[GREETING] Thank you for joining me today. Over the next half hour or so, I’ll offer AB’s assessment of the

global economic and capital markets landscape. I’ll also offer our insights on the opportunities and risks we see globally.

If we start with the 30,000-foot view, we’ve seen continued positive momentum so far in 2017. But today, we’ll look at the various stories within the story, because once you scratch the surface,

you start to see issues that could change the direction or the force in economies and markets—both globally and locally.

Over the past six or so years, we’ve gone from the Great Beta Trade, to After the Beta Trade, then the Trump Bump, which started to unwind in March of this year, even as markets, in general, continued to do well. But there are questions as to when fiscal policy may step in, and if and when further monetary tightening may reach a point of changing the current course of the markets.

And while the global growth theme is one of broad improvement—both developed and emerging—possible stress points are always just under the surface.

The issue for investors now is where to find growth, but without going too far out on a limb. It’s been a long time since we’ve had a notable correction, so it’s important for investors to determine how to participate and also defend.

With that in mind, let’s take a look at how markets did in the third quarter.

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The third quarter produced solid to strongly positive performance generally across the board. In equities, there was a continuation of strength that’s been going on for some time.

Across the board, equity returns are in double-digits year to date, with emerging market returns strongest.

And the major fixed income indices are all positive, with a rather strong showing by munis. Also, alternatives have generally done better than 2016, notably long-short equity.

But there’s an extremely important story within the story, and we all need to examine the big picture so that we can get back to the basics of steady and safe long-term investing—that ability to both participate and defend.

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For many years, we’ve talked about 4 pillars that have been major drivers of the global economy: Moderate, below trend, but improving global growth Low global inflation but not deflationary

As a result of those two conditions, we got the third and fourth pillars: Highly accommodative, well below trend rates – particularly in the developed world; and Large amounts of nontraditional monetary support in the form of QE and the like.

For many years, these have been the structural backdrop that underpins our perspective on economic and market movements—as balance to the “noise” of short-term shifts. But once again, things appear to be changing, so this backdrop is important to keep in mind to invest with objectivity and insight.

The first pillar—global growth. After quite a number of years of saying “below trend global growth,” we can update that and remove “below trend”, because global growth has now reached trend-level growth. Now, it’s moderate and improving global growth.

But usually, if you have synchronized, improving global growth, you’d expect there to be inflationary pressures. Essentially, economic growth is supposed to drive consumption and more hiring; then more hiring drives more wage gains, and more wage gains are inflationary. So, improving growth should eventually lead to inflationary pressures. But we’re not yet seeing that corresponding rise in inflation.

As a result, monetary policy has to navigate this interesting world where growth would say you should tighten monetary policy, but low and sluggish inflation would say you can stand pat. Central banks are testing the coexistence of these two pillars, and they seem to be OK with potentially structurally low inflation while still allowing for a tightening of policy. But they do think more inflation pressure will happen over time, because you can’t continue to take down available labor force candidates and not get some kind of pressure over time.

Let’s look at what’s driving global growth today and its return to the long-term trend. Global growth rose to 3.2% in the second quarter, the best showing since the first half of 2011.

And survey data in the composites of the Purchasing Managers Indexes (PMIs) suggest that this strong performance continued through the third quarter. There’s a strong correlation between manufacturing PMIs and GDP, as the left-hand chart shows. The continued climb of the global manufacturing PMI reflects the synchronized global growth picture—the back-to-trend growth that we’ve now got.

And the middle chart shows that’s true for both the developed market and emerging market pictures.

And it’s broad within developed markets by country and region as well—with upward trends in manufacturing output for the US, euro area and Japan

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And with economic growth, as we mentioned a moment ago, you’d expect that developed market jobs will grow. And they have.

The left-hand chart shows that unemployment is now well below-trend in the developed world. But wages haven’t yet climbed with that job growth. The middle chart shows that wage gains have

continued to be pretty benign. Consequently, with no wage pressures pushing through, overall CPI inflation—specifically core

inflation—continues to run below trend.

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While developed markets have this improving growth and moderate inflation story, so do emerging markets—but with a twist.

The left-hand chart shows that EM market growth is picking up, but headline inflation is now lower, which is fairly benign relative to its history.

Along with that, the middle chart indicates that general country balance sheet metrics have improved following the Taper Tantrum. So you’ve got EM countries with pretty good growth that’s getting better, low inflation and improved balance sheets.

