerable risk of loss over short-term periods. High-quality,

intermediate bonds would diversify that equity risk, while adding

stability and income. Active management could boost return and

reduce risk, though asset allocation would be the primary driver of

both. Call those the navigation charts in the “Old Normal.”

The credit crunch of 2008 and subsequent recovery seemed to

upend those verities. In a period often dubbed the “New Normal,”

central banks around the world slashed interest rates to zero or

below, and eventually bought up massive quantities of bonds to flood

the financial system with money (Display 1). Investors responded as

policymakers hoped they would—by moving into riskier assets to

earn a decent return. As a result, in the New Normal Era, almost all

asset classes (save cash) delivered strong returns.

The US election set off a sea change in market sentiment, and a rotation into and out of asset classes and sectors. How durable are these changes, and what do they mean for markets going forward?

DISPLAY 1: CENTRAL BANK LIQUIDITY PUSHED STOCKS UP

0

500

1,000

1,500

2,000

2,500

0

4

8

12

16

07 08 09 10 11 12 13 14 15

S&P

500U

SD T

rillio

ns

BOJ

ECBCentral BankAssets

US

UK

S&P 500

(left axis)

Past returns are not necessarily predictive of future results.

Through September 30, 2016

Source: Haver Analytics, International Monetary Fund (IMF), Standard & Poor’s, and AB

The Retro Normal: Investing in the Changing Landscape 3

But it hasn’t been easy sailing. Although volatility in the New Normal

Era was usually low, several shocks drove investors out of stocks and

into bonds. Consequently, many investors missed much of the bull

market.

In addition, returns for individual securities within asset classes

differed unusually little (Display 2). As a result, few active managers

beat the indexes. There was one notable exception: Seemingly

safe securities, often characterized by high income, outperformed.

In what we called the “Safety Bubble,” investors poured into those

securities and the managers who emphasized them.

Now, the torrents of central bank liquidity are beginning to ebb, at

least in the US, and market sentiment and behavior are changing

globally. In the wake of the surprising US election results, the Safety

Bubble in high-yielding securities lost air. And as Display 2 also

shows, the dispersion of stock returns has widened. Being in the

right securities, as well as the right asset classes, once again matters

to returns.

In some ways, market conditions today resemble conditions in the

Old Normal Era before 2008. But as the wave of monetary stimulus

recedes, it’s becoming apparent that the flood has altered the river’s

course. We believe that markets have entered a “Retro Normal Era”

that revives the Old Normal, but isn’t quite the same. The defining

features of the Retro Normal Era include:

� Low expected returns for most asset classes;

� Higher volatility than in recent years that remains subject to sharp spikes; and

� Increased opportunity for active managers to add return and reduce risk.

DISPLAY 2: MARKET CONDITIONS HAVE ALREADY IMPROVED FOR ACTIVE MANAGERS

Intra–Stock Market Correlations* Approaching Precrisis Levels

S&P 500Stock Market Dispersion†

Has Widened

Last Five Years Last Three Months0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

90 94 98 02 06 10 14 16

Since2008Began

PrecrisisAverage

December2016

Historical analysis does not guarantee future results.

As of December 31, 2016

*Correlation is a measure of how similar individual stock returns are to each other; data shown are a six-month moving average, except for the December 2016 point. Precrisis average is from 1990 through 2007. †Dispersion is a measure that captures the magnitude of return differentials among stocks in the universe. Percentile ranking is since 1980. Last Five Years reflects the monthly average of the 2012 to 2016 period, ranked.

Source: FactSet, Standard & Poor’s, and AB

4

AN INFLECTION POINTThe Federal Reserve stopped adding to its bond holdings in 2014.

When it took a first small step to drain liquidity in December 2015,

raising short-term rates by 25 basis points, the markets for risk

assets swooned. But when the Fed took a second step of the same

size in December 2016, the market reaction was quite different,

suggesting that the markets had reached an inflection point.

The bullish response to the US election in November underlined the

change in mood. Within hours of Donald Trump’s surprising win, US

equity markets rose on expectations that his proposals for tax cuts,

higher infrastructure spending, and deregulation would drive up

economic and earnings growth; bond markets fell on expectations

that faster growth, fiscal deficits, and new barriers to imports and

immigration would drive up inflation and interest rates.

Expectations of accelerating US economic growth and deregulation

lifted US stocks (Display 3). The greatest expected beneficiaries of

rapid US growth—small-caps, cyclicals, and some commodities—

did particularly well, as did banks, which also tend to benefit from

rising interest rates and deregulation. Companies that paid higher

taxes also outperformed, as investors anticipated that they would

gain from lower corporate tax rates. Expectations of increased trade

barriers hurt non-US stocks, particularly emerging-market stocks,

and the Mexican peso.

