March 2014

Troubles Emerge Executive Summary The global market environment at the start of 2014 has given investors pause. After a strong 2013, risks appear to be affecting market sentiment. The proximate cause of the volatility in global markets and declines in U.S. stocks year to date has been concerns of contagion from some troubled emerging market (EM) countries. Our view is that this situation is somewhat similar to periods in 2011 and 2012 when concerns regarding contagion from the Eurozone weighed on the global markets. In this month’s Investment Outlook we explore:  submerging markets;  the fragile five;  eurozone fragility;  developed markets to watch;  decoupling; and  current market environment.

E. William Stone, CFA®, CMT Managing Director, Investment & Portfolio Strategy Chief Investment Strategist Marsella Martino Senior Investment Strategist Rebekah M. McCahan Investment Strategist Nicholas M. Srmag, CFA® Fixed Income Strategist Ryan Whidden Senior Portfolio Strategist Paul J. White, PhD, CAIA® Director of Portfolio Strategy Michael Zoller Investment Strategist

There is debate on whether the EMs will repeat 1997–98 or whether it is different this time around—mainly because the world is different. As we have seen in the recent U.S. crisis, despite a more developed and different world, history tends to repeat itself. Not to be doomsayers, but it is important to be pragmatic and look at the hard core data and not wish things away. It is impossible to accurately predict a draconian scenario for the EMs, but the evidence appears to point to caution. While EM tensions, at least from a market perspective, have seemed to quiet a bit in February, the data remain troublesome in spots and we anticipate a volatile 2014 as the market digests news and data worldwide. In other markets, the Eurozone situation, an overhang for several years due both to the sovereign debt threats and ultimately the double-dip recession the region faced, seems to have eased some. We believe the support from the European Central Bank (ECB) and cooperation among country leaders has brought needed confidence to the markets. However, data point to a recovery that is somewhat fragile. We continue to closely watch the economic situation, particularly among periphery nations. A recovery in Europe would be a positive for global economic growth.

Investment Outlook Data out of China are of concern to many, with a slowdown in economic growth considered likely, the extent of which has yet to be determined. And Japan is seeming to falter some, with the end game of Abenomics unclear. The PNC Economics team projects the U.S. recovery will continue in 2014 at a slightly accelerated pace over that of 2013, albeit with a few gaps. The weatherrelated impact remains unclear at this point, with most economists forecasting a resultant slight hit to GDP in first-quarter 2014. PNC’s six traditional asset allocation profiles are shown on the last page of this outlook.

Emerging Markets Are the New Eurozone The proximate cause of the volatility in global markets and declines in U.S. stocks year to date has been concerns about possible contagion from some troubled EM countries. Our view is that this situation is somewhat similar to periods in 2011 and 2012 when concerns regarding contagion from the Eurozone weighed on the global markets. In this month’s Investment Outlook we will explore the roots of the EM woes and discuss their financial market implications.

Submerging Markets? The MSCI EM index declined more than 6.5% in January following a return of -2.3% for all of 2013. Market pressures have eased a bit in February, but the index is still down 4.2% through February 21, 2014. While the S&P 500® gained more than 32% in 2013, January 2014 brought declines of almost 3.5%, which has added to contagion worries. Through February 21, 2014, the S&P 500 is just slightly in the black, returning 0.4% on a total return basis to date, supported by a bit of ease in global worries plus a solid fourth-quarter 2013 earnings season. Interestingly, little of the story surrounding the emerging markets is really new. Our October 2013 Investment Outlook, Emerging from the Shadows, highlighted the slowing of EM country GDP growth relative to the improvement in developed economies. Also noted was that EM countries could no longer be viewed as monotonous, but rather there is divergence between countries. Table 1 EM Market Declines Median Occurrence (2004-13) Days 28 MSCI EM -12% S&P 500 -6% Trade-Weighted Dollar 2% 10-Year Treasury Yield -21 basis points

As most institutional investors are aware, EM equities are subject to pullbacks. In fact, even excluding the large decline during the financial crisis, the MSCI EM has declined 5% or more in local currency terms 19 times in the past decade, according to Goldman Sachs. Interestingly, the S&P 500 has tended to fall roughly half the amount of the EM index in the median case, which is quite similar to the current episode so far (Table 1). Despite the drop, equity valuations in EM are still not cheap. And market indicators could signal a continued downtrend.

