PERIOD ENDING: DECEMBER 31, 2019 Investment Performance Review for Imperial County Employees’ Retirement System Table of Contents VERUSINVESTMENTS.COM SEATTLE 206‐622‐3700 LOS ANGELES 300‐297‐1777 SAN FRANCISCO 415‐362‐3484 Investment Landscape TAB I Investment Performance TAB II Review 1ST QUARTER 2020 Investment Landscape Recent Verus research Visit: https://www.verusinvestments.com/insights/ Annual outlooks Topics of interests CAPITAL MARKET ASSUMPTIONS WHY BENCHMARKS MATTER RISK IN MANAGER SELECTION Some important developments occurred in In this Topics of Interest paper, we seek to In our latest Topics of Interest paper, we the last year. During our 2020 Capital Market outline the importance of benchmark provide a framework for assessing the Assumptions webinar, we discussed: selection within the investment process. candidacy of a manager for portfolio The white paper addresses the following inclusion and consider the implications of points: one manager versus alternatives. It ― Market movements of 2019 and how these addresses the following questions: shifts have affected our long‐term outlook ― Benchmarks which appear similar can ― The impact of falling interest rates on fixed behave very differently, even over long ― Does the manager add a desired income expectations periods of time exposure? ― Why it is important to differentiate between ― Unconsidered benchmark selection can ― Does the manager exhibit skill? shorter‐term and longer‐term forecasting introduce uncompensated tracking error ― What does the manager add to the exercises ― Tools available to investors to assist in broader portfolio relative to other determining appropriate benchmark candidates? indexes Consulting | Outsourced CIO (OCIO) | Risk Advisory | Private Markets Investment Landscape 2 1st Quarter 2020 Table of contents VERUSINVESTMENTS.COM SEATTLE 206‐622‐3700 LOS ANGELES 310‐297‐1777 SAN FRANCISCO 415‐362‐3484 Economic environment 6 Fixed income rates & credit 17 Equity 23 Other assets 34 Appendix 36 3 4th quarter summary THE ECONOMIC CLIMATE THE INVESTMENT CLIMATE A neutral risk — Real GDP grew at a 2.1% rate year‐over‐year in the third — In October, the Federal Open Market Committee cut stance may be quarter (2.1% quarterly annualized rate). Falling imports interest rates by 0.25% to a new range of 1.50 – 1.75%. and weak fixed investment (‐0.2% contribution) acted as a This marked the third consecutive rate cut by the appropriate in drag on growth, while personal consumption continued to committee. p. 18 today’s as the greatest driver of growth. p. 7 — Global sovereign bond yields picked up modestly in Q4, on environment — U.S. and Chinese negotiators signed the “phase one” trade higher inflation and growth prospects. The dollar value of agreement, and Boris Johnson’s Conservative Party in the negative‐yielding outstanding debt fell from nearly $15 U.K. won a decisive victory. These events appear to have trillion to just above $11 trillion. Central bankers appealed removed some uncertainty from the geopolitical landscape for fiscal action, citing the limited capacity of monetary over the short‐ to intermediate‐term. p. 15 policy to sustain further economic expansion. p. 18 PORTFOLIO IMPACTS ASSET ALLOCATION ISSUES — Global equity markets exhibited strong performance — Most risk assets provided sizable gains in Q4. Global through Q4, and U.S. equity performance was in‐line (MSCI equities delivered +9.0%, U.S. high yield increased +2.6%, ACWI +9.0%, S&P 500 +9.1%). Emerging markets were the and Emerging Market Local Debt rose +5.2%. Longer top performing asset class (+11.8%). p. 40 duration fixed income saw losses as interest rates — U.S. headline inflation increased 2.3% YoY in December, rebounded. p. 40 alongside the core inflation growth figure, and up from — The U.S. dollar weakened ‐0.5% against both developed 1.7% in September. Although this was a notable jump in and emerging currencies in Q4, reversing moves of the the inflation rate, investors appear more concerned about prior quarter. Dollar volatility remains low relative to the global deflationary forces, as indicated by the 10yr U.S. big swings that occurred throughout 2014‐2018. p. 35 TIPS Breakeven Inflation Rate of 1.73%. Cyclical price pressures remain surprisingly absent from the current — Although risk assets appear to have rocketed higher in environment. p. 9 2019, which may create concerns over valuations, it is important to note that much of this performance was due to assets recovering from a sharp fall in late‐2018. p. 25 Investment Landscape 4 1st Quarter 2020 What drove the market