2019 Investment Outlook Uk

Investment Outlook 2019
Contents
Multi-asset. . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
2019 Investment Outlook
Fixed income. . . . . . . . . . . . . . . . . . . . . . . . . . 8
Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
Should investors accept the market’s warning
Commodities. . . . . . . . . . . . . . . . . . . . . . . . 20
signs of a downturn or embrace risk amid cheaper
ESG. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
valuations? Where are the potential opportunities
for active managers to add value in equity markets?
Can positive fundamentals for commodities outweigh
lingering headwinds? Where are we in the credit cycle?
What are some key areas of focus for ESG engagement?
As we head into the new year, thought leaders from

across our investment platform share their views on
these questions and more.
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Table of contents
2019 Investment Outlook

Drawing on our marketplace of ideas
We have no “house view” — the perspectives of our investment professionals can vary, sometimes
significantly. We believe this diversity of thought strengthens our investment processes by creating a
robust “marketplace of ideas.”
multi - asset Down but not out » 3

By Nanette Abuhoff Jacobson and Daniel Cook, CFA
Time to accept the market’s warning signs and position defensively, embrace risk amid cheaper
valuations, or something in between? We consider global fundamentals, the policy outlook, and
valuations, and offer our views across asset classes.
Fixed income Where are we in the credit cycle? » 8

By Nate Levy and Michael Garrett
Amid economic, political, and trade policy uncertainties, our credit specialists highlight their
views on where the asset class stands across geographies and sectors.
equity Reinventing the core: Alpha opportunities in an evolving 14

market efficiency landscape »
By Gregg Thomas, CFA; Tom Simon, CFA, FRM; and Matt Kyller, CFA
We identify inefficiencies across a range of equity markets, creating a nuanced picture of
where we believe active managers may have the greatest ability to add value — and potential
ways to do so.
China: From emerging markets component to stand-alone allocation? » 17

By Philip Brooks, CFA; Joshua Berger, CFA, CMT; and Bo Z. Meunier, CFA
Heading into 2019, we make the case for a stand-alone allocation to Chinese equities, a market
with many structural attractions — including relatively high inefficiency.
Commodities Can positive fundamentals outweigh lingering headwinds? » 20

By David Chang, CFA and Joy Perry
Following several years of capital restraint, we think commodity fundamentals are as attractive
as they have been in a decade. But trade disputes and fears of a global growth slowdown have
clouded the picture. We provide our assessment, sector by sector.
ENVIRONMENTAL, Resilience and adaptability as competitive advantages » 23

SOCIAL, AND By Carolina San Martin, CFA
CORPORATE Climate change resilience, human capital management, and risk oversight are key ESG consider-
GOVERNANCE (ESG) ations for companies across sectors. We believe engagement on these issues can help us identify
potential sources of alpha for our clients.
Investment Outlook 2019 3 Wellington Management
Nanette Abuhoff MULTI-ASSET
Down but not out

Jacobson
Global Investment and
Multi-Asset Strategist
Key Points
Daniel Cook, CFA Based on fundamentals (slowing but solid), fiscal and monetary policy (a little
Multi-Asset Analyst tighter), and valuations (enticing but not extreme), we would consider the following:
Reduce but don’t abandon risk; favor equities over bonds but move to more
defensive sectors
Favor US equities relative to Europe, Japan, and EM
Our multi-asset views Favor bank loans, short duration, and higher-quality securitized products relative
Asset class View Change to other areas of credit
Our differentiated views:
Developed Moderately
— –– US equities over other regions
market equities bullish
Moderately –– Rotation into defensive equity, away from technology
US —
bullish –– Broad commodities exposure, including precious metals, as a hedge against
higher inflation and lower growth
Europe Neutral —
Risks: Trade war, aggressive Fed tightening, material global growth slowdown
Japan Neutral —
Some investors see a difficult choice: Accept the market’s
Emerging market warning signs of a downturn and position defensively or
Neutral —
equities defy the market and embrace risk amid cheaper valuations.
We anchor our 2019 views to fundamentals, policy, and valuations. Global
10-year Moderately
— economic fundamentals are turning weaker but should be solid enough to
govt bonds bearish
support modestly higher inflation and interest rates; fiscal and monetary
Moderately
US — policy are likely to be a little tighter; and valuations are enticing but not
bearish
yet at extreme levels. Return expectations need to meet a higher bar, in
Moderately our view, given that US cash now yields around 2.5%.1 We think this adds
Europe —
bearish
up to a case for compromise: positioning portfolios defensively without
Moderately abandoning risk.
Japan —
bearish
We would consider favoring equities (over bonds), shorter-duration credit,
Credit Neutral Ç and commodities, but also reducing risk in each asset class. Within equi-
ties, we would consider the US over other markets, given our view that the
Moderately US economy is strongest and US equities are least exposed to changes in
Investment-grade Ç
bearish
global growth. From a sector standpoint, we would consider leaning into
High yield Neutral — defensives such as consumer staples, health care, telecommunications, and
utilities, which, despite their rate sensitivity, may offer steady income and
Bank loans
Moderately
— some market upside. Within credit, we would consider the relative stability
bullish of bank loans over high yield, and have softened our bearish view on invest-
Emerging market ment-grade credit as spreads have widened and companies with healthier
Neutral Ç
debt (external) balance sheets look more attractive. We see potential for commodities to
Moderately play the dual role of a hedge against rising inflation and slower growth,
Commodities — and thus would consider energy and precious metals.
bullish
Change is from previous quarter. Views

expressed have a 6 − 12 month horizon and are
those of the authors. Views are as of December
2018, are based on available information, and
are subject to change without notice. Individual
portfolio management teams may hold differ-
ent views and may make different investment
decisions for different clients. This material is
not intended to constitute investment advice or
an offer to sell, or the solicitation of an offer to 1
Source: Bloomberg, 10 December 2018
purchase shares or other securities.
Any views expressed here are those of the author as of the date of
publication, are based on available information, and are subject to change
FOR PROFESSIONAL OR without notice. Individual portfolio management teams may hold different
INSTITUTIONAL INVESTORS ONLY views and may make different investment decisions for different clients.
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Investment Outlook 2019 | Multi-asset 4 Wellington Management
Figure 1 Growth, rates, and inflation

Easy monetary conditions are moving We think the global economy should expand at a slower pace in 2019
in reverse
than in the past several quarters, yet remain strong enough to reduce
GDP-weighted M1 money supply, y/y %
excess capacity and drive modest increases in inflation and interest rates.
change1
Monetary policy has become less supportive (Figure 1), but we expect poli-
18 cymakers to be cautious in further reducing accommodation given slower
global growth and poor market performance.
15
We think the US Federal Reserve (Fed) will hike rates in December but
revisit its forecast of three hikes in 2019 as growth slows and financial
12
conditions tighten. We expect the European Central Bank to end its asset
purchase program by the end of 2018 but also become more dovish in its
9 forward guidance on rates as growth slows and inflation signals remain
benign. We think the Bank of Japan will remain committed to its accom-
6 modative stance despite allowing a wider band in which the yield on the
10-year Japanese government bond can trade. In China, despite growth
3 concerns, authorities remain intent on reducing supply in heavy industries,
which we think will help lift global inflation and rates.
0 We expect modest appreciation in the US dollar because the Fed is the least
accommodative major central bank and the dollar tends to play a defensive
-3 role when growth slows.
12/96 5/99 10/01 3/04 8/06 1/09 6/11 11/13 4/16 9/18
Includes US, Europe, Japan, and China | Sources:

1 Country and regional equity fundamentals
Bloomberg, Wellington Management | Chart data: US
December 1996 – October 2018
We expect the US economy to continue outpacing its developed market
peers but to slow some as fiscal stimulus fades and higher interest rates
dampen demand in areas like housing. However, US consumers continue
to power the economy and are supported by a strong job market and higher
wages. Despite falling in the wake of this quarter’s stock market sell-off,
consumer confidence remains at healthy levels.
Capital expenditures may not fulfill the hopes for a stimulus-fueled bump
as trade concerns increase uncertainty for businesses, but should still add
We sense that the to growth in coming quarters. We sense that the US administration could
capitulate on its most severe trade threats given softer growth and weaker
US administration equity markets.
could capitulate on Based on our more favorable outlook for the US economy relative to other
developed markets, we would consider US equities over their higher beta
its most severe trade peers. US valuations are still relatively high, but that is a lesser concern
threats given softer over our 6 – 12 month horizon.
growth and weaker

