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PGAM 4Q17 Investor Letter

The 2017 rally in global equity markets continued through year-end. The catalysts which led to higher share prices through the first three quarters of 2017 continued in the fourth quarter. This included robust global economic growth accompanied by growth in corporate earnings as well as accommodative monetary policy by the Federal Reserve, European Central Bank, and the Bank of Japan. Below is a summary of global stock market performance on a total return basis for various time periods. Reversing the “medium-term” trend, the emerging markets and international developed markets outperformed the U.S. in 2017:

The factors which drove global equity prices higher in 2017 should continue to be supportive of share prices this year.  However, it is almost inevitable that the equity markets will be more volatile in 2018.  2017 was a slow, steady grind (a very different story than cryptocurrencies!!!) as the Standard and Poor’s 500 Index climbed 12 consecutive months and the maximum daily gain was a rise of just 1.38%. The last time that the S&P 500 Index suffered a correction of even 5% was the period between December 31, 2015 and February 11, 2016, with a decline of 10%.  The span of almost two years between 5% corrections is unprecedented and time alone should lead to the increased volatility, regardless of positive fundamentals.

An Equity Rally Like Few Others:

Slow, Steady, Incremental:

As for the positive background, accommodative monetary policy worldwide will have a favorable impact on economic growth. While the Federal Reserve is likely to raise short term rates several times in 2018, the increases are unlikely to crimp economic growth. The European Central Bank and the Bank of Japan stimulus programs are likely to continue this year. On balance, we expect the pattern of synchronized global economic growth which prevailed last year should continue through 2018. In the U.S., high levels of consumer confidence should be supportive of sustained growth in consumer spending.  The recently enacted tax reform legislation resulting in a significant decline in the corporate tax rate and incentives for companies to return overseas cash to the U.S. will have a positive impact on earnings through at least 2019.  Similarly, the provision which allows companies to expense capital investment (e.g. machinery or manufacturing plants) will have a favorable effect on capital spending this year.

Capital spending should accelerate in 2018 to close the growing gap between current and projected spending:

Outside the U.S., the European economy looks stronger than it has in years, with the Eurozone manufacturing purchasing managers index for December showing the highest level since surveys began in 1997. Japan is showing its best growth trend in decades. While Chinese economic growth is likely to slow this year, the level of gain is expected to exceed 6%, while many emerging market economies are benefiting from strong uptrends in commodity prices and a weaker U.S. dollar.

There are areas of risk which we will monitor closely.  The most important would be a resurgence of inflation, particularly in the U.S. As of early 2018, inflation in the U.S. remains quiescent at below 2% as measured by the key personal consumption deflator.  So far, full employment has not led to a surge in wage inflation. Should wages start to increase at a significantly accelerated pace, the Federal Reserve would respond by increasing short-term interest rates at a faster rate, increasing the risk that interest rates should reach a level which slows economic growth and increases the cost of servicing private and government debt.

The second area of risk is trade. Actions taken by the Trump Administration in 2017 include the renegotiation of NAFTA and the withdrawal of the U.S. from the Trans Pacific Partnership. Taken in isolation, these developments have not had a negative impact on global trade. However, and escalation of trade tensions would be a negative if leading to protectionism through competitive tariff increases, particularly with China. As of the present, these two risk areas seem unlikely to materialize but need to be watched for indications that they become reality. In the geopolitical arena, the main area of uncertainty is the Korean peninsula.

Overall, PGAM’s sector strategy remains unchanged and is supported by our positive assessment of global stock markets. We continue to expect cyclical areas such as Energy, Financials, and Industrials to continue to regain favor this year, reflecting the positive trend in global economic growth. Technology and Healthcare remain attractive focusing on reasonably priced secular winners and free cash flow compounders.

In our Global Equity strategies, we are increasing representation in emerging markets where we see positively inflecting earnings revisions and attractive valuations vs. other regions. Also, we see the opportunity for these valuations to expand as investors recognize the more secularly attractive composition of emerging market companies vs. five to ten years ago (i.e. more technology, less commodities). While the performance of emerging markets was strong in 2017, the rate of gain over five and ten-year time frames continues to lag the performance of developed markets, so that emerging markets should have more years of outperformance ahead.  Another area of increased emphasis is Japan. The Japanese stock market is at its highest level in twenty-five years, but the economic outlook is more favorable than it has been in decades. Given favorable economic prospects, the Japanese stock market should provide relative outperformance in 2018.

After 7 challenging years, Emerging Markets earnings revisions are inflecting:

Emerging Markets performance lag could be an opportunity:

In our Dividend Growth strategy, we continue to find more attractive stocks in the cyclical areas (i.e. Semiconductors, Chemicals, diversified Financials) over traditionally more defensive sectors and high-yielding “bond proxy” stocks (i.e. Utilities, Telecom, REITs). The 2018 outlook for U.S. companies to grow dividend payouts is strong supported by higher cash flows driven by solid global economic growth, significantly lower tax rates, and incentives to return cash from overseas. We are pleased with the solid outperformance of the Dividend Growth strategy in its inaugural year and we are confident this investment strategy and approach will deliver strong long-term results in various macroeconomic environments:

*Source: Ned Davis Research, based on an analysis of Russell 3000 stocks.

Fixed Income:
The multiple short-term rate increases by the Federal Reserve in 2017 impacted the shorter end of the U.S. bond market. By the end of 2017, 2-year Treasury rates had reached 1.9% compared with 1.2% at the beginning of the year. In contrast, strong demand for longer term Treasuries resulted in rates changing little during last year.  The year-end rate of 2.41% on 10-year U.S. Treasuries compares with a yield of 2.44%. At the beginning of the year. Outside the U.S., the yield on ten-year German bonds increased from 20 basis points to 42 basis points during 2017, while the yield on ten-year Japanese Government bonds remained at 4 basis points during the year.

The change in Federal Reserve Chair from Yellen to Powell should not materially impact Federal Reserve policy.  We expect the Federal Reserve to implement two or three further increase in short term rates this year which would bring the Federal Funds rate to 2% by year end. This increase should be primary reflected in the shorter end of the bond market. The rate on longer term obligations should also rise during this year although the difference between short and longer-term yield should continue to narrow. Given this outlook, we continue to maintain shorter than average durations in our taxable and tax-exempt portfolios. Simply stated, two-year bonds look more attractive than ten-year bonds.

Sincerely,

Princeton Global Asset Management LLC

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