Lastly, the right-hand chart shows the inflation-adjusted real rates for both EM and DM and how much more attractive EM real rates—especially when you look at the differential between them, which is slightly larger than EM because some DM real rates are currently negative. The net result of this combination allows EM countries to generally stay accommodative in policy and even cut rates, which some of them are doing.

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So broadly, on a relative basis, for both the developed and emerging markets, growth is good and getting better; inflation is moderate and below trend, probably structurally so. But in the developed markets, that’s generally translating into neutral to tightening policy; while in EM, it’s translating into neutral to easing policy.

Now, some of that has to do with the developed market countries also using a great deal of QE, which is something that was largely absent from emerging markets, except maybe China with its ongoing fiscal policy stimulus.

So on our map: In Canada, strong growth has warranted tighter policy rates, but we expect them to proceed cautiously. US has announced its reduction in the balance sheet, which should, more or less, cut the level of the Fed’s

balance sheet in half by sometime in 2020 [thereby taking most of their “excess” reserves close to zero]. The ECB will mostly likely (in October) start talking about beginning tapering, and run down their program

through 2018, at which time they may start taking their rates up. Even the Bank of England has talked about possibly raising rates—in part, because they have to keep up

with the rest of the DM. With so many of their developed neighbors on the world stage tightening, the BOE’s policy by comparison, becomes more stimulative as others tighten, so they might have to move directionally that way, too.

Only Japan seems likely to stay with its QQE YCC [quantitative and qualitative easing / yield curve control] policy of targeting the 10-year rate at zero. But if they’re successful in continuing to generate a level of inflation and growth, even they could have a form of QE, because the amount of bonds they would have to buy to keep the yield up around zero would be less. So that would be more of an indirect QE reduction, if they just simply had to buy less bonds.

Meanwhile, on the other side, emerging markets are getting neutral to easing policy. And probably the two most notable “easing” discussions are around Russia and Brazil. Largely, those are becoming stabilizing economies, and stable or declining inflation, that allows for rather aggressive easing of policy in both countries. Russia – undershooting on inflation targets allows them to do more cutting Brazil – everyone has been expecting the Selic rate [Sistema Especial de Liquidação e Custodia—i.e.,

Brazil’s overnight rate] to ease for some time. Overall, what this means for the world in light of those four pillars, is that the global economy is growing

pretty well, with continuing improvements expected. Inflation remains benign, with the developed world using that opportunity to start taking down some of their stimulus measures, particularly by reducing the amount of QE—with the Fed taking down its total amount, while the ECB starts tapering the amount they will buy. And in the emerging market world, they’re using that combination of economic growth with subdued inflation to keep policy relaxed or, in some cases, cutting rates, to benefit their economies.

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But let’s now couple this economic growth story with the question of valuations today. One central issue is that during the Great Beta Trade, you were essentially prepaid future market returns on the promise of future economic growth—and the explicit support you would get from central banks.

And we definitely got that. Markets took off long before we were able to take away the “below trend” qualifier to our global growth story. This means that just because we have synchronized global growth, we won’t necessarily have synchronized very strong equity market performance as well.

One indicator of the current disconnect between the US markets and the US economy is shown in the left-hand chart. It quantifies the S&P 500 Market Cap as a percentage of US economic output. The average over the past 45 years has been slightly below 80%. But there have been three times since 1974 that the markets have gotten far ahead of the economy: just before the dot-com tech bubble burst; right before the financial crisis in 2008; and today. The disconnect shows up whether you look at the S&P 500 against GDP or today’s elevated P/E valuations.

Another way to see where markets stand in relation to the economy is to look at valuations of equities to the underpinning earnings—aka, P/E. In theory, the earnings of companies within an economy are broadly supposed to reflect the growth in the economy (adjusting for different factors such as impacts from other economies and trade). What we see today is that we’ve got moderate economic growth, but much stronger EPS growth—that’s largely been because of net margins—and we’ve also had a major valuation expansion that has equities sitting well above normal valuations around the world. And that means today’s strong economic growth won’t necessarily translate into strong equity markets.

The right-hand chart shows that, historically over the last 45 years, when you’ve got top quartile valuations in the S&P 500, in the ten years that followed, you’ve had single-digit or lower returns 99% of the time over the following ten years. And we would expect that to be the case going forward. We’ve estimated that equity returns will likely be in the 5 ½ – 6 ½ percent range on average over the next 5 years.

