September 2016
INVESTMENT OUTLOOK
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"Someone is sitting in the shade today because someone planted a tree a long time ago."
— Warren Buffett
Warren Edward Buffett (1930- ) is a U.S. businessman and investor who is chairman, chief executive officer, and
largest shareholder of Berkshire Hathaway. A billionaire and notable philanthropist, Mr. Buffett has pledged to give
away 99% of his fortune. Mr. Buffett’s investment strategies have been long studied and revered.
Inflation is an important and often-discussed topic
among investors, given the impact of higher prices
on real purchasing power. Inflation as measured by
the Consumer Price Index (CPI) has not been a
problem for some time, but a few key variables,
including a rise in oil prices, could change that. This
leads to a discussion of monetary policy as the
Federal Reserve (Fed) monitors inflation, along with
employment, as part of its two-pronged measure to
determine when to raise interest rates.
U.S. economic growth will likely persist
uninterrupted in the near term, in our view, and we
are in a lower-for-longer yield environment. The
Treasury yield curve is anchored at the short end
due to continued accommodative U.S. monetary
policy, while longer-maturity yields are being pulled
lower largely by the term premium in light of global
concerns and ongoing central bank easing. We
think inflation expectations will rise as surveybased measures used by the Fed have remained
relatively flat, commodity prices have stabilized, and
wages have trended higher as the United States
moves closer to full employment.
With this changing outlook, we think it is wise to
consider the composition of the fixed-income asset
class. We believe in a disciplined and long-term
approach to investing, and remind investors of the
importance of fixed income, not only in terms of a
portfolio’s composition but also in terms of risk
management.
In this month's Investment Outlook we discuss:
 the current inflation environment;
 the Fed and inflation; and
 Treasury Inflation-Protected Securities
(TIPS).
Our 2016 U.S. outlook is for continued expansion of
the economy. PNC expects U.S. economic growth of
1.5% in 2016 and 2.3% in 2017. Markets are tuned to
the dynamics in the oil industry, monitoring supply
projections and price moves. Markets will likely
continue to watch the Fed for signals of additional
interest rate increases while tracking policy actions
from central banks worldwide.
We are following developments after the Brexit vote
as well as the changing dynamics in economies
around the world. Currency movements are also
key factors. Finally, we believe geopolitical
concerns remain on the radar as among the biggest
perceived risks to markets.
We believe stock market volatility will be elevated in
the near term as the market continues to digest
economic data, outlooks, and unforeseen events.
While we acknowledge the difficulty for us, or
anyone, to predict with great accuracy the
short-term behavior of stocks, we feel investors
should continue to focus on their long-term goals,
working with their PNC advisors to focus on an
asset allocation that matches their risk and return
objectives.
PNC’s six traditional asset allocation profiles are
shown on the back page of this outlook.
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Inflation Trends
Inflation has been of little concern for more than a
few years (Chart 1). A confluence of factors,
including low wage pressures, falling oil prices, and
dollar strength, have kept inflation at bay. Of the
CPI, food comprises about 15%; energy, 10%; and
housing, 30%. The rest is labor and other finished
goods. Recently however, these trends have shifted
a bit, leading to the need for further discussion.
Chart 1
U.S. Consumer Price Index
As of 7/31/16
upward movement of prices. Spending on clothing
has not been strong, which does not explain the
price movement. Air fares are typically volatile.
Prices are benefiting from international dynamics,
in conjunction with stable food and commodity
prices. Weaker international growth, especially
among the emerging market countries, is keeping
overall prices muted. In addition, the dollar is
benefiting from weaker global growth. The rising
dollar makes imported goods cheaper for the final
consumer and forces domestically produced
competing products to check price increases.
In recent years, some monetarists have pointed to
the dynamic of banks holding higher levels of
excess reserves on their balance sheets rather than
increasing lending and the money supply. Others
have noted that the velocity of money (how quickly
money circulates) is well below its historical
average, and by some measures may be at a record
low. In a monetarist framework, there is no
evidence of inflation accelerating when the velocity
of money is slowing.
Source: Bureau of Labor Statistics, PNC
The labor market has much improved since the
days of the recession. However, it was a gradual
and slow recovery, with employers using caution in
adding workers and raising wages.
Chart 2
Core CPI
As of 7/31/16
The unemployment rate is now trending just below
5%. Unit labor costs have risen higher, albeit slowly
and still at historically low levels. Unit labor costs
are up 1.9% in the first quarter versus last year.
Labor costs lead the CPI by approximately one year.
Core inflation, however, has moved gradually
(Chart 2). Core inflation is key given that the Fed
uses core CPI, which excludes the more volatile
gasoline and food prices, in its analysis on whether
to increase interest rates to cool down or heat up
the economy. The underlying causes for the rise in
core inflation are limited to a few areas: new
vehicles, clothing, health care, and travel. Vehicle
sales have been strong, which helps explain the
Source: Bureau of Labor Statistics, PNC
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Chart 3
Producer Prices
As of 7/31/16
Source: Bureau of Labor Statistics, PNC
Producer prices have not contributed much in
terms of inflationary pressures. The Producer Price
Index (PPI) actually contracted in July (Chart 3).
