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The Key to Investing in Markets Today May be in Knowing Who You Are and What You Do… Rick Rieder CIO, Global Fixed Income Trevor Slaven Dez Desai Annelise Eschmann May 18, 2017 The opinions expressed are those of BlackRock as of 18 May 2017, and are subject to change at any time due to changes in market or economic conditions. This document contains general information only and does not take into account an individual’s financial circumstances. An assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a professional adviser before making an investment decision. Reference to any security, holding or company is for discussion purposes only. The issuers referenced are examples of issuers BlackRock considers to be well known and that may fall into the stated sectors. BlackRock may or may not own any securities of the issuers referenced and, if such securities are owned, no representation is being made that such securities will continue to be held. For Professional, Permitted, Institutional, Qualified and Wholesale Investors/Professional Clients Only. Not for Public Distribution – Please Read Important Disclosures 20170517-160346-445949 Dial-in information • Date: May 18, 2017 • Time: 8:00am Eastern Standard Time* • Conf. Call Name: Monthly Markets Call • Passcode: 6474262 • US Dial-in #: 1-800-289-0496 • International Dial-in #: 1-913-312-0644 • Replay Information: US Dial-in #: 1-888-203-1112 International Dial-in #: 1-719-457-0820 Passcode: 6474262 *Due to potentially high call volume, we recommend dialing in 15 minutes before the start of the call. For Professional, Permitted, Institutional, Qualified and Wholesale Investors/Professional Clients Only. Not for Public Distribution – Please Read Important Disclosures 20170517-160346-445949 2 Markets today have become incredible in their convergence of thought… Seemingly everyone crowds into the same views and then watches those positions underperform due to lack of followthrough potential… • For example, it is incredible that a select few do all the deep analysis in areas like oil such as production capacity, technology innovation, political dynamics, etc. but everyone in the market has an opinion on where oil is going… • Markets seem to coalesce around one consensus view on complex subjects, and like to simplify the key drivers within that view; e.g. ECB tightens and Euro rallies. • Consequently, markets tend to converge toward one overriding principle or theme related to what the experts have discerned, particularly in an era of media/social media ever-presence. • Markets move up with the crowd, and then when they don’t have anyone else to sell their ideas to, they go down, unless there is a secular theme which persists to drive the concept further, or the underlying technical conditions within that concept are extraordinarily deep and durable… • In other words, the consensus wins for a while and then ultimately loses, unless the secular and technical factors overwhelm the crowding into one view. For Professional, Permitted, Institutional, Qualified and Wholesale Investors/Professional Clients Only. Not for Public Distribution – Please Read Important Disclosures 20170517-160346-445949 3 However, knowing who you are, and what the environmental conditions are, could ultimately drive success in today’s unusual market conditions, and can prevent reacting to superfluous noise which detracts from the objective at hand… Today’s Call is organized to address three key drivers in the market: 1) Major secular trends and drivers that persist over many years and are the underlying foundation of long-term investment direction… 2) Medium-term trends/cycles which can determine prices and market moves, and can tangibly drive returns and profitability… 3) Short-term news or noise which can influence very shortterm market prices but can easily reverse Investors Major trends: important to build from here given long-term return objectives or liability-matching requirements Medium-term cycles: critical to evaluate effectively as they can be major drivers of return… they vary in length, but usually with two or three main themes a year that drive annual return proficiency… News / Noise: require incredible fortitude and conviction to ignore, or scale in a very small way… Speculators / Traders Major trends: should generally not be interested here Medium-term cycles: these are helpful for background… News / Noise: there is money here today still, but the era of instantaneous information dissemination, transparency, and central-bank influence on volatility make this difficult, requiring speed, efficient scaling, and an ability to quickly decipher news from noise… For Professional, Permitted, Institutional, Qualified and Wholesale Investors/Professional Clients Only. Not for Public Distribution – Please Read Important Disclosures 20170517-160346-445949 4 … we just had a full refresher on these exact concepts during the prior week… Some of the recent Chinese data has turned down, but is coming off of a heretofore surprisingly solid growth trajectory which should remain intact in our view… 53.5 Last Thursday, the PPI data was strong, stoking the “reflation” theme again, but then on Friday morning, the CPI