2018 Capital Market Assumptions Research Report by The Multi-Asset Strategies and Solutions Team Paul Zemsky, CFA, Chief Investment Officer Barbara Reinhard, CFA Head of Asset Allocation Elias Belessakos, PhD Senior Quantitative Analyst Timothy Kearney, PhD Asset Allocation Strategist Jonathan Kaczka, CFA Asset Allocation Analyst Daniel Wang Research Analyst Nor FDIC Insure IMay Lose Value | No Bank Guarantee INVESTMENT MANAGEMENT Reliable Partner | Reliable Investing? VOYA.Table of Contents Foreword 2 Executive Summary 3 Forecast Environment 3 Assumptions for the Target Date Glide Path 4 How Returns Are Forecast 6 Macroeconomic Considerations 10 Tracking the Business Cycle 10 Inflation Trends to the Downside 16 Methodological Considerations 24 Covariance and Correlation Matrices Methodology 24 Time Dependency of Asset Returns and Its Impact on Risk Estimation 26 Multi-Asset Strategies and Solutions Team 28 Foreword When financial market historians look back at 2017, the year probably wil be highlighted for its tightly compressed levels of volatility. Another notable aspect of the year is that, heading nto late December, there has not been a single month of negative returns forthe ‘SAP 500 index. I's an impressive gain by almost any measure and relatively uncommon; the last time it happened was in 1995, Globally, equity market gains were strong, Average gains of more than 20% for develoged markets were outshone only by the emerging markets, wth average gains over 30%. Though such retumns are striking by most measures, they probably waule not make it inta the chronicles of Martin Fridson’s 1998 book, It Was Very Good Year: Extraordinary Moments in Stock Market History, a must reac for anyone Interested in financial market history. What we find most impressive about this year’s gains Is that they are being notched inthe elghth year of an expansion. [As we look forward to 2018, we think it useful not only to consider what the capital markets vill delve, but also what they have the potential to deliver, As we survey the landscape we are reminded thatthe starting point matters. Our work suggests that the robust returns wich equities and bones have produced over the past five years have extracted a certain amount of future return potential from our equilorium assumptions. Our methocology assumes that markets will achieve equilibrium over the 10-year horizon, Toa certain extent, returns that the S&P 500 index has delivered In recent years have borrowed from future potential gains. ‘As we have previously noted, among the unusval hallmarks of ths expansion has been how well-anchored bond yields have stayed inthe face of strongly rising equity ma Lack of inflation tao has been noticeable, wage and price pressures usually accompany aging growth cycles, A dearth of capital investment also has plagued this cycle, These issues, while not new, again confront investors as they think through portfol positioning for the ninth year of this economic expansion. We have given these issues a great deal ‘of esearch, which we share with our readers in the Macroecanamic section — with Investment thought leadership on the business cycle and inflation. We hope our readers find this content helpful as they navigate the year and next decade ahead. At Voya, we asaire to oe America’s Retirement Company; to plan, invest and pratect ‘every stop of the way. We thank you for your continued confidence in us. Paul Zemsky, CFA Barbara Reinhard, CFA Chief Investment Officer Head, Asset Allocation Mutt-Asset Strategies and Solutions Mult-Asset Strategies ane SolutionsExecutive Summary (ur 2018 Long Term Capital Market Assumptions detals our Vaya capital markets forecasts of assot class returns, standard deviation of returns and correlations aver the 2018-2027 timeframe, These estimates are key inputs to our strategic asset allocation process for our muli-asset portfolios; they also provide a context for shorter-term economic and ‘nancial forecasting We continue to expect that the next 10-year period will be characterized by below-average historical returns, to-varying degrees, across all asset classes. Our current forecasts for U.S. and international developed market equities to produce low, single-digit returns, which i lower than we forecast a year ago. Part ofthis is due to the unexpectedly strong performance by risk assets this year, wiich raised the bar forthe coming 10 years. Howover, itis also a function ofthe current slow potential grawth trajectory, influenced by the headwinds of slowing labor supply and an economy mired ina low-productivity regi Risk-adjusted returns for developed international market assets are in mast cases lower than those for comparable US. assets. Ths partially reflects our expectation that the U.S. dollars unlkely to depreciate meaningfully over the 10-year horizon due to tighter monetary paliies and the potential for higher relative growth. Returns for emerging market equities are above U.S. large-cap retuns on aoth an absolute basis as well as a Sharpe ratio basis given the positive overall growth trends anc potential for re-ating (Our bond return assumptions show that retutns wil generally be in the ow single digits. Two exceptions to this ‘trond are the emerging markets and leveraged loans. In the case of emerging markets, sustained growth would aid this high yielding sector. We expect leveraged loans to deliver asthe Fee goes through a potentially long hiking cycle, We nate that our projections do assume that bath bond term premium moves and real rate premium moves will pressure bond prices lower. Beyond our rskireturn assumptions, this paper has two special sections: Macroeconomic Considerations anc Methodological Considerations, The macroeconomic section features deep dives on two Important questions: () \where are we in the current business cycle? and (2)'sthete a dynamic in play which ill kep inflation trencing to the downside? The methadalagical section discusses our pracess of forecasting the covariance and correlations of returns, including the concept of turbulence, Turaulence bespeaks the fact that while 70% ofthe time markets ‘oxhibit “normal” behavior, market covariances reflect greater risk 30% of the time Forecast Environment (Our long-term capital market assumptions provide our estimates of exnected returns, volatlities and corrlations among major US. and global asset classes over 2 10-year horizon, These estimates guide the strategic asset allocation for our mult-asset portfolos anc provide a context for shorter-term economic ane financial forecasting, ‘As has been the case forthe past seven years, our farecast models an exalcit pracess of convergence to a steady- state equilibrium for global economies anc financial markets through 2018-2027, In our madeling process, we worked with Macroeconomic Advisers. ‘We beliove that cyclical fuctuations are an inevitable aspect of market economies and therefore recognize that the steady-state equilorium incorporated as the terminal point of our forecasts unlikely tobe fully attained over any single 10-year period, Nonetheless, we believe that ths is 2 useful construct for anchoring the forecast As a resul, the forecast does not assume a further recession or contraction over its 10-year horizon,‘We make this explict forecast in recognition of the angoing effects of the 2007-09 financial crisis and recession, the European debt crisis and the fscal and monetary policy responses to these events. Although the world economy is several years past its most acute point of crsis in 2008 and the U.S. economy has been recovering from the Great Recession for more than eight years, a number of economic and financial variables remain far ‘rom levels consistent witha steady state. In particular, short-term interest cates remain near zero in mast developed economies, long-term interest rates have ceclined substantially, and government debt-to-GOP ratios remain elevated Still Low Growth Te estimates for our US. economic and financial variables that underpin the analytics which formulate our expectations for asset class returns are shown in Figure 1. We forecast U.S. GDP growth to average 2.2%, a marginal 0.2% increase from our forecast last year. We believe the United States remains in a low growth environment, as the main sources of incremental growth would likely come from meaningful increases in the labor force growth or in productivity. These two components imoly potential GDP growth of only slightly above what we have experienced since the last recession, Given this backdrap our Federal Funds forecast has been downgraded to 2.7% from 3.1% last year and the 10-year U.S. Treasury yele forecast has declined to 3.6% from 4.1%, Figure 1 shows the 2027 values of aur key macro assumptions from ths forecast, whichis consistent with our estimates ofthe longer-term steady state for key U.S. economic variables {GOP Growth Infaton(C-U) (Pletclusing Fead and Energy 2a Fed Funds Rate 2 Ter-Yoar Treasury Vile 35 SEP 500 Earings Grown ar Savings Rate 58 Source: Vya lvesinent Management and Macroeconomic AavSer Forecasts aresubectio change Assumptions for the Target Date Glide Path While 10-year forecasts guide our strategic asset allocations, our long-run equiloxium return assumptions refer to horizons much longer then our ten-year forecasts, and are the underlying inputs inte our glide path estimations. Typically, we assume the horizon for these forecasts is 40 years, al wiicn point the economy is thought of as being ina steady state where GOP grows at its trend rate, infation is at target, unemployment equals the non- accelerating inflation rate of unemployment, the real interest rate equals the natural rate of interest and all capital and goods markets are in equllrium,ur glide path model solves the portfolio choice problem aver te lifecycle, incorporating human capital in addition to financial capital. The crucial correlation between labor income and equities, which is low on average, Provides the bass for the declining allocation to sky assets asa function of age. Early on, bond-like human capital's a large share of wealth and allows the individual to allocate a lage share in the risky asset given the low relative riskiness of human capital As investors age, and have fewer years of labor income ahead of them, nancial capital becomes a greater share oftheir wealth, The optimal response isto reduce the allocation tothe risky asset ‘to compensate forthe increase in riskiness of wealth, Thus, human captalis the driving force behing the glide path’s declining allocation to equities as a function of age. These forecasts use @ bullaing block methodology. Staring with our expectations of real short-term ylele and inflation, we generate a rsicfvee rate forecast and, from thal all equities and fixed income assets are derivec by adding relevant risk premiums. The risk premium for U.S. equities is derived from the Gordon growth model as ‘the sum of the dividend yield and the nominal earnings growth rate in excess ofthe ristetree rate. International ‘equities incluge the addition ofan international equity isk premium, Government bond return forecasts are the sum of the risk-free rate and an appropriate term premium, Corporate bond return forecasts further inchide the addition ofa crecit risk premium, From a theoretical perspective, all risk premiums in long-run equllisrium ate mean reverting since the economy has reached a steady state. Qur econometric work confirms the stationarity of a number of isk premiums, which in turn justifies cur assumption of constant average risk premiums, term premiums and credit soreads in the long-run equilibrium. Our equiliarium return forecasts are shown in Figure 2. Figure 2. Long-Run Equilibrium Return Assumptions Diet US. nfatan 20 Real Risk-Free Rae 10 Us. cash 39 ‘Aggregate Tor Poni 08 ‘Agregate Cred Premium 03 US. Ivestnent rade (Aggregate) a2 10.¥ea: Tem Prema 12 ‘year US. Teseuy a 30-40 Year Term Premium os s0-Year US, Toasury an [AA Corporate Cradt Priam 12 US. AA Corporate 54 US. Eauty Ris Premium 40 SP 500 10 InterationalEquiy Pram 05 lMscl ACW 15 Source: Voys vesiment Management data a5 ofDecee! 