Chart 4
FOMC Dot Plot
As of 8/26/16
Source: Bloomberg L.P., PNC
several indicators in mind which can tend to cause
inflation to rise:

The Fed and Interest Rates
As the U.S. economy continues along its path of
recovery, there is less of a need for extraordinary
interest-rate policy. As we have seen over the past
year or so, markets are highly attuned to
monitoring and trying to forecast decisions from the
Fed regarding interest rates.
The Fed essentially ended the zero interest rate
policy program, which began in 2008, when it voted
to increase interest rates by 25 basis points in
December 2015. The Fed continues to reiterate its
stance that subsequent raises will be gradual. PNC
forecasts one additional hike in 2016.
Looking to the Fed and markets for guidance, we
can see the Fed’s dot plot—a chart that shows
where Federal Open Market Committee members
think the interest-rate benchmark is going—has
moved a bit higher (Chart 4). The median view has
the federal funds rate at 0.75% by the end of 2016.
The terminal rate per the Fed, 3.00%.
Given the analysis of current trends and the Fed
policy outlook, we believe investors should keep



continued vigor in monetary growth, with a
pickup in the money multiplier, which has
been noticeably low during the current
deleveraging cycle;
faster wage growth;
further increases in energy prices, given the
geopolitical situation; and
continued improvement in the
unemployment rate.
Higher prices for consumer goods are generally the
drivers of purchasing power and economic activity,
and we believe they should be monitored above all.
Inflation expectations based solely on monetary
policy or unemployment trends are also notable,
given the Fed-aided recovery. However, the slow
pace of the U.S. recovery does not add to inflation
pressures.
Inflation and Investing
In considering an investment portfolio, research has
shown that over a long holding period, stocks
provide a hedge against inflation. This is not always
the case in shorter holding periods, in our view.
Keep in mind that volatility usually accompanies a
higher-inflation period. Since 1926, 28% of annual
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stock market returns and 8% of annual bond
market returns were negative. However, only rarely
(about 2% of the time) did both stocks and bonds
post simultaneous annual negative returns. It
follows, then, that managing the stock/bond
allocation can benefit the stability and predictability
of portfolio performance. In addition, managing the
fixed income asset class components can help in
this regard.
In observing the correlation of five-year returns on
U.S. stocks, bonds, and Treasury bills (T-bills) with
realized inflation from 1930 to 2014, we note the
nominal return on each asset class is positively
correlated with subsequently realized inflation. As
might be expected, nominal T-bill returns have the
highest correlation with inflation (Table 1). This is
consistent with the fact that money market rates
reset frequently and tend to track significant
changes in inflation, at least on average.
Table 1
Correlation of Five-Year Returns with Realized
Inflation
12/30-9/14
Stocks
Bonds
Bills
Nominal
Return
0.26
0.01
0.51
Capital Gain
0.25
-0.37
Income
0.06
0.49
Real Return
-0.08
-0.56
-0.54
Source: Ibbotson/Morningstar, PNC
What we are primarily concerned about is the real,
inflation-adjusted returns on these asset classes.
The real return on stocks is essentially
uncorrelated with realized inflation. That is good
news, since it implies that stocks tend to do a good
job of protecting purchasing power.
Real returns on bonds and bills, however, are
strongly negatively correlated with inflation. We
conclude that both of these asset classes do a poor
job of protecting purchasing power.
It may seem odd that the correlations of nominal
returns with inflation are positive and not
dramatically different for stocks and bonds, yet the
correlations are very different when reviewing real
returns. The explanation lies with differences in
volatility between stocks and bonds. Correlation
reflects the tendency of two random variables to
move in the same direction (positive correlation) or
in the opposite direction (negative correlation)
relative to their respective average values. It
indicates nothing about the relative magnitude of
the movements. Just because nominal returns on
both stocks and bonds tend to move in the same
direction as realized inflation (that is, they are
positively correlated with it) does not mean that they
both move enough to fully offset the impact of
inflation. If inflation turns out to be 1% higher, then
an asset’s nominal return must also be 1% higher
to help protect purchasing power. Simply moving in
the right direction is not good enough. Nominal
stock returns are much more volatile than nominal
bond returns. Hence, given similar correlations with
inflation, they are much more likely to rise or fall
enough to fully offset changes in inflation. Ironically,
higher (nominal) volatility works in the investor’s
favor here.
TIPS
PNC’s Investment Policy Committee, at its regularly
scheduled meeting on August 15, 2016, made the
following changes to PNC’s recommended
traditional asset allocation profiles and the core
fixed income profile:


reduced the tactical allocations to absolutereturn oriented fixed income, global bonds,
and leveraged loans within the bond
allocation; and
initiated a tactical allocation to TIPS within
the bond allocation.
The proposed new tactical allocation focuses our
Treasury allocation on inflation-hedged holdings,
while reducing our tactical overweight to spread
product. The proposed tactical change retains our
allocation to stocks versus bonds at the baseline
level across the six traditional profiles. Please
speak with your investment advisor for the
allocations across the profiles.
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This allocation is expected to offer several key
benefits including:




reducing our significant underweight to
Treasury-related securities;
providing insurance against an increase in
inflation expectations;
increasing duration to a less underweight
position relative to the benchmark in a
lower-for-longer yield environment; and
modestly increasing yield while
simultaneously boosting aggregate credit
quality.