Problems in the EMs are complex, and there is concern about credit. Private sector leverage has risen quickly, and there is some debate on whether the EMs will repeat the conditions of 1997-98 or whether it is different this time around—mainly because the world is different. As has occurred in the recent U.S. crisis, despite a more developed and different world, history tends to repeat itself. Not to be doomsayers, but it is important to be pragmatic and look at the hard core data and not wish things away.

Source: Goldman Sachs, FactSet Research Systems, Inc.

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March 2014

Troubles Emerge It is impossible to accurately predict a draconian scenario for the EMs, but the evidence appears to point to caution. While the focus has been on the EMs in recent months, it is worth noting that frontier markets (a subset of EMs) have and are facing greater challenges. Currency pressures have forced countries such as Ukraine, Kazakhstan, Argentina, Ghana, and Serbia to take extraordinary measures, including capital controls and in some cases devaluation. While frontier markets certainly feel contagion pressures from the larger group of EMs, many are facing their own problems, notably Ukraine and Argentina. The biggest risk regarding Ukraine is possible contagion to other EMs, most notably Russia. Russia is facing declining manufacturing PMI, industrial production, and GDP growth. The ruble is beginning to decline, which spells trouble for inflation.

The Fragile Five We find it helpful to focus on the attributes (or more appropriately weaknesses) of the countries most in the cross-hairs of the global markets, the so-called “Fragile Five”—Brazil, India, Indonesia, South Africa, and Turkey. In general, these countries share twin deficits—current account and budget, which means they have significant external financing requirements and are subject to more risk when capital seeks safer areas (Table 2). In contrast capital tends to flee to safer assets, such as Treasuries, in times of fear and volatility, which is why 10-year Treasury yields tend to fall during disruptions in emerging markets, as shown in Table 1 (page 2). Turkey and South Africa also have large amounts of debt denominated in foreign currency—both greater than 40% of GDP—which makes debt repayment more difficult as their domestic currencies weaken. Table 2 Characteristics of the Fragile Five Brazil 2014 2013 Current Account (% of GDP) -3.6% -3.4% Government Borrowing (% of GDP) -3.0% -3.9% Inflation (CPI, year-over-year) 6.2% 6.0% Unemployment 5.4% 5.8% Real GDP Growth (year over year) 2.3% 2.1% Percentage of Global GDP (2012) 3.3% N/A Equity Returns (in dollars)** -26.8% -9.6%

India Indonesia South Africa Turkey 2013 2014 2013 2014 2013 2014 2013 2014 -4.4% -2.6% -3.5% -2.7% -6.8% -5.6% -7.4% -6.5% -5.7%* -5.0% -2.1% -1.9% -4.4% -4.2% -1.4% -2.2% 10.9% 9.6% 7.0% 6.5% 5.8% 5.7% 7.5% 7.2% N/A N/A 6.4% 5.9% 24.9% 24.9% 9.5% 9.5% 4.7% 4.7% 5.7% 5.4% 1.9% 2.8% 3.9% 3.0% 2.5% N/A 1.3% N/A 0.6% N/A 1.2% N/A -7.4% -1.4% -20.3% 3.5% -2.0% -7.7% -26.6% -13.3%

Note: Numbers in bold are consensus estimates * as of 9/30/2013 ** 2014 Equity Returns as of 1/31/14

Source: Bloomberg L.P.; FactSet Research Systems, Inc.; Ned Davis Research; PNC

In addition, consensus expects only one of these five economies to grow more quickly in 2014 than they did in 2013. Inflation rates for all five were well above the levels of the developed economies in 2013 and are expected to remain well above the below-2% inflation rate expected for developed economies in 2014. A key point to note is that emerging market central banks continue to remain behind the curve in their response to rampant inflation and slower economic growth. They need to enact further tightening even though GDP growth is slow. Fragile Five concerns include the following.  Brazil looks to have entered a recession at the end of 2013.