2016, Aesunatione ae subject changeHow Returns Are Forecast We derive asset class return forecasts from the blend of base case and alternative case econamic scenarios. Together these caature the mast important upside and downside risks the world econamy and markets wil face over the forecast horizon. The base case forecasts growth to average 2% through 2027 driven by continued below-treng productivity growth and subdued labor force growth, The alternative scenario assumes slightly faster procuctivty growth, madestly higher corporate profit share of income, higher dividend payout ratio and an assumption that the Fed lets the economy run a Itle hatter than in the base case, Given these assumptions, returns to risky assets are higher in the alternative scenario than in the base case We assign a probability of 65% ta the base case anc 35% to the alternative case. The higher probability for the base scenario reflects our view that recent trends toward an aging population, reduced labor force participation and more restrictive immigration could continue and result in a sustained, low U.S. growth rate, For US, equities, we estimate earnings and dividends forthe S&P 500 index using our blended macroeconomic. assumptions. Earnings growth is constrained by the neoclassical assumption that profs as a share of GDP cannot increase without linit, but converge to 2 long-run equilibrium. We then use @ dividend discount model to determine {alr value fr the index each year during the forecast period, Returns for ather US. equity indices, including RETTs, are constructed using a single index factor model in which beta sensitivities of each asset class with respect to the market portfolio are detived from our forward-looking covariance matrix estimation. For a detaled discussion on this, please refer tothe covariance and correlation section. Each equity asset class retutn isthe sum ofthe risk-free interest rate and a specific market-risk premium determined from our estimate of beta sensitivity anc’ market risk premium forecasts, For US. bonds, we use the blended scenario interest rate expectations to calculate expected retutns for various durations. Bond expected returns are modeled as the sum of curtent yield and a capital gain (or loss) based on duration and expected change in yields. For non-U.S. bonds, the process is similar and includes an adjustment {ot expected curtency movements. Return expectations for credi-related fhed income reflect yield spreads and expected default-and-recovery rates.Figure 3. Voya Investment Management 10-Year Returns Forecast uP 500 fusse1000 Growth fosst1000 Vae SC1US. Minimum Vtaily fasse3000 fasseMideap usse'2000 scl Ere setae scien vsctacm Hoonberg Comnodity c30E By-wrie ISL LPRRINARLT Developed ox US FISE EPRANAREIT Developed sets Rett NRE ODCE Pavate RealEstate ees Barclye US Aggregate arclys US. Goverment Long BarchysUS 15 Barchys US. High Viel Cedi suisse Leveraged Loon Baclys abst gorepate BarcaysGobat aggregate ex Us JPMorgan eB Us. Treasury Bill -Month or eg 39 55 46 50 62 64 28 a 55 45 Emerita at 45 23 a4 45 a Ca cry 25 oe 2 48 62 0 05 47 2A 59 57 er 52 64 18 eo 45 55 92 59 roo re cH) 43 52 49 sr ” 82 Sect oo 165 048 188 oat 160 ose 47 opt 169 ost 185 ose ai ost 194 020 8 ost 24 048 m0 60 ror (%) 187 oat 23 ost 28 oa a8 ost 2s 038 m2 224 ror (%) mt 055 2 o2t 92 ose 23 026 er om er oss 108 016 30 87 1 sr ear 10 08 13 1s 1 10 12 ot os on 10 18 29 08 14 30 80) cn 45 08 a4 a 162 18 05 on a o2t oa 026 ozs 02s 028 028 ont 019 028 020 Se 02 oz on 018, oz 028 See 08 06 owe 02s 036 om 02 oz 00 “Soute: Vos Ivesimen! Management Rens sown rein US. dlr rms. Forecasts are abject lo caneFigure 4. Correlation Matrix ee Peon Pres eee) errr ee ed ees Pe Pee Russell 300 ene Pee fee Pe fe ere Ero eae ao Gece Bee ference NCREIF ODCE Private Real Coen ee) Barclays U.S, Government Long Eee Ce Ne} Cereie Pee eee Praca ieee Moraes eee Source: oya vesimentWanapemeny, data aso December 2017 Projections ae subject change orecero PTET on Prooreaeyy STE TET Cram Err Dore TEE) AIooun er recent] rrr) Error)Macroeconomic Considerations Tracking the Business Cycle ‘The curtent exgansion has lasted for mote than 100 months as of this writing, and is long duration 's creating concerns about the risk af an imminent recession, According tothe National Bureau of Economic Research (NBER) there have been tf business cycles from 1945 to 2009, with the average cycle lasting 69 months. The average ‘oxpansion has lasted about 58 manths with the average recession lasting about 1, This historical data show that expansions do nat exhibit whats called “duration dependence,” thats there is ‘no empirical relationship between the curation of an expansion and the kelinood of entering a downturn. By ‘contrast, recessions have shown duration dependence, as do whale cycles. We have calculated the uncondltional probability of being ina recession at any point over the coming 12 months. Assuming expansions end with a constant probabilty and without any other precictive variables we fin: = A19% unconditional probability of recession over any coming 12-month period = About a 50% recession probability over any 40-month period '= An 18% unconditional probabilty of an expansion as long as the current one The cutrent expansion is not of an unlikely curation, being only a tle longer than the average 92 months ofthe last three expansions. By comparison, our concitional ecession probability mocel estimates the probabilty of a U.S. recession over the noxt 12 months on the basis of financial ané macroeconomic indicators — such as the yield curve slope, changes in the Conference Board index af leading economic indicators, non-farm payrolls the return ofthe SAP 500 and the federal unds rate, Using this mocel, we find 1 Less than 5% probability of recession in 12 months 1 Greater than 50% probability of recession over three years Figure 5. Recession Probability vs. Actual Recessions, 1968-2017 100% US. Non-farm ator Proauctity = High Produc Regine 0 °0 0 2 +068 078 08 1998 08 2at6 Soute: Naira urea of Economic Research, Voy nestren Management, at sof 10807, FX, Dieold an G0, Rudebusch Have Postwar Economic Fctuatons Bee Stablzec” Business Cetes: Durations, Dynami, and Forecasting, Princeton univers Pres 1998,Business cycles have moderated in the postwar period as the volatility of real output around trend has declines. That i, while complete business cycle durations have not changed, expansions have become longer while contractions have become shorter, In fact, the average duration of postwar expansions is double that of prewar expansions, with the average postwar contraction curatian haf that of prewar contractions.? Some ofthe reasons for the longer expansions are structural? 