Report from the CIO
Fiscal Year 2018: Another Strong Year for the Fund

The Fund experienced a second consecutive year of strong performance in Fiscal Year (FY) 2018, earning returns of over 9%, net of all manager fees and internal investment costs. This occurred in a period when many financial markets performed well, with several recording double-digit returns.

  • Equity markets performed particularly well in FY 18. However, performance toward the second half of the fiscal year came with significantly more volatility, although still moderate by historical standards. For the year, the MSCI All-Country World Index rose 10.7% while different regions displayed somewhat different results.  The S&P 500 in the U.S. was up 14.4%, international developed equity markets gained 11.7% while emerging market (EM) equities advanced 8.5%.

  • Bond markets delivered disappointing returns. Investment-grade bonds registered slightly negative returns, with the Barclays Aggregate Bond Index down -0.4% and the U.S. Government Intermediate Treasuries Index dropping -0.7%.  Below-investment-grade loans and bonds in the U.S. gained under 4%.

With stock markets up about 11% and bond markets flattish-to-up-a-little for the fiscal year, the Fund’s 9.3% net-net return is solid, with the Fund generating helpful absolute and relative contributions from public equities, credit, and most alternative asset classes.

While the Fund has exposure to many markets globally, our portfolio is meaningfully affected by how equity markets behave. Management is looking to modify this to some degree going forward, but we expect that equity markets will continue to be an important influence on the Fund’s returns.

Continued Earnings and Economic Growth,
Rising Inflation, Shrinking Unemployment

Despite being nearly nine years into an economic recovery and over nine years into an equity bull market, earnings and economic growth continue to trend upwards not only in the U.S., but in most of the world.

Economic Growth. Global growth in Calendar Year (CY) 17 among Organisation for Economic Co-operation and Development (OECD) countries was 3.7%, the strongest since 2011, and is tracking to grow 3.8% in CY 18. Moreover, the International Monetary Fund believes that “advanced economies as a group will continue to expand above their potential growth rates this year and next before decelerating, while growth in emerging market and developing economies will rise before leveling off.”  U.S. growth could grow in excess of 4% in several quarters in CY 18.

Earnings Growth. Corporate earnings growth both in the U.S. and abroad has been robust.

  • In the U.S., the S&P 500’s first quarter 2018 year-over-year earnings growth, turbocharged by the tax cut, exceeded 25%. This represented the seventh consecutive quarter of positive earnings growth.

  • A similar story played out in Europe and Japan, where first quarter year-over-year earnings grew 10% and 11%, respectively.

  • Earnings are expected to continue to expand, particularly in the U.S. due to the impact of the fiscal stimulus and abroad due to relatively low rates and still-accommodative monetary policies by the Bank of Japan (BoJ) and European Central Bank (ECB).

However, despite continued earnings growth across markets, equity market performance in the second quarter of CY 18 did not follow the same pattern as in the first. U.S. equity markets continued their 2018 gains while European, Japanese and emerging market equities sold off.

Inflation. The recent economic and earnings growth has been accompanied by rising prices.

  • In the U.S., consumer price inflation picked up, reaching 2.9%, the highest inflation rate since 2012

  • Inflation in Europe also increased in June, hitting 2%, a 16-month high. This has primarily been due to the rapid increase in energy prices while price growth elsewhere remains muted

  • In the rest of the world, inflation broadly remains low but is expected to pick up due to decreasing unemployment levels and increasing labor shortages

Fiscal Stimulus. In late 2017, President Trump managed to push fiscal stimulus through Congress with the Tax Cuts and Jobs Act of 2017 (TCJA). This should provide a boost to the American economy via reduced corporate and personal tax rates as well as a reduced rate on cash repatriation for corporations. Together, these are likely to spur consumption and investment, particularly in 2018 and 2019. Following the passage of TCJA, unemployment in the U.S. continued to drift lower, reaching 3.8% in May, an 18-year low, before rising slightly to 4.0% in June.

The result may be additional inflation, which will likely allow the Fed to continue hiking rates for the remainder of 2018 and 2019.  The interest rate differential relative to Europe and Japan may lead to further strengthening of the U.S. dollar (USD). This will have impacts on both trade and commodities, and may lead to trouble for emerging markets, as it often has in the past.