Europe
European economic growth continues to disappoint, and leading indi-
equity markets. cators point to further sluggishness in coming quarters. Business cycle
indicators are soft, and recent data suggests that Europe’s bright spot,
consumers, could start to be affected. Politics are likely to impact business
and market sentiment, including Brexit and Italy’s budget woes, which risk
spooking the bond market. European companies also derive a substantial
portion of their revenues from overseas, which makes them susceptible to
changes in global growth (Figure 2).
While our opinion of Europe’s economy is generally negative, we remain
optimistic that consumers will continue to enjoy a strong job market and
can help Europe avoid a more material slowdown in 2019. In addition,
equity valuations look attractive and margins have ample room for expan-
sion, so we are maintaining a neutral stance.
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Figure 2 Japan
Europe is more globally exposed Japan’s economy continues to muddle through at a reasonable pace but
Revenue exposure by market (%) lacks a catalyst for meaningful expansion. Consumers are benefiting from
a historically tight labor market, while companies are turning record prof-
MSCI USA
18%
its and cash balances are high. However, we are concerned that Japanese
stocks are highly sensitive to changes in the global economic cycle and
that the yen is at risk of appreciating during bouts of global market weak-
ness. Despite attractive company fundamentals and cheap valuations, we
are neutral on Japanese equities given the slowdown we expect in global
growth and rising geopolitical and economic risks.
20%
63%
Emerging markets
We continue to hold a neutral view on EM equities but are closely watching
Domestic (US) the impact of China’s recent policy loosening. Thus far, China’s structural
Emerging markets deleveraging campaign is continuing to depress money supply, and we
Other developed markets
suspect a soft landing in 2019 is in order. Looking across the breadth of
emerging markets, we acknowledge that performance will vary and some
MSCI Europe markets may outperform meaningfully, but at the index level we fear that a
step down in global growth will restrain returns.
29%
Taking the long view
42%
Our views are based on a 6 – 12 month time frame, and thus we focus more
on economic fundamentals and policy than on equity valuations, which
have tended to be better predictors of returns over longer periods. Over a
longer time horizon, we would consider leaning into developed and emerg-
ing markets that have lower equity valuations than the US. What’s more,
28% we believe that longer-term growth prospects are brighter for emerging
Domestic (Europe)
markets, which have superior demographic profiles.
Emerging markets
Commodities
Other developed markets
Changes in inflation can have a meaningful impact on a portfolio, and
As of 30 November 2018 | Source: MSCI commodities are the only asset class that has historically had a high beta
to those changes. The supply backdrop continues to support commodity
prices in areas such as industrial metals, where China has reduced invest-
ment, and oil, where shale bottlenecks may crimp output in the first half
of 2019 and major oil company investment has lagged. We would also con-
sider precious metals as a potential hedge against a softer growth outcome
than anticipated, as well as a plethora of geopolitical risks.
Better valuations in credit

Cheaper valuations Cheaper valuations may offer an opportunity to upgrade the quality of
may offer an credit portfolios. Idiosyncratic risk stemming from the struggles faced by
General Electric and Pacific Gas & Electric Company, plus the pressure
opportunity to on energy companies from the decline in oil prices, contributed to wider
spreads in investment-grade and high-yield bonds in November. Spreads in
upgrade the quality both markets are now above the historical median (since inception).2
of credit portfolios. We are moderately bearish on investment-grade credit given high leverage
and the dominance of lower-quality names in the index. However, cheaper
valuations and a more benign interest-rate outlook mitigate these negatives
somewhat, and we think wider spreads offer an opportunity to upgrade
from highly levered BBB names to less levered, higher-rated names that
may be more insulated from a downturn. We also think a flat corporate
yield curve supports shorter-duration credit.
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Source: Bloomberg, 10 December 2018
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We remain neutral on high yield. The yield on the index is about 7.25%,
and we see the strongest potential in the US-oriented revenue sources of
high-yield companies.3 We also think the high-yield sector is supported
by structural changes: Over the past 20 years, we believe it has become a
larger, better-diversified sector with an improved average credit quality,
as well as a source of permanent funding for more public companies. We
maintain our moderately bullish view on bank loans given our expecta-
tion that interest rates will rise and given the sector’s low default rates,
strong interest coverage, and low level of maturing debt until 2023 – 2024
(Figure 3). Huge growth in the sector and the proliferation of “covenant
lite” issuance are legitimate concerns, but we think they call for moving up
in quality and being more selective, especially in new issues.
Figure 3
No bank-loan maturity wall in the next few years
Maturity breakdown of S&P/LSTA Leveraged Loan Index,
as of 30 November 2018 (US$ billions)
350
324 328
300
250
213
200
150
119
100
71
50
27 29
2 8
0
2018 2019 2020 2021 2022 2023 2024 2025 2026
Maturity year
Source: S&P
Another way to potentially move up in quality in credit is to increase expo-

sure to securitized credit, which may offer diversification and structural
credit enhancement. We would consider high-quality collateralized loan
obligations (CLOs), which may have more call protection than bank loans
and provide more diversification. We also find structures related to resi-
dential housing attractive, as consumers are benefiting from higher wages
and low oil prices.
We have upgraded our view on EM external debt (USD-denominated) to
neutral from moderately bearish. While this may seem counterintuitive
given the potential for slowing global growth, many emerging markets
have already gone through the painful foreign-exchange adjustment pro-
cess that allows a country’s finances to improve via the current account,
3
Source: Bloomberg Barclays US High Yield Bond which is likely to benefit debt relative to equities. In addition, EM spreads
Index, 10 December 2018 are wide on an absolute and relative basis compared to US high yield.
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Downside and upside risks

About the authors The recent sell-off in risk assets reflected many of the risks we have dis-
Nanette Abuhoff Jacobson consults
cussed in the past: trade tensions, higher rates, global populism, and
with clients on strategic asset alloca- crowded trades in technology. In fact, given the extent to which these risks
tion issues and works with investment have been priced into the market, we are mindful of upside risks that could
teams throughout the firm to develop spark a sharp rally — if, for example, the Fed backs off from its hiking path
relevant investment solutions across or there’s a positive political turn of events in the UK or Europe, or in US/
asset classes. China relations. In such a case, we would expect the riskiest assets to rally
most, including EM equities and commodities.
Daniel Cook analyzes and interprets
markets and translates this work into That said, the global economy is slowing, the bull market is 10 years old,
investment insights for clients. He also and US equity valuations are relatively high, leaving little cushion against
consults with clients on strategic asset
adverse news in fundamentals, policy, or politics. We maintain that more
allocation issues.
restrictive trade policies are the biggest risk for the global economy, with
the potential to dent business confidence and investment, and to raise
prices for manufacturers and consumers. For now, an increase in tariffs
on US$200 billion of Chinese goods from 10% to 25% has been postponed
until March, avoiding the worst-case scenario of an all-out trade war.
However, there is still the threat of tariffs on the remaining US$267 billion
of Chinese exports to the US, which would affect most consumer goods, and
the possibility of a 25% tariff on European autos is back in the headlines.4
Another risk is that higher-than-expected inflation puts the Fed on a more
aggressive hiking path than the market anticipates, a scenario that is not
our base case but could cause higher rates, lower growth, and a severe mar-
ket sell-off.
Investment implications
Equities over bonds — While the global backdrop may be weaker in 2019,
we think growth will be strong enough to consider equities over bonds.
US equities over other regions — We continue to think the US stands out
as the strongest economy and would consider favoring US equities, which
may be least exposed to a broader global slowdown.
Defensive sectors — Stable earnings and cash flow are the key character-
istics of defensive companies. Sectors with these features typically include
consumer staples, health care, telecommunications, and utilities. Value-
oriented or cyclical sectors that are at depressed valuations, such as natural
resources, may also represent opportunities. Technology companies are
likely to face continued headwinds on the regulatory front.
Commodities as a dual hedge — We think commodities could be additive
to a portfolio in the event of a rise in inflation (e.g., energy) and/or slower-
than-expected economic growth (e.g., precious metals).
Credit upgrade — Wider spreads may provide an opportunity to shift
corporate exposure into companies with less leverage or cyclicality, shorten
duration, or move into securitized products that offer more potential diver-
sification and credit enhancement.
Seek out idiosyncratic stories — Idiosyncratic stories that rely less on a
rising tide of strong global growth and easy monetary conditions may offer
downside protection amid higher volatility.
4
Source: Bloomberg, 28 November and
4 December 2018
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Nate Levy FIXED INCOME
Where are we in the credit cycle?