1 The decline in share of manufacturing and agricukure sectors relative to less volatile services sectors. Services now represent 71% of the value-added to U.S. GOP 1 About 69% of fll and parttime employment is concentrated in the private service sector. This figure rises to 85% with government jabs included 1 The broader availabilty of consumer credit has reduced consumer liquidity constraints and allows for consumption smoothing over business cycles. That i, there has been less direct dependence on current isposable income, which has led to a less volatile consumption pattera| '= Government spending has increased its share of GDP, with @ more persistent spending pattern than private sector spending 1 Better monetary policy in recent decades has helped reduce cyclical fluctuations Although every business cycle is different in that there i tle evidence of periodicity or regularity in timing ‘of the cycles, they al share the characteristics of co-miovement of macroecanamic series and persistence, The co-movement characteristics thought to be due to common, economy-wvide shocks ar underlying factors. Ther exist a number coincident ecanomic activity indicators based on the idea af common factors extracted via principal components analysis, ‘Two such indicators are the Chicago Fed National Activity Index (CFNAl} based on 85 individual indicators anc the Aruoba-Diobole-Scoti (ADS) activity index based on six indivicual indicators of diferent frequencies. We use both ofthese indicators in our madel ofthe stage ofthe business cycle. Our model exploits both co-movement and persistence via a Markov regime switching model, and attempts ta Identify the stage ofthe business cycle and Predict turning points in economic activity 1 This analysis identities the current stage as mid-cycle with an expected duration of 1 months and a standarcé Ceviaton of 8 months, but as mentioned eatller expansions do net show duration dependence Diebold an 6.0. Rudebusch “Shorter Recessons ans Longe Expansions.” Busines Princeton Unversy Press 988 yes: Duration, Dynamics, and Forecasting, » 4. rasord DeLong ana H. Summers, “The Changing Cyl Varsity of Economic Economie Research NBER Working Pager No. HSS, November 1885, “4. Zarit, Busnass Cycles: Theory, History, nsiatrs and Forecasting Te Unversity f Chicago Press, 185), pp. 251-264 tty inthe United Sites The Nation Bureau of "2 Figure 6, Stages of the Business Cycle — ADS and CFNAI 167 807 a0 2007 ar Chicago Fed National Actty Index — Cycle Sage Source: Chcege Federal Reserve, Voy Investment Management data of 91H, Persistence makes business cycles predictable to a certain degree. Some ofthe persistence factors also explain the lengthening of expansions, such as the facts thal consumers tend to smooth consumption, that business investments sticky and that government spending has alow level of variability. Arumber of indicators exhibit cyclcalty and can serve as proxies for the business cycle, e.g, business investment, housing and durable ‘goods spending 1m These three factors cited above along with exports and final sales comprise the Duncan Leading Indicator (DLN, ich has led economic downturns on average by about four quarters 1 The DL curently continues to imaly growth Figure 7, The Duncan Leading Indicator Tends to Signal Economic Downturns about Four Quarters Ahead on aa za 28 ae oz za ‘688 Zo00 2001 2002 2003 2008 2005 2006 2007 2008 2008 2010 a0vT 2012 2019 2014 2078 2016 2017 ADL Recession Soutce: acme, Voy Investment Management, dst eof 8/2007,1 Gains in household weath, n employment, real wages and a low and declining equity risk premium (which we estimate to be under 4% currently) support consumer and business spencing Figure 8. The Equity Risk Premium Has Been Declining Since 1982 1967 1968 1975 1072 1075 977 1978 1961 1983 1985 1007 189 1098 1098 1985 1997 1998 2001 2002 2008 2007 2008 ott ora 215 san7 Soute: Bloomberg, Yoy Investment Management dats 9¢ 1 Both the supply of crelt as measured by the Federal Reserve's senor loan officers’ surveys (SLO) of bank lenging standards for small businesses, along withthe Kansas City Fed financial Stress Index {KCF FSI, have been useful indicators of crecitconcitions and exhioit cyclical, '= On the basis of our Markov regime switching model, these two composite indices together currently imal credit conditions consistent with the late stage of a credit cycle '= Wo estimate the expected duration ofthe late-cycle phase to be about six quarters with a standard deviation of about half quarter. As of 3017 our modlimplis the econamy has been inthis phase for wo consecutive quarters 1 Historically, there has been an inverse relationship between high yield credit spreads and the stage of the crit cycle: spreads falls the cycle progresses from recession towards late stage. Nevertheless, we have not found significant dtferences in average high yield spreads between mid and late cycle. High yeld credit spreads are cuttently at 350 basis points (bp), somewhat below their average mid-cycle value of about 400 bp. We thus expect credit spreads to rise an average from here Figure 9. Stage of The U.S. Credit Cycle: SLO and KCF FSI % sa nm es \y 9 “63 ssa a8 183 5a 64 2a GT GAHKETHEMUDHUGKTUMOH DE OT Senior Loan Oca’ Suey —Cyee Stage Source floomberg, oye Ivesient Management, dla a of 10/017 cy“ Te yield curve has shown a consistent pattern of fattening, as the Fed hikes affect the short end much more than the long end, Figure 10 shows the time serles ofthe slope af the yield curve, defined as the difference between the ten-year U.S. Treasury note and the three-month Treasury ill (or all NBER expansions since 1958. Even though the paths are not monotonically