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Indonesia’s growth rate remains strong, but appears to be slowing some. Growth prospects for Indonesia are weakening as China’s growth slows, since 10% of Indonesia’s exports go to China, and we believe there was a pull forward in fourth-quarter 2013 due to new regulations on exports. India’s rampant growth appears to be a thing of the past. Real GDP growth was 9.7% in 2011, and nearly half that in fourth-quarter 2013 at 4.8%. Coupled with that, inflation is running rampant, at 8.8% in January. Wage inflation is having a marked impact. India’s industrial production has been flat for three years. In South Africa, the central bank, in efforts to curb inflation, has implemented tightening policies. This is causing stagflation, which is cutting corporate profits and killing GDP growth. It has forced the South African central bank to tighten despite 1.8% GDP growth in fourth-quarter 2013. The political crisis in Turkey is not likely to abate in the near term, continuing to affect the financial market and economy in the country. Turkey is scheduled to hold two or three major elections in the next year, which could bring additional interparty fighting and street protests.

So far the picture we have painted has been pretty dismal for at least the Fragile Five, but there are some mitigating factors for the EMs and the global economy as a whole. When EM crises are discussed, most point back to the major rolling crises of the 1990s. This was the time when we first heard the phrase, submerging markets, to give a sense of the pervasive nature of the situation. One of the primary causes of these crises was that many EM countries had pegged their currencies to the dollar. When the Federal Reserve (Fed) started to raise short-term interest rates in 1994, it Chart 1 became more difficult (and in the end impossible) for Fragile Five Currency Spot Rates versus the Dollar many of these countries to defend their fixed exchange rates versus the dollar. Using the Fragile Five as an example, the currency adjustment versus the dollar has been ongoing, with all five of their currencies falling sharply against the dollar since 2011 (Chart 1). This is in contrast to the financial shock to the system when countries abandoned their exchange rate target and their currency plunged. Looking at EMs as a whole, total foreign currency debt is lower than it was in the 1990s, which makes the EMs less vulnerable to the additional debt servicing costs of a currency shock. We noted the current account deficit as a risk within the Fragile Five, but the EMs as a whole (thanks to China) have a current account surplus, so they are not as vulnerable to foreign capital outflows as they were in the 1990s.

Source: Bloomberg L.P., PNC

Revisiting China A big concern for global markets in 2014 is what is happening in China in terms of an economic slowdown. Importantly, economic data show China’s February HSBC flash manufacturing PMI at 48.3, below the expected 49.3. A reading below 50 indicates contraction. The usual seasonal qualifiers apply, but the data were still on the soft side and come after soft January PMI readings. Industrial production and retail sales were not reported for January and will instead be combined with February

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March 2014

Troubles Emerge to minimize Lunar New Year distortions, and PMIs suggest weak numbers to come. The stronger-thanexpected January trade data should be seen as an outlier, with other measures in China likely to point to softer growth in first-quarter 2014.

Chart 2 Imports, China and United States

China is sensitive to interest rates, given the high rate of investment within the country. Credit has been a big fuel to China’s growth, and higher interest rates are a headwind to growth. Rates have been rising for at least three quarters. In addition, China policy makers appear to be trying to curtail excessive credit by tightening, which could further slow growth. Worrisome to global markets is the impact that a China slowdown would have on other markets. One way to think about this is to look at imports. China’s imports total 11% Source: International Monetary Fund, PNC of global exports, almost on par with the United States (Chart 2). If imports slow for China, exporters to China will also slow. A few countries that rely heavily on exporting to China include Canada, Australia, and some of the EMs. China is certainly a country we are paying close attention to. Some argue the country is resilient enough to withstand a slowdown. We believe it is too soon to tell. It is likely the country will experience further weakness and data scrutiny in the coming months.

Eurozone Fragility As we have noted in past publications, the recovery in the Eurozone is fragile. While Germany is relatively strong, France is not doing as well. Eurozone flash PMIs for February came in weaker than expected, with the composite at 52.7 against forecasts for 53.1. The manufacturing PMI came in at 53.0 (expected at 54.0) while the services PMI was 51.7 (expected at 51.9). The services PMIs for France at 46.9 and Germany at 54.7 were notably lower than expected. The data will support speculation that further action by the ECB is forthcoming. Flash PMIs, while they have risen year over year, have recently been a bit lower across the globe. The one exception is the United States (Chart 3). While France’s PMI moved slightly higher, the country continues to lag behind its counterparts. France is the only major European economy with a PMI still below 50, in contraction territory.

Chart 3 Selected PMI

Source: Markit Economics, PNC

Industrial production for the Eurozone declined 0.7% month over month in December. Fourth-quarter GDP was a stronger 1.1% but remains well below the 2008 growth rate. German GDP has surpassed its 2008 peak and France is at its prior peak. Italy and Spain remain well below 2008 peaks.