data was soft, invoking a “lack of inflation” theme again… 2.2% 55 53.0 2.0% 53 50 51.5 49 48 51.0 Yield 51 52.0 2.0% 1.8% 47 50.5 1.9% 1.6% 1.8% Yield GDP PMI 52 PMI Output Prices 52.5 50.0 2012 2.2% PPI Surprises Higher 2.1% 54 1.7% 1.4% CPI Surprises Lower 1.2% 1.6% 1.5% 46 2013 2014 2015 GDP Weighted PMI Headline 2016 45 2017 GDP Weighted PMI Output Prices (rhs) 1.0% 1.4% US 3Y Breakeven US 10Y Breakeven (rhs) We believe in the title of our last monthly: • “Investing Within a System that is Only ‘Flating’ During a Time of Increased Uncertainty and Historic Technical Conditions” • … and we agree with the FOMC’s recent assessment of the US earlier this month that “…inflation will stabilize around 2 percent over the medium term…” And we believe that a lot of the inflation data released last week was largely noise around what is a roughly stable dynamic… • Hence, we think that investing today is all about focusing on: 1) The large secular themes as a foundational backdrop, 2) … married to some major intermediate cyclical dynamics that can drive a good deal of annual returns, 3) …as well as maintaining an incessant focus on separating the daily news from the noise… Source: Bloomberg as of 5/15/2017 For Professional, Permitted, Institutional, Qualified and Wholesale Investors/Professional Clients Only. Not for Public Distribution – Please Read Important Disclosures 20170517-160346-445949 5 1) Major secular trends – We still think that few appreciate how powerful they are in 2017, and in virtually every month within it… Demographics and technology keep driving all the major market moves… The growth in demand for fixed income assets is outpacing the supply of liabilities to generate the cash flows 1 $150 Fixed Income: $89 trillion Equity: $58 trillion Growth of Supply and Demand for Global Fixed Income $2,500 USD Billions $2,000 $1,500 $600 bn in annual interest income to US households is 7x higher than the $85 bn “cost” of a 1% increase in mortgage rates (and mostly only new mortgages would be affected) $1,000 $500 $0 USD Trillions $6 $4 $2 2018 2017 2016 $8 $0 Demand-Supply Imbalance Net G4 Issuance, Net of CB QE Checkable Deposits Savings Deposits Net Demand, Global Fixed Income Assets ex. CBs *Net Demand assumes Global Fixed Income Demand Base maturities of approximately 7 years (in-line with the duration of Barclays Global Agg) and coupon payments in-line with the five-year trailing yield (currently 2.0%) A normalization of yields on household financial assets (100-120bps higher) would equate to $500600 billion in additional interest income per year 2 2015 US Insurance EU Corporates JP Corporates SWFs US HF, PE, MF & ETF 2014 2016 2013 2014 2012 US Corporates EU Households JP Households JP Insurance Int. FX Reserves 2012 2011 2010 2010 2008 2009 US Households US Pensions EU Insurance + Pension JP Pension CBs 2006 2008 2004 2007 $0 2002 2006 $25 2003 $50 $10 2005 $75 $12 $14 $12 $10 $8 $6 $4 $2 $0 2004 $100 USD Trillions USD Trillions $125 Household deposits and money market fund holdings exceed $11 trillion; A 1.0% increase in the rate earned on cash assets equates to over $110 billion of annual income 2 Money Markets … hence the inflows in Fixed Income that continue to press yields & spreads to very aggressive levels 4 The demand for income from the aging global demographic is stark, especially as an aging population tends to slow growth, resulting in lower interest rates 3 • The amount of implicit demand for yielding financial assets from retirees alone is incredible 500,000 400,000 Source: Census as of 12/31/16 1987 1997 2007 2017 2027 Population Ages 65+ (MMs) % of the Total Population 29.6 12.2% 34.4 12.6% 37.8 12.6% 51.1 15.6% 69.5 19.7% Yield: 50/50 Portfolio of TSY & HY 11.4% 7.3% 6.8% 4.0% 4.1% Annual Interest Income Desired Fin. Assets Req. to Generate Income $9,485 $13,276 $17,349 $20,000 $24,380 Agg. Fin. Assets Req. for 65+yr 300,000 200,000 100,000 0 -100,000 $83,315 $181,586 $253,955 $497,055 $589,408 -200,000 05/13 $ in BNs HH Interest Income USD, millions There is nearly $150 trillion of liquid assets seeking out yield around the world 1 $2,468 $6,247 $9,606 $25,377 $40,937 HH Interest Income @ 4.0% Yield Source: 1) Barclays as of 9/30/16; 2) Federal Reserve as of 12/31/16; 3), Census as of 12/31/16; 4) EPFR, as of 5/10/17 For Professional, Permitted, Institutional, Qualified and Wholesale Investors/Professional Clients Only. Not for Public Distribution – Please Read Important Disclosures 05/14 05/15 05/16 05/17 All Global Bond Mutual Fund Flows North America Bond Mutual Fund Flows 20170517-160346-445949 6 1.A.) Demographic influences continue (and will continue) to be one of the biggest forces driving this major secular demand for yield… Central banks continue to use extreme policy to plug what is largely a demographicallydriven “lower potential growth” impact, consequently driving immense demand into Fixed Income/Rates markets… 4,500 350 4,000 300 3,500 250 3,000 2,500 2,000 1,500 14,000 10,000 150 100 50 Japan: Increm. Govt Debt Eurozone: Increm. ECB B/S Japan: Increm. BOJ B/S … hence why Europe and Japan still have negative net supply after taking the purchases of the ECB and BOJ into account 2 Net G4 Issuance, Net of CB QE BOJ Balance Sheet (USD) 2016 