Fixed Income
Portfolio Manager
key points
Michael Garrett Although economic, political, and trade policy uncertainties remain, they have
Fixed Income not dramatically changed over the past several months.
Portfolio Manager
We believe credit fundamentals are healthy and current spreads compensate
investors for unresolved risks.
Though we are entering the later stages of the credit cycle and the economy is
About the authors currently more vulnerable to shocks, we do not think a recession is imminent.
Nate manages US multisector port- At this stage of the cycle, we feel agency mortgage-backed securities (MBS) are
folios for clients with customized risk poised to benefit from their higher quality, while securitized credit assets tied to
and return objectives. He also develops the US housing and consumer sectors are well positioned.
credit strategies and manages credit and
high-yield-only accounts for clients.
Despite risks, we believe the backdrop for credit remains
Michael manages agency mortgage,
supportive heading into 2019
securitized credit, and government
bond portfolios for fixed income clients. Corporate bonds weakened along with many other risk assets during
He focuses primarily on overall risk October and November 2018. Spreads widened on the growing belief that
positioning and sector allocation, while the economy will slow in 2019 and amid concerns about the effect of higher
working with the portfolio managers on rates and the fading impact of fiscal stimulus on corporate fundamentals.
his team to collectively formulate invest-
Tighter monetary policy — both from the US Federal Reserve (Fed) rate
ment strategy.
hikes and shrinking global central bank balance sheets — also contributed
to the market malaise, given its potential to drain excess reserves out of the
financial system and rebalance the supply and demand for credit. In addi-
tion to macro concerns, idiosyncratic issues arose such as liabilities from
recent California wildfires, company-specific events, concerns about the
impact of a China slowdown and rising materials costs on the auto sector,
and regulation of the tobacco sector.
While some of these and other risks remain unresolved, we think current
spreads fairly compensate investors for these risks and have become more
constructive on credit heading into 2019. In this piece, we further explore
our views on credit across geographies and sectors as the asset class moves
into the later stages of the cycle.
Credit investors are demanding more spread for the same risks
What is common across these disparate stories is that less risk appe-
tite translates to less support for credit when issues occur. Political
risks remain, including Italy’s budget, the UK’s impending exit from the
European Union (Brexit), and ongoing US trade wars. But market par-
ticipants are now demanding — and receiving — a higher premium to
be exposed to those risks. We do not necessarily believe that spreads will
Any views expressed here are return to their tight levels of this year, but if our base case of continued eco-
those of the author as of the date nomic growth continues, then we think investors will still be able to earn
of publication, are based on avail- an attractive carry from credit markets. If some of the risk cases turn out
able information, and are subject favorably, we could see spreads tighten.
to change without notice. Individual
portfolio management teams may Credit fundamentals appear healthy
hold different views and may make
different investment decisions for Backstopping our view on credit is that current credit fundamentals appear
different clients. healthy overall, although leverage is elevated for this late stage of the cycle.
Many companies will likely be reliant on continued strong economic growth
and higher earnings for deleveraging to occur, since most free cash flow has
been directed to dividends and share buybacks thus far. However, these
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Investment Outlook 2019 | Fixed income 9 Wellington Management
companies have the flexibility to deleverage if they shift their strong free
The economy is more cash flow toward debt reduction (Figure 1). While many investment-grade
vulnerable to shocks, (IG) companies have not yet made the shift, we think as growth slows, man-
agements will look to start protecting their balance sheets.
but a recession is likely
not imminent
Figure 1
We expect growth will slow toward
Free cash flow as a % of debt for investment-grade industrials companies
trend growth but not fall into a reces-
40
sion in 2019, and forecast that the next
recession is most likely at least 18 – 24
months away. Many of the leading
indicators for past recessions are not
30
yet pointing to an imminent economic
downturn. We have not witnessed the
same excesses — asset bubbles, highly
leveraged investment vehicles, poor
20
and irrational lending practices — that
preceded past recessions. We also note
that interest rates are still low by his-
torical standards, financial conditions
10
remain accommodative, and con-
sumer confidence is high. In addition,
though the US Treasury yield curve
has flattened, it has not yet inverted,
0
as measured by the yield differential 3/95 3/98 3/01 3/04 3/07 3/10 3/13 3/16
between the 10-year note and 3-month
T-bill. Finally, companies are not out- Sources: CapitalIQ, Wellington Management | Chart data: 31 March 1995 – 30 June 2018 | For
spending their cash flow despite a illustrative purposes only.
pickup in shareholder-friendly activities.
This slowdown is necessary, in our United States: Political and trade policy uncertainty
view, given the economy is at full could offset fiscal stimulus
employment, based on our estimates.
We believe protectionism in the form of tariffs represents a negative supply
Absent a slowdown, inflation could
accelerate, triggering a more aggres-
shock that is likely to weigh on global growth in 2019. In our view, trade
sive reaction from the Fed in which rate policy uncertainty, along with political risk in the US and Europe, will
rises could trigger a recession. A risk also limit the economic impact of fiscal stimulus enacted earlier this year.
case to our outlook that could bring Moreover, the midterm election results could prompt a shift away from the
an earlier onset of recession would business-friendly policies that have contributed to revenue growth. Still,
be if the combination of quantitative valuations of short-maturity corporate bonds look increasingly attractive,
tightening and the lagged impact of
especially short-dated issues from US banks. We are particularly construc-
Fed rate hikes slows the economy just
tive on the US banking and utility sectors. We think banks are also less
as fiscal stimulus rolls off heading into
mid-2019. Although in aggregate we do vulnerable to the shareholder-friendly activity that represents another
not believe these factors would tip the source of issuer-specific volatility in the industrial sector, where active
economy into a recession, they make it security selection will be critical.
more vulnerable to shocks. Other key
risks to our thesis include trade wars, Europe: Enduring political risk could undermine economic growth
European political uncertainty, and
Continued political tensions in Europe highlight the enduring European
emerging market weakness.
Union (EU) political vulnerabilities, and have shifted the focus away
from much-needed structural EU reforms. While the European Central
Bank remains accommodative, and would likely act to help dampen
spikes in volatility, it appears less willing to underwrite sustained politi-
cal uncertainty in Italy or any other single country. Therefore, in our view,
the budget process in Italy remains a near-term risk. The combination
of political tensions and trade policy uncertainty could undermine busi-
ness and/or consumer confidence, which have already begun to decline
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(Figure 2). This could turn the recent loss of economic momentum into a
more pronounced growth slowdown. We are more cautious on European
banks given their greater fundamental and market exposure to European
political uncertainty.
Figure 2
Eurozone business and consumer confidence
20
We are more cautious Industrial confidence Consumer confidence
on European banks 10
given their greater

fundamental and 0
market exposure to -10
European political
uncertainty. -20
-30
10/12 10/13 10/14 10/15 10/16 10/17 10/18
Sources: Bloomberg, European Commission | Chart data: 31 October 2012 – 30 November

2018 | For illustrative purposes only.
Emerging markets: Heightened trade policy and currency risks

