Capital Markets: Observations & Insights

Spring 2019

Capital Markets: Observations and Insights Capital Markets: Observations and Insights Birthday Wishes

Birthday Wishes

“You can’t help getting older, but you don’t have to get old.” – George Burns

If the U.S. economic expansion continues past its birthday at the end of this quarter, it will be the longest ever at over 10 years old. This is a tremendous achievement, one that most did not foresee in 2009 coming out of the financial crisis. However, investors are asking more frequently: will there be other birthdays to celebrate in this cycle? Many seem confident that the end is near—a sentiment that could perhaps be the wall of worry the market can climb to higher levels. While this cycle is clearly old in chronological terms, it appears more youthful by several other measures. For example, cyclical components of GDP, the proportion of the population employed, cumulative growth in GDP, the real Federal Funds rate, and debt service ratios are all at levels that are not indicative of a peak in economic activity. While we hope that this expansion has more birthday celebrations ahead of it, our focus at Alger has always been to understand the companies we invest in with an eye towards finding innovation and change rather than to try and forecast overall economic activity. In the long run, we believe what matters most is that innovation triumphs over economic volatility and is the primary contributor to long-term wealth creation.

Daniel C. Chung, CFA Chief Executive Officer Chief Investment Officer

Brad Neuman, CFA Senior Vice President Director of Market Strategy

Page 1

Key Observations

• While investors are preparing for the end of the economic expansion, various data points signal continued growth • Sentiment has significantly improved after reaching levels that we had flagged as overly depressed • Regardless of economic activity, we believe innovation will drive equity returns and wealth creation as it has historically done

Table of Contents

Birthday Wishes

Pages 3-10

Performance

Pages 11-17

Fundamentals

Pages 18-23

Valuation

Pages 24-28

Page 2

Cycles Have Been Lasting Longer ​ Birthday Wishes

• U.S. economic expansions have been increasing in duration. Driving factors include: ‒ Increased fiscal and monetary intervention (e.g., tax cuts/spending and assertive Fed)

‒ Structural changes in the economy (e.g., larger proportion of services) ‒ Technological advances (e.g., improved inventory management)

Age of U.S. Economic Expansions

12

10

8

6

4

Years of Expansion

2

0

1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 2020

Source: FactSet and Alger. Note: double-dip recession in early 1980s accounted for as one recession.

Page 3

Cyclical Spending Signals More Expansion ​ Birthday Wishes

• The cyclical components of GDP – business investment, residential investment, and consumer durables – have historically risen much higher prior to economic peaks

• The implication is that the economic expansion has room to expand

Cyclical Components % of GDP

Low cyclical spending may indicate room for expansion

30%

28%

26%

Average

24% % of GDP

22%

20%

1970

1971

1973

1975

1976

1978

1980

1981

1983

1985

1986

1988

1990

1991

1993

1995

1996

1998

2000

2001

2003

2005

2006

2008

2010

2011

2013

2015

2016

2018

Source: U.S. Bureau of Economic Analysis.

Page 4

​ Birthday Wishes

More Workers Available?

• However, the ratio of employed to total eligible population is low relative to historical economic peaks ‒ Suggests worker availability may dampen inflation and keep the Fed at bay

• The traditional unemployment rate indicates an economy operating at full capacity ‒ Implies higher inflation and higher interest rates on the way

…But Employed / Population Indicates Slack

The Official Unemployment Rate Is Low…

65%

12%

63%

10%

61%

8%

59%

6%

57%

4%

55%

2%

Source: U.S. Bureau of Labor Statistics. Shaded regions indicate U.S. recessions. Quarterly data through 2018.

Page 5

The Upside of Being Slow ​ Birthday Wishes

• While this expansion is chronologically old, it has not grown GDP as much as economic recoveries of comparable length

• This suggests a possibly longer runway of economic expansion now

60%

1960

50%

1990

40%

1981

30%

Room to catch up?

