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  Investment Strategy Update, August 2015

The first half of 2015 can be characterized as directionless and turbulent, as investors continued to assess the global economy, earnings growth outlook, geopolitical risk, and heightened uncertainty regarding monetary policy. Volatility in both equity and fixed income markets has been gradually increasing, albeit with clear signs of technical support for both asset classes. Simply stated, both markets are wedged in trading ranges due to the uncertainty associated with the direction of the global economy and monetary policy.

There is no question that global asset prices have been supported by low interest rates, and as a result, asset prices will likely require robust economic growth to withstand tighter monetary policy on a forward looking basis. Fragmented economic conditions across developed and emerging markets make for diverging monetary policies, which both facilitates uncertainty and potential opportunity through the expression of active management views. In order to adapt to evolving conditions, the Wilshire Funds Management Investment Strategy Committee (ISC) meets monthly to reassess a variety of factors, including but not limited to economic, fundamental, technical, and risk indicators. Although our views are directly reflected in our portfolios, we also have included a broad summary of the changes in our views since January, with a discussion of our rationale in the succeeding sections.

Fixed Income Outlook

We maintain our view of underweight in fixed income relative to equities. Although we recognize that valuations are high across both equities and fixed income, the risk in fixed income is more asymmetrically pronounced to the downside. Equities should be able to weather a rise in interest rates provided that economic growth is robust, however this asset class is subject to volatility given the uncertainty regarding the future trajectory of interest rates in the face of a mixed bag of economic data. Despite our decision to underweight fixed income, we maintain our view of neutral duration relative to the Barclays Capital Aggregate Bond Index, as interest rate sensitivity may still provide a diversification benefit, albeit more limited, in the event that the economic growth and inflation surprise to the downside. Recent indications of both Gross Domestic Product (GDP) (Exhibit A) and inflation have been somewhat mixed, which may simply be due to transitory factors and lower commodity prices, respectively. We have also adopted a more negative outlook with regard to Treasury Inflation Protected Securities (TIPS), as a result.

Exhibit A: Real U.S. GDP (QOQ): 2Q 2009 – 1Q 2015

Source: Department of Commerce (BEA)

As our view of credit markets has become more conservative we have reduced our overweight view to a neutral posture in credit relative to government exposure and have also reduced our overweight in high yield relative to investment grade to reflect a neutral view. While corporate fundamentals remain healthy, we are concerned with the technical deterioration in the performance of the credit sector and the potential spill-over of low energy prices, as energy represents approximately 15% of the high yield market. Exhibit B demonstrates the impact of both the Energy sector and liquidity, as spreads have widened between cash bonds in the high yield market relative to the CDX High Yield Index, which reflects an equal weighted composition of the most liquid bonds, and a considerably lower allocation to the Energy sector.

Exhibit B: Widening Spread Between CDX High Yield Index Relative to Cash High Yield Bonds

Source: Bloomberg

Exhibit C shows the government option adjusted spread (OAS) of the BAML High Yield Master II Index relative to the one standard deviation boundary (shaded in gray) around the historical average OAS. It’s important to note that despite the concerns noted above, we recognize that high yield OAS relative to government bonds remain within a reasonable range of historical averages. As a result, we believe that high yield exposure is warranted at a neutral allocation, as opposed to a move to an underweight position.

Exhibit C: BAML High Yield Master II Index (Govt Option Adjusted Spread)

Source: Bloomberg

Exhibit D: Leveraged Loans (USD) - Covenant Light

Source: Bloomberg

Within the lower quality spectrum of the corporate market, we remain neutral in our allocation to bank loans relative to high yield bonds. We find the floating rate structure of bank loans to be appealing in this environment, but we are also concerned by the growing issuance of covenant light loans (as shown in Exhibit D), which is clearly a sign of complacency. Although the negative implications of this lending activity may not come to fruition in the near-term, the trend is concerning, particularly as these securities continued to get securitized into investment vehicles which exhibit liquidity characteristics that are inconsistent with the loan market.

With respect to Non-U.S. fixed income, valuations are even more stretched than within domestic fixed income. Any incremental yield and capital appreciation that can be earned from select Non-U.S. bonds may not be sufficient to offset future strength in the U.S. dollar. We see a number of fundamental dislocations in developed market bonds, most specifically in Europe, where investors are certainly not being compensated for economic, political, and currency risk. Our outlook for Emerging Markets debt has also shifted from an overweight to an underweight view. Although the economic outlook for emerging markets is fragmented by country/regional specific economic conditions, the combination of a slowing global economic growth outlook, declining commodity prices, and inflation pressures across a number of emerging markets is concerning. Tighter monetary policy in the U.S. may further exacerbate the situation, coinciding with a strong U.S. dollar.

Exhibit E: Equity Valuations Look Healthy

Source: Bloomberg

Following six years of sizable returns from equities, we believe that valuations are beginning to look rather healthy, as shown in Exhibit E. We continue to favor growth over value equities, primarily based on relative valuation and secondarily due to the potential negative impact of rising rates on value sectors. With U.S. equity prices touching historic highs, as measured by the S&P 500 Index (SPX), measures of volatility have remained muted by historical standards and may represent just another sign of complacency in risk assets. Exhibit F shows the historic price and annualized volatility of the SPX, with the shaded red area representing the one standard deviation boundary around average SPX volatility.