Although most emerging markets (EM) countries have been less dependent
on foreign capital for financing than in the past, we saw that those with
more challenging debt dynamics, such as Argentina, Turkey, and Brazil
were exposed during the recent bout of market volatility. Broadly, EM
countries are responding to pressures in an orthodox manner that protects
their credit quality by allowing their currencies to depreciate. This has
allowed countries to maintain ample reserves; however, it does have pass-
through impacts on inflation, prompting EM central banks to raise rates.
While this can act as a headwind to growth, we think EM fundamentals
are starting from a point of relative strength. We believe the more countries
that adopt orthodox policies, the less likely deteriorating economic condi-
tions in these countries will cause contagion to spread, and the less likely
US credit fundamentals will be adversely impacted.
High yield: Selective as risk/reward is less attractive

We remain constructive on global high yield given the backdrop of stable
corporate fundamentals, a supportive macroeconomic landscape, and con-
tinued demand for yield-producing assets. Spreads trade just inside their
historical average following recent widening, but in our view are reflective
of a strong economy and solid company fundamentals. While geopolitical
events and tighter-than-expected central bank monetary policy are risks,
valuations appear reasonable relative to our outlook, especially given our
expectation for a benign default environment over the next year. We are
particularly positive on conditions in the US, and favor issuers expected to
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benefit from a stable or growing US domestic economy. In our view, high

yield maintains an attractive yield advantage and the ongoing “search for
yield,” given the low absolute levels of interest rates around much of the
globe, coupled with low supply, should continue to provide a tailwind for
the asset class going forward.
Agency MBS: Potential to benefit from investors

upgrading portfolios
As we enter the later stages of the credit cycle, we believe agency mortgage-
backed securities have the potential to benefit from investors upgrading
their portfolios and turning to higher-quality assets. While corporate fun-
damentals are starting to show some vulnerability to the late-stage cycle,
we believe mortgage fundamentals look particularly strong. Mortgage
prepayment risk is substantially lower than at any period before the crisis,
since just over 80% of the market, as proxied by the Bloomberg Barclays
30-year MBS Index as of 11 December 2018, has a borrower rate below the
As we enter the later current mortgage rate. Further, realized prepayment speeds on 30-year
FNMA mortgages, for example, are the slowest they have been in 10 years
stages of the credit as of 30 November 2018 according to eMBS. At the same time, mortgages
cycle, we believe have already extended substantially given the increase in rates. The aver-
age duration of the Bloomberg Barclay’s MBS Index has consistently been
agency mortgage- above 5 years in 2018, which is rare. Therefore, we think the potential for
extension from further increases in rates is quite limited.
backed securities From a valuation perspective, the spread on current coupon mortgages
have the potential to over US Treasuries is sitting at five-year wides. In addition, the spread dif-
ference between agency MBS and A rated corporates is near its tightest
benefit from investors level since the crisis (Figure 3).
upgrading their port-

Figure 3
folios and turning to MBS valuations have become more attractive
higher-quality assets. Spread to US Treasuries
300
Current Coupon Agency MBS A Corporate
200
100
-100
12/10 12/11 12/12 12/13 12/14 12/15 12/16 12/17
Sources: Citigroup, Bloomberg Barclays | Chart data: 31 December 2010 – 29 November 2018 |

For illustrative purposes only. Past results are not necessarily indicative of future results and
an investment can lose value.
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In our view, MBS technicals have deteriorated. The Fed’s balance sheet
normalization process is well underway, having steadily reduced the
amount of MBS paydowns that it reinvests each quarter, though this has
mostly been priced into the market. Additionally, banks, which are typi-
cally significant buyers of agency MBS, have been largely absent from the
market this year, and increased demand from money managers and other
relative-value investors has not been enough to fill the void. However, we
appear to be past the seasonal peak in mortgage supply, which should help
in the short run. Furthermore, the longer-term technical picture looks
even better considering we believe the supply of US Treasury debt is set to
increase relative to agency MBS.
Still, we do worry that the market backdrop remains choppy as the eco-
nomic cycle matures and central banks tighten policy. Interest-rate volatility
has risen over the last few months, but is still low by long-term standards.
In our view, this suggests the market is not pricing in a return to a volatile
The consumer bal- environment that would hurt MBS. Mortgage spreads could widen in a risk-
off environment, but we would expect them to come out ahead of competing
ance sheet is strong, spread sectors due to their higher quality and relative stability. Additionally,
many investors have been underweight agency MBS versus corporate
having delevered credit as central banks injected unprecedented amounts of liquidity into
dramatically since the system. As loose monetary policy draws to an end, we suspect investors
may look to derisk their portfolios into higher-quality, more stable assets,
the crisis, leaving which should benefit agency MBS. Within our agency MBS approaches, we
are overweight mortgages, with a bias toward assets that we believe can
consumers better generate income and provide more stable cash flows, such as Fannie Mae
positioned to meet
Delegated and Underwriting Servicing bonds and agency CMOs.
their debt service Securitized credit: Fundamentals are supportive for

US housing and consumer-related assets
obligations relative to Away from agency MBS, we are also constructive on securitized credit,
corporations. particularly assets that are tied to the US housing and consumer sectors.
There has been some slowing in housing activity this year, which we deem
to be a healthy response to the decline in affordability from rising rates and
home prices. We expect moderating, but still positive home price growth,
which should continue to benefit the credit performance of postcrisis
non-agency residential MBS. Additionally, we think consumer fundamen-
tals remain in good shape — underpinned by a strong labor market and
gradually rising wages. Moreover, the consumer balance sheet is strong,
having delevered dramatically since the crisis, leaving consumers better
positioned to meet their debt service obligations relative to corporations,
which have been adding leverage (Figure 4). Within our securitized credit
portfolios, we are expressing our constructive view on US housing and
the consumer via investments in non-agency residential mortgage-backed
securities and consumer asset-backed securities.
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Figure 4
Corporate sector showing more signs of late-cycle behavior than securitized
50 14.0
We maintain a con- 13.5
structive outlook for

45
13.0
credit heading into 40

12.5
2019, but continue to 12.0
monitor signals that 35

11.5
would indicate a turn Debt service coverage ratio nonfinancial

11.0
in the cycle. 30
corporations (LHS) 10.5
Household debt service payments as a 10.0

percent of disposable personal income (RHS)
25 9.5
3/99 3/02 3/05 3/08 3/11 3/14 3/17
Source: Board of Governors of the Federal Reserve System, Bank for International
Settlements | Chart data: 31 March 1999 – 31 March 2018
A constructive outlook for credit

Although economic, political, and trade policy uncertainties remain, they
have not dramatically changed over the past several months. Importantly,
we are now receiving greater compensation for being exposed to these
risks. We expect spreads to trade in a relatively narrow range as long as
the economy continues to grow. If some of the political and trade concerns
abate, spreads could tighten. We believe the primary risks to our credit out-
look are political — both in the US and Europe — and monetary, if rising
inflationary pressure leads to more aggressive central bank policy tighten-
ing. Reductions in central bank asset purchases also increase the potential
for market volatility. As investors position their portfolios for the later
stages of the cycle, higher-quality assets like agency MBS could benefit. We
maintain a constructive outlook for credit heading into 2019, but continue
to monitor signals that would indicate a turn in the cycle.
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Gregg Thomas, CFA

EQUITY
Portfolio Manager,
Factor and Risk In a pair of recently published white papers, thought leaders at the
Research firm explore emerging areas of potential value-creation for equity
investors. In the first piece, members of the Fundamental Factor
Tom Simon, CFA, FRM Team use a five-component framework to identify inefficiencies
Portfolio Manager, across a range of markets, creating a nuanced picture of where
Factor and Risk
Research
active managers may have the greatest ability to add value — and
the best ways to do so. In the second, the authors make the case
for a stand-alone allocation to Chinese equities, a market with
Matt Kyller, CFA
many structural attractions — including relatively high inefficiency.
Research Manager
Below are excerpts from this research, with links to the
complete papers.
About the authors