PNC’s recommended allocations continue to reflect
our view that U.S. economic growth will continue
uninterrupted, but that we are in a lower-for-longer
yield environment. The Treasury yield curve is
anchored at the short end due to continued
accommodative monetary policy within the United
States, while longer-maturity yields are being
pulled lower largely by the term premium given
global concerns and ongoing central bank easing. It
is our view that inflation expectations will rise,
particularly as survey-based measures used by the
Fed have remained relatively flat, commodity prices
are stabilizing, and wages trend higher as the
United States moves closer to full employment.
TIPS are issued with maturities of 5, 10, and
20 years.
 At maturity, the greater of the original face
amount or the inflation-adjusted principal is
returned to the investor; and
 The semi-annual interest payments and any
inflation-adjusted increase in principal are
taxed annually.
TIPS are subject to federal income taxes, but
exempt from state and local income taxes because
they are U.S. government obligations. However, the
inflation adjustment is taxed at the ordinary income
rate rather than the capital gains tax rate. We
recommend speaking with your tax advisor for
additional information on your individual situation.

Valuation Considerations
The most important measure of valuation for TIPS
is the inflation spread, or breakeven rate, which is
the yield of a conventional Treasury security minus
the real yield of a similar-maturity TIPS. This
provides an indication of market inflation
expectations while also determining the relative
value of TIPS versus Treasuries. As the inflation
spread widens, TIPS tend to outperform, all else
equal. With that, we reviewed historical 10-year
breakeven rates compared with the current spread.
A TIPS Primer
Breakevens
TIPS were introduced in January 1997 and are
issued by the U.S. Treasury. Although the asset
class shares the full faith and credit pledge of the
U.S. government, TIPS are distinctly different from
conventional Treasury securities, such as the
10-year Treasury note.
The 10-year inflation breakeven rate is off the
one-year highs with a rate of 1.47 as of August 10,
2016, versus the 1.72 high reached on April 28, 2016
(Chart 5, page 6). While potential downside remains
based on our analysis of the past year, actual
inflation as measured by the CPI and wages has
trended higher.
The main characteristics of TIPS include:


The principal value increases and decreases
with the level of inflation based on the
Non-Seasonally Adjusted Consumer Price
Index for Urban Consumers (CPI-U).
Coupons are paid twice a year with the rate
tied to the inflation-adjusted principal. In
other words, the coupon payment also
adjusts with inflation.
As survey-based measures remain stable, wage
pressure increases, and commodity prices stabilize.
With West Texas Intermediate up over 15% year to
date and analyst expectations of approximately
$50 per barrel at year end, we would expect
breakevens to move to the upside providing
potential relative outperformance for TIPS.
5
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1.7
term premium component of yields. Even as real
yields decline, so long as breakevens remain
relatively unchanged, we would expect TIPS to
outperform nominal Treasuries. Given our
expectations for the term premium to cap the
upside of real yields, we believe this is a relatively
likely scenario.
1.6
Historical Returns
1.5
We measured fixed income returns in periods of
rising rates given our expectation that the Fed will
ultimately continue to normalize monetary policy.
The challenge is that the sample size in which to
gather data is relatively small because asset class
did not exist prior to 1997. With that in mind, we
found that in the period in which the Fed was
raising interest rates (Table 2, page 7), TIPS
outpaced Treasuries and the Barclays Aggregate
Index. If the Fed were to remain on hold, which is
what the market is largely pricing in currently, TIPS
outperformance is possible in periods in which
interest rates were unchanged. Declining rate
environments were mixed; however, we would note
that the recent introduction of the asset class in the
first period measured may not be a fair
representation of how TIPS would generally
perform. We would also highlight that a Fed rate cut
is not our base case.
Chart 5
One-Year Analysis of 10-Year Breakeven Rates
(7/1/15-7/21/16)
2.0
10-Year Breakevens
1.9
Average
Lower
Upper
Breakeven Rate
1.8
1.4
1.3
1.2
1.1
1.0
7/15
9/15
11/15
1/16
3/16
5/16
7/16
Source: Bloomberg L.P., PNC
Chart 6
Historical Analysis of 10-Year Breakeven Rates
(1/1/07-7/21/16)
3.0
2.5
Breakeven Rate
2.0
1.5
1.0
0.5
0.0
10-Year Breakeven
Average
Lower
Upper
-0.5
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Source: Bloomberg L.P., PNC
Additionally, as exhibited in Chart 6, the current
10-year breakeven is below the lower bound of one
standard deviation using 10-year historical data.
Analyzing the past year, the breakeven is below the
average, but remains within one standard deviation.
While we are certainly in uncharted times, we
believe these technicals should favor the potential
for an increase in inflation expectation.
Real Yields
Given the extreme yield movements bond markets
have experienced since the financial crisis, we also
measured returns during these periods. The only
period in which TIPS significantly underperformed
was during the Taper Tantrum of 2013, in which the
10-year Treasury yield increased by approximately
100 basis points (bps) in roughly four months as the
market braced for the potential for less stimulus
from the Fed (that is, the end of bond purchases).
During this period, real yields were rising at the
same time that inflation expectations fell by over
20 bps. We do not anticipate this significant of a
shock to yields in the near term, especially given
global uncertainties and negative rates are keeping
the term premium in real yields at historically low
levels. Additionally, we expect inflation expectations
to increase, not decline.