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Developed Markets to Watch

Chart 4 Japan GDP

Looking at central bank actions around the globe, something we did in detail in our May 2013 Investment Outlook, Undeclared Currency Wars, and our November 2012 Investment Outlook, Europe: Tale of a Greek Tragedy?, we see the expansion of balance sheets in major economies, which should be watched. We focused in particular on Japan, outlining Prime Minister Shinzo Abe’s plans to lead a more aggressive Bank of Japan (BOJ). The BOJ has expanded its balance sheet and the biggest beneficiary has been the yen, which has strengthened appreciably. But the volatility that has been introduced in recent weeks indicates that there is no safety latch in place, which could prove problematic. As the yen has weakened, so have exports. Add to that the softening of other key data, including machine orders, which have dropped precipitously, indicating Japan’s recovery is moderating.

Source: Economic and Social Research Institute Japan, PNC

Japanese real GDP growth in the fourth quarter was 1.0%, below expectations, owing to lower trade data. While real GDP on an absolute basis has grown, nominal GDP is still below its 2007 and 1996 peaks (Chart 4).

Japan’s recovery is becoming very fragile as it appears clearer that growth was pulled forward ahead of the consumption tax about to be levied in April: Core machinery orders plunged 9.1% in December after being up 23% in 2013 through November; condo sales have plunged 29.4% since October 2013 after a near-30% surge from July through September; and capital expenditures, which were up in fourth-quarter 2013, appear likely to decline in the first quarter of 2014. Australia is feeling the effects of slower growth in China as capital expenditures (23% of GDP) through third-quarter 2013 declined 5.7%, which helps explain unemployment increasing to 6.0% (an 11-year high). Australia could be at risk of its first recession in 23 years.

Decoupling The Organisation for Economic Co-operation and Development’s leading indicators rose for the United States and Eurozone in December, but declined for several EM countries. Low inflation in the developed markets is in contrast to marked inflation and potentially dangerous excess credit in several EMs. As has occurred in both the U.S. and Eurozone financial crises, these may take several years to work through. In our view, the primary issue when thinking about EMs now is whether the developed world can decouple from the troubled countries both in economic and financial market terms. We believe the developed economies can decouple, but the question remains whether they will. There are a few reasons to believe that the developed world, and in particular the United States, can remain decoupled from the current EM woes. Our analogy to the Eurozone is a great place to start. Despite the Eurozone economy being close to the same size as that of the United States (23.8% of global GDP in 2012), the Eurozone’s recession starting in late 2011 did not cause a global recession. With the Fragile Five comprising less than 9% of global GDP (Table 2, page 3), it seems likely that it is not big enough to pull the rest of the world into recession.

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March 2014

Troubles Emerge As we noted, the emerging and developed economies actually began their decoupling last year. Using the 1990s as an example again, the United States exited recession in the early 1990s and did not re-enter recession until the early 2000s, with the bursting of the technology bubble. Economies such as Germany, Japan, Mexico, and Brazil, among others, suffered recessions in the 1990s while the U.S. economy continued to expand. (For more information on economic decoupling, please see our September 2013 Topical Commentary, Decoupling.) In terms of financial markets, 2013 certainly shows one example of decoupling, with the EM index down for the year, while the S&P 500 gained more than 32%. Going back to the 1990s example again, the EM index declined more than 37% in the two years ended 1998 while the S&P 500 gained almost 66% (Chart 5).

Table 3 Comparative Market Capitalizations (billions of dollars) Country Brazil South Africa India Indonesia Turkey

Mkt Cap* $371 262 233 87 50

Mkt Company Cap Google Inc. $395 Berkshire Hathaway Inc. 277 Wells Fargo & Company 238 3M Company 85 Starbucks Corporation 54

*Free-float market capitalization Source: MSCI, BofA Merrill Lynch, Bloomberg L.P., PNC

Chart 5 S&P 500 & MSCI EM Indexes 9/30/96-12/31/98

Another factor arguing for a possible decoupling between at least U.S. and EM stock markets is the relative size of some U.S. companies versus the entire market capitalization of the entire stock markets of the Fragile Five countries (Table 3). One factor arguing not necessarily for decoupling but rather for some downside protection to EMs is what looks like relatively attractive valuation. In any case one can argue that some amount of bad news is priced into the EMs—only time will tell if enough is priced in yet (Table 4). Source: Bloomberg L.P., PNC