Outlook for Financial Markets

Near-Term Outlook. In CY 17, we had a goldilocks scenario of easy monetary policy, low interest rates, low inflation rates, and global, synchronized growth. This resulted in an equity bull market in which volatility remained muted and new market highs were achieved every month in the U.S. while many equity markets abroad notched double-digit returns.

Much of this scenario remains true in CY 18, and we expect equity markets to continue to produce positive performance. However, there are greater uncertainties this year, reflected in greater volatility. Several issues weigh on investors’ minds, including greater political and social turmoil, rising inflation, a potential shift from accommodative monetary policies (lower interest rates and quantitative easing) to more constraining ones (quantitative tightening), and the threat of a global trade war -- particularly commercial conflict with China.

While the outlook is positive for the U.S. in the short to medium term, the long-term picture is less clear. The fiscal stimulus that was passed in late 2017 came at a time when the economy was already achieving above-trend growth. While it has extended the bull market in equities, it may have adverse fiscal consequences in 2020 and beyond.

Intermediate-Term Outlook. By 2020, much of the impact of the TCJA will have occurred and have been priced into markets. At the same time, the Fed’s continuing staccato of quarterly interest rate hikes may lead to a more difficult credit environment. In the long run, unless the fiscal stimulus leads to sustained significantly higher levels of economic growth, the rising U.S. trade deficit and increasing government debt could also weigh on the U.S. economy and USD.

One concern right now in the U.S. is the continually flattening U.S. Treasury yield curve which, if Fed rate hikes continue, may invert. A yield curve plots the interest rates, at a set point in time, of bonds with differing maturity dates, as illustrated in the nearby graphic. Interest rates in the U.S. have begun to rise, particularly for shorter maturities (the front end of the curve). As shown in the graphic, longer-dated maturities (the back end of the curve) have not kept up, partly constrained by low intermediate- to long-term interest rates globally. Historically, an inverted yield curve has been a sign that the economy is heading towards a recession. After nine years of central bank intervention, it is possible that many parts of the curve might need to invert for credit creation to meaningfully slow and induce the next recession.

Yield Curve

International Outlook. The outlook for countries outside of the U.S. is mostly positive in the medium to long term, but less so in the short term, particularly the EM countries. In Europe, growth has picked up, core inflation remains low, and monetary policy is still accommodative. However, geopolitical risks remain with populism still alive, as demonstrated by the recent events and volatility in Italy and England. For EMs, the aforementioned elevated U.S. growth, and interest rates have caused the USD to appreciate. This has placed some strain on some EM currencies. As a result of a stronger USD, funding costs for EMs with U.S. dollar-denominated external debt has increased (Turkey and Argentina, for example) and U.S. investments appear more attractive on the margin. However, EMs broadly have higher growth rates relative to the U.S. and most other developed countries and offer the potential for greater longer-term growth.

All in all, the global economic outlook remains positive, with strong and rising growth predicted for the next couple of years. While inflation is increasing in the U.S., it is still low on a global level. This should allow the BoJ and ECB to maintain their accommodative monetary policies for the near future. While equities currently appear somewhat expensive, bonds look even more expensive.  As such, equities may continue to be well bid.

Political tensions have picked up globally, with continued populist and nationalist fervor on display including the ongoing uncertainty in the Brexit negotiations and the actions and posturing of many global leaders with respect to trade and tariffs.

Highlights of Fund Performance (Net of All Investment Costs)

Highlights of Fund Performance Net of Costs
The Fund takes a long-term perspective in its asset allocation and investment decisions as well as in evaluating performance. We summarize our fiscal year results in each Annual Report. In FY 18, a year of strong returns in the investment markets, the Fund performed quite well, gaining 9.3% net of all investment costs. We ended with $7 billion of investment assets, up from $6.6 billion one year ago.

To gain a sense of how our portfolio is performing, the Fund has created a composite benchmark that is a best estimate of the types of risks we are willing to accept and types of exposures we are trying to have. The Fund has underperformed its composite benchmark in only one of the last nine fiscal years and has exceeded this metric over the last five and seven years. The 10-year numbers do not compare favorably due to the weak relative performance during the Great Financial Crisis. Changes made since then to the Fund’s asset allocation, exposure measurement and risk management make such a degree of underperformance unlikely, all else the same.