20%

1969

1973

2001

Current

10%

0%

Real Cumulative GDP Growth

-10%

0

2

4

6

8

10

12

14

16

18

20

22

24

26

28

30

32

34

36

38

40

42

44

Number of Quarters from Peak

Source: U.S. Bureau of Economic Analysis and Alger as of March 2019. Dates indicate beginning of measurement periods.

Page 6

Monetary Policy Is Not Restrictive ​ Birthday Wishes

• Over the past half century, every U.S. recession has been preceded by a materially positive real Fed Funds rate — 2% or higher

• In contrast, today we have a relatively low real Fed Funds rate of under 1%

Real Federal Funds Rate

15%

10%

Today real short-term interest rates are far

5%

lower than what induced previous recessions

0%

-5%

-10%

1960

1962

1965

1967

1970

1972

1975

1977

1980

1982

1985

1987

1990

1992

1995

1997

2000

2002

2005

2007

2010

2012

2015

2017

Source: FactSet, as of March 2019. Real Federal Funds rate is equal to the Federal Funds rate less the year-over-year change in the PCE Price Index ex-food and energy. Shaded regions denote U.S. recessions.

Page 7

Low Debt Burden Birthday Wishes

• Despite higher levels of debt as a % of GDP, the U.S. non-financial private sector debt service ratio is much lower than in the past two recessions ‒ Because more than 80% of U.S. consumer and business debt is fixed, higher interest rates should not have a dramatic impact on service costs

U.S. Debt Service Ratio

20%

Debt service ratio indicates households and corporations are not burdened by debt payments

18%

16%

14%

12%

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

Source: Bank for International Settlements, March 2019. Debt Service Ratio is the share of income used for interest payments and amortizations in the non-financial private sector. Shaded regions indicate recessions.

Page 8

Follow the Leader Birthday Wishes

• The Leading Economic Index is a good indicator of future economic growth or lack thereof

• Historically, it has declined on a year-over-year basis leading up to a recession

• Currently, it is rising, indicating continued economic growth, albeit at a slower pace

Leading Economic Index Prior to U.S. Recessions Year-over-year % Change

3.0%

Leading economic index

does not indicate recession

-1.3% -1.0%

-1.6%

-2.0%

-4.2%

Average is -3.4%

-5.8%

-7.7%

Jul '81

Jul '90

Jan '80

Mar '01

Current

Dec '69

Nov '73

Dec '07

Source: The Conference Board and Alger analysis as of March 2019

Page 9

Innovation Through Economic Cycles Birthday Wishes

• Innovation can flourish even if the economy languishes

‒ History shows that there are areas of innovation and growth throughout recessions, depressions and panics over the past 150 years*

U.S. Internet Ad Revenue

U.S. E-Commerce

U.S. Total Retail Sales

140

130

120

+30% Growth

110

100

90

80

Q208

Q308

Q408

Q109

Q209

Q309

Q409

Q110

Q210

Q310

Q410

Q111

Q211

Source: Bureau of Economic Analysis, PwC, Census Bureau. *See Alger’s white paper “The Enduring Force of Innovation.”

Page 10

​ Performance

Innovation as Wealth Creator

• Studies have shown, and our research demonstrates, that the most innovative companies grow their sales, earnings, and stock prices faster*

Innovation Drives Excess Performance 10 Years

60%

Most Innovative +4% per year

50%

40%

30%

20%

10%

0%

-10%

-20%

Cumulative Excess Return

Least Innovative -2% per year

-30%

Source: FactSet. Most/least innovative stock excess performance is derived from highest and lowest S&P 1500 quintiles based on R&D as % of sales, normalized for market value, using one month returns for 10 years ending 12/31/18. * Baruch Lev and Suresh Radhakrishnan, “The Stock Market Valuation of R&D Leaders.”

Page 11

​ Performance

Sentiment Swing

• Year-to-date returns have been broadly consistent with historical precedent • Annual returns averaged 19% after double-digit declines in P/E

• Last year, equity valuations had their second largest decline in three decades (-21%) • This year sentiment has rebounded (+14%)

Change in S&P 500 P/E

Double-Digit S&P 500 P/E Declines

40%

P/E Change Following Year Return

50%

30%

40%

20%

+14%

30%

10%

20%

0%

10%

-10%

0%

-20%

-10%

-21%

-30%

-20%

-30%

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

2014

2016

2018

1987 1994 2000 2002 2005 2008 2018

Source: FactSet and Alger. Data is 1987-2019.