At the same time, expectations of higher inflation and interest rates

pushed down the prices of most bonds and higher-yielding stocks,

such as utilities and real estate investment trusts (REITs). Municipal

bond prices were further depressed by expectations that lower

personal income-tax rates would make their tax-advantaged status

less valuable. Treasury Inflation-Protected Securities (TIPS) outper-

formed other bonds, as investors sought greater protection from

inflation.

The speed and magnitude of the market response to the election

were stunning, although there had been some evidence that

sentiment was shifting in the third quarter. We’d been anticipating an

eventual unwind of the Safety Bubble, and the US equity portion of

client portfolios benefited from post-election moves.

DISPLAY 3: REFLATIONARY EXPECTATIONS DROVE POST-ELECTION RETURNSGlobal Asset Reaction—First Week After the US Election

Accelerating US Economic Growth and Deregulation

Higher Inflation andInterest Rates

Increased US Trade Barriers

2.0%

9.0%

14.2%

5.6%

(1.8)% (1.4)% (1.2)% (1.3)%

(6.7)%

(10.6)%

US Large-Caps

US Small-Caps

Copper

USBonds

MuniBonds

EMStocks

Non-USDevelopedREITs

Banks

MexicanPeso

Past performance is not necessarily indicative of future returns.

November 8–15, 2016. Asset classes represented, in order, by the S&P 500, Russell 2000, S&P GICS bank sector, S&P GSCI Copper Index Spot, Bloomberg Barclays US Aggregate Index, Bloomberg Barclays Municipal Bond 5-Year (4–6) Total Return Index, FTSE NAREIT US Real Estate Index, MSCI EAFE Index, MSCI Emerging Markets Index, and Mexican peso versus US dollar.

Source: Bloomberg and AB


WHAT’S NEXT? The Economic OutlookWhile the specifics of policy proposals are still unclear, it’s reasonable

to expect that expansionary fiscal policy, corporate tax cuts, and

deregulation will boost US economic growth, as well as inflation, and

extend the life of the slow economic recovery that began in 2009.

However, a stronger dollar and potential barriers to free trade and

immigration could slow the pickup in growth.

We now expect 2.9% real US GDP growth (Display 4), with 2.8%

inflation, rising fed funds rates in 2017, and higher levels for all three

in 2018. The details—how policy proposals are modified as they go

through Congress or the regulatory process—will determine how

much growth, inflation, and interest rates rise. They will also affect

which and how much companies benefit.

Japan’s and Europe’s economies remain far weaker, though we

expect both to pick up slightly in 2017. In both regions, export-ori-

ented sectors are stronger than domestic and consumer sectors.

The European Central Bank and the Bank of Japan continue to pump

out liquidity, which is finally paying off in improving credit growth,

and thus flowing through to the real economy. Also, faint rumblings

that governments may turn to fiscal policy to spur growth could be

amplified by US moves in that direction.

China’s domestically focused consumer sectors are stronger than

export-oriented sectors. Its overall real growth rate is slowing to

below 6% from nearly 8% over the past eight years, with resilient

consumer demand partly offset by weaker investment and exports.

Exports could be further weakened if President Trump acts on his

threats to tear up trade agreements or impose stiff tariffs.

DISPLAY 4: THE US ECONOMY IS LIKELY TO CONTINUE RUNNING FASTERCumulative Real GDP Growth

90

95

100

105

110

115

Inde

xed

to L

evel

at Y

ear-

End

2008

120

125

09 10 11 12 13 14 15 16 17

US

Forecast

Japan

Europe

CAGR2009–2016E 2017F

US 2.1% 2.9%

Japan 1.2 1.5

Europe 1.0 1.4

Historical results and current forecasts do not guarantee future results.

Reported data from 2009:1Q through 2016:3Q; forecast data from 2016:4Q through 2017:4Q; both as of December 10, 2016.

Source: Haver Analytics, national accounts, and AB forecasts

6

The Market OutlookInvestors excited by the potential boost from the US election should

recall that starting conditions matter. This is not 1981, the beginning

of the Reagan era, when the economy was in a deep recession

induced by extremely high interest rates intended to wring out infla-

tionary pressure. Back then, the S&P 500 was trading at around nine

times depressed earnings (Display 5).

Today, after nearly eight years of a slow economic recovery and

powerful market rebound, the S&P 500 is trading at 17.9 times

earnings—and earnings are close to all-time highs. Yet, the fed funds

rate is 0.5%, and the 10-year Treasury rate is 2.5%. While both

interest rates are higher than a few months ago, they remain close to

all-time lows, and are poised to go higher.