declining, the slope at the end of each cycle has been lower than atthe beginning, Furthermore, at ths time the term premium, as estimated by the Fea's Adrian-Crump-Maench (ACM) model, continues to be negative {-0.48%) and the Fed's estimate of the natural rate of interest remains around zero, 1 The torm premium and the natural rate of interes limit the 10-year yield fair value and contribute to flattening of ‘the yield curve. Both ukimately depend on productivity, which curtentl is ina low-level regime Figure 10. Yield Curve Slope During Expansions: 1958-2017 4% Exp 1988 —89p 1970 exp 1982 —5sp 2001 2 Exp 1951 Bp 1075 . Exp 1801 — Esp 2009 — Ep 1880 1 5G 19-17 21 2% 29 38 37 41 45 49 55 57 61 65 59 73 17 1 95 89 83 OF 101 105 100N18 117 Number af Mone Source Bloomberg, oye vesnert Marageren, dla 9 f 1 We estimate the average duration of the low-productivty regime to be 10 quarters. As of 3017, the duration of the current low-productivty regime has been 28 quarters. This is close toa tall event given past history. What's more, productivity egimes seem to exhibit postive duration dependence, making regime termination more Ikely with increasing durationFigure 11. Productivity Regimes 10. 50. a0 rr} 40 0. 148 188 168 78 08 +08 zoe 2016 US. Non-anm Labor Producvty Sigh Procuctly Regime Source: looms, Voy Investment Management, dat 9 08/2007 ‘Assuming the terminal Federal Funds rate is 2.75%, which implicitly assumes thatthe natural rate of interest rises from zero to 0.75% as productivity gradually rebounds, then the term premium rises from -0.48% to at least zero. There are good reasons to expect a productivity revival as there are a number of new technological opportunities in healthcare, robotics, education and the technology of invention that have the potential to raise ‘rend productivity growth from the current 0.75% to 2.2586 {estimates of Bransteter and Sichel) and thus double ‘rend GDP growth from 15% (0.25% from productivity and 0.75% from labor force growth’) to 3%, With three Fed hikes in 2017, if we also assume that the Fed hikes three times in 2018 and twice in 2019, then the implied 10-year US. Treasury yield fai value is about 2.6%. Thus, wth the long end at 2.6% under the current environment and five more hikes, the yield curve is set to flatten and probably invert by the end of 2018, Conclusion We estimate U.S. economic activity to be currently somewhat above trend and consistent with levels most likely associated with the mid-stage of the business cycle. ‘Our estimates of the credit conditions point towards levels consistent withthe late cycle phase. The probabilty ‘of recession over the next 12 months on the basis of our estimates is low, butt rises above the unconditional probability of 80% in three years’ te. Assuming the economy avoids recession in the next 12 months, past relationships suggest that equlties will move higher, thus an asset allocation towards risky assets continues to be appropriate. We favor international over domestic equities a tis stage ofthe global cycle as equity correlations between domestic and international ‘equities remain low. We favor emerging markets over developed markets given the strong growth ofthe global ‘economy, and favorable valuations L aranstelr, ane DSchel"The Cas for an American Prosuctviy Reval Petersen state for nernatioal Economies, June 2017 « kccotsng tthe Un ted Nations, popuaien growth in developed econamles ns fale om about nthe 195050 ess hen 05% curently ad is expected contin ali. 66 1 We continue tobe in an environment of low cross-asset average volatility, low average correlation and low systemic risk fa 15-year low) '= We measure systemic risk bythe absorption ratio, which isthe variance explained by the fist principal component of a cross-asset covariance matrix of 21 asset classes Figure 12) Figure 12. Systemic Risk Is Low at This Juncture 285-7 — Absorption Rate aso] — Thesls 078: a0 ons. a 088. 080) ous. oo. ogg Le 2003 2006 2005 2006 2007 2008 2008 2010 ont zOtz 20rd aot aOtS 2016 THT Soute’ looms, Yoy Investment Management data oo 1178 But given where we are in the cycle, we expect volatifty to Increase and estimate the probabilty ofa five-daly standard-ceviation drawdown (median return of -8% over the past 30 years} aver the next 12 months at 60% even as the expansion continues. Itis also likely thatthe yleld curve will continue ta flatten as the Fed continues hiking gracually. We expect the cyclical component af inflation to push PCE inflation higher but there is some evidence thatthe underlying structural component of ination is below 2%, Finally, we exgectcrecit spreads to widen graduelly consistent with the stage of the credit cycle Inflation Trends to the Downside ‘There is an old joke about looking for your lost wallet under a lamppost at night, Because that’s where the mast Ightis. seems that the same problem besets research on the inflation outlook, Over the past few years, as the labor markets have been tightening and slack in the economy has been cleared, many market participants have been looking for economic relationships from proviaus cycles to transpire. Qur Voya hypothesis i that the trend to low inflation is in part a function of a globalizing U.S. economy where outsourcing, capital investment and import competition have combined to keep inflation anchored at levels below the FOMC’s 2% target. Many financial market participants have pointed tothe size ofthe Fed's balance sheet as a potential inflationary issue, but it does not appear to be a problem. The Federal Reserve Open Market Committee (FOMC) has made lear that twill take necessary steps to unwind the balance sheet as such emergency measutes ate no longer essary. We postulate it's credible monetary policy wich anchors expectations, fullstop. Consider thatthe current 25-year average infaton rate as measured by the personal consumption expenditure (PCE) detiator is 118% with 2 one standard deviation of 0.9%; the Fed has a target for a 2% PCE rate. Interestingly, the distribution is slightly skewed to the downsice, which means its actualy a bit mare likely that ination could reach 1% than 3%.We think