Table 4 Global Valuations (January 27, 2014) MSCI World Price to Book (x) 2.16 Price to Sales (x) 1.28 Price to Earnings (x) 14.82 Dividend Yield 2.39%

MSCI EM 1.53 0.94 10.13 2.60%

S&P 500 2.59 1.57 16.41 1.94%

Brazil 1.41 1.09 10.01 3.84%

South Africa 2.66 1.76 14.25 2.87%

India 2.75 1.66 14.61 1.36%

Indonesia 3.19 2.60 12.73 2.65%

Turkey 1.45 0.9 8.75 2.65%

Source: MSCI, PNC

Current Market Environment Consider that 2013 was abnormal in terms of stock market volatility. The S&P 500 declined only about 6% at any point during the year despite the historical average intrayear decline being close to 15% (Chart 6, page 8). It is also worth noting that the U.S. stock market had gone longer than normal without a 5% correction. Until the losses on February 3, the S&P 500 had gone almost three times longer than normal without a 5% correction (Table 5, page 8). It is normal for the market to go longer than normal without a pullback during a bull

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Investment Outlook Chart 6 Stock Market Returns (Through December 31, 2013)

Table 5 S&P 500 Market Days without a Correction (January 3, 1928 to January 31, 2014) Decline Current Case Average Multiple of Average

5% 143 49 2.9

10% 575 161 3.6

20% 1224 635 1.9

Source: Ned Davis Research, PNC

market (and the declines stemming from the financial crisis earned extra leeway). However, it should be expected that eventually there would be a meaningful pullback because it is a normal and healthy part of market behavior. Before 2014 began, we forecast more downside volatility for the year, and so far that expectation seems likely to be Source: J.P. Morgan Asset Management, Standard and Poor’s, PNC met. Our projection was based on the two points noted above and our view that U.S. stocks are no longer cheap. We do not subscribe to the notion that U.S. stocks are in a bubble or are abnormally expensive, but they no longer qualify as cheap, and that reduces the margin of safety, which we also believe should result in added volatility. Minutes from the last Federal Open Market Committee meeting indicates the Fed may deviate from previous guidance as the unemployment rate nears the targeted 6.5%. Members discussed adding “qualitative” language to the guidance. We expect more clarification at the March meeting. One thing remains likely—the Fed continuing to taper the monthly bond purchases (QE3)—and we anticipate another $10 billion ratchet down to be announced at the next meeting. We believe the markets fully anticipate such action at this point. Chart 7 Fed Tightening

Source: Federal Reserve, Bloomberg L.P., PNC

Fed tightening is not anticipated for the near term. It is an eventuality the markets and economy will have to face at some point. But we believe it is not necessarily a bad thing for the markets. It would indicate that the economy is stronger, which tends to bode well for stocks, if not in the short term then in the long term. History shows markets tend to trade sideways initially after tightening begins, and in a longer term trade higher (Chart 7). Given the extended low-interest-rate environment that has prevailed, it is not a stretch to ascertain that markets may have a bit more difficulty than in the past absorbing a higher rate environment. One need look back only to the summer of 2013 when the mere speculation that interest rates would eventually move higher caused some tension in the market. After bouncing around some, the market settled and once again found its footing of course, but only under the salve of explicit language from the Fed that rates would not rise in the near term or quickly.

The impact of severe winter weather in North America is unclear at this point. Many economists view data being released as having qualitative attachment to the weather. We believe it is too soon to tell on the actual hard data (Chart 8, page 9). Though the current winter has been among the worst since records have been kept in terms of

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March 2014

Troubles Emerge snowfall, the overall affect on the broader economy is expected to be modest and temporary. Certainly, there are disruptions in the immediate term. U.S. payroll growth slowed sharply in December and January, along with residential construction and retail spending. But, given that there was no structural or infrastructure damage (unlike Superstorm Sandy, for example), there is little to suggest these troubles will be permanent.