Page 12

Yield Curve Flattens ​ Performance

• During the first quarter, the Treasury yield curve, or spread between the 10-year and 2-year Treasury yields, flattened • While an inversion in the curve often signals a recession ahead, we believe 1) the very low level of interest rates is distorting its signal and 2) equity returns are often strong after inversion

Yield Curve Flattens

Equity Performance After Initial Yield Curve Inversion

4%

31%

27%

Average is 22%

3%

21%

2%

1%

7%

0%

-1%

1986

1988

1990

1992

1994

1996

1998

2000

2003

2005

2007

2009

2011

2013

2015

2017

Source: FactSet as of 3/31/19. Yield curve represented by 10-year less 2-year Treasury yield (monthly data).

Page 13

The Search for Yield ​ Performance

• In 1Q19, dividend yield outperformed as interest rates declined while the secularly challenged low price-to-book stocks continued to lag

1Q19 Excess Return (%)

2018 Excess Return (%)

2.2 2.0

1.8 1.6

1.4 1.1

0.9 0.6 0.4 0.1

-0.3

-1.0 -1.2 -1.4 -1.5 -1.5

-1.0 -1.3

-2.3

-2.1

-2.6

-5.8

Market Cap

Book / Price

EPS Growth

Debt / Equity

Market Cap

Book / Price

Price Volatility

EPS Growth

Dividend Yield

Debt / Equity

Trading Activity

Earnings / Price

Revenue / Price

Price Volatility

Dividend Yield

Relative Strength

Trading Activity

Earnings / Price

Revenue / Price

Relative Strength

Earnings Variability

Earnings Variability

Source: FactSet as of 3/31/19 using Northfield defined quantitative factors for the Northfield broad U.S. market database.

Page 14

​ Performance

Structural Issues Driving Growth vs. Value

• Growth stocks have dramatically outperformed (~30%) Value stocks over the past decade

• The driver has been the very weak performance of the valuation metric Price-to-Book, which is used heavily in index classifications of Growth vs. Value stocks • As accounting fails to keep up with the changing economy, book value may no longer be as relevant (e.g., R&D is not capitalized in book value)

120

Style classification too dependent upon flawed book value

100

80

Low P/B

Russell 1000 Value / Growth

60

40

20

Total Return Index

0

2009

2011

2013

2015

2017

2019

Source: FactSet as of 3/31/19. Low price-to-book returns are based on the B/P Northfield factor for the Northfield broad U.S. market database.

Page 15

​ Performance

Has Active Relative Performance Troughed?

• Factors that impact U.S. active relative performance often prove to be cyclical ‒ Interest rates/bond-like equities ‒ Small cap performance

‒ Overall market performance ‒ Non-U.S. stock performance

Active Relative Performance Is Cyclical

100%

80%

60%

40%

20% % of Fund Assets Outperforming

0%

1970

1973

1976

1979

1982

1985

1988

1991

1994

1997

2000

2003

2006

2009

2012

2015

2018

Source: Nomura/Instinet, Joseph Mezrich and FactSet through 3/31/19. Fund performance is trailing five-year data of U.S. active equity mutual funds in existence for five years or more and part of the growth, growth & income, and income categories based on CRSP codes.

Page 16

​ Performance

What Outperforms in a Slowdown?

• Growth equities typically outperform when overall EPS growth decelerates, likely because:

‒ Growth equities are less cyclical

‒ Value stocks have more operational and financial leverage

‒ Higher growth is more scarce

Equity Returns in Periods of Profit Deceleration (1982-2018)

15.8%

Growth has historically

outperformed Value when fundamentals decelerate

14.1%

Russell 1000 Growth

Russell 1000 Value

Source: Bank of America Merrill Lynch Quantitative Strategy. Median data for periods: Jun 1984-Dec 1985, Jun 1988-Dec 1991, Mar 1995-Sep 1998, Mar 2000-Dec 2001, Dec 2003-Jun 2005, Mar 2006-Mar 2009, Jun 2010-Sep 2012, and Dec 2013-Dec 2015.