in Q4? “U.S. trade deficit falls 7.6% in October to 16‐month low on decline in U.S. MONTHLY TRADE DEFICIT (BILLIONS) Chinese imports” $80 U.S. FEDERAL TRADE DEFICIT ($BILLIONS) $60 Jun Jul Aug Sep Oct Nov $40 53.7 52.7 53.5 51.1 46.9 43.1 $20 Article Source: MarketWatch, December 5th, 2019 $‐ Jan‐92 Jan‐98 Jan‐04 Jan‐10 Jan‐16 “As markets climb higher, are stocks becoming overvalued?” Source: Bloomberg, as of 11/30/19 BLENDED FORWARD 12‐MONTH P/E RATIO OF THE S&P 500 INDEX FORWARD PRICE/EARNINGS RATIO (BLENDED 12‐MONTH EARNINGS) Jul Aug Sep Oct Nov Dec 30 17.0x 16.6x 16.9x 17.3x 17.8x 18.3x 25 Article Source: CNBC, December 30th, 2019 20 15 10 5 “Fed ‘prepared to adjust’ balance sheet to prevent repo market flare‐up” Jan‐90 Jan‐96 Jan‐02 Jan‐08 Jan‐14 MONTHLY CHANGE IN THE SIZE OF THE FED BALANCE SHEET ($BILLIONS) S&P 500 Index 30‐year average Jul Aug Sep Oct Nov Dec Source: Bloomberg, as of 12/31/19. ‐47.7 ‐19.2 97.8 162.1 33.1 112.7 YEAR‐END LIQUIDITY OFFERED UP BY THE NEW YORK FED (BILLIONS) Article Source: Yahoo Canada Finance, December 11th, 2019 $200 $150 $150 “China’s pork price jumps 110 per cent, sending consumer inflation $110 $100 rocketing to eight‐year high” $49 $54 $50 $43 $43 $35 $35 $35 $50 $25 $25 $25 $31 $29 $27 $26 CHINA CPI INFLATION (YoY % CHANGE) $18 $0 Jul Aug Sep Oct Nov Dec 11/25 12/2 12/9 12/16 12/19 12/23 12/26 12/30 12/31 2.8 2.8 3.0 3.8 4.5 4.5 Demand Supply Article Source: South China Morning Post, December 10th, 2019 Source: New York Fed, as of 12/31/19. Investment Landscape 5 1st Quarter 2020 Economic environment Investment Landscape 6 1st Quarter 2020 U.S. economics summary — Real GDP grew at a 2.1% rate year‐ strong financial position, with Most Recent 12 Months Prior over‐year in the third quarter (2.0% balance sheets that appear quarterly annualized rate). Falling increasingly robust. At the end of GDP (YoY) 2.1% 3.1% imports and weak fixed investment Q3, U.S. household debt 9/30/19 9/30/18 (‐0.2% contribution) acted as a outstanding was equal to about drag on growth, while personal 74% of GDP, the healthiest level Inflation 2.3% 2.2% consumption continued to be the since Q4 2001. (CPI YoY, Core) 12/31/19 12/31/18 greatest driver of growth. — U.S. and Chinese negotiators Expected Inflation — U.S. headline inflation came in at signed the “phase one” agreement 1.8% 1.8% (5yr‐5yr forward) 12/31/19 12/31/18 2.3% YoY in December, in line with on trade, and Boris Johnson’s the core inflation growth figure. Conservative Party won a decisive Despite more than 10 years of victory in the U.K. These Fed Funds Target 1.50 – 1.75% 2.25 – 2.50% economic expansion, cyclical price developments may ease some of Range 12/31/19 12/31/18 pressures seem surprisingly absent the economic uncertainty across from the current environment. the global economy, providing a 10 Year Rate 1.9% 2.7% Investors appear more concerned tailwind to future growth. 12/31/19 12/31/18 about global deflationary forces. — Existing home sales grew +2.7% U‐3 Unemployment 3.5% 3.9% — The U.S. labor market showed YoY in November. New home sales, 12/31/19 12/31/18 further strength in the fourth a far smaller portion of the overall quarter and unemployment market, grew at a stronger rate of U‐6 Unemployment 6.7% 7.6% remained at 50‐year lows of 3.5%. +16.9% YoY, as construction activity 12/31/19 12/31/18 further accelerated. Rising — Consumer sentiment indicators homebuilder activity in recent remain near all‐time‐highs and years may ease some of the low improved slightly over the quarter. inventory pressures in the current market environment. — American households are in a Investment Landscape 7 1st Quarter 2020 GDP growth Real GDP grew at a 2.1% rate year‐over‐year in the third the “phase one” trade deal. A partial trade resolution, or at quarter (2.1% quarterly annualized rate). Falling imports least an indication that negotiations are headed in a more detracted ‐0.3% from the overall GDP print, along with weak positive direction, could provide a lift to the economy and fixed investment (‐0.2% contribution). Personal markets. consumption, the largest component of gross domestic product, continued to drive the economy forward. The U.S. On January 17th, the Federal Reserve Bank of Atlanta economy is pacing near the 2.0% rate that economists GDPNow forecast indicated GDP growth of 1.8% in the fourth generally expect for full year 2020. quarter. This forecast dipped recently due to weak personal consumption expenditures. While trade policies and conflict likely resulted in a mild drag on economic growth in 2019, the U.S. and China have signed U.S.