current forecasting models may be overstating the inflaton outlook, Actually, the rsk that inflation could head back towards 1% rather tran moving higher as the Fed hikes; ths Is not widely understood by market particioants and thus caulé delver a wrenching outcome. (One comman infation-forecasting tools the Philips Curve, which posts that there isan inverse relationship, in the short-un between infation and the unemployment rate, That is, the higher the unemployment rate the lower the inflation rate, and vice versa, While Philips studied the relationship between nominal wages anc the unemployment rate, it's commonly accepted to cansider the inflation rate, given the high correlation between them. Philips érew conclusions from a sample that largely was dened by an entirely citferent monetary regime when currencies were given a ‘xed parity (pice) wth gold, Tis concept gave rse to what is known as the "sacrifice ratio,” which is the relationship of how much outaut must be last to reduce inflation. Itmay have contributed 2 bil to economics being known as the dismal science. Rather than alow unemployment rate, data tend to show that arise in productivity is required to move real wages higher. This aligns with economic theory, which holds that employee compensation isnot a cost-push phenomenon. itis possiole that inftation will remain in its current tend for longer than market participants and possialythe Fed expect, Figure 13. Real Wages and Productivity 8 % Change — Real ages Produstny eee 965 3971075880085 «tee T6000 208m Source floomberg, VoysIvesinert Marageren, Dats sof 1/207 ‘The unreliability ofthe Philips Curve was obvious as fr back as 1982, when Timothy F. Kearney wrote “The Philips Curve has had an extremely poor forecasting performance...The model was ata great loss to explain stagflation in the 1970's, and consistently over-predicted [si] inflation inthe 1980s."* I's eye-opening to realize that, despite the shift to a floating currency monetary policy regime which has proven the Philips Curve to be a long-term felure as a reliable ex-ante tool for inflation prediction, the Fed and private forecasters continue to return to such thinking > A Pits, “The Reishi Between Unemployment ad he Rate of Cheage of Morey Wages inthe Usted Kingdom, 1661857) Feoramic, 1858. "TF Kearney, “The Ral of Commady Pes, Make Prices and Business Expectations in Pesicing Changes in the CP” Ph.D Dissertation, CUNY-Groate Cen, 982 ”1 In an important ceview of ination, Steven Ceccehti et. al* “We then askif the deviation of inflation from the recursive estimate of the local mean s elated to either the deviation of inflation expectations from that same ‘mean, orto the unemployment gap fonce we contol forthe lagged deviation of inflation from the local mean that our model tells uss present) ..we find neither ination exaectations nar labor market slack help us to ‘explain quarter-to-quarter deviations of inflaton from its local mean, 1 Robert Gordon’: “Has the slope ofthe American Philips Curve flattened in the past two decades? Research at the Federal Reserve believes so 1 Janet Yellen": “A more important issue from a policy standpoints that some key assumptions underlying the baseline outlook could be wrong in ways that imply that inflation will remain low for longer than currently projected. For example, labor market conditions may not be as tight as they appear to be, and thus they may exert less uaward pressure on infation than anticipated.” Dr. Yellen's 2017 speech gives tise to an intriguing idea: the model she puts forward is selling Her model is based on aj expected long-run inflation, b slack and c} import prices. She defines “slack” as the level ‘of resource utilization, \e. (fr) estimation purposes, slack s approximated using the unemployment rate less the Congressional Budget fice’ (CBO) historical series forthe long-run natural rate” Ina sonse the Fed perceives the amount of slack t sets. She offered that “On balance, the unemployment rate probably s correct in signaling that overall labor market conditions have returned to pre- Tobranes Rais = . © Nomal & © Turbulent 2 ow i boos 2 2 oo 2 & : os ato 8 2m 918 010-45) 8° S00 rox Ret) Source: oya mvesimentWanapemen, data as of December 2017 Turbulence: Evolution of a Concept ‘The turbulence framework we use to estimate correlations and standard deviations of returns among asset classes is derived from the academic work of the applied statistician Prasanta Chandra Mahalanobis. Inthe early twentieth century, Mahalancbis analyzed human skull resemblances among castes and tibes in India. He created a formula to capture cifferences in skull size, which incorporated the standard deviation of measures of various sul parts. He then squared and summed the normalized differences, generating a single composite distance measure. ® P-Mahatnobs, “On the Generatned Distance Statist” Proceedings fhe Natio! sti (935) #855, te of Slences a naa vl 2n0.1This formula evalved into a statistical measure called the “Mahalanobis distance." The measure was ground: breaking in that it helped analyze data across standard deviations bu also Incorporated the correlations among data sets, More then 60 years later, the Mahalanobis distance was used by Kritzman ané Lito formulate a conceot called financial uraulence’* They postulate financial turoulence as a condition in which asset prices, given their historical patterns of rturns, behave in an uncharacteristic way including extreme price moves. They further noted that financial turbulence often coincides with excessive rsk aversion, iiquidty and price declines for risky assets Itis this turbulence framework for unusualness of returns and correlations of returns) that we have used to forecast risk measures in our capital market assumptions. Observing Turbulence Turbulence can be calculated for any glven set of asset classes. Back to our example of US. equities an bonds, the two dimensions can be visualized as the equation ofan ellipse using the returns of the S&P 500 index and the U.S. Barclays Aggregate index Figure 22). The center ofthe ellipse rearesents the average of the joint returns of