Ultimately the devil is in the details. It will be a matter of managing rates as QE gets taken away and, ultimately as rate policy starts to move up. It will also mean managing equity choices as valuations are elevated and we expect returns to be modest but positive. This will give lots of opportunities, but those opportunities will likely be on a stock-by-stock basis—investors will need to find those idiosyncratic opportunities to drive performance in a world where valuations are elevated.

In a rates world, where rates and spreads are generally low, the task is to find pockets of opportunity and combine them to produce a portfolio that can navigate this environment—to be able to participate but also defend.

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Risk assets—like high yield and other credit markets—have been rallying for about a year and a half. While sentiment remains positive, and the growth backdrop is positive—typically a good environment for risk assets—valuations are now less attractive as spreads have tightened.

However, in this low yield environment, we believe select opportunities still exist. We feel it’s critical to hunt for these opportunities, because even small additions can positively impact the total return of your fixed income portfolio.

Also, there’s still a lot of uncertainty, which makes it equally important to maintain a balanced approach to credit and interest-rate risk, because there’s no way to predict what might or might not happen next. Given tighter spreads, a market correction is not out of the question and having an allocation to interest-rate-sensitive assets can help to mitigate a portfolio’s volatility if—or when—a correction occurs. At the same time, our expectations of solid growth support a tilt toward credit.

With the interest-rate-sensitive portion of your bond portfolio, now is a good time to be flexible with your duration exposure while pursuing market opportunities. Intermediate maturities still present the most attractive opportunities, where you can take advantage of the power of roll—the natural price gain a bond experiences as it moves closer to maturity, assuming interest rates don’t change. Roll varies considerably based on where you are on the curve, with the intermediate maturity range affording better roll potential. Adding global high-quality bonds (on a currency-hedged basis) is also an easy way to maintain defensive bond characteristics, by diversifying exposure to the US rates market. And as mentioned above, we believe it’s still prudent to balance high grade bonds with credit exposure to generate income and lower rate sensitivity. Within the credit component, we suggest combining sectors such as high-yield corporates, securitized assets and emerging market debt that has been benefiting from better growth and more stable commodity pricings.

More than simply keeping this balanced exposure to both credit and interest-rate sensitive bonds, it’s important to monitor the interplay between these two segments and to be flexible in managing the dynamics between them. Today we would be more diversified in the credit allocation, notably with emerging markets and floating-rate Agency Credit Risk-Transfer securities (CRTs).

Now, on the surface, nothing’s particularly shouting with appeal, but there’s still some pockets of relative value, you just need to know where to look. Let’s take a deeper dive into credit.

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Here we’re showing some credit opportunities around the globe where investors can potentially derive incrementally higher value.

In the US, we’re favoring securitized assets, like CRTs, but also some US high-yield corporates—notably longer-maturity high yield bonds, which we’ll discuss later in more detail—as well as select BBB-rated credit.

European corporates offer some good diversification, particularly with select opportunities in subordinated financials. And US-dollar based investors can generate a 2% yield pick-up when hedging the Euro denominated bonds into their domestic currency.

Within EM, Latin American bonds are strong, but that’s mostly within countries with improving fundamentals. Meanwhile, select African sovereigns can help to diversify investors’ commodity allocation while providing attractive yields. And although we’re underweight Asian currencies in general, there are some individual countries presenting appealing currency opportunities—such as the Sri Lankan rupee and Indonesian rupiah that have an attractive carry and help to diversify the portfolio’s currency allocation.

Now let’s take a closer look at US High Yield.

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While high yield spreads and yields continue to grind tighter, they still look quite good relative to passive equities, because they offer a similar return forecast but with less volatility.

The left-hand chart shows the Global High Yield index yield-to-worst, which is a metric used to evaluate the lowest possible yield an investor might receive on a bond (incorporating provisions like call options), provided the issuer doesn’t default. It’s been a pretty reliable indicator of the type of annualized returns you can expect over the next five years. And currently, US Corporate High Yield is about 5.5% and Global is roughly 5.1%. That’s compelling relative to our forecasted returns for passive equities which are around 5.8% for US equities, especially as high yield exhibits significantly lower volatility…but you need to be selective in the high yield space as valuations have shifted.

One area to look is within longer maturity high yield bonds—those with maturities of 10 years or more. As the middle chart shows, these haven’t rallied as much as shorter maturities, so there’s still some room for opportunities, with the yield differential between longer and shorter high yield bonds well above their recent average.