Fed Balance Sheet (USD) However, $180bn of annual run-off could start in 2018 once the Fed begins reducing its balance sheet, which is still moderate relative to the $60bn/mo the ECB is still buying (albeit in smaller size next year)… 3 Balance sheet scenario 4,000 5.00 4.50 3,000 Size of B/S ($,trillion) 4.00 2,000 1,000 0 -1,000 USD GBP EUR TOTAL 2016 2013 2010 2007 2004 2001 1998 1995 1992 1989 1986 1983 1980 -2,000 Total MBS 100 Scenario assumptions for a tapered runoff: 90 • In H1 2018, allow 5bn Tsy & 5bn MBS to run off per month • In H2 2018, allow 10bn Tsy & 10bn MBS to run off per month • Starting in 2019, Allow full runoff in MBS (i.e. fully stop MBS reinvestment). Continue to allow 10bn Tsy to run off per month • In mid 2023, when Fed’s SOMA holdings get down to $2.8 trillion, start to net buy Treasuries again (NY Fed’s assumption) 80 Tsy 3.50 70 3.00 60 2.50 50 2.00 40 1.50 30 1.00 20 0.50 10 0.00 0 JPY Source: 1) ECB, as of 3/31/17; 2) BlackRock, 5/2017; 3) Federal Reserve, as of 5/2017 For Professional, Permitted, Institutional, Qualified and Wholesale Investors/Professional Clients Only. Not for Public Distribution – Please Read Important Disclosures Monthly Run-Off ($, billion) 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 - 5,000 USD Billions $ in BNs 6,000 ECB Balance Sheet (USD) SUPPLY DEMAND Net Demand, Net G4 Global Fixed Gross G4 Net G4 Issuance, Income Issuance Issuance Net of CB Assets ex. QE CBs 3,832 2,038 2,038 9,703 4,357 2,282 2,282 10,553 4,350 2,101 2,101 9,609 4,902 1,986 1,986 9,662 4,907 2,077 2,077 10,626 4,861 1,273 1,273 11,504 7,268 3,874 3,871 11,640 6,929 3,911 3,550 12,754 6,693 2,770 1,739 12,312 7,094 2,584 2,076 11,478 6,933 2,673 1,609 10,643 6,928 2,202 1,394 8,676 6,350 1,728 636 8,458 6,528 1,901 351 7,907 6,658 1,924 484 7,778 7,786 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 Eurozone: Increm. Govt Debt Supply of fixed income is being overwhelmed by demand, especially when taking central bank demand into account… 2 $3.2tr in May 2007 2,000 2005 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 (100) 2006 - 2005 500 8,000 4,000 - (50) $13.2tr in May 2017 12,000 200 1,000 An incremental $10 trillion in Central Bank assets have been put to work a number that is still growing… 2 US$ billions Yen in Trillions EUR in Billions The ECB and BOJ have essentially bought all of the net issuance of their governments since before the crisis 1 20170517-160346-445949 7 … the supply/demand imbalance could change significantly over the next two years (possibly led by Europe), consequently taking some of the pressure off of US rates… And, the US paradigm of deficit spending and borrowing could very well change over the next couple of years, but probably not for a bit of time… 2017 net supply estimates today – which will change quite a bit when the ECB tapers 1 Germany | net supply net of QE purchases 5 10 5 0 bns bns France | net supply net of QE purchases 11 -10 -20 -30 -11 -13 -12 -13 -16 -16 -17 -19 -23 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 20 10 0 -10 -20 -30 -40 15 bns bns 1 -5 -9 20 0 -9 -10 -10 -9 -13 -15 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec -24 -28 6 4 1 2 0 -1 -5 -15 3 0 -3 -10 -20 -17 -23 -30 -40 -24 -32 -50 1 -60 0 -10 8 2 0 -19 5 0 -20 2 Italy | net supply net of QE purchases 5 -4 EMU-11** | net supply net of QE purchases 10 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 12 -10 11 -9 10 10 13 10 Spain | net supply net of QE purchases 20 8 4 bns 20 -70 -1 -67 -68 -80 -9 -12 -12 -13 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Positive Supply -82 -90 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Negative Supply 90% 16 80% 14 70% 12 60% 10 50% 8 40% 6 30% 4 20% 2 10% 0 1945 1955 1965 Federal Govt 1975 1985 1995 2005 State & Local Govt 2015 0% 1975 Net Treasury Issuance vs. Federal Budget Deficit $2,000 -$1,600 -$1,400 $1,500 USD Billions 18 -$1,200 -$1,000 $1,000 -$800 -$600 $500 -$400 2017 data is -$200 LTM Net $0 Issuance $0 USD Billions, inverse $ Trillions U.S. government debt has been growing, but so have tax receipts… Yet, ultimately, entitlement-spending will likely overwhelm this in the coming years… 2 $200 -$500 1985 1995 2005 Federal Gov't Debt to GDP $400 2015 Tsy Issuance Federal Budget Deficit, rhs Source: 1) ECB, as of 3/31/17; 2) Federal Reserve, as of 12/31/16; ** EMU = Economic and Monetary Union, EMU 11 refers to 11 initial European Countries in the EMU 20170517-160346-445949 For Professional, Permitted, Institutional, Qualified and Wholesale Investors/Professional Clients Only. Not for Public Distribution – Please Read Important Disclosures 8 … in the meantime, the central bank “crowding-in” consequently drives huge demand for the (meager) available supply of reasonable-yielding U.S. assets… US trading partners are by far the largest holders of TSY debt 1 And specifically, the amount held by foreign investors in the 7 – 10 year point of the curve, where rates are close to zero internationally, is pretty amazing… 1 50% FX Reserves: a source of demand for much of the past decade, this became a source of supply in 2015-2016… but is now stable 2 45% $14 35% $1.2 tn “net supply” since 9/30/14 $12 FX Reserves (USD tn) 30% 25% 20% 15% 10% 5% 0% $10 $8 $6 $4 $2 2016 Saudi Arabia US$ bn 2016 2015 2014 2013 2012 2011 2010 2009 50 China Mar-17 Dec-16 Jun-16 2,600 Sep-16 -50 -100 Mar-16 2,800 Dec-15 Jan-17 Oct-16 Jul-16 Apr-16 Jan-16 Oct-15 Jul-15 Apr-15 Jan-15 Oct-14 400 100 0 Jun-15 450 3,000 Sep-15 500 3,200 Mar-15 550 150 3,400 Dec-14 600 200 3,600 Jun-14 650 250 3,800 Sep-14 FX Reserves (USD bn) 700 Cumulative Japanese net purchase of foreign bonds by fiscal year ($bn) $1tn peak to trough 4,000 Mar-14 $225bn peak to trough Jul-14 2008 … while the Japanese have poured money into foreign markets for 3 straight years… 3 4,200 750 Apr-14 2007 World Pegged currencies and commodity producers were hit particularly badly over the past couple of years… 2 Jan-14 2006 Mutual Funds RoW 2005 2015 2014 2013 2012 2011 2010 2009 2008 Banks Insurance $0 2004 HHs Pensions Fed 2007 2006 2005 2004 2003 2002 2001 2000 -5% FX Reserves (USD mm) % holding of Tsy debt 40% 0 4 8 12 16 20 24 28 32 36 40 44 48 52 # of weeks from the start of each fiscal year in April FY 2011 FY 2012 FY 2013 FY 2014 FY 2015 FY 2016 FY 2017 YTD For Professional, Permitted, Institutional, Qualified and Wholesale Investors/Professional Clients Only. Not for Public Distribution – Please Read Important Disclosures 20170517-160346-445949 9 … and companies are now also looking for yielding assets for their cash hoards, resulting in this \major secular influence on markets (with demographics being at the core of this) ---> there aren’t enough attractive assets for the organic demand in markets today… Corporate debt has been growing and should continue to grow (not too much larger), and much of the issuance has come, meaning record cash balances have themselves become a major source of demand for yield, including back into credit-assets! 1 400 200 0 5.0% 4.0% Cash / Assets 2016 200% 150% 100% 50% 0% Brazil Indonesia India Colombia Turkey South… South Africa Mexico Thailand China Canada U.K. France Spain U.S. Italy Japan Gross debt as a % of GDP 250% 2001 6.4x 2.2x 5.4x 2.0x 4.4x 1.8x 3.4x 213 200 110 96 100 29 0 2.4x 1.6x 1.4x 1.4x -200 -1 -33 -41 -29 -95 -98 -129 -180 -300 2004 2006 2008 2010 2012 2014 2016 … particularly where yield is available in the 2017 “yield vs. duration mess” 5 With reasonable valuations and only moderate need for debt in much of EM, supply may not meet the demand for EM bonds (and equities) 4 35,000 30,000 25,000 20,000 15,000 10,000 5,000 (5,000) 12/16 305 308 300 -100 Cash (rhs) Sovereign leverage levels in EM are now lower or still at low levels relative to debt in developed markets 3 2.4x $ in Billions 6.0% 7.4x 2017: Yield vs. Duration, Returns from 7/31/2016 to 5/15/2017 12% Returns from 7/31/20165/15/2017 10% LatAm Sov & Gov't, $1,016, +12.7% 8% US HY, $1,122, +8.9% 6% 01/17 EM Bond 02/17 03/17 04/17 EM Equity US IG, $4,461, -0.4% EM Corp, $569, +4.7% Yield 800 600 7.0% 400 2.6x 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 8.0% Securitized Net Issuance 2.8x IG ex Fin Debt/EBITDA (rhs) 8.4x Cumulative Flows (USD mm) 9.0% 3.0x IG ex Fin Net Debt/FCF 9.4x Debt/EBITDA 1,400 1,200 1,000 10.0% 10.4x Net Debt/ FCF 1,800 1,600 11.0% S&P 500 Cash ($ in BNs) S&P 500 Cash / Assets 12.0% In securitized markets, regulatory change in the US and Europe would be required for more securitized asset supply, but this market could grow in the coming years, albeit not for a while 2 UK Sov & Gov't, $1,339, -1.3% EUR HY, $353, +6.6% 4% MBS, $5,268, -0.5% 2% EUR IG, $1,411, -0.7% Conclusions here: we believe that developed market rates will move higher, but maybe not for a few more months (especially given the noise becoming news in Washington), so we like Emerging Market rates better… We like Securitized assets until the supply technicals really change (not for a while)… And ultimately, DM rates will be driven higher by monetary policy-evolution in Europe, and further by deficit-financed government borrowing in the US… 0% -2% US Sov & Gov't, $7,422, -1.3% 2 3 Euro Sov & Gov't, $6,843, -4.1% 4 5 6 Source: 1) CapIQ, as of 12/31/16; 2) Bloomberg, as of 5/2017; 3) Datastream, as of 12/31/16; 4) Bloomberg, as of 5/15/17; 5) Barclays, as of 5/15/17 For Professional, Permitted, Institutional, Qualified and Wholesale Investors/Professional Clients Only. Not for Public Distribution – Please Read Important Disclosures Japan Sov & Gov't, $7,228, -2.7% 7 8 9 10 Duration 20170517-160346-445949 10 1.B.) The Second Secular Influence (Technology) – Playing out in May 2017 (and in every month of 2017)… We showed these remarkable charts on last month’s call. They played out again in a major way this past month… Charts below are repeats from last month. Historically, technology has proved to be deflationary 105 200 90 190 85 180 170 80 160 150 Headline CPI 140 500 80 400 60 300 IT Subcomponenets(rhs) 20 0 2013 2014 Disruptor Energy Comm. Fracking Tech-Disrupted Sectors (excluding Energy) 0.0% Audio Equip. Streaming, smartphones Sports Equip. Amazon Photographic Equip. Smartphones with cameras Books eBooks Toys Smartphones, tablets PCs & Peripheral Equip. Smartphones, tablets -0.1% Contribution to YoY Change Smartphones, tablets -0.1% -0.2% -0.2% -0.3% Computer Software App Store Leased Cars & Trucks Over supply, ride sharing -0.3% Netflix, digital media -0.4% Video