The members of the Fundamental
Reinventing the core: Alpha
Factor Team manage multi-factor
portfolios, conduct market and man-
opportunities in an evolving
ager research, and partner with clients
on factor-based investment solutions,
market efficiency landscape
including strategies to pursue custom-
ized risk and alpha objectives. Key points:
We believe variations in active management results across markets relate to dif-
ferences in market efficiency. Our framework for evaluating these differences is
based on five groups of metrics: diversity, consensus, idiosyncrasy, accuracy,
and substitution.
Based on our analysis of these metrics, we believe active equity managers may
have the greatest ability to add value in Japan, the small-cap market, emerging
markets, and non-US stocks.
We are increasingly working with clients to exploit varying levels of market inef-
ficiency in three ways: expanding the opportunity set, pursuing differentiated
betas, and making betas more efficient.
The Market Efficiency Scorecard: Our framework for evaluating

market efficiency and the active management opportunity
We’ve developed a set of 10 metrics — our Market Efficiency Scorecard —
to help institutions assess the degree of relative efficiency across markets
they invest in. We bucket these 10 metrics into intuitive groups: diversity,
consensus, idiosyncrasy, accuracy, and substitution.
Diversity assesses the breadth of market participants.
Consensus is based on earnings estimate dispersion and the average abso-
lute difference between announced earnings and consensus expectations,
Any views expressed here are which we refer to as “event surprise.”
those of the author as of the date Idiosyncrasy is a function of two factors that relate to fundamental inves-
of publication, are based on avail-
tors’ ability to better analyze an individual company’s risk and be rewarded
able information, and are subject
to change without notice. Individual accordingly: the level of stock-specific risk in a market and market breadth.
portfolio management teams may Accuracy combines 12-month consensus forecasting error with the level
hold different views and may make of sell-side coverage. When the level of forecasting error is high and fewer
different investment decisions for
sell-side ratings exist, active managers who can narrow the range of out-
different clients.
comes may have a significant advantage.
Substitution measures both the cost and tracking risk of an exchange-
traded fund (ETF) — neither of which is zero, despite what some academic
studies assume.
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Investment Outlook 2019 | Equity 15 Wellington Management
The opportunity for active: What does this data tell us?
Figure 1 below summarizes the overall findings of this framework. Based
on this analysis, active equity managers may have the greatest abil-
ity to add value in Japan, the small-cap market, emerging markets, and
non‑US stocks.
Exploiting market structure opportunities — reinventing the core

in the most efficient areas
A growing number of institutions now default to passive strategies, par-
ticularly in the US large-cap space. But the challenge many face is that
their alpha objectives may be unrealistic when more than half of their port-
folio is indexed. In addition, while the equity markets have been incredibly
strong over the past 10 years, making alpha largely irrelevant, valuations
are now very full and margins are at peak levels, suggesting that return
expectations should be much lower prospectively. Going forward, alpha of
1% – 2% may be a significant portion of a portfolio’s total return.
In light of this, there are three ways we are working with clients to exploit
varying levels of market inefficiency, which we highlight in Figure 2 and
discuss in greater detail below.
Expand the opportunity set — These strategies emphasize allocating
more capital to inefficient segments of the market while introducing other
tools to manage the risk. Extension strategies and “alpha pods” are two
examples we’re using in our client solutions today:
• In extension strategies, the long-only constraint that often applies in
portfolios is eliminated by allowing investors to be both long and short
securities while still being managed to a beta close to the long-only bench-
mark. This allows investors to own significantly more mispriced securities
down the market-cap spectrum. At the same time, it allows investors to
short securities to potentially help manage risk while still adding alpha.
• With alpha pods, a manager seeks to take the alpha from a less efficient
market and hedge the beta and currency in order to move it to a bench-
mark of a more efficient market (e.g., cash, S&P 500, EAFE). The goal
with alpha pods is to have little correlation with other asset classes.
Figure 1
The Market Efficiency Scorecard
US large cap Global Europe EAFE US small cap Japan EM
Diversity Breadth of participants
Nonbenchmark stocks
Consensus Estimate dispersion
Event surprise
Idiosyncrasy Stock-specific risk
Big winner %1
Accuracy Forecast error
Median # of analysts
Substitution ETF tracking risk
ETF cost
Theoretically more efficient Theoretically less efficient
Data suggests:
Highly efficient Moderately efficient Inefficient
1
Big winners defined as those stocks in the index that have outperformed the index by more than 25% over the trailing 1-year period. | Source: Wellington Management
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Figure 2 Pursue differentiated betas — A manager can seek to exploit segments

Reinventing the core: Building blocks of the markets that are not well known and typically not well modeled
by quantitative firms and risk models. In other words, they may be “non-
Expand the opportunity set ETFable” because fundamental insights would be required to define the
Extension strategies beta. Examples include strategies focused on founder-based businesses,
Regional/cap alpha pods companies improving capital stewardship, capital-compounding fran-
chises, “fly wheel” businesses, and brand value. These strategies tend to be
mid-cap heavy and own stocks in sectors/geographies not typically known
for consistent capital generation (cyclicals, financials, brands in noncon-
Pursue differentiated betas sumer areas), which is why they can be difficult to assess in risk models. In
Owner-operated more efficient areas, these strategies allow a manager to introduce signifi-
cant idiosyncratic risk into a portfolio.
Improving stewardship
Capital compounders Make betas more efficient — Here the focus is on strategies that share
Brands
the common characteristics of a base fee similar to an index fund and a
performance fee component to the extent that they outperform. A manager
can implement industry-neutral strategies with this structure. Similarly,
factor-based strategies can be devised in which the exposure to different
Make betas more efficient
factors (value, growth, and quality) are actively managed to exploit the
increase in extreme factor returns we have seen in the markets in recent
Factor opportunities
years, but with the factors passively implemented to achieve a low cost. In
Sector neutral many regards, this could be considered a “new active” approach in efficient
segments of the markets and an important opportunity to pursue cost-
effective results.
Passive Overall, we believe structural efficiency in the markets is, at a minimum,

evolving and that it likely is deteriorating outside of the well-trod areas. We
encourage investors to challenge their historical structural biases and con-
sider new ways to exploit these trends.
Learn more at https://www.wellington.com/en/insights/reinventing-the-core-
alpha-opportunities-in-an-evolving-market-efficiency-landscape.
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Philip Brooks, CFA

Investment Director
China: From emerging markets
component to stand-alone allocation?
Key points
Joshua Berger,
We believe the size and scale of China’s equity market already make the country
CFA, CMT
worthy of a stand-alone portfolio allocation, yet at the moment it remains under-
Associate Director
represented in the MSCI Emerging Markets Index. As a result, many near-term
opportunities may be overlooked in broad emerging market equity portfolios.
China’s A-share representation in the indexes is expected to increase signifi-
Bo Z. Meunier, CFA cantly over time, and we believe the breadth of the opportunity set and China’s
Equity Portfolio Manager importance to the global economy also warrant a stand-alone allocation.
We believe a dedicated allocation to China makes sense, and recommend
structures that encompass A-shares, H-shares, and US-listed Chinese stocks.
Ultimately, regardless of location of listing, the economic exposure to China
About the authors is the common thread uniting these different subcomponents of the Chinese
equity market.
Philip is responsible for the suite of
approaches managed by our Singapore- China’s equity market is characterized by high inefficiency, liquidity, and momen-
and Hong Kong-based investors. He tum, all of which we believe create opportunities for institutional investors with a
works closely with these equity invest- long-term investment horizon in particular.
ment teams to help ensure the integrity In a wider portfolio context, we believe there are also attractive diversification
of their investment approaches. and risk-adjusted return benefits from China equities’ lower correlations to
stocks of developed and other emerging markets.
Josh helps lead the group’s global team of
equity investment directors, investment
specialists, and investment analysts. His Much attention has been paid to the prospect of significant expansion
focus is to help drive the firm’s strategic of China’s representation in the MSCI Emerging Markets Index once
initiatives in the Americas, specifically to A-shares are fully included. But the case for a stand-alone allocation to
support strategies managed by invest- China can be built on much more than its eventual fuller inclusion in
ment teams located in EMEA and the Asia EM indexes.
Pacific regions.
On a 5- to 10-year horizon, we believe it will be commonplace for insti-
Bo is a Hong Kong-based equity port- tutional investors — whether pension funds, endowments, or sovereign
folio manager on the Emerging Markets asset pools — to have stand-alone China allocations. The prerequisites
Team. She currently manages China- are already in place. China has significant size, breadth, and liquidity, and
focused regional portfolios and provides
already represents the second-largest market by equity market capitaliza-
research to her team on China and the
real estate industry.
tion in the world, after the US. China also has one of the largest listed stock
universes, with more than 4,000 companies listed locally. This compares to
approximately 3,600 stocks listed in the US. In addition, 438 initial public
offerings (IPOs) launched in the A-share market in 2017 alone, compared
to only 184 in the US.1 The growing importance of China’s equity market in
a global context is undeniable.
World Federation of Exchanges Annual
1
Statistics Guide 2017. The evolution of China’s equity market is evident in its changing sector
makeup too. There has been a slow but sustained transition of companies
from “heavy” (manufacturing and industrial companies) to “light” (service
Any views expressed here are and intellectual property [IP]-driven businesses), resulting in typically
those of the author as of the date more opportunities in consumer-oriented plays, technology, and health
of publication, are based on avail- care. Innovation supports this evolution as China is now second only to the
able information, and are subject
US in total annual research and development (R&D) expenditure, accord-
portfolio management teams may
ing to both the Organization for Economic Cooperation and Development
hold different views and may make and the World Intellectual Property Organization. As R&D spending has
different investment decisions for increased, so too has the focus on the development of intellectual prop-
different clients. erty, and the rise of strong IP protection and global patents. This focus
on higher-value-added areas of opportunity has created the potential for
higher future returns.
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Underrepresented now but not forever