the two assets. The boundary isa level a tolerance that separates normal from turbulent observations. The boundary takes the form of an ellise rather than a circle because it takes into account the covariance of the asset classes, The idea captured by this measur is that certain periods are considered turbulent not only because retums are unusually high or low but also because they moved in the opposite direction of what would have been expected given average correlations. Using Turbulence to Create Portfolios Note that the threshole of normal and turbulence in Figure 22 isnot static but rather is dynamic through time. Our process identifies turbulent market regimes by estimating a covariance matrix covering those periods of market stress alone and isthe eutcome of a Markov madel. The madel classifies regimes rather than arbitrary threshelds because thresholds would fal to capture the persistence of shifts in volatilty. The Markov model output in Figure 23 llustrates turbulent and normal regimes. Figure 23, Markov 12-Asset Normal and Turbulent Regimes 100 — Mato Neral = Marko Turbulent wo. Fuad Tested ware a= =SCRT~SC«CSSCSCORSCSCODSC SSN TNT Source: oya mvesimentWanapemen, data asf Octser 207 Turbulent market regimes make use of the conceot of multivariate outlers in a return cistribution, That is, we take into account not only the deviation ofa particular asset class's return from the average, but also its volatility and correlation with other asset classes. We subsequently estimate a covariance matrix based on geriods of normal and turbulent market performance. Finally, we use a procedure to blend these two covarlance matrices using “M. staran ard. "Skul, Fnac Trulece, ae isk Maragenert Fiano Anat Journ ol 66 no, 5 2019: 30-8 226 weights that allow us to express beth views about the Ikelihood of each normal or turbulent regime and to capture the differential risk attitudes toward each, The weights we use are 60% normal anc 40% turbulent to create our slrategic asset allocation portfolios. We overweight the turbulent regime at 40% — higher than its observed frequency of 20% — to account for structural issues such as globalization, cemographics and worldwide central bank intervention, which are prevalent today. From this blended covariance matrix, we then extract the implied correlation matrix ang standarc deviations for each asset class. In our view, this process helps create a strategic asset alocation portfaio that can account for the empirical evidence that correlations will deviate through time. Time Dependency of Asset Returns and Its Impact on Risk Estimation Recent research suggests that expected asset returns change overtime in somewhat predictable ways and that these changes tend lo persist overlong periods. Thus, changes among investment opportunities — all possible combinations of risk and roturn — are found to be persistent. This Appendix will sot cut the economic reasons for return predictability, ts consequences for strategic asset allocation and the adjustments we have made to control for itin our estimation process, In our view, the common source of predictability in financial asset returns isthe business cycle. The business cycle itselis persistent, and this makes real economic growth ta some extent predictable, The fundamental reason for the business cycles persistence Is that its components share the same qually. Consumers, for example, have a tendency to smooth consumption since they cistke abruat changes in their lifestyles. Research on permanent income and lifecycle consumation provides the theoretical bass for consumers’ desire fora stable cansumetion path, When Income is affected by transitory shocks, consumption should not change since consumers can use savings or borrowing to adjust consumption in wel-unctioning capital markets. Rebert Hall has formalizes these ideas by showing that consumers will optimally choose to keep a staale path of consumption equal ta 2 fraction oftheir present discounted value of human and financial wealth * Investment, the second component of GOP, i sticky, as corporate investment in projects is usually long-term in nature, Finaly, government expenditures also have a low level af variatility. Over @ medium-term harizon, negative serial correlation sets in as the growth phase ofthe cycle Is falawed ay a contraction and then that contraction is followed by renewed growth.* How does this predictability of economic variables affect the predictabilty of asset returns? Consider equities as ‘an example, The value of equities is determined asthe present discounted value of future cash flows and depends ‘on four factors: expected cash lows, expected market risk premium, expected market rsk exposure and the term slructure of interest rates. Cash flows and corporate earnings tend to move with the business cycle. The market risk premium s high at business cycle troughs, when consumers are trying to smooth consumplion and are less willing to take rsks with theirincome; and low at ausiness cycle peaks, when people are mare willing to take risks, The market risk premium Is @ component ofthe discount rate in the present value calculation ofthe dividend discount madel. Afims risk exposure (beta), another component ofthe discount rte, changes through time and is a function of is capital structure. Thus, a fms risk increases with leverage, which is related tothe business cycle The last component ofthe ciscount rate is the ristfree rate, whichis determined by the term structure of interest rates. The term structure reflects expectations of real interest rates, real economic activity and inflation, which are connected to the business cycle. Thus, equity returns, and financial asset returns in general, are ta a certain extent astcInpliations of he Life-Cycle-Permanent come Hypothesis Theory and Evidence” Journal af Poitia corey 36 588 "J Poteb and. Summers, Mon Reversion n Stack Pies Evidence and knbatons Jounal of Financia Economic 2 (688) 27-60,predictable. Expected retumns of many assets tend to ae high in bad macroeconomic times and low in good times. This precictabilty of returns manifest itself statistically