  Annual Fund Performance Net of Investment Costs

However, we would note that the Fund has intentionally begun to increase its exposure to strategies that differ meaningfully from those of the Fund’s benchmarks. This is being done to generate superior absolute returns over time and is essential for the Fund’s continued success and ability to both enhance our Funding Level and award sustained higher interest credits.

Annual Fund Performance Net of Investment Costs

While we would expect that over most relevant time periods, the Fund would continue to outperform its benchmarks – and by greater amounts than in the past – there will be years and even multi-year periods when the Fund will underperform its benchmarks, perhaps by a few hundred basis points. Fund Management, with the support of Trustees, has elected to accept greater short-term variance from its benchmark in return for higher expected absolute returns over a cycle.

The Fund performed positively on both an absolute and relative basis over the benchmark this year. However, we caution that the investment strategies we pursue are not expected to provide positive returns or better returns than a given benchmark every single year. Rather, we select these strategies to provide the long-term returns necessary to support Fund benefits. While we pay close attention to interim results and make course corrections along the way, our ability to take a long-term perspective is one of the Fund’s key investment advantages.

Assets that had performed well in FY 17 tended to lead performance in the year just completed. The Fund’s overweight allocation to Public Equity drove the strong performance on both an absolute and relative basis. Strong manager selection in the U.S. and Emerging Markets was a large contributor to this outperformance. Elsewhere in the portfolio, outperformance was driven by our Private Equity and Credit exposures.

The Fund outperformed its benchmark in FY 18 by 81 basis points, further increasing our positive absolute and relative returns over longer periods.

Investment Strategy

Management continues to take several steps to fulfill the Fund’s mission in the face of a challenging environment of elevated valuations for nearly all asset classes. Historically, about half of the Fund’s exposure has been to public equities, particularly U.S. equities, which has served us well during this bull market. However, as we enter the tenth year of continued economic expansion in the U.S., the Fund has begun to reduce U.S. long-only equity exposure. To be clear, public U.S. stocks are currently the Fund’s largest exposure and we expect they still will be, just less so. Instead, we will be allocating more to private investments, including buyouts, growth capital, venture capital, real estate, and natural resource-related opportunities. Most of these will likely continue to be U.S.-based.

Asset Diversification Pies

We continue to pursue return streams that are less correlated to both economic growth and financial market valuations, which are some of the main factors that drive equity values. Steps we have taken to accomplish this goal include:

  • Increasing our allocation to certain Diversifying Strategies that are not highly correlated to public equities and that we expect will produce attractive (or at least acceptable) long-term returns; these types of exposures, taken as a whole, can comprise a portfolio that retains value or appreciates during periods of equity market distress

  • Increasing our allocation to certain alternative Directional Strategies; this includes private equity managers, activist investors and certain hedge fund strategies that pursue attractive absolute returns with mitigated risk

  • Maintaining exposure to U.S. government securities in our Rates portfolio

  • Continuing to allocate to assets with differentiated risk factors, such as in the Credit, Real Estate and Natural Resources portfolios

Managing the Portfolio’s Risks

Risk measurement, monitoring and management are critical aspects of investing. As previously mentioned, the challenging investment environment has led your Fund’s Management to adjust our investment strategies. In some cases, these changes entail greater portfolio complexity.

To keep pace, we have been enhancing our risk-related systems and processes. Our Director of Investment Risk is coordinating and upgrading our exposure analysis and other risk functions. Below are some of the many steps we take to measure, monitor and manage risk in the portfolio:

  • We perform quantitative modeling to understand a variety of portfolio risks and sensitivities to possible economic scenarios.

  • We manage the Fund’s liquidity based on a combination of historical analysis and forward-looking projections, to ensure an uninterrupted stream of benefit payments.

  • We regularly monitor our exposures to and concentrations in various categories to ensure appropriate diversification across a variety of metrics. We monitor certain key items daily, while we track others weekly or monthly or, in the case of most private (illiquid) asset classes, quarterly.

Looking Forward – Committed to the Vision

Fund Management remains focused on both setting a thoughtful asset allocation that balances the collection of risks we accept and carefully selecting and sizing a range of strategies and managers that we believe can achieve our investment objectives. We are committed to the Fund’s mission and aim to achieve attractive returns that, over the long run, will enable us to provide our participants with sound benefits that help ensure economic security for a career of service to the YMCA. We remain confident that the Fund’s evolving portfolio positions will allow the Fund to achieve our goals.