Another consideration is the movement in real
yields, which include the growth expectation and
6
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Table 2
Historical Periodic Fixed Income Total Returns
TIPS
Agg
Tsy
TIPS
Agg
Tsy
Declining Rate Environment
8/31/07-3/31/09*
12/29/00-6/30/03*
12.3%
6.0%
9.1%
5.8%
8.9%
10.6%
Taper Tantrum
5/15/13-9/5/13
-8.2%
-3.9%
-3.4%
Rising Rate
Environment
5/31/04-7/31/06*
4.2%
3.6%
3.2%
Post-Brexit
6/23/16-7/18/16
6/23/16-7/8/16
1.5%
2.5%
1.9%
1.2%
2.3%
1.1%
Stable Rate Environment
12/31/08-11/30/15*
6/30/03-5/31/04*
4.5%
4.2%
-0.3%
4.2%
-2.2%
2.4%
Year to Date
1/1/16-7/20/16
6.3%
5.4%
5.0%
*Annualized Return
Source: Bloomberg L.P., PNC
The most recent example of extreme yield
movement is the period immediately following the
U.K. referendum vote to leave the European Union,
also known as Brexit. The 10-year Treasury yield
fell 39 bps in just two weeks, with the largest
portion of the decline due to safe-haven flows, or
the term premium.
Meanwhile, inflation expectations fell 9 bps during
the same period. Although the spread declined,
TIPS outperformed Treasuries during this short
time frame. Again, we do not believe this is likely to
be a long-term trend, and since July 9 yields have
moved nearly 20 bps higher with inflation
expectations up just incrementally, as of August 9.
Key Risks of TIPS Allocation
From a tactical perspective, we believe the
recommended TIPS allocation change is warranted
based on the considerations outlined above.
However, there are potential scenarios in which the
allocation may result in underperformance.
Lower Inflation Expectations
Should breakeven rates break to the downside, TIPS
would underperform versus Treasuries, and
potentially relative to other fixed income asset
classes. However, given the already low levels of
inflation expectations and the general stability of
inflation measures, as highlighted above, this is not
our base case scenario.
Additionally, if investors anticipate a decline in
inflation, it is likely there is less confidence in the
economic recovery, and longer real yields would
also likely decline. So while relative performance
would likely suffer, absolute returns should still be
favorable (Table 3, page 8).
Rising Real Yields
Another consideration is if real yields increase at a
much faster pace than we expect, as was the case
during the Taper Tantrum. If this occurs and
inflation expectations via breakevens remain
relatively stable or move higher, this should not
result in underperformance relative to Treasuries.
However, there is the potential for inflation
expectations to decline in tandem with a rise in real
yields, which would be a negative for performance.
Modest Increase in Duration Exposure
Our duration exposure modestly increases with the
TIPS allocation within the fixed income profiles
given the somewhat longer-duration nature of the
index. While this positioning may not be favorable in
times of significant yield increases, we note that the
duration will remain underweight versus respective
benchmarks but to a lesser extent.
7
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Table 3
Proposed Allocation Characteristic Impact
As of 7/29/16
Characteristic
Duration
Yield
Maturity
Credit Quality
Current Proposed Current
Barclays
Aggregate Total Rate Total Rate Core
Index
of Return of Return Profile
4.32
3.81
5.55
3.76
2.71%
2.39%
2.49%
1.97%
6.44
5.63
6.10
7.88
A+
AAAA
A+
Current
Proposed
Proposed Barclays
Municipal
Core
Tax-Sensitive Tax-Sensitive
Profile
Profile
Profile
Index
3.51
3.12
4.56
4.94
2.04%
1.65%
2.01%
2.48%
9.98
10.25
13.18
6.91
A
AA
AAA-
Source: Bloomberg L.P., Fund Websites, PNC
Implementation Discussion
The TIPS allocation was funded from our current
fixed income tactical allocations: one-half from the
global bond allocation, one-fourth from the
absolute-return oriented strategy allocation, and
one-fourth from the leveraged loan allocation. This
makes our profiles modestly less overweight credit
versus both our baseline and previous tactical
recommendations.
Our recommendation is to use the Barclays U.S.
TIPS Index as the benchmark to measure the
effectiveness of this recommendation for
Investment Policy Committee purposes.
Currently, products residing on the PNC platform to
express the TIPS allocation are:


Vanguard Inflation Protected Securities
Fund (VAIPX); and
iShares U.S. TIPS (TIP).
Conclusion
Year to date, TIPS are outpacing Treasuries by
about 130 bps, and we believe the asset class has
the propensity to continue its recent strength. In our
opinion, it is likely real yields will continue their
trend higher in the near term; however, in the
medium term, we believe there is a cap to the
upside of yield movement.
TIPS can be a favorable alternative to conventional
Treasuries; TIPS provide both a comparable yield
and the credit quality of Treasury notes, while also
furnishing protection against the risk of higher
inflation. In addition, since TIPS return the greater
of the face value or the inflation-adjusted principal
at maturity, these securities would increase in real
value even during a deflationary period. With
commodity prices finally finding some footing
following a volatile period recently, TIPS are indirect
beneficiaries due to the CPI adjustment. While not
our base case in the near term, we think TIPS are
likely the best defense against stagflation because
high inflation coupled with low growth provide the
optimal environment for TIPS performance.