Page 17

Better to Be Behind? ​ Fundamentals

• The output gap measures economic output relative to potential, with a lower output gap indicating more growth left in the cycle • While most major regions are at or near potential output, some, such as Europe, are further behind the U.S.

U.S. Output Gap

Source: FactSet and Oxford Economics as of 3/31/19. Shaded regions indicate U.S. recessions.

Page 18

​ Fundamentals

Innovation Deflation

• While the positive output gap in the U.S. indicates inflation pressures, we believe innovation in the form of pricing transparency, new business models, and automation is driving down inflation

‒ An indication of this dynamic is the declining correlation of wages and inflation

Correlation of Wages and Inflation

88%

Wages are having less impact on prices likely because of innovation

60%

1960-1999

2000-2018

Source: Alger analysis, U.S. Bureau of Economic Statistics, and U.S. Bureau of Labor Statistics. Wages are year-over-year change in unit labor costs and inflation is year-over-year change in PCE price deflator ex-food & energy.

Page 19

​ Fundamentals

Growth Acceleration

• After an impressive 2018, EPS growth has been under pressure in early 2019

• While the economy has slowed, idiosyncratic issues are also at work, as illustrated by the stronger S&P 500 median EPS growth rate

• Importantly, the economy and EPS growth are forecasted to accelerate through 2019

S&P 500 EPS Growth Is Forecasted to Improve

Aggregate Median

10%

EPS growth forecasted to quickly return to solid levels

8%

6%

6%

2%

2%

0%

-4%

1Q19

2Q19

3Q19

4Q19

Source: FactSet and Alger analysis. EPS for 2019 are consensus estimates and actual earnings per share might be materially different than shown.

Page 20

​ Fundamentals

China Is Stimulating

• Chinese growth has been a key driver in the volatility of global equities

• Through various means, China is working to stimulate its economy

• A trade deal would go a long way to help the decelerating Chinese economy but stimulus may pick up some of the burden

Is easing working again?

5.5%

30%

Lower rates helped equities bottom

20%

4.5%

S&P 500 YoY

10%

0%

3.5%

China Interest Rate

-10%

2.5%

-20%

Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16 Jan-17 Jul-17 Jan-18 Jul-18 Jan-19

Source: FactSet as of March 2019. China interest rate is SHIBOR one year rate.

Page 21

Smaller Capitalization Stocks Poised to Outperform ​ Fundamentals

• Compelling valuation : Small cap P/E multiple premium is low relative to history

• Stronger fundamentals : Estimated small cap EPS growth for ‘19 & ‘20 is double that of large cap

• More levered to domestic economy : U.S. small caps have less exposure to international economies

Price-to-Earnings Russell 2000 / Russell 1000

Earnings Per Share

0% 10% 20% 30% 40% 50% 60% 70% 80%

R2000 R1000

140

Small caps growing faster

120

Median

EPS Indexed to 100

100

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

2018

2019

2020

Source: FactSet as of March 2019 . EPS for 2019-2020 are consensus estimates and actual earnings per share might be materially different than shown.

Page 22

​ Fundamentals

The Growth Advantage

• Three variables drive P/E multiples: growth, return on capital, and risk

• As compared to the Russell 1000 Value Index, the Russell 1000 Growth Index has higher expected EPS growth, higher return on equity, and lower risk in the form of better balance sheets

Stronger Growth

Higher Returns

Lower Risk

R1000G R1000V

R1000G R1000V

R1000G R1000V

14.5%

2.6x

31.7%

8.4%

1.0x

12.4%

Long-Term EPS Growth

Return on Equity

Net Debt / EBITDA

Source: FactSet as of 3/31/19. Growth represents consensus long-term analyst estimates and actual future EPS growth rates might be materially different than the forecasts shown.