Exhibit F: Historically High Equity Prices and Low Volatility

It’s important to recognize that we are near historic lows of equity volatility, which has been gradually ticking higher as of late. This increase in volatility is due to a combination of fundamental, economic, and geopolitical factors. As we see declining expectations of global economic growth and uncertainty regarding the future path/pace of interest rates, and a recent resurgence in geopolitical factors, we expect volatility to continue to rise. We also give credence to the potential impact of earnings topping out in U.S. equities, but recognize the outsized effect that the Energy sector has on current earnings expectations (Exhibit G).

Exhibit G: Energy is Primarily Attributable to the Recent Decline in Earnings Expectations

Source: Wilshire Compass

the most commonly cited issue by management during quarterly earnings calls continues to be the strong dollar/FX, according to Factset. This factor will continue to create headwinds for large cap companies, as a result of more dependence on earnings abroad relative to small cap companies. Small Cap equities may benefit from being more closely aligned with the domestic macro environment (which continues to push ahead, albeit slower than hoped for). That being said, small caps no longer present a strong valuation argument (when measured relative to their own historic multiples) and exhibit higher equity beta. In light of these objective factors, we see no strong case to express a bias towards large caps or small caps, and are currently positioned for a neutral allocation relative to our asset allocation policy.

Given that the U.S. is likely embarking on a path towards tighter monetary policy while a number of developed Non-U.S. countries are likely to push forward with continued quantitative easing, we believe that government policy will be more supportive of Non-U.S. equities (albeit likely with currency headwinds). We are maintaining our overweight posture in foreign equities as a result. Valuations abroad appear attractive on the surface, however foreign equities have historically traded at lower multiples. When comparing foreign valuations to their own historic multiples (as shown in Exhibit H) we see a more neutral valuation picture, and therefore, our rationale is primarily a function of monetary policy.

Exhibit H: Current Equity Valuations (Current Price to Earnings Ratio/10 year Average)

Despite the valuation picture above, we have become more bearish towards emerging market equities, as we believe that this segment of the market is exposed to a number of negative conditions that merit more defensive positioning. Given the outsized debt to GDP in China, and continued government manipulation, extreme volatility in China will likely persist which could curtail fund flows directed into Chinese markets and breed increased risk aversion. With China now representing nearly 25% of the MSCI Emerging Markets Index, the risk is substantial to the broader market. Consistent with our concerns regarding Emerging Market Debt, the combination of a slowing global economic growth outlook, declining commodity prices, and inflation pressures across a number of emerging markets is concerning. Tighter monetary policy in the U.S. may further exacerbate the situation, coinciding with a strong U.S. dollar.

REITS & Commodity Outlook

Loose monetary policy has been most supportive of Global REITS. As a result, we have become even more bearish on this asset class as a result of concerns primarily related to interest rates and valuations. We acknowledge the recent outperformance of Non-U.S. REITS relative to their U.S. counterparts, however given the interest rate sensitivity and high degree of leverage, we believe a large underweight is prudent, which represents a downgrade relative to our previous view of underweight. Given that this asset class typically represents a very small portion of our asset allocation risk budget, the impact of this change in our view is more limited.

Exhibit I: WTI Crude Remains Under Pressure

Source: Bloomberg

We have become increasingly bearish on the commodity sector as expectations of global growth continue to get revised downward and inflation remains relatively muted. Furthermore, the technical trend in commodities has been weak on a broad basis. Most notably, the Energy sector has been punished as oil prices tumbled on higher supply and geopolitical factors, including but not limited to OPEC and Iran. Exhibit I above plots the price of WTI Crude relative to CFTC Net Long Futures contracts, which clearly indicates that institutional traders are not betting on a recovery anytime soon. This serves as another indicator which is not supportive of higher energy prices in the future. Similar observations can be made in other segments of the commodity market.

Disclosures

Wilshire Funds Management (“WFM”) and Wilshire Consulting are business units of Wilshire Associates Incorporated (“Wilshire®”). Wilshire is a registered service mark of Wilshire Associates Incorporated, Santa Monica, California. All other trade names, trademarks, and/or service marks are the property of their respective holders.

This material contains confidential and proprietary information of Wilshire. It may not be modified, sold or otherwise provided, in whole or in part, to any other person or entity without prior written permission from Wilshire Funds Management. This material is intended for informational purposes only and should not be construed as legal, accounting, tax, investment, or other professional advice. Past performance does not guarantee future returns. This material may include estimates, projections and other “forward-looking statements.” Due to numerous factors, actual events may differ substantially from those presented.

This material represents the current opinion of Wilshire based on sources believed to be reliable. Wilshire assumes no duty to update any such opinions. Wilshire gives no representations or warranties as to the accuracy of such information, and accepts no responsibility or liability (including for indirect, consequential or incidental damages) for any error, omission or inaccuracy in such information and for results obtained from its use. Information and opinions are as of the date indicated, and are subject to change without notice.

Copyright© 2015 Wilshire Associates Incorporated. All rights reserved.

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