We expect below-average returns for almost all asset classes over

the next five years. Over the long term, bond returns are typically in

line with starting yields: We expect bond returns of about 1% over the

next five years, far below their 20-year averages (Display 6). Rather

than getting a huge boost from falling interest rates as they did in the

DISPLAY 6: EXPECTED RETURNS ACROSS ASSET CLASSESAnnualized Index Returns

1.0% 1.0%

3.0%

6.6%

5.7%

5.7%

USMunicipals

USInvestment-

Grade Bonds

Global High-Yield Bonds

GlobalEquities*

USEquities

DevelopedInternational

Equities

Emerging-MarketEquities

Median Five-Year Forecast†

Past 20-Year Average

3.5%

5.6%

8.1%7.4%

4.3%

7.9%

7.4%

5.2%

Neither past nor forecasted performance is necessarily indicative of future results or a range of future results. There is no guarantee that any estimates or forecasts will be realized. Markets are represented by the Lipper Short/Intermediate Blended Muni Fund Average, Bloomberg Barclays US Aggregate Index, Bloomberg Barclays Global High-Yield Index, S&P 500 Index, Russell 1000 Growth Index, Russell 1000 Value Index, Russell 2500 Index, MSCI EAFE Index, and MSCI Emerging Markets Index. *Global equities are represented by 21% US diversified, 21% US value, 21% US growth, 7% US small-/mid-cap, 22.5% developed international, and 7.5% emerging market. †Median five-year forecast reflects Bernstein’s estimates and the capital-market conditions as of September 30, 2016. See Note on the Bernstein Wealth Forecasting System at the end of this paper.

Source: Bloomberg Barclays, FactSet, Lipper, MSCI, Standard & Poor’s, and AB

DISPLAY 5: STARTING CONDITIONS MATTERConditions as New President Took Office

Trump Reagan

Expansion/Recession Expansion Recession

Inflation 2.2% 12.5%

Fed Funds Rate 0.5% 18.9%

10-Year Treasury Rate 2.5% 12.6%

Unemployment Rate 4.6% 7.2%

Net US Debt/GDP* 77% 26%

S&P 500 P/E (forward) 17.9x 9.0x


*Net debt excludes debt the government owes itself.

Source: Congressional Budget Office, Haver Analytics, Tax Foundation, and AB


1980s, bond prices are likely to be depressed by rising rates. But

returns will likely be positive for intermediate-duration fixed-income

portfolios. While bonds may occasionally fall quickly in price, the

increase in yield should replace market losses within a year or two.

Stock returns are also likely to be subpar. Our central case calls for

US stock returns of less than 6% annually over the next five years,

below their nearly 8% average over the past two decades. Even if the

new administration and Congress agree on policies that boost GDP

growth and extend the economic cycle, earnings growth is likely to

be limited and much slower than in the early years of the recovery.

Why? Profit margins are at record levels and could be hurt by protec-

tionist trade policies.

A reduction in US corporate tax rates could add to after-tax earnings

for some companies. This is an area where research-based stock

selection will be critical. Overall, we expect modest gains from

earnings growth and dividends to be somewhat offset by valuation

contraction.

We expect global equity returns to be somewhat higher. Because

the economic and earnings recovery in Europe and Japan has been

slower and more fragile, there’s far more potential for economic

growth to surprise on the upside, and far greater support from valua-

tions for non-US developed-market stocks. However, downside

risks related to long-standing structural weaknesses in Europe’s and

Japan’s economies and currencies remain. Emerging-market stocks

offer higher expected earnings growth and much lower valuations

than developed-market stocks, but the potential for increased

US protectionism and a strong dollar poses risks that vary widely

by country and company.

Anxious reactions to political events that could disrupt growth may

well propel more spikes in volatility, like those seen repeatedly

in recent years (Display 7). Just as the UK vote for Brexit and the

US election briefly drove up volatility in 2016, elections in the

Netherlands, France, and Germany could deliver shocks in 2017. We

expect stock and bond market volatility to remain highly variable, as

it often is near inflection points.

DISPLAY 7: VOLATILITY SHOULD CONTINUE TO SPIKE PERIODICALLYCBOE Volatility Index (VIX)

16

Inde

x Le

vel

0

20

40

60

09 10 11 12 13 14 15

ChinaRenminbi

Devaluation

Oil/Fed/ChinaFears Brexit

Vote US Election

European Sovereign Bond

Crisis European

Sovereign Bond Crisis

Past results are not necessarily indicative of future results.

Through December 31, 2016

Source: Chicago Board Options Exchange (CBOE) and AB

8

NEGOTIATING THE RETRO NORMAL Low expected returns and higher volatility in the Retro Normal Era

mean that investment success will require garnering additional return

and managing risk effectively at every level of investment portfolios.

Steering adroitly around the eddies created by the end of the Safety

Bubble will be crucial to these efforts.