Chart 8 Winter Impact

Anecdotally it seems apparent that fewer people are out and about shopping, looking for homes, or job seeking, but the evidence remains to be seen. Several economists, including PNC’s own have shaved firstquarter GDP growth estimates to account for the severe weather impact. As PNC Senior Economist Gus Faucher said in a recent interview on Bloomberg Radio, “Any disruptions in productivity and output Source: Bureau of Labor Statistics, PNC will quickly be restored as power is turned back on, roads are cleared, and construction projects restart.” Indeed, we believe the recent retrenchments in retail sales and housing starts will be short-lived and offset by bounce-back gains in the coming months.

PNC Investment Strategy Recommendations Based on our discussion above, a few recommendations to consider at this time follow.  We believe institutional investors should revisit their asset allocation and confirm that it matches their objectives, risk budget, expected investment holding period, projected liabilities, cash flows, and other specific needs. Since the S&P 500 is now more than 2.5 times its 2009 lows and up more than 32% for the past year, investors should at least consider rebalancing back to their target asset allocations because stocks may have grown to an outsized portion of a portfolio. We expect that the woes in EMs may continue to provide occasional worries for the global markets similar to what was experienced during periods of the Eurozone crisis in 2011 and 2012. Our expectation is that emerging markets will also fail to drag the global economy into crisis. Investors should position themselves to be able to withstand any volatility from the concerns though, since investors forced out of stocks during the Eurozone crisis paid a heavy price in terms of missed market returns as worries abated.  Consider our recommendation to global dividend focus stocks as a method to tactically participate in looking for possible opportunities in the dislocation caused by the EM turmoil. The managers used to implement this allocation focus on global companies, including EM companies, which can grow dividends over time. Because this allocation focuses on dividend growth, it tends to focus on high-quality companies and thus has a bit less volatility during market stresses. Please see our September 2013 Investment Outlook, Dividends without Borders, for more details.  As illustrated in Table 1 (page 2), disturbances in emerging markets tend to cause 10-year Treasury yields to decline. This occurrence is no different; the 10-year Treasury yield has fallen to around 2.65% from above 3% at the start of 2014. Given our economic forecast, we believe this is a good opportunity to reduce interest-rate risk in bond portfolios, through shortening maturities,

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increasing credit risk, or both. Our fixed income recommendations include allocations to floating-rate bank loans (leveraged loans), absolute-returnoriented fixed-income, and global bonds. Even though this Outlook has focused on equities and currencies, EM bonds have also declined recently, offering a possible opportunity to add global bonds. Please see our July 2013 Investment Outlook, Breaking the Bonds, for more details. Investors concerned about the risks of traditional assets—stocks, bonds, and cash—should consider the addition of alternative assets. Our definition of risk includes both volatility and the retention of purchasing power, which is why cash is included in the list. PNC has designed a risk-targeted alternative strategy using mutual fund style alternatives (with daily liquidity and pricing). Both in testing and since inception in April 2013, it has provided consistent risk levels to help mitigate portfolio volatility with attractive risk and return characteristics during times of market stress. Please see our June 2013 Investment Outlook, Evolution of Alternatives, for more details.

Finally, while we will be monitoring a multitude of factors including the proprietary PNC Financial Market Stress Watch Indicators1, one focus will be on global PMI data. Our studies have shown that global PMI data remain one of the best real-time economic forecasting tools available, so this data will be invaluable in continuing to monitor the degree of decoupling within the global economy. Please see our January 2014 Topical Commentary, PMI, Early Indicator of Economic Activity?, for more details. Our analysis so far points to decoupling thus far and few signs of economic contagion (Chart 5, page 7). Though more of a backward looking measure, U.S. fourth-quarter real GDP was reported last week at a revised 2.4% rate, which is above the annual rate for both calendar 2012 and 2013. We believe that emerging market countries (and for that matter developed economies or stocks in general) should be judged on a case-by-case basis because the globe has distanced itself from the financial crisis and individual characteristics have emerged.

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 REITs;  a tactical allocation to leveraged loans within the bond allocation;  a tactical allocation to absolute-return-oriented fixed-income strategies within the bond allocation;  an allocation to emerging markets 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 dividend-focused stocks; and  an allocation to alternative investments for qualified investors.

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For details, see the September 2011 white paper, Financial Market Stress Watch

Indicators.