From both a valuation and goal-based methodology,
TIPS are likely a good addition to many portfolios. In
particular, tax-deferred and tax-exempt accounts
are likely beneficiaries of TIPS allocations. In our
opinion, TIPS provide some measure of insurance
against the risk of inflation and reduced real
purchasing power, while protecting against severe
deflation. This seems especially true for investors
holding excess cash or nominal Treasuries.
8
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PNC Current Recommendations
PNC’s recommended allocations continue to reflect
our positive view regarding the durability of the
economic expansion while considering the
continued downside risks inherent in the market
and economic outlook:
 a baseline allocation of stocks relative to
bonds;
 a tactical allocation to PNC Systematic
Tactical Asset Rotation (STAR);
 a tactical allocation to real estate
investment trusts (REITs);
 a tactical allocation to leveraged loans
within the bond allocation;
 a tactical allocation to absolute-returnoriented fixed-income strategies within the
bond allocation;
 a tactical allocation to Treasury
Inflation-Protected Securities (TIPS) within
the bond allocation;
 an allocation to emerging markets within
the international equity component;
 a tactical allocation to Europe focused
equities—FX hedged within the international
equity component;
 a tactical allocation to Japan focused
equities—FX hedged within the international
equity component;
 a preference for high-quality stocks;
 a tactical allocation to global bonds within
the bond allocation;
 a tactical allocation of 52% value and 48%
growth within U.S. large-cap stocks;
 a tactical allocation to global dividendfocused stocks; and
 an allocation to alternative investments for
qualified investors.
Baseline Allocation of Stocks Relative to
Bonds
Since one cannot accurately determine the shortterm movement of stocks, we believe investors
should focus on what is knowable and controllable.
The one thing investors can truly control is asset
allocation reflective of their needs and risk
tolerance. PNC’s six baseline asset allocation
models are shown on the back page of this Outlook.
Preference for High-Quality Stocks
Any relapse to stressed capital markets or to
another credit crunch from a financial crisis likely
poses a higher threat to lower-quality and highly
leveraged companies. Companies with weak
balance sheets and less-robust business models
have a much higher risk to their survival.
Unfortunately, the economic outlook continues to
be subject to continued downside risks in the wake
of the financial crisis.
We favor a preference for high-quality stocks as a
method of risk control against unexpected shocks
to the economic system. This is also consistent with
our explicit allocation to dividend-focused stocks.
International Equities
International equities offer geographic
diversification and open the opportunity set to invest
in firms worldwide. Beyond the benefits of
diversification and exposure to many of the world’s
leading companies, there are other potential
benefits to investing outside U.S. borders, including
unique opportunities in Asia and Europe. Within the
international equity component we recommend an
allocation to emerging markets.
It is reasonable to assume that the United States
and other developed markets have similar longterm expected returns. Much of the difference is
likely to come from currency gains or losses. We
remain mindful of the currency risk inherent in
international investing. While at times the weaker
dollar makes international investing look more
attractive than underlying fundamentals might
dictate, the reverse is true when the strong dollar
punishes U.S. investors' international returns.
Allocations to Europe- and Japan-Focused
Foreign-Exchange-Hedged Equities
Our tactical allocation within the international
allocation focuses on Europe-based and Japanbased holdings. Stabilizing recoveries in both
9
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Chart 7
FX Hedged Europe and Japan
Monthly, 4/30/08 through 6/30/16
Chart 8
Source: Bloomberg L.P., PNC
Source: Barclays Capital, PNC
Barclays Capital Global Aggregate by Country
As of 7/25/16
Europe and Japan, relative valuations, improving
corporate earnings, and low energy prices are a few
of the dynamics that support strength of equities in
the regions. Equities in both regions have
underperformed in recent years, but we believe the
aggressive monetary policy actions by both the
Band of Japan and European Central Bank are
supportive of financial assets (Chart 7). Our view is
these asset purchases should support their
economies and function to continue to make
equities in their respective countries more
attractive relative to fixed-income assets and to
bolster equity valuations.
A primary motivation for allocating to global bonds
is to introduce currency exposure to a portfolio.
Although currency adds another level of volatility to
a portfolio’s fixed-income allocation, it provides for
investors a natural hedge against devaluation of the
dollar, which traditional domestic fixed-income
asset classes cannot offer (Chart 9).
The hedged currency recommendations reduce
currency risk for our U.S.-based investors who have
most, if not all, of their liabilities denominated in
dollars.
Chart 9
Barclays Capital Global Aggregate Excluding United
States, Unhedged, Correlation with Dollar
Monthly, 1/29/93 through 6/30/16
The prospect of higher global economic growth
outside the United States is another motive for
allocating fixed income globally. As world
economies grow more quickly, international bond
investors may have the opportunity to reap the
Allocation to Global Bonds within Bonds
The strategic rationale for including global bonds in
the portfolio rests on expanding the opportunity set
within the investible bond universe. The Barclays
Capital Global Aggregate Index, our proxy for highquality global bonds, contains less than 40% U.S.
issues (Chart 8). (For further details of our view on
global bonds, see the July 2011 Investment Outlook,
Pulling the Fourth Lever.) We believe investors who
decline to look outside the United States may be
missing opportunities for diversification and
enhanced returns.