Bonds In the Old Normal Era, bond investors viewed their core bond

portfolios like a Swiss Army knife: a single tool that could perform

at least three key tasks: diversify equity risk, provide stability, and

deliver income.

In the New Normal Era, bond investors had to choose among distinct

objectives—and with central banks driving government bond yields

to record lows, many income-hungry investors opted for income,

sacrificing stability and diversification. Many investors sought the

highest-yielding securities they could get, such as 30-year callable

municipal bonds or high-yield exchange-traded funds (ETFs). Both

traded off sharply when interest rates rose after the recent US

election.

But bonds are now providing strong diversification benefits once

again (Display 8, top), and yields are rising. We urge investors not

to overreact to short-term losses due to rising rates and to remain

invested in intermediate-duration bond portfolios.

Remember: Coupon income tends to heal the initial sharp losses

from rising interest rates, and rising rates ultimately lead to higher

reinvestment yields (Display 8, bottom). Bond investors whose time

horizons are longer than their portfolios’ durations will benefit. If

you’re investing for the next 10 or 20 years and your portfolio has a

five-year duration, you should benefit over time from reinvesting at

higher yields, even if sharp jumps in rates create short-term losses.

Moving to short-duration bonds may sound appealing, but it cannot

provide the income that most bond investors require. Similarly,

ladders (portfolios of bonds that mature in successive years) may

appear to be safe if the investor holds each bond to maturity, but the

long, callable bonds within them are subject to huge swings in market

value if interest rates move quickly.

Investing in bond indexes has several drawbacks. Bond indexes can

become dominated by the companies, governments, or sectors that

issue the most debt. Recently, most bond indexes have also become

COUPON INCOME HEALS BONDS’ INITIAL LOSSES FROM RISING RATES†

Illustrative Paths of Bond Returns as Rates Rise

0%

OneYear

TwoYears

Path if Rates Rise 0.9%

Path if Rates Rise 2.0%

Tota

l Ret

urn


Past results are not necessarily indicative of future results. There is no guarantee that any estimates or forecasts will be realized.

*Correlation of monthly returns, rolling over three months, for the S&P 500 and 10-year US Treasury bonds since 1988. †Yields assume a parallel shift across Treasury yield curve and a 0.54% fee for a portfolio of municipal bonds with a four-year average duration.

Source: Bloomberg, J.P. Morgan Markets, Municipal Market Data, and AB

DISPLAY 8: BONDS’ DIVERSIFICATION BENEFIT HAS PROVED ITS WORTH RECENTLYEquity and Bond Correlation (1988–2016)*

Diversification Benefit Weakest

Diversification Benefit Strongest

1.0

(1.0)

Today(0.64)

Median0.0


longer in duration, because issuers have refinanced to lock in low

interest rates. Owning a bond index tilted to large issuers and long

duration is not a safe investment strategy.

In the Retro Normal Era, active bond management can add substantial

value. Here are some of the ways we are actively positioning bond

portfolios to manage risk and add return.

To provide stability, our core municipal portfolios avoid below-

investment-grade debt and long bonds. Today, our portfolios

emphasize bonds with about five years to maturity, which offer yield

plus roll comparable to long bonds, but much less risk.

To add return, we’re now emphasizing single-A credits, rather than

the highest-rated munis, because single-A’s provide wider spreads,

and municipal credit conditions are strong and likely to improve,

which could drive price gains. In 2016, we also added to return with

relative value trades: small, opportunistic allocations to corporate

bonds and Treasuries—something no passive ETF can do.

As for taxable bonds, our actively managed portfolios are under-

weight overall interest-rate risk and positioned for a flattening yield

curve. They’re emphasizing credit (corporate and securitized) to

obtain higher yields and benefit from a strengthening economy. We

think floating-rate credit risk transfer (CRT) securities issued by the

mortgage agencies now offer a particularly attractive risk/return

trade-off, while hedged, non-US bonds offer yield and diversifi-

cation benefits.

StocksYield-hungry investors also turned to stocks in the New Normal

period. After all, the S&P 500’s dividend yield has exceeded 10-year

Treasury yields for much of this period—and safety stocks, such

as utilities, consumer staples, and REITs, have yielded far more.

Bond-like safety stocks have outperformed handsomely in recent

years as interest rates fell, adding to the perception of safety created

by their lower sensitivity to stock-market returns.

But safety stocks are not really safe: Their bond-like behavior

means that they fall more than other stocks when interest rates rise.

Furthermore, sustained outperformance and massive capital flows

over the past three years inflated their valuations. While the “safest”

quintile of US stocks (as measured by low beta) has traded at an 8%

average discount to the market since 1970, at the end of the first

half of 2016 it was at a 23% premium (Display 9). That premium fell

to 16% by the end of November, as the 10-year Treasury yield rose

from a low of 1.5% to 2.5%. If interest rates continue to rise, as we

expect, safety stocks should continue to underperform the broad

stock market.