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Troubles Emerge Baseline Allocation of Stocks Relative to Bonds Since one cannot accurately determine the short-term movement of stocks, we believe that institutional investors should focus on what is knowable and controllable. The one thing institutional investors can truly control is asset allocation reflective of their goals, cash flows, and risk budget. PNC’s six baseline asset allocation models are shown on page 19.

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.

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 high-quality global bonds, contains less than 40% U.S. issues (Chart 9). (For further details 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 out on opportunities for diversification and perhaps enhanced returns. A primary motivation for allocating to global bonds is the introduction of currency exposure to a portfolio. Although currency adds another level of volatility to a portfolio’s fixed-income allocation, investors gain what traditional domestic fixed-income asset classes cannot offer—a natural hedge against devaluation of the dollar (Chart 10, page 12).

Chart 9 Barclays Capital Global Aggregate by Country (February 21, 2014)

Source: Barclays Capital, PNC

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 benefits of tightening global credit spreads relative to the United States. More importantly, 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 lower the correlation with U.S. bond returns (Chart 11, page 12). In general, we suggest that active management makes the most sense in this allocation. Generally, global bond index construction 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 safely 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

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Investment Outlook Chart 10 12 10-Year Treasury Barclays Capital Global YieldsAggregate Excluding United States, Unhedged, Correlation with Dollar

Chart 11 Barclays Capital Global Aggregate Excluding United States, Correlation with U.S. Aggregate

Source: Bloomberg L.P., PNC Source: Bloomberg L.P., Barclays Capital, PNC

Source: Bloomberg L.P., Barclays Capital, PNC

developed and emerging economies, provides a possible opportunity for active managers in terms of credit and foreign exchange exposure.

Chart 12 10-Year Treasury Yields

In our opinion, it is likely that many managers’ allocations will differ greatly from the index. This also affects the 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 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 12). We also see this as an opportunity to benefit from higher bond yields elsewhere in the world.

Source: Bloomberg L.P., PNC

Allocation to Leveraged Loans within Bonds2 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 adjustablerate instruments tied to short-term interest rates (typically the 3-month London Interbank Offered Rate, or LIBOR), we believe holders should benefit from rising 2

The March 2010 Investment Outlook, Shakespeare for Primates, provides details about leveraged loans.

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March 2014

Troubles Emerge rates (Chart 13). 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.

Chart 13 3-Month LIBOR

In summary, 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 FixedIncome within Bonds3

Source: British Bankers’ Association, Bloomberg L.P., PNC

We believe an allocation to absolute-return-oriented fixedincome 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 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 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 Federal Reserve (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. Absolutereturn 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 6 (page 14) 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.

3

The July 2013 Investment Outlook, Breaking the Bonds, provides details about absolute-return-oriented fixed income.

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Investment Outlook Table 6 Periods of Rising Rates Begin Date End Date 10-Year Yield Begin End Basis-Point Change

12/30/08 6/10/09

10/8/10 2/8/11

9/22/11 10/27/11

1/31/12 3/19/12

7/25/12 8/16/12

12/6/12 3/11/13

2.05% 3.95% 190

2.39% 3.74% 135

1.72% 2.40% 68

1.80% 2.38% 58

1.40% 1.84% 44

1.59% 2.06% 47

7.97% 7.75% -22 -212

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

-0.47% 13.08% 10.77% 5.23%

-3.09% 4.65% 0.55% -0.62%

-1.68% 2.26% -0.20% -0.96%

-1.18% 3.29% 1.22% 0.09%

-1.21% 0.48% 0.31% -0.37%

-1.01% 2.42% 1.73% 0.60%

BAA Yield Begin End Basis-Point Change Spread Basis-Point Change Total Return during Period Barclays U.S. Aggregate Driehaus Active Income (LCMAX) BlackRock SIO (BSIIX) PIMCO Unconstrained (PFIUX) Source: Bloomberg L.P., PNC

Overweight of U.S. Large-Cap Value Stocks Relative to Growth4 We believe the majority of the seven components of our decision framework continue to support an overweight to U.S. large-cap value style relative to growth. These components are:  earnings growth;  interest-rate level;  inflation;  volatility;  foreign growth;  valuation; and  yield-curve slope. In particular, we focus on the yield-curve slope because the results of our analysis show that a steep curve is supportive of value style outperformance relative to growth. To be clear, it is not a concrete rule that value outperformance over growth in a steep yield curve always exists, but it is an indication of a higher probability. Though recent Fed activities have flattened them to a degree, both the 2- to 10-year (Chart 14, page 15) and 10- to 30-year (Chart 15, page 15) Treasury slopes remain historically steep and supportive of the value overweight. We continue to monitor the possibility that the typical impact of the steep yield curve might be derailed by:  the credit cycle;  capital constraints; or  lack of loan demand.