Discs & Other Media Wireless Telephone Serv. Smartphones saturation, price war 80 60 2016 2017 WTI(rhs) 2000 2005 2010 Toys Appliances Window, Floor Coverings, Linens Photo Equipment Personal Computers IT Commodities Sports Equiment 2015 Furniture & Bedding Household Equipment IT Hardware & Services Audio Equipment Video & Audio Products Leased Cars & Trucks Weakness in March 2017 CPI Report – driven by the introduction of “unlimited data” Household Furnishings IKEA, Amazon Televisions 2015 Production per Rig: Permian Oil Tech-disrupted sectors contribution to CPI Inflation Category 100 40 100 0 2012 120 40 200 75 160 100 Headline CPI Core CPI CPI Food Food at Home Food Away From Home (nsa) CPI Energy Energy Commodities Fuel Oil (nsa) Motor Fuel Energy Services Core CPI Core goods Apparel New Vehicles Used Cars and Trucks Medical Care Commodities Alcoholic Beverages Tobacco & Smoking Products Core Services Shelter Medical Care Services Transportation Services Recreation Services Education & Communication Wireless Telephone Services MoM% -0.29 -0.12 0.34 0.48 0.16 -3.20 -6.01 -0.76 -6.11 -0.29 -0.12 -0.33 -0.70 -0.30 -0.90 0.23 0.22 0.48 -0.06 0.12 0.12 0.36 0.19 -1.94 -6.98 YoY% 2.38 2.00 0.5 -0.9 2.4 10.9 19.8 24.9 19.9 3.4 2.0 -0.6 0.6 0.2 -4.7 3.9 1.1 3.6 2.9 3.5 3.4 3.8 3.5 -2.1 -11.4 Wireless Telephone Services, Inflation NSA 1% 0% -1% -2% -3% -4% -5% -6% -7% -8% 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 210 180 600 MoM Change 95 200 120 Price Index 220 We can see this has taken root across a variety of products and industries WTI Headline CPI - Index Level 100 230 700 IT Components – Index Level 240 bbl/day 250 And when technology starts seeping into or disrupting traditional industries, this can put a lid on prices and on historical drivers of inflation Source: BLS, Bloomberg as of 5/12/2017. References to securities are shown for illustration purposes only and should not be construed as investment advice or recommendation. 20170517-160346-445949 For Professional, Permitted, Institutional, Qualified and Wholesale Investors/Professional Clients Only. Not for Public Distribution – Please Read Important Disclosures 11 … wireless prices drop again again having a major influence on the CPI readings… … while PPI was very impressive and reflective of buoyant global growth, IP, exports, etc., the consumer impacts from wireless, and obviously from food, apparel, etc., are truly incredible.. YoY% 2.20 1.88 2.4% 0.20 0.18 0.22 1.14 1.34 -0.33 1.20 1.19 0.95 0.07 -0.17 -0.25 -0.32 -0.25 -0.82 0.31 0.40 4.23 0.14 0.30 0.03 -0.16 0.04 0.50 -0.80 2.30 9.30 14.50 22.10 14.40 14.30 4.40 1.90 -0.60 -1.40 0.50 -1.40 2.60 1.30 -1.40 7.70 2.70 3.50 3.10 3.10 3.20 2.1% -0.24 -2.40 -1.73 0.17 -12.90 3.20 2.3% YoY 2.2% 2.14 2.06 2.0% 2.00 1.9% 1.90 1.8% 1.7% 1.6% 1.5% 2015 2016 2017 Core CPI (adjusted for wireless) CPI: Wireless Services Price Index 2017 2016 2015 40 2014 50 2013 60 2012 70 2011 YoY 80 2010 90 2% 0% -2% -4% -6% -8% -10% -12% -14% -16% 2009 100 2008 2014 Core CPI 2007 2013 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 CPI Food Food at Home Food Away From Home CPI Energy Energy Commodities Fuel Oil Motor Fuel Gasoline Energy Services Core CPI Commodities less Food & Energy Household furnishings Apparel Transportation Goods ex Fuel Medical Care Goods Alcoholic Beverages Other Goods Tobacco & Smoking Products Services less Energy Services Shelter Medical Care Services Transportation Services Recreation Services Education & Communication Services Wireless Telephone Services Other Services MoM% 0.17 0.07 Index Headline CPI Core CPI CPI: Wireless Services YoY … how could the technology influences in these sectors be any more dramatic? … and why would these ever slow down a Fed which is focused more so now on financial conditions, given that the intermediate projection for inflation is around 2%? Clearly, the next few data releases need to be considered, but we think that it would be irrational for this technology-influenced data (which is generally beneficial to consumers and particularly for lower and middle 12 income families) to be considered as a negative for the Fed (and slow down their path), unless the news in Washington becomes more concerning... Source: BLS, Bloomberg as of 5/12/2017 For Professional, Permitted, Institutional, Qualified and Wholesale Investors/Professional Clients Only. Not for Public Distribution – Please Read Important Disclosures 20170517-160346-445949 12 … especially with these dynamics below… We think that the trends below are some of why the Fed’s focus has shifted and will likely result in the Fed proceeding down its pre-ordained normalization path for 2017 and 2018, assuming there is no major shock to the system…… Household Net Worth as % US Nominal GDP 1 Index 0.5 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2017 2012 2007 2002 1997 1992 0.4 1952 2017 2012 2007 2002 1997 1992 1987 1982 1977 1972 1967 1962 1957 1952 400% 0.8 0.6 1987 450% 0.9 0.7 1982 500% 1.0 1977 550% 1.1 1972 Ratio Ratio 600% 1.2 1967 650% SPX Market Cap / US Nominal GDP 1 500% 480% 460% 440% 420% 400% 380% 360% 340% 320% 300% 1962 700% 1957 Household Net Worth as % Disposable Income 1 Household Net Worth as % of US Nominal GDP Household Net Worth as % of