Interest-rate risk is greatest for investors who focus their investments

in bond proxies such as utilities and REITs. It also poses significant

risk to index investors, who gain that risk inadvertently. We estimate

that between 50% and 60% of the US stock market’s capitalization

is currently vulnerable to the unwinding of the so-called safety trade.

That creates opportunity for active managers, who outperform over

time by not mimicking the index’s outsized weight in stocks that were

yesterday’s stars, and by allocating more capital to tomorrow’s likely

winners.

In our core US and international equity portfolios, we have been

underweight overpriced income-oriented stocks for several years.

The stocks we favor vary widely by sector and factor characteristics.

DISPLAY 9: THERE’S RISK IN SAFE STOCKS, TOOSafe Stock* Valuation Premium to the Market

23%

16%

(8)%

Jun 2016 Nov 2016

Long-TermAverage

As of November 30, 2016

Past performance is not necessarily indicative of future returns. There is no guarantee that any estimates or forecasts will be realized.

*Safe stock defined as the lowest quintile of monthly beta within the AB US Large Cap universe of stocks. Premium/discount uses price to book and is versus the universe average. Long-term average is since 1970.

Source: Bloomberg, Center for Research in Security Prices (CRSP), FactSet, MSCI, and AB

10

Today, we generally find stocks with higher profitability, lower valua-

tions, or higher quality more attractive than safety stocks, although in

recent months, the huge opportunity in value has narrowed, while the

opportunity in growth and quality has widened (Display 10).

Many of the stocks we favor are within the groups that traded up

after the US election, but we’re using our research to hone our

investments more finely.

Banks stand to benefit from rising interest rates and President

Trump’s proposed cuts to corporate tax rates and to regulation, but

not all banks will benefit equally. In our Strategic Equities service

we added to Bank of America before the election on expectations

that modestly rising interest rates would boost its earnings. Bank of

America relies on its vast retail deposit base for much of its funding,

so its funding costs should rise more slowly than the rates it charges

on loans, increasing its margins. Banks that rely on institutional

funding sources don’t have the same advantage.

Our research also suggests that holdings such as Bank of America,

Wells Fargo, and U.S. Bancorp are high taxpayers that would benefit

from proposed cuts in corporate tax rates. In addition, Bank of

America and Wells Fargo are among the large, heavily regulated

banks that would benefit from lower compliance costs in an era of

less-stringent regulation.

We also favor some pharmaceutical and biotech firms that may

benefit from proposed tax breaks for overseas profits brought back

to the US, especially if the repatriated earnings spur merger and

acquisition activities. Pharmaceutical firms, however, would get a

below-average boost to profits from corporate tax reform that elimi-

nates many deductions, because they have aggressively managed

their tax expenses. Any changes to Obamacare could have diverse

ripple effects throughout the industry. For example, managed care

companies could benefit if they can exit unprofitable contracts for

state or federal exchanges.

We’ve been cautious, however, about seeking opportunities from

the $1 trillion infrastructure plan that President Trump has promised.

While share prices have soared for engineering and construction

firms and sand and gravel companies, it could be a long time before

any new infrastructure spending that is approved turns into company

revenues—let alone new roads and bridges. Many projects funded by

the 2015 highway bill have not yet been built, because they weren’t

truly shovel-ready.

Outside the US, we see rich opportunities to exploit the wide

dispersion in stock returns. In general, European companies are

likely to benefit from stronger export growth; we favor Safran and

Siemens in International Strategic Equities. In Asia, we generally

prefer companies that benefit from stronger domestic consumption,

such as WH Group, a Hong Kong–based pork processing company.

WH bought Smithfield Foods, the US pork processing firm, in order

to meet Chinese consumers’ growing appetite for American-style

processed pork products, such as sliced ham. Ironically, US protec-

tionism won’t hurt—and might help—WH to profit from this strategy.

We’re also investing in Asian technology stocks that we think have

traded down too far on fears that President Trump will impose high

tariffs on US imports. We expect such tariffs to be limited to specific

DISPLAY 10: MANY TYPES OF STOCKS ARE MORE ATTRACTIVELY VALUED THAN SAFETY STOCKSRelative Valuation of Factors, Ranked vs. History

Most AttractiveQuartile

Least AttractiveQuartile

Safety

Profitability

Quality

Growth

Value

As of November 30, 2016

Past results are not necessarily indicative of future results. There is no guarantee that any estimates or forecasts will be realized.

Individual factors can be defined in multiple ways. In the display above, value is represented by price/forecast earnings, growth by return on assets (ROA), quality by persistent ROA, profitability by free cash flow to assets, and safety by a combination of both low beta and yield.