Source: Bloomberg L.P., Barclays Capital, PNC
10
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Chart 10
Barclays Capital Global Aggregate Excluding United
States, Correlation with U.S. Aggregate
Monthly, 1/29/93 through 6/30/16
Source: Bloomberg L.P., Barclays Capital, PNC
benefits of tightening global credit spreads relative
to the United States. More importantly, currently
investors can take advantage of higher interest
rates abroad to gain higher yields. The addition of
the currency exposure that comes with an
unhedged global bond can act to help lower the
correlation with U.S. bond returns (Chart 10).
In general, we suggest that active management
makes the most sense in this allocation. Global
bond index construction usually focuses on
allocating more assets to countries with more
outstanding debt. This may or may not be a good
thing. Larger and more stable economies are likely
to be able to support higher debt levels, but some
fundamental analysis is likely helpful. We also
believe that the current state of the global economy,
with the large dichotomy between most developed
and emerging economies, provides a possible
opportunity for active managers in exposure to
credit and foreign exchange.
In our opinion, it is likely that many managers’
allocations will differ greatly from the index. This
also affects risk metrics, typically to the upside in
terms of volatility, index tracking error, and
historical drawdowns. This was explicitly taken into
consideration by the PNC Investment Policy
Committee (IPC) when it sized the recommended
allocation to global bonds.
Given the concerns regarding how the United States
will handle upcoming monetary and fiscal policy
decisions, as well as what effects those decisions
might have on the value of the dollar, we believe an
allocation outside traditional fixed-income bond
sectors is prudent. We believe the advantage of
higher global growth and diversification benefits,
along with the ability to benefit from currency
exposure outside the dollar, make investing in the
global bond sector a viable complement to
traditional dollar-based fixed-income assets. This
allocation can be seen as adding to PNC’s defensive
posture on U.S. interest rates, with 10-year
Treasury rates now above 2% and our view that
yields will rise over time as the current economic
soft patch and the flight to safety fade (Chart 11).
We also see this as an opportunity to benefit from
higher bond yields elsewhere in the world.
Chart 11
10-Year Treasury Yields
Daily, 1/3/11 through 7/25/16
Source: Bloomberg L.P., PNC
Allocation to Leveraged Loans within Bonds 1
We believe an allocation to leveraged loans within
the bond portion of a portfolio should help defend
against higher interest rates. Since leveraged loans
are adjustable-rate instruments tied to short-term
The March 2010 Investment Outlook, Shakespeare for Primates, provides details about leveraged loans.
1
11
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Chart 12
3-Month LIBOR
Daily, 1/1/10 through 7/25/16
This allocation could be characterized as lowering
the portfolios’ interest-rate risk while raising their
credit risk and correlation with equities. We believe
it accomplishes this without a large impact on
portfolio income. In our opinion, this correlation
with equities, which we have noted since
recommending the allocation, has become more
apparent in the recent stock market downturn,
allowing investors an attractive entry point.
Allocation to Absolute-Return-Oriented Fixed
Income within Bonds 2
Source: British Bankers’ Association, Bloomberg L.P., PNC
interest rates (typically the 3-month LIBOR), we
believe holders should benefit from rising rates
(Chart 12). If longer-term interest rates rise, we
expect the shorter duration of leveraged loans
should result in much better performance relative
to longer-duration fixed income, such as the
Barclays U.S. Aggregate Bond Index.
Table 4
Periods of Rising Rates
Begin
End
10-Yr Yield Begin
10-Yr Yield End
Chg in 10-Yr Treasury (bps)
We believe an allocation to absolute-returnoriented fixed-income strategy within the bond
portion of a portfolio has several benefits, including:
 defending against higher interest rates;
 further expanding the opportunity set for
fixed income; and
 increasing exposure to credit.
Given our belief that the economy will continue to
improve, strategies that help protect against the
risk of rising rates will become increasingly
important. While we do not believe interest rates
will necessarily move markedly higher in the near
12/30/08
6/10/09
2.05%
3.95%
190
10/8/10
2/8/11
2.39%
3.74%
135
9/22/11
10/27/11
1.72%
2.40%
68
1/31/12
3/19/12
1.80%
2.38%
58
7/25/12
8/16/12
1.40%
1.84%
44
12/6/12
3/11/13
1.59%
2.06%
47
5/2/13
12/31/13
1.63%
3.03%
140
BAA Yield Begin
7.97%
BAA Yield End
7.75%
Change in BAA Yield (bps)
-22
Change in BAA Spread (bps)
-212
Total Return during Period:
BarCap U.S. Aggregate
-0.47%
Driehaus Active Inc (LCMAX)
13.08%
Blackrock SIO (BSIIX)
10.77%
MetWest Unconstrained (MWCIX) N/A
Western Asset
Unconstrained (WAARX)
12.01%
5.62%
6.25%
63
-72
5.04%
5.46%
42
-26
5.07%
5.42%
35
-23
4.73%
5.09%
36
-8
4.55%
4.94%
39
-8
4.47%
5.37%
90
-50
-3.09%
4.65%
0.55%
N/A
-1.68%
2.26%
-0.20%
N/A
-1.18%
3.29%
1.22%
3.71%
-1.21%
0.48%
0.31%
1.75%
-1.01%
2.42%
1.73%
2.23%
-3.04%
1.27%
0.63%
0.70%
1.13%
0.14%
1.08%
0.32%
1.13%
-0.76%
Source: Bloomberg L.P., PNC
The July 2013 Investment Outlook, Breaking the Bonds, provides details about absolute-return-oriented fixed income.