We also recommend looking outside of a typical high-yield benchmark for corporate opportunities. For example, today’s BB-rated bonds are looking rather expensive. However, we do see value in select BBB-rated bonds. The middle display shows that there is a significant overlap in yields offered by BBB- and BB-rated bonds, but BBB issuers have lower credit and extension risk, which we will address shortly. On the flip side, BBB bonds have higher duration, which can be viewed as either a positive or negative factor depending on the rest of the portfolio.

The higher extension risk of BBs is worth addressing in more detail as it makes these bonds more vulnerable in rising rate environments—like today. At low yield levels, many callable bonds trade at a price/yield that assumes they will be called; as rates rise, an issuer may decide not to call its bonds since doing so could result in refinancing at higher yields. In that scenario, investors would see the duration on their bonds grow at the worst possible time—we call this extension risk. In contrast, BBB rated bonds typically do not have a call provision—adding to their attractiveness today.

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With rates going up, many investors look to floating rate investments for protection. We see value in floating rate instruments, but investors should exercise caution.

For example, the floating-rate coupons on bank loans are a big draw for this asset. But refinancing risk is a concern in this sector as it can offset the benefits from rising rates. Bank loans

have a feature that allow issuers to refinance them at any time. The refinancing has been significant in the past year as a substantial amount of them reach par, and overall yield levels remain low. Despite a rise in LIBOR rates, spreads have narrowed leading to a record wave of refinancings, keeping coupons low. Allowing companies to refinance their loans at lower rates defeats the whole idea of buying floating rate debt for rising yields.

For investors who want floating rate exposure, we feel a more efficient alternative is using Agency Credit Risk-Transfer Securities (CRTs) in the mortgage market. CRTs are floating rate mortgage securities that reset monthly (they are linked to 1-month LIBOR). And unlike bank loans, they’re not callable and are therefore able to benefit from rising LIBOR rates. Additionally, the US real estate market is earlier in its credit cycle (vs corporates). The middle chart shows that the fundamentals in the US real estate residential mortgage market are very strong. For example, current FICO scores—the creditworthiness scoring of the individual homeowners—have greatly improved over the last 10 years and the debt-to-income ratios are also at very healthy levels. An improving labor market and solid economy further support this market.

CRTs also offer better liquidity and provide attractive portfolio diversification—away from corporates to real estate. They also offer a similar range of yields to bank loans.

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Diversifying a credit portfolio also means looking to the emerging markets. We see value in emerging markets today due to their strong fundamentals, technicals, and valuations

that look compelling relative to other sectors. Today we see opportunities in three different segments of emerging market debt; EM local bonds,

currencies, and EM hard currency sovereign debt, particularly of higher-yielding issuers. The left-hand chart highlights the appeal of local-currency debt today. EM local currency debt offers a

modestly higher yield than US corporate high yield. Also, over the last seven years or so inflation for EM markets in general has fallen and real policy rates have risen, offering potential for more attractive income in this area. Additionally, low levels of inflation leave room for central banks in these countries to ease monetary policy even as central banks in developed markets are beginning to withdraw monetary accommodation. This bodes well for their government bonds. We recommend focusing on countries with improving fiscal balances, where inflation is stabilizing and monetary policy is either on hold or is expected to ease. Keeping some of the local bonds unhedged gives investors exposure to EM currencies as well.

As displayed in the middle chart, EM currencies are generally trading at discount to history and some can offer attractive carry.). They also represent an easy and liquid way of gaining or reducing exposure, which makes them a great tool in efficiently managing the overall risk budget of the portfolios.

The right-hand chart gives several examples of appealing lower-rated US-dollar sovereigns, which are supported by more stable global growth and high carry. We show the examples of the yields on the Intermediate maturities in select countries in the right graphic.

Argentina has some idiosyncratic factors leading to improving country fundamentals, while Ivory Coast and Gabon are commodity exporters.

We’re also highlighting Brazil for opportunities in some corporates, which are poised to benefit from improving economic growth in the country.

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But while you’re hunting for credit opportunities, don’t abandon your exposure to interest rates. And we find a global approach is the best route for rates.

The US raised rates another 25 basis points in June, and one more hike this year looks likely. Also likely is that the Fed will continue its slow and steady rate increases next year. Some investors are concerned about having exposure to fixed income when rates are rising.

But rising rates don’t impact all parts of the fixed income market to the same degree, and don’t have to mean disaster for bond portfolios. In the left-side display, we’ve calculated hypothetical returns for two bond indices assuming a range of interest rate and yield spread scenarios. These different scenarios allow investors to look at a range of possible outcomes, depending on their expectations for movement in Treasury yields and spreads, regardless of past correlations between the two.