Disposable Income S&P Market Cap/ US Nominal GDP Indexed … the recovery in consumers’ balance sheets has somewhat supported the solid pace of consumption, and to reiterate on technology’s influence on inflation (and growth), the deflationary impacts are largely sector specific and are in no way reflective of a negative demand shock (hence the Fed’s ability to maintain its course)… in fact, quantities are very strong while prices are in full-on deflation (actually a sign of innovation, lower production costs, and a good thing for consumers’ quality of life)… These charts below couldn’t be any more profound today in depicting technology’s influence on certain sectors… As we have noted, it is important to look below the hood on headline growth numbers… Goods sector quantities have been very strong, with weakness driven by prices… 2 30% 8% 25% 6% 20% 2% 0% -2% Video and Info Processing Equipment” (beneficiaries of tech-led deflation) 10% -5% • In that time, prices have come down by 80% -10% • Relative to 1985, Americans are consuming -6% -20% 1985 2000 Goods: Quantity 2005 2010 Goods: Prices 2015 over 10% growth since 1985, a 27x increase 0% -15% 1995 • Recreational Goods quantities have averaged 5% -4% -8% 1990 annual consumption on a real basis, or 37% of all Durable Goods consumption • And 2/3rd of Recreational Goods is in “Audio, 15% 4% YoY Change YoY Change 10% • Recreational Goods accounts for $600bn of 1990 1995 2000 2005 2010 PCE Goods: Recreational: Quantity YoY Change PCE Goods: Recreational: Price YoY Change 2015 27x more Recreational Goods at 1/5th the price/unit • BUT WE STILL USE OLD, HISTORIC GDP DATA Data source: BEA as of 4/30/2017 Source: 1) Bloomberg, as of 12/31/16; 2) BEA, as of 4/30/17 For Professional, Permitted, Institutional, Qualified and Wholesale Investors/Professional Clients Only. Not for Public Distribution – Please Read Important Disclosures 20170517-160346-445949 13 We were absolutely blown away by these charts that we showed last month, and now we have witnessed this evolution pick up speed again this month… This is a secular evolution that is playing out at light-speed every single day… For example, the auto industry (which has enormous macro implications for the US and global economies) is beset by some very unique trends… PCE: Motor Vehicle 1 Hertz stock price 2 30% $150 25% Average new vehicle sales incentive by passenger car 3 Used car prices YoY 2 Hertz 14% 15% 30% 10% $0 2007 -5% 2013 2016 …down another 50% this month??? -20% 1985 1990 1995 2000 2005 2010 2015 PCE Goods: Motor Vehicle: Quantity YoY Change PCE Goods: Motor Vehicle: Price YoY Change Share Price -15% 04/12/17 -5% 2% -15% 04/19/17 YTD Price Change 2025 Electric 04/26/17 05/03/17 05/10/17 -10% 2005 2007 2009 2011 2013 2015 2017 YoY Growth Rate (rhs) Passenger Car Incentive/Market Value (lhs) Technology performance vs. autos is incredible in what has happened this month, and obviously this year… 5, 6 0% Hybrid 0% $12 $10 20% Regular 6% $14 Forecast 2020 5% 0% -5% 60% 2015 10% 8% -10% $16 80% 2010 15% 4% 100% 40% 5% $18 Global car sales by engine type, 2010-2030 4 % of Global Auto Sales 2010 Precent $50 0% -10% 20% 10% 2030 20% 50% 10% 40% 0% -10% 01/17 02/17 S&P 03/17 S&P Auto 04/17 05/17 Nasdaq 100 2% 0% YTD Price Change 5% 12% YoY Change 10% 25% $100 MTD Price Change YoY Change 15% YoY Change Share Price 20% 30% 20% 10% 0% -10% -2% -20% 01/17 -4% 5/3/17 5/6/17 5/9/17 5/12/17 5/15/17 02/17 S&P 03/17 04/17 S&P Auto 05/17 Tesla Maybe prices have overshot, but this secular influence can’t be close to finished in terms of technology’s influence on the economy/markets… Source: 1) BEA as of 3/31/2017; 2) Bloomberg, as of 4/17/2017; 3) Wells Fargo as of 1/2017; 4) BII, LMC Automotive as of 4/2017; 5) Bloomberg, as of 5/2017; 6) Tesla Media Reports, as of 4/2017. Securities referenced for illustrative purposes only and should not be construed as a recommendation to buy or sell any security. 20170517-160346-445949 For Professional, Permitted, Institutional, Qualified and Wholesale Investors/Professional Clients Only. 14 Not for Public Distribution – Please Read Important Disclosures Visually this becomes even more profound to look at… We can spend hours on these charts, and where they are headed… Yet, the ultimate conclusion will be that they will, in some combination relative to size and growth today, depict future cash-flow dynamics which represent a very intense consolidation of those cash flows going forward which has major ramifications for debt and equity markets… S&P 500 Consumer Discretionary Info Graphic (size relative to rank) Market capitalization Revenue #1 rank in market cap – 16% of cons disc sector market cap #3 rank in revenue – 7% of cons disc revenue Sales per employee Source: Bloomberg, as of 5/2017. Reference to the names of each company mentioned in this communications is merely for explaining the investment strategy, and should not be construed as investment advice or investment recommendation of those companies. 