2
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term, rate volatility has certainly increased, and we
expect that the downside risk to holding excessive
duration will increase the longer rates remain low.
We believe it makes sense to further hedge against
this risk while maintaining the ability to participate
in upside credit potential. This is also consistent
with our current tactical allocations to global bonds
and leveraged loans.
We believe the Fed will continue to support the
economy as necessary until the economy can grow
and function without additional monetary policy
accommodation. This should lend itself to further
credit spread tightening over the short to
intermediate term. Even with spreads at relatively
attractive levels compared with historical
standards, we admit the absolute low level of yields
increases the difficulty of adding alpha within
spread sectors. This is one aspect in which we
believe an absolute-return long-short approach can
add value. Absolute-return strategies have the
ability to exploit mispricing via both long and short
positions and also expand the opportunity set of
strategies typically not accessible by traditional
long-only managers. Typical trading strategies
include, but are not limited to, capital structure
arbitrage, convertible arbitrage, event driven, and
pairs trading.
Table 4 (page 12) illustrates the behavior of various
products on the PNC platform consistent with the
absolute-return-oriented fixed-income strategies
during periods of rising interest rates. The strong
relative performance in rising-rate environments is
notable and is consistent with our expectation.



valuation; and
yield-curve slope—
continue to support an overweight to U.S.
large-cap value style relative to growth.
We focus on the yield-curve slope because results
of our analysis show that a steep curve is supportive
of value style outperformance relative to growth. It
is not a concrete rule that value always outperforms
growth in a steep yield curve, but it is an indication
Chart 13
2-Year to 10-Year Treasury Yield Spread
Weekly, 1/6/78 through 7/22/16
Source: Bloomberg L.P., PNC
Chart 14
10-Year to 30-Year Treasury Yield Spread
Weekly, 1/6/78 through 7/22/16
Overweight of U.S. Large-Cap Value Stocks
Relative to Growth 3
We believe the majority of the seven components of
our decision framework—
 earnings growth;
 interest-rate level;
 inflation;
 volatility;
 foreign growth;
Source: Bloomberg L.P., PNC
The March 2011 Investment Outlook, Quest for Value, provides details about the value style recommendation.
3
13
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of higher probability. Though recent Fed activities
have flattened them to a degree, both the 2- to 10year (Chart 13, page 13) and 10- to 30-year
(Chart 14, page 13) Treasury slopes remain
historically steep and supportive of a value
overweight.
We continue to monitor the possibility that the
typical impact of the steep yield curve might be
derailed by:
 the credit cycle;
Chart 15
U.S. Banks’ Willingness to Make Consumer Loans
(percentage more willing minus percentage less willing)
Quarterly, 1Q00 through 2Q16


capital constraints; or
lack of loan demand.
Bank loan data seem to be past their worst levels,
and we believe there are reasons for cautious
optimism.
 Banks are showing a greater willingness to
extend consumer loans (Chart 15).
 Bank loan quality has continued to improve,
implying a tailwind to bank earnings and a
possible turn in the deleveraging cycle
(Chart 16).
 Bank capital ratios have more than
recovered, which should allow for loan
growth and likely help prevent relapse of
financial crisis within the banking industry
(Chart 17).
Chart 17
U.S. Bank Core Capital Ratio
Quarterly, 1Q84 through 1Q16
Source: Federal Reserve, Bloomberg L.P., PNC
Chart 16
U.S. Delinquency Rates for Loans
Quarterly, 1Q91 through 1Q16
Source: Federal Deposit Insurance Corporation,
Bloomberg L.P., PNC
Our value allocation has underperformed in the
market downturn, given its more cyclical exposure.
We believe it will perform better as global growth
concerns fade.
Allocation to Global Dividend-Focused Stocks
Source: Federal Reserve, Bloomberg L.P., PNC
A global dividend-focused allocation expands the
opportunity set to invest in high-quality dividendpaying stocks, where in some cases companies
have exhibited faster dividend growth, essentially
opening up the opportunity to invest in firms outside
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Chart 18
Dividends and Dividend Growth around the World
1995 to 7/22/16
Source: Société Général S.A.; MSCI; BlackRock, Inc.; PNC
the United States, including emerging markets. In
addition, focusing on the combination of dividends
and dividend growth has historically been a winning
combination.
The reinvestment of dividends greatly enhances an
investor’s return and is a large component of the
dividend-focused strategy. Over time, the
compounding of dividends drives the total return. As
an investor’s investment holding period increases,
dividends typically comprise a larger portion of
return. As a reference point, from 1926 to 1959
dividends contributed more than 50% to total
returns for the S&P 500.
We believe the global dividend-focused allocation is
positioned to take advantage of global opportunities
and diversify across countries and sectors
(Chart 18). A globally generated income stream is
inherently more diverse than one from a single
country or region. This can help to avoid
concentration in terms of end markets, which may
drive sales and revenues. A global dividend
allocation may also allow an investor to invest in
sectors perhaps underrepresented by a particular
country.
provide an effective risk management tool for
portfolios. Our argument is that if alternative and
traditional investments are put on even footing with
regard to expected returns, then solely by virtue of
the two investments being different, the risk of the
overall portfolio is reduced without altering the
portfolio’s expected return. The risks may not be
less, but they are in some ways different, so we
believe this diversification may help manage overall
portfolio risk.