The 1,000 largest-cap US stocks were ranked monthly on the basis of each factor and divided into quintiles. Then, we ranked the relative valuation of the most attractive quintile for each month since 1990.

Source: FactSet and AB


products, such as Chinese steel or Mexican auto parts, that can be

replaced by items that continue to be manufactured in the US. But

little technology manufacturing occurs in the US: Over the past three

decades, a vast and complex supply chain has developed in Asia

as US technology firms stopped manufacturing the products they

design.

Thus, we find Taiwan-based Largan Precision and TSMC attractive.

Largan makes high-quality lenses for smartphone cameras,

including the iPhone; no other comparable supplier is available.

TSMC has built huge, high-quality foundries for making computer

chips. Efforts by Intel and others to bring semiconductor foundries

back to the US have not been successful.

In the Old Normal, allocations to diversifying asset classes such

as hedge funds and real assets added to long-term returns, while

reducing risk over time in overall portfolios. In the New Normal period,

that didn’t work: While hedge funds and real assets did diversify risk

in recent years, they’ve been a drag on returns. Both have done much

better in the past few months, however, in another sign that a Retro

Normal Era is upon us.

Hedge FundsThink of hedge funds as superactive managers with the potential

to tap different sources of return and manage risk more effectively.

Most hedge-fund strategies derive more of their return from security

selection, a trait that should be valuable in the period ahead when

market returns are likely to be low, but the dispersion of returns

within asset classes is likely to be higher.

Like long-only equity managers, hedge funds have delivered disap-

pointing returns in recent years, as extremely low interest rates

dampened volatility and reduced the dispersion among stock

returns. That disappointing result appears to be linked to central

bank policy: Hedge funds as a group have generated hardly any

alpha (returns from active management decisions) during periods of

monetary easing (Display 11).

On the other hand, hedge funds have produced 2.9% annualized

alpha during stable policy regimes and almost 10% during periods

when the Fed withdrew liquidity. In our view, tighter monetary policy

in the Retro Normal Era should provide tailwinds for various types of

hedge-fund strategies.

Real AssetsWith inflation likely to rise from the subdued levels of recent years, we

think investors who don’t already have an allocation to inflation-sen-

sitive assets should consider adding one. But the inflation-sensitive

assets you choose can make a big difference in the reliability and

magnitude of the protection afforded.

The face value of Treasury Inflation-Protected Securities (TIPS) rises

with inflation, so many investors poured capital into TIPS after Trump’s

election raised the prospect of higher inflation. Unfortunately, TIPS

also are highly sensitive to interest rates, which can partly offset

their inflation-protective benefits. If there’s one thing inflation almost

guarantees, it’s higher policy rates, which push down TIPS’ value.

DISPLAY 11: HEDGE FUNDS HAVE FARED BETTER WHEN FED WASN’T EASINGHedge Fund Alpha vs. Stock and Bond Markets, by Periods of Federal Research Policy

2.9%

9.9%

Easing Stable Tightening

0.1%

As of September 30, 2016

Historical analysis does not guarantee future results. Alpha was calculated using a linear regression with the HFRI Fund Weighted Composite Index return, the S&P 500 Index return, and the Bloomberg Barclays Corporate High-Yield Index return. The Bank of America Merrill Lynch Three-Month Treasury Bill Index, representing the risk-free rate of return, was subtracted from each return series. Easing periods were defined as June 1998–June 1999, August 2000–December 2001, and September 2007–October 2014. Stable periods were defined as April 1996–May 1998, January 2002–May 2004, September 2006–July 2007, November 2014–December 2015, and January 2016–September 2016. Tightening periods were defined as July 1999–July 2000 and June 2004–August 2006.

Source: BofA Merrill Lynch, Bloomberg Barclays, Federal Reserve, Haver Analytics, Hedge Fund Research, Standard & Poor’s, and AB

12

To avoid this pitfall, investors can supplement some TIPS exposure

with other assets that tend to trade up as inflation rises, such as

commodities, currencies, and shares of natural resources, real

estate, and other inflation-sensitive companies. Typically, the basic

consumption basket includes some goods whose prices are rising

faster than others—and even some goods whose prices are actually

falling. Over the last two years, for example, energy prices have

fallen, while rents, tuition costs, and healthcare prices have risen.

A diversified portfolio of these real assets can provide protection,

regardless of the dominant sources of inflation at any given moment.

We’ve recently begun to position our real asset portfolios to adjust

for the changing sources of inflation risk. With healthcare prices rising, our real asset portfolios own a pharmaceutical company with a stronger patent pipeline than its peers, which should support

earnings even if inflation rises.