Page 23

Stocks Are Cheap Relative to Bonds ​ Valuation

• Historically, the “earnings yield” of equities (inverse of the P/E) has been just modestly above 10-year Treasury yields • Since the Global Financial Crisis, however, that spread has widened out and has yet to normalize, making equities attractive relative to bonds

S&P 500 EPS Yield

Treasury Bond Yield

16%

14%

12%

10%

8%

Spread of >350bps indicates stocks are attractive relative to bonds

6%

4%

2%

0%

1958

1962

1966

1970

1974

1978

1982

1986

1990

1994

1998

2002

2006

2010

2014

2018

Source: FactSet, Federal Reserve, and S&P, as of 3/31/19.

Page 24

What Is In and Out of Favor? ​ Valuation

• Sector valuation varies with the more bond-like equity sectors trading at premiums to the market

P/E Relative to 20-Year Median

28%

27%

17%

16%

16%

11%

8%

4%

-1%

-2%

-4%

-9%

Energy

Utilities

S&P 500

Materials

Financials

Industrials

Health Care

Real Estate

Consumer Staples

Information Technology

Consumer Discretionary

Communication Services

Source: FactSet and UBS, based on S&P 500 Index as of 3/31/19. The Communication Services, Consumer Discretionary, and Technology sectors’ historical data have been restated to reflect September 2018 changes to the GICS sector classifications. Note that Consumer Discretionary ex-Internet Retail is a 1% premium to its 20-year median.

Page 25

Growth and Value Near Equilibrium ​ Valuation

• Despite their outperformance over the past several years, Growth stocks are not very expensive compared to their Value equity counterparts relative to expected growth rates or history

Russell 1000 Growth vs. Russell 1000 Value PEG Ratio (P/E Divided by Long-Term Growth Rate)

Russell 1000 Growth Relative to Russell 1000 Value P/E

1.7x

Growth stocks are cheaper relative to long-term growth

1.4x

47%

Median

Russell 1000 Value

Russell 1000 Growth

Source: FactSet, Bank of America as of 3/31/19.

Page 26

Global Equity Valuations Are Reasonable ​ Valuation

• Price-to-earnings multiples around the world are modestly above their historical average, which is reasonable relative to very low global interest rates

= current

Price-to-Earnings Multiple +/- 2 Standard Deviations from 15-Year Average

= +2 std dev

20x

= average

= -2 std dev

15x

EM is least expensive in

10x

absolute terms while EAFE is cheapest relative to history

5x

S&P 500 MSCI AC World MSCI EAFE MSCI EM

Z-Score (Standard Deviations Above/Below Mean)

1.1

0.7

0.1

0.7

Source: FactSet. Monthly estimates over past 15 years ending 3/31/19. MSCI AC World represents developed and emerging markets globally. MSCI EAFE represents developed countries in Europe, Australasia and the Far East. MSCI EM represents emerging markets globally. A Z-Score is the number of standard deviations a data point is from the mean. A z- score equal to zero, it is on the mean. If a z-score is equal to +1, it is 1 standard deviation above the mean. Standard deviation measures how much the data has deviated from its average. If data has a high standard deviation, there is large deviation from its mean, and vice versa. Standard deviation is generally used to compare the relative volatility of data sets.

Page 27

​ Valuation Framework for Forecasting Returns

• There is a strong relationship between starting valuations and ensuing 10-year returns

• Current valuations suggest equities should materially outperform bonds over the coming decade

S&P 500 P/E vs. 10-Year Returns

Russell 1000 Growth P/E vs. 10-Year Returns

= Month

= Current

Tech Bubble

25%

25%

R² = 0.79 (0.85 ex-tech bubble)

R² = 0.85

20%

20%

15%

15%

10%

10%

5%

5%

0%

0%

-5%

-5%

-10%

-10%

5

10

15

20

25

30

5

10

15

20

25

S&P 500 10-Year Annualized Return

Russell 1000G 10-Year Annualized Return

Russell 1000 Growth Price/Earnings

S&P 500 Price/Earnings

Source: FactSet. Each dot represents the P/E during that month and the returns generated over the subsequent 10 years. The starting P/E ratio is the price divided by the next 12-month earnings per share estimate at the start of each 10-year period measured. Monthly data through March 2019 and beginning in January 1986 (S&P 500) and December 1978 (Russell 1000 Growth). The tech bubble, represented by the 10-year returns beginning in April 1987-March 1990 and ending in April 1997-March 2000, skewed the regression by resulting in higher returns for given valuations than the historical relationship would imply.