Every action (or inaction) involves risk, and we
believe investors should think about risk when they
consider alternative investments. However, our
research suggests that adding carefully selected
alternative investments to a diversified portfolio of
traditional investments may reduce the overall risk
(as defined by the volatility of returns) of that
portfolio without affecting expected returns. We
believe that, for qualified investors, alternative
investments should be considered as a tool for
managing portfolio risk, not for adding risk to
increase returns.
As an example of the possible value alternatives, in
particular hedge funds, can bring to a portfolio in
the current environment, look at the correlation
between the S&P 500 and the HFRX™ Macro Index
(Chart 19). Low correlation with stocks at times
when they are falling would be a distinct positive in
terms of reducing the downside. While at times
Chart 19
HFRX Macro Index and S&P 500 Correlations
Daily, 1/2/07 through 7/21/16
Allocation to Alternative Investments
We also believe alternative asset classes should be
considered for qualified investors because they may
Source: HFR Asset Management, LLC; Bloomberg L.P.; PNC
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Chart 20
HFRX Macro Index and S&P 500
Daily, 5/1/11 through 7/25/16
Chart 21
10% PNC STAR/90% S&P 500 Combination Total
Return
Monthly, 10/90 through 6/16
Source: HFR Asset Management, LLC; Bloomberg L.P.; PNC
Source: Bloomberg L.P., PNC
these two very different assets move nearly in
unison, the hedge funds do have exposure to other
factors than solely stocks and also might adapt to
the environment by changing exposures. In fact, the
HFRX Macro Index had significantly outperformed
the S&P 500 during previous downturns since late
April 2013 (Chart 20).
Given the current market environment, including a
number of factors (such as low returns on cash and
occasional spikes in macroeconomic concerns) that
could continue to result in increased volatility, we
believe alternative investments are worthy of
consideration for qualified investors. 4
Allocation to PNC STAR
The PNC STAR strategy uses exchange-traded
funds to systemically apply momentum exposure to
industries, size, and international factors. We
believe adding a small allocation of the PNC STAR
strategy may help a portfolio increase return
without increasing risk and, with small allocations,
marginally reduce risk (Chart 21).
In backtests, PNC STAR has produced excess
returns with a volatility level similar to the
benchmark S&P 500, resulting in a higher Sharpe
4
ratio. In addition, the analysis has shown that the
strategy has handled periods of crisis better than
the S&P 500 and was generally quicker to recover.
While past performance is not indicative of future
results, historically this model has produced
outperformance of just under 0.40% per month. In
addition, the drawdown analysis has shown that the
strategy has handled periods of crisis better than
the S&P 500 did and was generally quicker to
recover.
Momentum performance has dipped since the
financial crisis, but appears to be regaining some
momentum (to turn a phrase). If momentum
continues to work in the future as it has historically,
the strategy may lead to excess returns that should
help improve the tactical allocation portfolios.
Allocation to REITs
The strategic rationale for including REITs in the
portfolio rests on expanding the opportunity set for
income investors. REIT’s are required to distribute
at least 90% of income to shareholders in the form
of dividends. Given the nature of the dividend model,
we believe REITs fare better with investors not
aiming for quick capital gains but for dividend
income and modest price appreciation. Over a long
For more details, see our October 2009 Investment Outlook, Alternative Medicine, and our August 2009 white paper The
Science of Alternative Investments.
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Chart 22
FTSE NAREIT All Equity Index versus S&P 500
Daily, 6/20/00 through 7/22/16
management to professionals. REITs historically
have had lower correlations versus other stocks,
providing diversification benefits. Given the complex
nature of the interrelated economics and industry
fundamentals, leaving the investment in real estate
to the professionals and buying for the long term
into strong companies is a standing argument for
long-term investing versus market timing. We
believe the asset class should bring some
diversification benefits in spite of the correlation
tightening with the S&P 500.
REITs are not so much interest-rate sensitive as
dependent on economic growth. Dividend growth
rates have outpaced inflation over the past decade
(Chart 23).
Source: Bloomberg L.P., PNC
investment holding period, REITs have tended to
outperform the S&P 500 on a total-return basis
(Chart 22). The total-return perspective is unique
for REITs in that it has historically kept pace with or
exceeded the broader market, with the additional
benefits of:
 modest correlation with stocks;
 less market price volatility; and
 higher current returns.
REITs provide steady current-income-producing
dividend yields competitive with investment-grade
bonds, with the potential for increases in dividend
and share price.
Chart 23
REIT Dividend Growth versus CPI
Source: NAREIT®, Department of Labor, PNC
REITs allow shareholders to invest in commercial
real estate while remaining liquid and leaving the
E. William Stone, CFA®, CMT
Managing Director, Investment and Portfolio
Strategy
Chief Investment Strategist
Rebekah M. McCahan
Investment Strategist
Katie S. Sheehan, CFA
Fixed Income Strategist
Chen He
Senior Portfolio Strategist
Paul J. White, PhD, CAIA®
Director of Portfolio Strategy
Marsella Martino
Senior Investment Strategist
Michael Zoller
Investment Strategist
17
August 2016