A 50 basis-point rise in the US Treasury yield curve doesn’t derail the returns of the US Aggregate bond index over the next year, because of the power of income and roll (roll being the change in the price of a bond as it gets closer to maturity). A more dramatic spike would push return expectations into negative territory.

If we turn to the high yield market, return expectations look attractive even under assumptions of rising rates and widening spreads—that’s the power of the roll and carry in higher yielding bonds.

Even though investors can initially experience negative returns when yields rise, with bonds, time heals the pain of rising rates. The middle chart shows how it’s important to stay invested, because over any two-year rolling period, the US and global hedged aggregate have never delivered a negative return—illustrating the power of roll and carry to offset the negative impact of rising rates over time.

Again, though, a global approach is more attractive during rising rate environments: when the Fed hiked in 2004-2006 and again when rates rose during the 2013 Taper Tantrum, the global hedged aggregate did better.

Global bonds provide an overall better upside / downside potential. In the right display, we’ve sorted quarterly returns over a 25-year stretch into periods when the US Aggregate was positive and periods when it was negative. During those times when it was positive, it returned, on average, 2.2%. The hedged global aggregate performed almost as well during those same quarters, capturing 96% of that performance. That’s the “up capture” part. But it’s the “down capture” part where hedged global bonds excel. When the US aggregate was negative, it returned, on average –1.0%. While the hedged global aggregate was also negative, it did better and was down only –0.7% on average. That “down capture” represents just 71% of the US bond decline. This lower downside of global bonds will become even more important to investors as the Fed continues to hike.

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Valuations haven’t just compressed in the taxable market; they’ve also compressed in the municipal market. But there’s still value there, and for tax-sensitive investors, munis still represent a good and necessary opportunity.

The strong technicals for the market are quite supportive currently, as evidenced by the LH great which shows that supply has declined from the previous two years.

New issue supply traditionally increases in the fall and support from coupon payments and maturities typically diminishes. So the increase of supply could put pressure on high quality municipals. That’s why it’s good to have the flexibility to hold US Treasuries in the interim and eventually use their liquidity to buy back into munis as their price becomes more appealing.

Of course the big issue that has resurfaced in relation to munis is the possibility of their being impacted by potential tax reform. What we believe in light of the possible tax implications being discussed, is that tax reform shouldn’t significantly disrupt muni valuations. In the middle chart, we’re showing a variety of muni tax-advantages over US Treasuries. The 5-year average is currently 0.8%, and at the current 43.4% top tax rate, the advantage is 0.7%. If the top tax rate were to be lowered to 35%, that tax-advantage of municipals would still be 0.5%, which in today’s yield starved environment, any advantage is a worthwhile advantage.

So for instance, while we’re looking for better yield opportunities, being selective is absolutely necessary in a very inefficient market like municipals. Recently, the muni market in general has a very healthy run—especially in certain sectors, notably tobacco, which has actually outperformed the S&P 500.

But it’s potential for strong future returns has diminished, as you’re unlikely to keep getting those strong returns from this sector. But that doesn’t mean there aren’t other opportunities. Today, for example, we see value in Senior Living bonds. This sector benefits from aging demographics and a stronger economy. The aging demographic is certainly a long-term trend opportunity, and the stronger economy allows for many seniors to transition from individual home ownership to selling their homes and moving into a variety of assisted living housing that will provide better services and care opportunities as they age.

As we note in the right-hand chart, the yield to worst for Senior Living is currently better than the overall yield to worst for high yield munis.

We continue to believe that municipal bonds remain attractive, supported by strong technicals.

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But positioning matters. Today’s muni opportunities balance intermediate high quality bonds with longer-maturity muni credit. In other words, adding income with muni credit exposure is a better approach than reaching for yield by buying longer-maturity high-grade munis. If inflation increases and yields rise—or if tax reform is passed—longer-maturity high-grade munis face the most downside risk.

In this display, we look at the combination of yield and roll for munis at different maturity ranges—grouped into short, intermediate and long-term. We’ve talked about the power of roll for some time. It’s the natural price gain a bond experiences as it moves closer to maturity, assuming interest rates don’t change. Roll varies considerably based on where you are on the curve.