Page 28

Disclosure ​The views expressed are the views of Fred Alger Management, Inc. as of April 2019. Alger has used sources of information which it believes to be reliable; however, this publication is not intended to be and does not constitute investment advice. These views are subject to change at any time and they do not guarantee the future performance of the markets, any security, or any funds managed by Fred Alger Management, Inc. These views should not be considered a recommendation to purchase or sell securities. Individual securities or industries/sectors mentioned, if any, should be considered in the context of an overall portfolio and therefore reference to them should not be construed as a recommendation or offer to purchase or sell securities. References to or implications regarding the performance of an individual security or group of securities are not intended as an indication of the characteristics or performance of any specific sector, industry, security, group of securities, or a portfolio and are for illustrative purposes only.

​ Risk Disclosures : Investing in the stock market involves gains and losses and may not be suitable for all investors. Growth stocks tend to be more volatile than other stocks as the prices of growth stocks tend to be higher in relation to their companies’ earnings and may be more sensitive to market, political and economic developments.

​The S&P 500 Index is an unmanaged index generally representative of the U.S. stock market without regard to company size. The S&P Composite 1500 is an unmanaged index that covers approximately 90% of the U.S. market capitalization. The Russell 1000® Growth Index is an unmanaged index designed to measure the performance of the largest 1000 companies in the Russell 3000 Index with higher price-to-book ratios and higher forecasted growth values. The Russell 1000 Value Index measures the performance of those Russell 1000 companies with lower price-to-book ratios and lower forecasted growth values. The Russell 2000 Growth Index is an unmanaged index generally representative of common stocks designed to track performance of small-capitalization companies with greater than average growth orientation. The Russell 2000 Value Index is an unmanaged index generally representative of the small-cap value segment of the U.S. equity universe and measures the performance of Russell 2000 companies with lower price-to-book ratios and lower forecasted growth values. The Russell 3000® Growth Index is an unmanaged index designed to measure the performance of those Russell 3000® Index companies with higher price-to-book ratios and higher forecasted growth values. The Russell 3000 Value Index is an unmanaged index generally representative of stocks from the Russell 3000 Index with lower price-to-book ratios and lower expected growth rates. The MSCI ACWI Index (gross) is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The MSCI ACWI consists of 45 country indices comprising 24 developed and 21 emerging market country indices. The MSCI ACWI ex USA Index (gross) captures large and mid cap representation across 23 of 24 Developed Markets (DM) countries excluding the US) and 23 Emerging Markets (EM) countries. The index covers approximately 85% of the global equity opportunity set outside the US. The indices presented are provided for illustrative purposes, reflect the reinvestment of dividends and do not assess fees and expenses that would have the effect of reducing returns. Investors cannot invest directly in any index. The index performance does not represent the returns of any portfolio advised by Fred Alger Management, Inc. and actual client results might differ materially than the indices shown. Note that past performance is no guarantee of future results. Comparison to a different index might have materially different results than those shown. ​Frank Russell Company (“Russell”) is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell ® is a trademark of Frank Russell Company. Neither Russell nor its licensors accept any liability for any errors or omissions in the Russell Indexes and / or Russell ratings or underlying data and no party may rely on any Russell Indexes and / or Russell ratings and / or underlying data contained in this communication. No further distribution of Russell Data is permitted without Russell’s express written consent. Russell does not promote, sponsor or endorse the content of this communication. ​ ALCAPPRESSPRP-0419

Fred Alger & Company Incorporated • 360 Park Avenue South, New York, NY 10010 • 800.992.3863 • www.alger.com

Page 29