China is the second largest economy in the world, behind the US. Yet,
while the US made up 55.1% of the MSCI All Country World Index, as of
30 September 2018, China’s weight was just 3.4%. Japan, whose economy
is only 40% of the size of China’s, had an index weight that is more than
double China’s, at 7.6%.2
What is more intriguing still is that foreign institutional ownership is
anemic, representing about 3% in China’s A-share market, compared to
22% in the US market.3
Using the MSCI All China Index as a proxy for the China equity universe,
about 49% of the market is represented by A-shares.2 Yet, as a component
of the MSCI Emerging Market Index, A-shares make up less than 1%. This
is in stark contrast to China A-shares’ pro forma adjusted weighting in the
MSCI Emerging Market Index of about 16% of the total 40% exposure to
broad China (based on MSCI’s eventual full inclusion of A-shares).2 With
China (including A-shares) potentially dominating the structure of the EM
index, we believe many clients will adopt stand-alone allocations to China.
This notion was reflected in our conversations with clients in multiple mar-
kets over the last year.
Inefficiency can create opportunity

China’s stock market is deeply inefficient. Retail investors drive more than
80% of trading volume, and tend to be momentum focused, very short term
in horizon, and less focused on company fundamentals. This short-term-
We believe investors focused, momentum-driven activity can flow through to local institutional
with a fundamental
investors as well. The market’s short-termism and lack of emphasis on fun-
damentals drive its inefficiency.
focus, long-term time We believe investors with a fundamental focus, long-term time horizon,
horizon, and an abil- and an ability to look past the noise could be able to exploit this inefficiency
and potentially capture attractive portfolio returns.
ity to look past the The perks of low correlation
noise could be able to We believe an additional advantage of a dedicated China exposure is the
exploit this ineffi- low level of correlation to both developed markets and other emerging
countries. Over the last 10 years the correlation of the A-share market with
ciency and potentially developed markets (MSCI World and S&P 500 indexes, respectively) was
approximately 0.4, with even lower correlation to frontier markets.4 These
capture attractive are much lower than the typical correlation levels between equity markets.
portfolio returns. China’s economy marches to the beat of its own drum, and the pattern of
performance of Chinese companies is similarly consistently different from
those in other markets.
This low level of correlation opens the possibility for improving risk-adjusted
returns at the portfolio level when adding dedicated China exposure.
2
MSCI, 30 September 2018. | 3CEIC, Bank of
America Merrill Lynch, 31 December 2017. | 4MSCI,
S&P 500, Wellington Management, 10 years ending
30 September 2018.
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Additionally, valuations are inexpensive relative to those of developed mar-

kets, and relative to China’s own history (Figure 3), which we believe has
created a compelling investment opportunity in Chinese companies. Our
views on valuations are long term, so we have highlighted the cyclically
China’s economy adjusted price-to-earnings (P/E) ratio of the longest tenured MSCI China
index relative to developed markets to illustrate the attractive valuations.
marches to the beat
of its own drum, Figure 3
China is attractively valued relative to other markets
and the pattern Comparison of cyclically adjusted P/Es
of performance of
60
US World China
Chinese companies is
similarly consistently
different from those
40
in other markets.
20
Associated risks
0
9/05 9/06 9/07 9/08 9/09 9/10 9/11 9/12 9/13 9/14 9/15 9/16 9/17 9/18
China is a more volatile market,
especially in terms of A-shares.5 Sources: CLSA, MSCI, Wellington Management. Trailing 10-year cyclically adjusted P/E
Debt levels have increased in ratios. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS AND
recent years, in particular in AN INVESTMENT CAN LOSE VALUE. Forward-looking statements are subject to numerous
the corporate sector, although assumptions, risks and uncertainties, which change over time. Actual results may vary, perhaps
the majority of the debt is significantly, from estimated data shown. | Indexes: MSCI USA, MSCI World | Chart data: 30
domestically denominated. September 2005 – 30 September 2018
Growth, which continues to be

higher than in other large econo- China: A compelling investment opportunity on offer today
mies, is on a structurally slowing
We believe that China’s market dynamics discussed here, along with the
trend as the economy matures.
breadth of its potential opportunity set, underrepresentation in global
While we believe that the regula-
indexes, and potentially attractive relative valuations, may make it a com-
tory environment is improving,
there have been a number of regu- pelling investment opportunity across global financial markets today.
latory interventions — and some Wellington’s deep analytical resources, on-the-ground research team, and
missteps — in recent years. highly skilled portfolio management team, make our China equity offerings
Political risk should be considered, a way to potentially gain exposure to these different opportunities. We leave
as there remain both positives and you with a question: Where does your portfolio’s exposure to China stand?
negatives to single-party central-
ized control.
Learn more at https://www.wellington.com/en/insights/china-from-emerging-
markets-component-to-stand-alone-allocation.
5
Over the 10 years ended September 2018,
the annualized volatility of the MSCI China
A Index was 27.8%, compared to 21.2%
for MSCI Emerging Markets and 15.4% for
MSCI World.
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David Chang, CFA COMMODITIES
Can positive fundamentals outweigh

Commodities Portfolio
Manager
lingering headwinds?
Joy Perry
Investment Director Keypoints
In our view, the commodities supply situation continues to be positive, given tight
inventories across most sectors, particularly energy and industrial metals.
That said, we recognize that headwinds remain, and that the economic cycle
About the authors could shift from late-stage to a downturn sooner than expected.
David Chang is portfolio manager of Ongoing tension in the oil market could potentially prolong high price volatility.
Wellington Management’s commodity We believe a positive driver for commodity prices in 2019 will be the recent
portfolios. He works closely with the Chinese economic stimulus.
firm’s global industry analysts and other
internal global resources, drawing on
their fundamental research in the energy, Following four successive years of capital restraint, particu-
metals, and agricultural markets. As larly in the energy and metals sectors, we believe commodity fundamentals
an investment director in Multi-Asset are as attractive as they have been in a decade. During the last six months
Product Management, Joy Perry works of 2018, however, trade disputes and the resulting fears of a global growth
closely with investors in her coverage to
slowdown have overshadowed the strong fundamentals picture. While we
help ensure the integrity of their respec-
tive investment approaches.
continue to have a positive view on the commodity supply environment, we
acknowledge the heightened potential for demand headwinds in 2019.
As Figure 1 shows, historically, commodities have traded between 1.2
and 1.4 times price/marginal cost (P/MC) at the later stage of the eco-
nomic cycle.1 In other words, margins for high-cost producers have ranged
between 20% and 40% during this phase. Today, the asset class is trading
slightly above marginal cost,2 a very low valuation implying that commodi-
ties may already be pricing in a deceleration in growth. If stable growth
prevails in 2019, and/or if supply deficits widen, commodity prices could
appreciate significantly, potentially reaching new cycle highs.
Figure 1
Commodity markets are tight; we believe valuations are attractive
160 30
P/MC (LHS)
Tightness (RHS)
140 20
1
Wellington Management data and 120 10
Price as % of marginal cost
research. | 2As of 30 September 2018;

Tightness index
Wellington Management data and research.