MANAGING THE RISK/REWARD TRADE-OFFIn the Old Normal Era, asset allocation was the primary driver of

return. In the New Normal period, asset allocation became even

more important as many investors swooped into and out of asset

classes on the basis of fear or a desire to ride the flows. Too often,

however, poor timing ended up hurting, not helping, their returns.

For example, many investors bailed out of stocks in the early 2016

sell-off and missed the subsequent rebound.

We’ve sought to refine our strategic asset allocation advice

throughout both periods, and in 2010 (the dawn of the New

Normal Era), we also began to take a more active approach to asset

allocation that we believe will be crucial in the Retro Normal Era as

well. Our Dynamic Asset Allocation (DAA) service systematically

adjusts clients’ asset mix in response to quantitative and funda-

mental signals of short-term expected return and risk, in an effort to

mitigate the short-term losses that can be so upsetting.

DISPLAY 12: DAA IS MODESTLY OVERWEIGHT EQUITIES AND BROADLY DIVERSIFIED

Adjustments Made Within DAA*April 2010 –December 31, 2016

(10)

+10

0

Ret

urn-

Seek

ing

Wei

ght (

Perc

ent)

Current

Year-End

2010

Year-End

2011

Year-End

2012

Year-End

2013

Year-End

2014

Year-End

2015

(4.8)

1.00.51.4

1.4

Underweight

Overweight

Current Allocation vs. Target (Percentage Points)

Japan

EUEMREITs

Bonds

Through December 31, 2016

*Allocations are based on a Moderate Growth portfolio with a normal target of 56% global stocks, 4% real assets, and 40% bonds. The current target is 59% global stocks, 5% real assets, and 36% bonds.

Source: AB


The moves are often small (Display 12). At year-end, DAA was

modestly overweight equities versus bonds, but the equity

overweight was entirely in non-US stocks. The DAA team had cut

back its US equity overweight to neutral after the US election–

spurred rally, as the US became more expensive relative to other

equity markets.

While bullish sentiment about the new administration’s policies

could continue to drive the market up for some time, we think high

valuations pose a risk (Display 13). Both the strong dollar and

rising interest rates could create a headwind for US multinationals’

earnings, at a time when many sectors are already at peak operating

profit margins. In addition, tight labor conditions and rising wages

seemed likely to prompt the Fed to raise interest rates higher while

other central banks continued to pump out liquidity. If these conditions

continue, we’ll likely cut our position in US equities to an underweight.

DAA moved to an overweight in Japanese and European equities,

because we think both regions may benefit more than the US from

a reflationary environment. Both markets are weighted more heavily

toward companies with cyclical earnings, both have lower valuations,

and in both, central banks continue to loosen monetary policy.

However, we’ve partially hedged exposure to the Japanese yen,

British pound, and Australian dollar. While weakening currencies

may boost exports for companies in Japan, Britain, and Australia,

dollar strength versus those currencies would hurt returns to US

dollar–based investors.

The DAA team is looking to add opportunistically to its small

overweight in emerging-market stocks, if the asset class continues

to underperform versus global developed stocks. Protectionist

rhetoric that ignites excessive fear in investors could create a buying

opportunity.

DAA is also slightly overweight real assets, which we expect will

benefit from higher infrastructure spending and recent cutbacks in

OPEC oil production aimed at rebalancing the oil market.

In all regions, political risk creates a particular challenge, since

the outcomes are often binary. The DAA team uses an array of

tools, including equity futures and options, currency hedging, and

bond-duration adjustments to blunt the potential impact of surprises.

DISPLAY 13: NON-US EQUITIES ARE MORE ATTRACTIVELY VALUEDPrice-to-Earnings (2017E)

17.9x

15.5

US International EmergingMarkets

13.1


US is represented by the S&P 500 Index, International by the MSCI EAFE Index, and Emerging Markets by the MSCI Emerging Markets Index.