We still see the “sweet spot” of the yield curve as intermediate maturities, in terms of combined yield and roll potential. For a 10-year A-rated muni bond, the combined potential of yield and roll amounts to about 2.9%. Yield plus roll is currently only slightly lower for a 10-year bond than a 30-year bond, which carries significantly more interest rate risk and volatility! So we favor high quality municipals in the intermediate range. However, we also believe investors can diversify their exposure in this part of the curve with US treasury bonds. This helps to hedge the portfolios from a possible correction related to a passage of tax reform. Additionally, municipal bonds have rallied this year, outperforming Treasuries and improving their relative valuations. Adding taxable bonds allows us to capitalize on that.

But we’re willing to buy longer-maturity bonds when dipping down in credit quality (which is where most of the lower-quality supply is). We still recommend some exposure to BBB-rated bonds, where investors get not only modest yield pickup, but lower interest rate sensitivity versus higher quality bonds. At the short end of the yield curve, we continue to favor short maturity municipals versus comparable maturity taxable bonds. But now let’s explore the concerns and potential opportunities we’re seeing in the equity markets.

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As we noted earlier, the first issue we face with equity investing today is that equities have been climbing for a good eight years now, and equity valuations look stretched across the board. You can see that in the left-hand chart, where all US market caps as well as global developed and emerging markets are currently above the 20-year median for each.

Those high valuations will make it difficult for equities to keep rising on multiple expansion as the indexes have generally enjoyed for the past several years. That makes it very likely that index returns will be lower over the next several years, but we see a market that will be far more grounded in individual company earnings. And that’s a healthier environment than returns driven by multiple expansion.

In the past several years, earnings growth wasn’t unhealthy, it just wasn’t growing, as you see in the left-hand chart. But consensus forecasts point to a pickup for both this year and next, which is a helpful, partial offset to the higher price tag stocks are carrying.

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Another issue causing investors’ concern today is whether we’re due for a correction, simply based on the extraordinary length of the current streak for stocks. And to a certain extent, they’re right to be concerned.

That’s because over the last 90 years large-cap US stocks typically had a correction of some magnitude much more frequently. A 5% correction, on average, happens about once every ten weeks—but as of the start of the 4th quarter, we’ve gone 64 weeks since the last 5% correction. The frequency of a 10% correction has usually been about 33 weeks: we’re at 83 weeks; and a 20% correction has, on average, occurred after about 127 weeks. We haven’t had that size downturn for 432 weeks—not since the summer of 2009.

But time alone can’t predict the when, if, or the magnitude of a correction. And it’s worth noting that stocks usually rebound pretty quickly after large intra-year declines, as we’re showing in the right-hand chart. Since 1990, we’ve had 39 drawdowns of 5.6% or more. The average decline has been about 8% over a typical period of about 17 days. The time to a halfway recovery has averaged only 7 days, while a full rebound has on average taken 69 days—about 3 ½ months. The issue, though, is staying in the market through these downturns, because typically, the subsequent 3-month forward return has been about 11%, and the 12-month forward return has, on average, been 16%.

While there’s concern over a possible correction, the economic backdrop still supports a picture of slow and steady growth. But now is a time to be selective. Even though equity valuations are pretty high, there are still some opportunities. Look for the “best in class” stories within each sector and capitalization. This is a market where you need to research and find the better topline growers, and watch out for the crowded trades of the stocks that basically act like bonds.

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Regardless of those concerns for high valuations and a possible correction on the horizon, we advise that investors not allow potential, short-term market volatility to override a sound, long-term plan. A component of such a good strategy is to be thoughtful regarding which equity investments make the most sense in today’s climate. Our view remains that those companies that can deliver superior and persistent earnings growth will prove rewarding for investors.

While we expect stocks to still deliver positive returns over the next market cycle, the composition of that opportunity is unlikely to be driven by multiple expansion—the big contributor to the “rising tide lifts all boats” market we had for US large-cap stocks during the Great Beta Trade from July 2012 through the end of 2016.

The left-hand chart shows that multiple expansion produced the lion’s share of the total returns then, but over the next five years, multiple expansion will likely be a detractor to overall returns. And dividends will remain relatively the same. We’re forecasting that overall returns will be much lower—roughly 6% annualized—and most of that gain will have to come from earnings.

The good news is that equities are still attractive relative to bonds. The right-hand chart compares the earnings yield of the S&P 500 (the aggregate earnings per share of the S&P 500 divided by the price level of the Index) to that of the 10-Year Treasury Note. The gap has narrowed a bit, but it still indicates opportunity for equities going forward.