20170517-160346-445949 For Professional, Permitted, Institutional, Qualified and Wholesale Investors/Professional Clients Only. 15 Not for Public Distribution – Please Read Important Disclosures 2) Medium-term trends/cycles – They can vary in length, but there are usually two or three main themes a year that pivot off of these and can drive annual return potential… # of Misses 6 6 9 5 Avg Miss Std Dev 0.94 0.76 0.39 0.58 Core CPI Q1 Q2 Q3 Q4 # of Misses 3 3 5 4 Avg Miss Std Dev 0.74 0.45 0.53 0.45 GDP QoQ Ann. Q1 Q2 Q3 Q4 # of Misses 2 1 0 2 Avg Miss Std Dev 0.44 0.05 0.00 0.08 Avg. Qtrly GDP Since 1988 (%) Avg. Qtrly GDP Since 2010 (%) 1st quarter 1.72 1.00 2nd quarter 2.50 2.50 3rd quarter 2.51 2.51 4th quarter 2.40 2.36 GDP QoQ Growth… Q1 was very weak, which we think will bounce back significantly in the 2nd quarter… 1 US GDP QoQ 5.0% 4.0% 10.0% QoQ growth 1.0% 2.0% 1.0% 0.0% Q1 2015 2017 Q3 Q4 Contributions to YoY Capex Equipment Growth 12% 10% 8% 6% 4% 2% 0% -2% -4% -6% -8% 5.0% 0.0% -5.0% World GDP in USD 2015 2012 2009 2006 2003 2000 1997 1994 1991 1988 1985 1982 -2.0% 2013 Q2 And there is a broad-based recovery in capital investment that is building momentum… 2 -10.0% 2011 Since 2010 3.0% 0.0% -1.0% Since 1988 4.0% 20.0% 15.0% 2.0% Since 1948 5.0% In fact, we think the global economy will stabilize in or around these growth levels… 1 6.0% 3.0% 6.0% Real GDP QoQ Retail Sales Q1 Q2 Q3 Q4 We talked last month about weakness in Q1 data bringing in to question the state of the US economy… and sure enough, the Q1 GDP print was the lowest in 12 quarters… however, we think 2017 and 2018 could likely be very fertile growth environments... 1 Q1 growth has been oddly weak relative to other quarters despite being seasonally adjusted… This is not entirely a post-crisis event as the pattern holds from at least 1988 1 YoY Data "Misses" vs. Survey since 2013 1 Headline NFP # of Misses Avg Miss Std Dev Q1 7 0.98 Q2 4 0.71 Q3 10 0.54 Q4 5 0.57 12% 10% 8% 6% 4% 2% 0% -2% -4% -6% -8% Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 2013 Energy Source: 1) Bloomberg, as of 5/17/2017; 2) BEA, Goldman Sachs as of 5/17/17 For Professional, Permitted, Institutional, Qualified and Wholesale Investors/Professional Clients Only. Not for Public Distribution – Please Read Important Disclosures 2014 Transportation 2015 2016 Information Processing 20170517-160346-445949 '17 Industrial 16 The backdrop for growth generally is fairly good… On a YoY basis, DXY strength is muted, trade is much better (especially EM), commodities are higher (although with recent weakness), and inflation is better (more stable at higher levels) than we’ve seen in recent years… Supportive environment for growth 1 EM : Export Nominal 20.0% 50% 15.0% YoY 10.0% 25% 5.0% 0.0% 0% -5.0% -10.0% -25% 01.14 -15.0% 2009 2010 2011 2012 2013 2014 2015 07.14 01.15 2016 07.15 01.16 07.16 01.17 Last Month EM Export Nominal (USD) SA 3m/3m annualized Broad USD YoY Export Nominal (USD) NSA yoy Top-line growth has been stagnant for several years now… 2 20% 6% 50.0% 15% 5% 40.0% 10% 20.0% 10.0% 3% 5% 2% 0% 1% -5% 0.0% 0% -10.0% -10% -1% -20.0% -15% 1995 -2% -30.0% 2009 2010 2011 2012 2013 2014 2015 2016 40% 4% 2000 2005 Revenue S&P RevGrowth Growth 2010 YoY Change 30.0% MS Leading Earnings Indicator 1.70 20% -0.30 0% -20% -2.30 -40% -4.30 2015 CPI YoY (rhs) Actual S&P 500 LTM EPS Growth MS Leading Earnings Indicator, Leading 1yr (rhs) Industrial CRB Source: 1) Bloomberg, as of 5/17/2017; 2) Barclays, BLS, as of 5/2017; 3) Morgan Stanley, as of 3/31/17 For Professional, Permitted, Institutional, Qualified and Wholesale Investors/Professional Clients Only. Not for Public Distribution – Please Read Important Disclosures 20170517-160346-445949 17 Index YoY Change 60.0% And while we see this dynamic improving this year and in to next, we believe M&A is still potentially an attractive avenue for growth for many… 3 YoY YoY Change Commodities have been much softer recently (which we will discuss) but are still elevated relative to the trajectories of 2014-2015 1 And we’ve talked about better growth weighing on the rates markets over the coming months... Re-Print from last month: We have discussed recently the need to have some duration exposure over the next few months as global growth could be impaired by uncertain news before it can ultimately stair-step a bit higher (albeit from very modest levels)… Historically, Real (and Nominal) Rates traded in-line with Real (and Nominal) Growth; yet, since the crisis, rates have continued to trade well below fundamentals… 6.0% 6.0% 5.0% 5.0% 4.0% 4.0% 3.0% 3.0% 2.0% 2.0% 1.0% 1.0% 0.0% 0.0% -1.0% -1.0% -2.0% -2.0% US 10Y - Core CPI DE 10Y - Core CPI US Real GDP EU Real GDP … this is in part due to central bank intervention but is also a reflection of the incredible technicals in the market, as well as a lingering pessimism on underlying growth 6.0% 6.0% 5.0% 5.0% 4.0% 4.0% 3.0% 3.0% 2.0% 2.0% 1.0% 1.0% 0.0% 0.0% -1.0% -1.0% -2.0% -2.0% UK 10Y - Core CPI UK Real GDP JP 10Y - Core CPI JP Real GDP We do believe that the bifurcation between growth and market rates today will ultimately evolve in the form of moderately higher rates, but we have to be respectful of the incredible technicals at play and the timing of data/events, as well as the seasonal factors that are so profoundly influential today… … and consequently, the timing of the duration reduction in 2017… Source: Bloomberg as of 5/15/17 For Professional, Permitted, Institutional, Qualified and