through autocorrelation. Autocorrelation in time series of returns describes the correlation aetween values af a return process at different paints in time. Autocorrelation can be positive when high returns tend to be followed by high returns, imalying mamentum in the market. Conversely, negative autocorrelation occurs when high returns tend to be folowed by low returns, implying mean reversion, In ether case autocorrelation induces dependence in tetuins overtime. Tractional mean-variance analysis focused on short-term expected return and risk assumes returns do net exhibit time dependence and prices folow a random walk Expected returns In a random walk are constant, exhibiting zero autocorrelation; realized short-term returns are not predictable, Voatilties and cross-correlations among assets are independent of the investment harizan. Thus, the ansualized voallty estimated from monthly return data scaled ay the square root of 12 shauld be equal tothe volatilty estimated from quarterly return data scaled by the square root of four. In the presence of autocorrelation, the square root of time scaling rule described above is nol vala, since the sample standard deviation estimator is biased anc the sign of autocorrelation matters for its impact on volatility and correlations. Positive autocorrelation leads to an underestimation of true volatly {A similar result holds for the cross-correlation matrix bias when returns exhibit autocorrelation, So for long investment horizons, the rskireturn tradeoff can be very diferent than that for shart investment horizons Ina multi-asset portfolio, in which differant asset classes display varying degrees of autocorrelation, fallure to correct forthe bias of volatilities and correlations wil lead to suboptimal mean variance optimized portfolios in ‘hich asset classes that anpear to have low volallties receive excessive allocations, Such asset classes include hedge funds, emerging markel equities and non-public market assets such as private equity of rivale real estate, among others ‘There are atleast two ways to correct for autocorrelation: = Aditect method thal adjusts the sample estimators of volallty, correlation and all higher moments 1 Anindivect method that cleans the data fist, allowing us to subsequently estimate the moments ofthe istrbution using standard estimators Given thatthe cirect methods become quile complex beyond the frst two moments, out choice isto follow the second method and clean the return data of autocorrelation. Before we do that we estimate and test the statistical significance of autocorrelation in our data series. We estimate first-order autocorrelation correlation as the regression slope of a first-order autoregressive process, We use monthly return data forthe period 1979-2014, We subsequently test the statistical significance of the estimated parameter using the Ljung-Box Q-statistic"” The Q-statistic isa statistical test fr serial correlation at any number of lags. Its distributed as a chi-square with k degrees of freedom, where kis the number of lags. Here we test for tstorder serial carelation, thus k~1, About 80% of our relurn series exhibit positive and stalstcally significant first-order seral correlation based on assaciated p-values atthe 10% level of igniicance'® Khandani and Lo provide empirical evidence that postive return autocorrelation is a measure of liquidity exhibited among a broad set offnancial assets including small-cap stocks, corporate bonds, mortgage-backed securlies and ° GI. jung and EP Box, “On # Mesut of Lack iin Tine Series Model Bometri, 65, 1676) 287-208, * The passe the probably ofelectng ne ralhypehess of esta creation wnen tiie 8, coneldg tat nee fess arretaton nthe data hen infact seal correlation doesnot ent, We set rial values ot 10% an thus let the nal hypothesis tno Serial creltion lo pastes 10% 2‘emerging market investments." The theoretical bass is that n a fictionless market, any predictably in asset returns can be immediately exploited, thus eliminating such predictabilly. While other measures of iliquldity exist, autocorrelation Is the only measure that applies to both publicly and privately traded securities and requires only returns to compute, Since the vast majority ofthe return series we estimate exhibit autocorrelation, we apply the Geltner unsmoothing process to al series, This process corrects the return series for first-order serial correlation by subtracting the product of the autocorcelation coefficient p and the previous periods return from the current period's return and dividing by 1-p. Ths transformation has no impact on the arithmetic return, out the geometric mean is impacted since it depends on volatility. This carection is thus important to make for long-hotizon asset allocation portfolios. New York city December 2017 Multi-Asset Strategies and Solutions Team Voya Investment Management's Mut)-Asset Strategies and Solutions (MASS) team, led by Chief Investment Officer Paul Zemsky, manages the fie’ suite of mult-asset solutions designed to help Investors achieve ther long-term objectives. The team consists of 25 investment professionals that have deep expertise in asset allocation, manager selection and research, quantitative research, portfolio implementation and actuarial sciences. Within MASS, the asset allocation team led ay Barbara Reinnard, is responsible for constructing strategic asset allocations based on thelr long-term views, The team also employs a tactical asset allocation approach, driven by market fundamentals, valuation and sentiment, whichis designed to capture market enomalles andor reduce portfollo risk RE Khancin’ and Lo, “guy Prema Asses Retr: ha Erin Ara of Hedge Funds, Mutual Funds. andUS.EoutyPerokes” Quartet Joumal of Finance (eon 205-264 Past performance doesnot guarantee future results ‘This commentary has Been ese, Noting colained herein shouldbe canstuee ssf an oferta seller, {alstation of an afer to buy any secarty a |) a ecommeneston ato he avssblty oven, purehssing or eling any secu. ny opens expressed heren ‘efect our judge ad ate subject to change. 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