Source: FactSet, MSCI, Standard & Poor’s, and AB

14

DISPLAY 14: THE RISK/REWARD TRADE-OFF IS CHALLENGING

100% Risk-

Mitigating

30%/70%

60%/40%

80%/20%

Projected Median Five-Year Annualized Return‡ Asset Allocation†

100% Return-Seeking

36%

22%

9%

<2.0%

<2.0%

6.3%

5.5%

4.5%

2.9%

1.2%

Normal§ Normal§

Probability of 20% Peak-to-Trough Loss Within Next Five Years*

*Probability of a 20% peak-to-trough decline in pretax, pre-cash-flow cumulative returns within the next five years. Because the Wealth Forecasting System uses annual capital-market returns, the probability of peak-to-trough losses measured on a more frequent basis (such as daily or monthly) may be understated. The probabilities depicted include an upward adjustment intended to account for the incidence of peak-to-trough losses that do not last an exact number of years. †100% risk-mitigating allocation is all bonds; 30%/70% allocation is 30% stocks/70% bonds; 60%/40% allocation is 60% stocks/40% bonds; 80%/20% allocation is 80% stocks/20% bonds; and 100% return-seeking allocation is all stocks. Stocks modeled as 21% US diversified, 21% US value, 21% US growth, 7% US small-/mid-cap, 22.5% developed international, and 7.5% emerging market. Bonds modeled as intermediate-term diversified municipals. ‡Represents projected median compound annual growth rates over the next five years.§Normal conditions reflect Bernstein’s estimates of equilibrium capital-market conditions, which are typically close to a very long-term historical average. Based on Bernstein’s estimates of the range of returns for the applicable capital markets as of September 30, 2016. Data do not represent past performance and are not a promise of actual future results or a range of future results. See Note on the Bernstein Wealth Forecasting System at the end of this paper.

Source: AB


A CHALLENGING ENVIRONMENTWith the floods of liquidity that central banks released beginning

to recede, a Retro Normal landscape is emerging—one that will be

difficult for investors to navigate.

Low expected returns for all asset classes mean that a moderate

growth portfolio, with a 60% exposure to stocks, will return only

4.5% over the next five years, in our central case. That’s less than

what we’d expect from an all-bond portfolio in a normal environment

(Display 14).

Yet we estimate that there’s a 9% risk that a moderate growth

portfolio will lose 20% from peak to trough within five years, as

Display 14 also shows. That’s close to what we’d expect from an

aggressive portfolio with an 80% stock allocation in a normal

environment.

These forecasts of disappointing returns and unusually high risk

assume passive investments in asset-class indexes. But that’s just

a starting point for planning, not the only route that investors can

follow. As declining liquidity reveals the contours of the Retro Normal

Era, we believe investors will find three tools essential to charting a

safe course to their intended destinations:

� An updated strategic investment plan for reaching your specific goals. Lower expected returns along with higher, more variable risk in the Retro Normal Era leave little room for error. You may need more diversifying asset classes or to enhance your plan to reflect, say, a particular need for growth or income.

� Active management of the underlying asset classes. Low expected returns for asset-class indexes also mean that you’re likely to need the added return and reduced risk that active management will provide. Fortunately, the higher dispersion of returns increases the odds that active management can provide these benefits.

� Active risk management of the overall portfolio. A cool head and skilled steering are needed when political or market developments spur a widespread flight from some asset classes to others. If you’re liable to overreact to short-term losses, you’d likely benefit from risk management services that seek to mitigate those losses.

In the Retro Normal Era, the odds of success are even lower for most

investors who try to go it alone, in our view. Bernstein can provide

the strategic investment planning updates, active management of

asset-class portfolios, and active risk management that we think all

investors need. �

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NOTE ON THE BERNSTEIN WEALTH FORECASTING SYSTEM

The Bernstein Wealth Forecasting SystemSM seeks to help investors make prudent decisions by estimating the long-term results of potential strategies. It uses the Bernstein Capital Markets Engine to simulate 10,000 plausible paths of return for various combinations of portfolios. For taxable accounts, it takes the investor’s tax rate into consideration. Additional information on Bernstein’s Wealth Forecasting System is available upon request.

NOTES ON THE BERNSTEIN CAPITAL MARKETS ENGINEThe Bernstein Capital Markets Engine is a Monte Carlo model that simulates 10,000 plausible paths of return for each asset class and inflation and produces a probability distribution of outcomes. The model does not draw randomly from a set of historical returns to produce estimates for the future. Instead, the forecasts (1) are based on the building blocks of asset returns, such as inflation, yields, yield spreads, stock earnings, and price multiples; (2) incorporate the linkages that exist among the returns of various asset classes; (3) take into account current market conditions at the beginning of the analysis; and (4) factor in a reasonable degree of randomness and unpredictability.

NOTE TO ALL READERSThe information contained herein reflects the views of AllianceBernstein L.P. or its affiliates and sources it believes are reliable as of the date of this publication. AllianceBernstein L.P. makes no representations or warranties concerning the accuracy of any data. There is no guarantee that any projection, forecast, or opinion in this material will be realized. Past performance does not guarantee future results. The views expressed herein may change at any time after the date of this publication. This document is for informational purposes only and does not constitute investment advice. It does not take an investor’s personal investment objectives or financial situation into account; investors should discuss their individual circumstances with appropriate professionals before making any decisions. AllianceBernstein L.P. does not provide tax, legal, or accounting advice. This information should not be construed as sales or marketing material or an offer or solicitation for the purchase or sale of any financial instrument, product, or service sponsored by AllianceBernstein or its affiliates.

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