4

The March 2011 Investment Outlook, Quest for Value, provides details about the value style recommendation.

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March 2014

Troubles Emerge Chart 14 2-Year to 10-Year Treasury Yield Spread

Chart 15 10-Year to 30-Year Treasury Yield Spread

Source: Bloomberg L.P., PNC

Source: Bloomberg L.P., PNC

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 16).  Bank loan quality has continued to improve, implying a tailwind to bank earnings and a possible turn in the deleveraging cycle (Chart 17).  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 18).

Chart 16 U.S. Banks’ Willingness to Make Consumer Loans (percentage more willing minus percentage less willing)

Our value allocation has underperformed during the market downturn, given its more cyclical exposure. We believe it will perform better as global growth concerns fade. Source: Federal Reserve, Bloomberg L.P., PNC

Chart 17 U.S. Delinquency Rates for Loans

Chart 18 U.S. Bank Core Capital Ratio

Source: Federal Reserve, Bloomberg L.P., PNC

Source: Federal Deposit Insurance Corporation, Bloomberg L.P., PNC

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Investment Outlook Allocation to Global Dividend-Focused Stocks A global dividend-focused allocation expands the opportunity set to invest in highquality dividend-paying stocks domiciled in North America and beyond, where in some cases companies have exhibited faster dividend growth, essentially opening up the opportunity to invest in firms outside the United States, including the emerging markets. In addition, focusing on the combination of dividends and dividend growth has historically been a winning combination.

Chart 19 Dividends and Dividend Growth around the World 1980 to March 2013

Source: Société Général S.A.; MSCI; BlackRock, Inc.; PNC

The reinvestment of dividends greatly enhances an investor’s return and is a large component of the dividendfocused 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 19). 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.

Allocation to Alternative Investments We also believe alternative asset classes should be considered for qualified investors because they may 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. Chart 20 HFRX Macro Index and S&P 500 Correlations

Source: HFR Asset Management, LLC; Bloomberg L.P.; PNC

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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 alternative investments should be considered as a tool for managing portfolio risk, not for adding risk to increase returns, for qualified investors. 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 20). Low correlation with stocks at times when they are falling would be a distinct positive in terms of reducing the downside. While at times these two very different assets move nearly in unison, the hedge funds do have exposure

March 2014

Troubles Emerge 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 the late-April 2013 market peak (Chart 21).

Chart 21 HFRX Macro Index and S&P 500

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.5

Allocation to PNC STAR The PNC STAR strategy uses broad exchange-traded funds to apply momentum exposure to industries, size, and international factors in a systematic way. We believe adding a small allocation of the PNC STAR strategy to a portfolio may help increase return without increasing risk and, with small allocations, may help marginally reduce risk (Chart 22). In backtests, PNC STAR has produced excess returns with a volatility level similar to the benchmark S&P 500, resulting in a higher Sharpe 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. If momentum continues to work in the future as it has historically and since inception in October 2013, the strategy may continue to lead to excess returns that should help improve the tactical allocation portfolios.

Source: HFR Asset Management, LLC; Bloomberg L.P.; PNC

Chart 22 10% PNC STAR/90% S&P 500 Combination Total Return

Source: Bloomberg L.P., PNC

Allocation to REITs The strategic rationale for including REITs in the portfolio rests on expanding the opportunity set for income investors. The REIT mandate requires at least 90% of income to be distributed 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 investment holding period, REITs have tended to outperform the S&P 500 on a totalreturn basis (Chart 23, page 18). 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;

5

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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Investment Outlook Chart 23 FTSE NAREIT® All-Equity Index versus S&P 500

Chart 24 REIT Dividend Growth versus CPI

Source: National Association of Real Estate Investment Trusts® (NAREIT), Standard & Poor’s, Bloomberg L.P., PNC

Source: NAREIT, Bloomberg L.P., Bureau of Labor Statistics, PNC

 

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. REITs allow shareholders to invest in commercial real estate while remaining liquid and leaving the 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 24).

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March 2014