100 0
Any views expressed here are 80 -10

those of the author as of the date
of publication, are based on avail-
able information, and are subject 60 -20
portfolio management teams may
hold different views and may make 40 -30
different investment decisions for 1/91 6/94 11/97 4/01 9/04 2/08 7/11 12/14 5/18
different clients.
The Tightness Index ranks 15 commodities based on inventory or spare capacity. A high
ranking indicates tight inventory and spare capacity levels; a low number indicates ample
inventories and spare capacity. Investments may not be made directly in an index. | Chart data:
January 1991 – September 2018 | Sources: USDA, DOE, IEA, LME, Bloomberg, Macquarie,
Brean Murray, BP, and Bernstein. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF
FOR PROFESSIONAL OR FUTURE RESULTS.
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Investment Outlook 2019 | Commodities 21 Wellington Management
Evaluating the sectors

In energy and industrial metals, our proprietary tightness measures are at
their highest since prior to the global financial crisis. Supply conditions in
agricultural and livestock markets generally remain a bit looser. In energy,
we believe tension in the oil market could prolong high price volatility. On
one hand, short-term supplies are adequate, particularly considering a
seasonal dip in demand that tends to occur in the first quarter of the cal-
endar year. On the other hand, to reach current supply levels, we believe
producers have either tapped obvious sources of spare capacity (as in
Saudi Arabia, which has ramped up output) or increased production at an
unsustainable rate (as with US shale). As a result, spare capacity, histori-
cally a good indicator of higher oil prices, is very low, leaving little room for
unplanned disruptions.
With industrial metal Despite the recent market correction, crude oil prices are not yet at
inventories at their extreme lows (although they are beginning to make producers nervous).
In our view, the timing of this correction may be opportune, as it is occur-
lowest since 2007, ring just as oil and gas exploration and production companies (E&Ps) are
preparing their 2019 budgets. While the recent correction is encouraging
significant capital producers to lower their production and spending plans, OPEC announced
expenditure (capex) on 7 December 2018 an agreement with Russia to jointly cut production by
1.2 million barrels per day for the next several months. We believe this may
will likely be required help restore balance to a market facing oversupply.
over the next few With industrial metal inventories at their lowest since 2007, significant
capital expenditure (capex) will likely be required over the next few years
years to balance to balance a combination of growing demand and depleting supplies, par-
a combination
ticularly with copper. Unfortunately, the global mining community seems
to remain nervous after the downturn of 2015. Although metal prices have
of growing demand recovered, miners are still maintaining very low levels of capex. In our
view, several of the world’s largest mining companies are spending less
and depleting sup- than required to sustain their current output of iron ore, copper, and other
base metals.
plies, particularly As for the gold market, we believe speculative positioning has had a nega-
with copper. tive effect on prices. With interest rates at their highest point of the current
cycle, gold has come under considerable pressure. As of September 30,
sentiment for gold was at a historical low, with short positions at a level not
seen since the late 1990s. Amid a pickup in equity market volatility over
the last few weeks, gold prices have found a floor and appreciated from the
lows of the 2018 summer.
Finally, commodities have felt the effects of the Trump administration’s
trade disputes with several major trading partners around the world. Steel,
aluminum, soybeans, and other commodities have struggled as a result. As
of this writing, tariffs appear to have been mostly discounted in commod-
ity prices, which may partially explain falling valuations.
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Investment Outlook 2019 | Commodities 22 Wellington Management
The China effect

As we look to 2019, we believe a positive driver for commodity prices will
be the recent Chinese economic stimulus. A slowdown in Chinese infra-
structure activity triggered a sharp reversal from credit tightening to
As we look to 2019, credit loosening. This shift, which reflects the government’s desire to spur
domestic growth and offset the effect of export tariffs, should be a tailwind
we believe a positive for commodities. According to the Chinese government, infrastructure
driver for commod- represents 25% of metals demand in China, so the deceleration has been a
considerable headwind this year. But a recently announced RMB 1.3 tril-
ity prices will be lion (US$187 billion) financing package earmarked for new infrastructure
projects is already starting to boost orders for base metals.
the recent Chinese Copper illustrates another interesting dynamic. As of 30 November 2018,
economic stimulus. the price of copper futures was very low, around US$2.77 per pound, consis-
tent with copper’s marginal cost of production. We find this unusual, as such
a low price would normally reflect a deceleration in global growth, which
is not evident. At the same time, low inventories and robust real demand
from China, including steady imports, has led to a sharp increase in the
physical price of copper. Given the supportive physical supply/demand sce-
nario and a futures curve in backwardation — which indicates falling global
inventories — we don’t think copper prices will stay low for very long.
Conclusion
In our view, the commodities supply situation continues to be positive.
Inventories remain tight across most sectors, positioning the asset class for
attractive potential returns. In addition, we believe inflation could surprise
to the upside next year. We are likely in the late stage of the economic cycle
with above-trend growth, flashing inflation signals, and higher volatility in
risk assets. Bottlenecks are starting to emerge in labor markets, the manu-
facturing sector, and other economic inputs. Order books are filling up and
we’re seeing longer lead times for the delivery of goods. Higher inflation
is generally supportive for commodities, so overall, we are positive on the
asset class. That said, we recognize that headwinds remain, and that the
cycle could shift from late-stage to a downturn sooner than expected.
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ENVIRONMENTAL, SOCIAL, AND CORPORATE GOVERNANCE (ESG)
Resilience and adaptability as

competitive advantages
Carolina San Martin, CFA
Key points
Carolina leads our ESG Research Team We intend to focus our stewardship efforts on climate change resilience, human
and oversees the firm’s ESG research capital management, and risk oversight.
and stewardship activities, including our Consistent with our ESG integration philosophy, we seek to identify proactive
company engagement and voting efforts. companies that are adaptable, with thoughtful strategies for the future.
In this capacity, she works to ensure We will continue to supplement our research with engagement learnings and aim
that the firm’s ESG capabilities meet the to influence better business practices whenever we see an opportunity to do so.
evolving needs of our clients globally.
A willingness to change and a desire to improve are signs of

a proactive organization. We believe companies that face new chal-
lenges and risks head on by listening to diverse perspectives are more likely
to succeed and remain competitive.
In 2019, we intend to focus our stewardship on companies’ approaches to
climate change resilience, human capital management, and risk oversight.
Reporting All three reflect responsible business and governance practices in com-
panies across sectors. We believe engagement on these issues can help us
on climate identify sources of alpha for our clients. We aim to distinguish companies
that proactively address these issues as having a competitive advantage
readiness will from those that need significant improvement or may be resistant to
help stakeholders
change. Where we see room for improvement, we aim to drive progress in
these areas through constructive feedback.
understand Climate change resilience
companies’ Over the past year, we have been encouraged to see many of our portfolio
willingness and companies adopt the Task Force on Climate-related Financial Disclosures
(TCFD) framework in response to shareholder recommendations.
ability to adapt to Reporting on climate readiness will help stakeholders understand compa-
nies’ willingness and ability to adapt to or mitigate climate-related risks.
or mitigate climate- So far, many disclosures have been incomplete; however, we view the act of
related risks. adoption as a positive signal in and of itself. We acknowledge that certain
elements of the framework — namely scenario analysis — are works in
progress, as standards have yet to develop. Nonetheless, we believe we have
already gained critical insight on each company’s assumptions about the
likelihood and pace of a transition to a low-carbon economy.
Many of this year’s TCFD reports made scant mention of the physical risks
posed to their business by a changing climate; this is an area about which
we will encourage companies to provide more detail. To help us do this,
Any views expressed here are
those of the author as of the date we plan to leverage findings from our collaborative initiative with Woods
of publication, are based on avail- Hole Research Center (WHRC), the world’s leading independent climate
able information, and are subject research organization. We believe integrating the work of WHRC’s cli-
to change without notice. Individual mate scientists and our investment research teams should enable us to ask
portfolio management teams may nuanced questions about specific physical risks and more accurately test
hold different views and may make climate-risk assumptions embedded in companies’ strategies. By narrow-
different investment decisions for
ing our engagement dialogue to address relevant threats, we believe we can
different clients.
encourage companies to take early action to address these threats, poten-
tially improving long-term investment outcomes for shareholders.
FOR PROFESSIONAL OR
G3195_A4_3
Investment Outlook 2019 | ESG 24 Wellington Management
Human capital management