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Another interesting aspect of low interest rates is that they have been an ingredient of the dampening effect on the market’s implied level of volatility. And, of course, low rates are a key driver of higher valuations in equities today (i.e., lower rates increase present values).

So, despite high valuations and concerns over a possible correction, volatility remains very low—well below the average of the past decade. As a typical red flag of investor complacency, and possible troubles on the horizon, the volatility index is pretty much asleep.

But while overall volatility for the S&P 500 index looks like a duck gliding smoothly across the surface of a lake, that duck is paddling like crazy underneath the surface! The right-hand chart gives you one indication of that churning with the sharp rotation among three stock categories—high dividend yielders, value stocks and growth stocks. The first half of 2016 saw major outperformance by those bond-proxy stocks, but the second half of 2016 shifted much more toward value. And so far in 2017, the outperformance of growth stocks has eclipsed the other two, as well as the overall index.

But the most direct “beneath the surface” volatility story relates to overall volatility versus the volatility being generated by some of the largest stocks.

On the left-hand side, we see that the top-50 largest stocks—one-tenth of the total index—is registering three times the volatility of the total index year-to-date. The reason for this is falling correlation—as the correlation between these largest equities and the overall market has declined in a meaningful way.

And when there’s low volatility—at least on the surface—that misleading picture induces complacency, which can create market imbalances that snap back violently. Extremely low volatility may make investors think that risky assets are less risky than they really are. And this misperception fuels an inflation of prices that may result in a sharp correction.

And the passive preferences of many investors for ETFs has led to an uneven distribution of different types of stocks, as investors buy passive vehicles to gain exposure to certain types of stocks. The right-hand chart shows that REITs and utility stocks are more likely to be owned in passive investment vehicles than stocks of other sectors. The main reason is that REITS and utilities are lower-risk stocks, and passive portfolios are usually geared to provide prepackaged exposure to lower volatility. But, both REITs and utilities are very sensitive to interest rates. So if rates rise, these stocks may lose some of their appeal, and we could see a mass rush to the exits—causing a major volatility spike in the very stocks that were valued for their low volatility. And passive ownership can reduce the true “float” (securities outstanding), a phenomenon which has contributed to higher volatility, as with the top-50 stocks on the left.

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Beyond REITs and utilities, let’s take a closer look at those high dividend-yielding stocks. They’ve been favored by many investors for six or seven years now. The result is that those high yield-oriented equity sectors are currently trading far above their long-term historical average, as the left-hand chart shows.

Since the Taper Tantrum, these sectors have outperformed, yes, but they’ve also seen massive capital inflows that have inflated their valuations severely.

This cohort of equities is trading at roughly 23 times earnings—significantly higher than their average P/E ratio of 13.8. We think that’s a hefty price tag for stocks that act a lot like bonds.

And dividend payers are straining: as shown in the middle display (which details the biggest stock holdings across the 10 largest dividend-focused exchange-traded funds), they’re paying out almost 90% of their earnings. That leaves precious little to reinvest in the business in order to either fuel future earnings growth or increase future dividends. Also, earnings growth for this group of dividend yielders is projected to be about 30% lower than that of their growth counterparts. This situation seems unsustainable.

At the same time, companies that are actually “delivering the goods,” are still underappreciated by the market. We like to look at companies with sustainable and solid levels of profitability. But safety and current income is still dominant for investors today, so they’re overlooking which companies have high profitability as we’re showing in the right chart. These companies with the highest Return On Equity (ROE, which is a key measure of profitability) are still trading below their long-term average valuations.

Again, taking an active approach to equity investing can help investors avoid overweights in seemingly safe—but crowded-trade—sectors that have diminished potential for positive performance.

Small-cap stocks are another good case in point for highlighting the advantages of active management.

Small caps have had some ups and downs since the election last November, and had a strong showing compared to their larger-cap counterparts in the latest quarter. Much of that volatility had to do with whether Trump’s corporate tax cuts were on or off the legislative table. They’re back on as we ended the quarter. And they could disproportionately help small caps, because they’re more domestically oriented, pay higher taxes and face disproportionately stiffer regulatory burdens than the larger firms.

Even so, while we remain positive on small stocks, we believe investors should be selective in how they get exposure. For example, rising rates are good for bank shares, but bad for interest-rate sensitive REITs and utilities. Those three sectors now make up a much larger portion of small-cap index, as we show in the left chart, making them riskier for passive, index investors.

Small-cap market gains over the past five years have been heavily skewed to stable-earners and high-dividend payers in healthcare, real estate, consumer staples and utilities. Cyclical, globally oriented technology, industrials and consumer discretionary stocks have trailed. The hunt for income and safety also steered capital away from fast-growth companies, which are more likely to reinvest profits back into their businesses.

As a result of these divergences, our right-hand chart shows that neglected small-cap cyclicals are trading at some of their lowest multiples relative to the index in nearly 30 years, while their defensive peers trade at some of their highest. Relative valuations for high-quality, secular growth stories also look extremely attractive. With the economy on a solid footing, this valuation gap creates rich pickings for active investors.

In this environment, autopilot index-tracking approaches are at a big disadvantage, in our view. They can’t interpret the varying ways that new policies and economic developments may impact individual sectors and companies, nor can they avoid risky concentrations in overvalued pockets of the market.

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And it pays to be active when in moderate return environments. In fact, it especially pays to be active when you’re in any environment where the correlations among stocks is low—exactly where we are today, as the left-hand chart shows.

That intra-stock correlation has declined noticeably as the Fed continues to normalize short-term interest rates. It’s much different than the last several years, when stocks moved more in lock step with each other over what had been extremely high levels.

Now, with that drop in correlation, the middle display shows a notable increase in active managers outperforming the benchmark so far in 2017. The fact that not all stocks are moving in lock step, is allowing good research to be rewarded for those managers with a more discerning lens.

And if we are correct that future stock market returns will moderate from their recent pattern, the chart on the right shows that during periods when the S&P 500 Index has returned 10% or less over the past 20 years, active managers have posted favorable results.

We feel an active approach is more suitable for the environment we foresee for equities; namely lower returns and higher volatility. This coupled with the fact that the Fed is in a tightening phase, warrants a more selective approach.

And we believe that approach to long-term investing will return to favor as investors start to feel the restraints and risks of passive strategies, and should stock market returns moderate over time.

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But such an approach, we believe has appeal beyond the US, as many opportunities exist in global equities. At an even higher level compared to US stocks, for the level of risk involved, global equity earnings overall, are providing more attractive yields relative to the global bond index yields.

The middle chart gives a more specific country-by-country comparison. In countries like Switzerland and Japan, bond yields are almost flat to negative.

As you move across Europe most yields are below 1%—UK and Norway slightly higher at roughly 1.5%—but all of them lower than the US (a little over 2%)

Parts of Asia are comparable to the US, around 2%. But the equity risk premium across them all is, at minimum, a good 3%–4% more than the bond yields.

While global equities do reward you handsomely for the risks you’re taking, we firmly believe that selectivity is warranted going forward. The right-hand chart reaffirms our US story—where some of the more yield-centric sectors offer less growth opportunities, but charge higher premiums.

That’s why we’re remaining selective and active in our research and stock selection process. Looking for companies with attractive valuations and compelling growth opportunities.

The watchword is don’t over extend yourself in areas of the market where the surface-level picture doesn’t truly reflect all the risks.

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Digging deeper into non-U.S. stocks, emerging market equities are typically a good area to approach through an active, discerning lens, and that’s very true right now.

EM stocks are trading at almost historically low discounts relative to their long-term averages—both on a price-to-earnings and price-to-book basis. So, valuations are attractive and ripe for EM investing.

But as with most equities today, you still need to remain selective within the EM space. Certain sectors can account for a lot of the return and risk to a broad market index. The right-hand

chart shows the year-to-date return for the US FAANG stocks of about 34%. However, when you remove the five FAANG stocks, the total return for the broad S&P 500 Index comes in at only 10.8%.

The same principle applies in the EM index, and is even more dramatic! Through September 30 of 2017, the EM’s version of the FAANG group of stocks delivered returns of roughly 64%, but when you remove the EM “FAANG” counterparts, you’re left with a performance of roughly 15.5% for the aggregate EM equity index.

The story remains the same: broad market exposure can expose you to almost “hidden” risk and return elements that many investors miss.

Considering the EM FANG stocks have accounted for such a large portion of the EM Index’s returns, should this group fall out of favor, taking a passive approach in this space would subject you to all of the downside that would ensue. Conversely, an active approach allows an investor more freedom to shop among the many other bargains to be had in these markets.

Altogether, to participate and defend in the current market conditions, we still suggest that investors need a solid foundation as their starting point – and we believe this Evergreen Advice makes for a good foundation: Keep a focus on ways to improve your up/down capture Keep a balance to non-correlated assets Be selective!

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