Wellington adopts the TCFD In 2018, we discussed diversity and inclusion at all organizational levels,
Because we believe that climate including in our targeted engagements with over 50 US mid- and large-cap
change is a strategic business issue companies that lacked a single woman on their boards. As a result of our
that can impact long-term financial efforts and those of other shareholders, over 35 of these companies have
performance, we published our inau- added a female director. In 2019, we intend to engage on additional aspects
gural TCFD report1 in 2018. We hope of human capital management that contribute to a company’s ability to
to provide increasing specificity in
attract, retain, and promote talent.
future reports.
The ability to perpetuate a strong, inclusive culture; align management
incentives accordingly; and incorporate employee feedback contributes
to a company’s competitive position. Since culture is challenging to assess
from the outside, we examine a company’s holistic approach. For example,
we evaluate whether or not a company has a well-articulated culture state-
ment and talent development strategy. To us, these efforts suggest that a
company appreciates culture and talent as competitive advantages that can
drive long-term value creation.
And although a strong culture matters more in some industries than oth-
ers, it sends a strong message when management compensation is linked,
The ability to when appropriate, to employee satisfaction. If the company conducts regu-
perpetuate a strong, lar employee engagement surveys, we look for leadership to articulate the
results — both positive and negative — so we can monitor patterns and
inclusive culture, hold them accountable for implementing changes based on the feedback
they receive. With businesses that compete for higher-skilled talent, such
align management as scientific research or information technology, we consider workplace
incentives accordingly, locations and how a company balances attracting talent with the costs of
operating in desirable cities.
and incorporate Many businesses that have traditionally relied on manual labor are lever-
employee feedback aging technology to drive efficiency. This can lead to challenging labor
negotiations, lower employee morale, or labor stoppages that disrupt
contributes to operations. For example, the trucking industry is cautiously navigating the
shift to autonomous driving. The retail banking industry has been closing
a company’s branches and reallocating resources to concentrate on customer-facing
competitive position. technology. We look for signs of constructive labor relations if employees
are unionized, and a focus on key employee concerns, such as safe working
conditions and competitive compensation.
Risk oversight
While idiosyncratic, headline-grabbing risks vary by sector and can be
difficult to predict, we believe companies must be prepared to respond.
As recent examples have shown, these risks can include cyberattacks, exec-
utive misconduct, and regulatory scrutiny, which can lead to supply chain
disruptions, loss of customer trust, or deterioration of corporate culture.
We look beyond the headlines, evaluating a company’s response to any
past incidences as evidence of its ability to weather future ones. Given the
increasingly complex set of risks to consider, we believe the best strategy
involves highly engaged leadership, oversight from a team with diverse
backgrounds, and a clear escalation process. We want to see proactive,
1
https://www.wellington.com/en/insights/ not reactive, corporate communications.
managing-climate-risk-our-approach-to-the-tcfd-
recommendations
FOR PROFESSIONAL OR
G3195_A4_3
Investment Outlook 2019 | ESG 25 Wellington Management
Discussions with board directors, which comprised approximately one

third of the ESG Research Team’s engagements in 2018, are an important
window into a company’s risk management and oversight. We look for
boards to acknowledge their role in mitigating risks, identifying appro-
We look forward priate oversight structures, seeking regular input from experts about the
to strengthening our
evolving nature of the risk, and explaining in detail the actions taken since
the last incident.
engagements on critical Conclusion
areas in the year to In 2019, we will intensify our focus on climate change resilience, human
come, with the goal of capital management, and risk oversight. Consistent with our ESG inte-
gration philosophy, we seek to identify proactive companies that are
improving long-term adaptable, with thoughtful strategies for the future. We will continue to
supplement our research with engagement learnings and aim to influence
investment outcomes better business practices whenever we see an opportunity to do so.
for our clients. Each of our ESG analysts seeks to identify the material issues for their
coverage sectors in consultation with their global industry and credit ana-
lyst counterparts, executing an engagement agenda designed to address
those issues. In most engagements, the ESG Research Team is joined by
analysts and portfolio managers. This collaboration integrates ESG issues
directly into the investment dialogue and reinforces our feedback to com-
panies. We look forward to strengthening our engagements on critical
areas in the year to come, with the goal of improving long-term investment
outcomes for our clients.
FOR PROFESSIONAL OR
G3195_A4_3
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Investment Outlook 2019

As we head into the new year, thought leaders from

2019 Investment Outlook

multi - asset Down but not out » 3

Fixed income Where are we in the credit cycle? » 8

equity Reinventing the core: Alpha opportunities in an evolving 14

China: From emerging markets component to stand-alone allocation? » 17

Commodities Can positive fundamentals outweigh lingering headwinds? » 20

ENVIRONMENTAL, Resilience and adaptability as competitive advantages » 23

Nanette Abuhoff MULTI-ASSET

Down but not out

Change is from previous quarter. Views

Figure 1 Growth, rates, and inflation

Includes US, Europe, Japan, and China | Sources:

threats given softer over our 6 – 12 month horizon.

growth and weaker

Better valuations in credit

Another way to potentially move up in quality in credit is to increase expo-

Downside and upside risks

Nate Levy FIXED INCOME

Where are we in the credit cycle?

We are more cautious Industrial confidence Consumer confidence

given their greater

market exposure to -10

Sources: Bloomberg, European Commission | Chart data: 31 October 2012 – 30 November

Emerging markets: Heightened trade policy and currency risks

High yield: Selective as risk/reward is less attractive

benefit from a stable or growing US domestic economy. In our view, high

Agency MBS: Potential to benefit from investors

upgrading their port-

higher-quality assets. Spread to US Treasuries

Current Coupon Agency MBS A Corporate

Sources: Citigroup, Bloomberg Barclays | Chart data: 31 December 2010 – 29 November 2018 |

their debt service Securitized credit: Fundamentals are supportive for

We maintain a con- 13.5

structive outlook for

credit heading into 40

2019, but continue to 12.0

monitor signals that 35

would indicate a turn Debt service coverage ratio nonfinancial

Household debt service payments as a 10.0

A constructive outlook for credit

Gregg Thomas, CFA

About the authors

The Market Efficiency Scorecard: Our framework for evaluating

Exploiting market structure opportunities — reinventing the core

Figure 2 Pursue differentiated betas — A manager can seek to exploit segments

Passive Overall, we believe structural efficiency in the markets is, at a minimum,

Philip Brooks, CFA

Underrepresented now but not forever

Inefficiency can create opportunity

Additionally, valuations are inexpensive relative to those of developed mar-

and the pattern Comparison of cyclically adjusted P/Es

Growth, which continues to be

David Chang, CFA COMMODITIES

Can positive fundamentals outweigh

research. | 2As of 30 September 2018;

Wellington Management data and research.

Any views expressed here are 80 -10

Evaluating the sectors

The China effect

ENVIRONMENTAL, SOCIAL, AND CORPORATE GOVERNANCE (ESG)

Resilience and adaptability as

A willingness to change and a desire to improve are signs of