Wholesale Investors/Professional Clients Only. Not for Public Distribution – Please Read Important Disclosures 20170517-160346-445949 18 The BlackRock Investment Institute has done some incredible analysis on these medium-term cycles of growth… Traditionally these have been evaluated in terms of time; yet analyzing the economy more appropriately on a continuum from growth-trough to ultimate economic potential suggests that these growth/inflation cycles have more to go in the US, as well as globally… Aligned cycle comparisons: Output gap as % GDP Avg 4Q (3 to 6) Scaled to average length of 16 quarters (range 3 to 39) NBER Definition 6 Each dot represents a quarter 4 Output gap as % potential GDP Avg 9 quarters (3 to 22) 2 0 Defined as closest quarter to when the output gap crosses zero -2 -4 NBER Definition Current positioning based on forecast of output gap closing in Q4 2018 -6 -8 Prior Trough 1953 1957 NBER Definition At Potential 1960 1969 1973 1981 1990 Peak 2000 2007 • We think that this work is incredibly powerful for investors in thinking about medium-term investment trends… • The wide-ranging consensus view is that we are nearing the end of the business cycle, because of some mythical time-based series in history. • Yet, it is amazing how consistent this recovery has been from a very deep recession, and how there appears to be plenty of room to run when analyzed this way. • Thus, we think that this analysis is an amazingly important foundation for understanding 2017 (and probably 2018), and what forces may drive returns. Source: NBER, BEA as of 3/31/17 For Professional, Permitted, Institutional, Qualified and Wholesale Investors/Professional Clients Only. Not for Public Distribution – Please Read Important Disclosures 20170517-160346-445949 19 The amazing pervasiveness of this cycle’s consistency can be depicted in numerous ways, and easily transcends a daily focus on the noise which distracts investors from the core fundamental trends at play… … such as the back and forth improving and deteriorating inflation releases, particularly with a reasonable wage trajectory underway as we go through a natural full employment dynamic… …especially in the face of tech-driven goods deflation Real GDP, relative to pre-crisis peak Price of Goods vs. Services, relative to pre-crisis peak Core CPI, relative to pre-crisis peak 170 150 160 140 150 130 120 110 100 90 Prior Peak Trough 1953 1981 At Potential 1957 1990 1960 2000 1969 2007 Peak 1973 100 Relative price of non-energy goods to services, peak = 100 160 CPI Core, prior peak = 100 GDP (pre-crisis peak = 100) The trajectory of inflation is in-line with most historic trends, and will move modestly higher as output gaps close… 140 130 120 110 100 Prior Peak Trough 1953 1973 At Potential 1960 2000 1957 1981 95 90 85 80 75 Prior Trough Peak Peak 1969 2007 1953 1981 At Potential 1957 1990 1960 2000 1969 2007 Peak 1973 Given these trends, long-term breakevens (TIPs) seem fair at levels just below 2%, given the liquidity discount for the product… A move closer to the mid-100’s should be bought and anything well above 2% should be sold… and hiring will continue with somewhat higher wages, allowing the Fed to move and start reducing the balance sheet… … wages will move moderately higher… …on its way higher… … especially for more skilled labor Average hourly earnings (AHE) YoY% Nonfarm Payrolls, relative to pre-crisis peak NFIB firms reporting jobs hard to fill 10 140 8 130 40 25 20 15 110 2 10 100 0 Prior Peak Trough 1981 30 120 4 At Potential 1990 2000 Peak 2007 90 Prior Peak Trough 1953 1981 NFIB firms reporting 1 or more jobs hard to fill, % 6 Nonfarm payrolls (pre-crisis peak = 100) Real average earnings % (3y core CPI) 35 At Potential 1957 1960 1969 1990 2000 2007 Peak 1973 5 0 Prior Peak Trough 1953 1957 1981 1990 At 1960 Potential 1969 2000 Pea k 1973 2007 Takeaways: • Rates can move moderately higher (with some timing to that). • But inflation breakevens are fair here, and should be bought or sold around significant variances from today’s levels.. Source: NBER, BLS, BEA, NFIB, Federal Reserve, Bloomberg as of 3/31/17 For Professional, Permitted, Institutional, Qualified and Wholesale Investors/Professional Clients Only. Not for Public Distribution – Please Read Important Disclosures 20170517-160346-445949 20 Inflation is running right on track, with goods-pricing declining faster, and services leading the way (consistent with the technology secular framework)... When you include R&D spend, business investment may be moderately low (in lieu of equity buybacks), but not grossly out of whack… … the system doesn’t need more buildings or a major plant and equipment spend like in the past… Business Investment, relative to pre-crisis peak Structures Investment, relative to pre-crisis peak 175 150 125 100 75 Prior Trough Peak 1953 1981 At Potential 1957 1990 1960 2000 1969 2007 Peak 125 100 1973 Despite contained CapEx, corporate debt has boomed, in part to buyback stock to capitalize on historically low funding costs… Is there any question here that the Fed has to continue to approach rate equilibrium given financial condition easiness and the forward risk attached to it? US Corporate Debt as % of Revenues, relative to precrisis peak 5 0 -5 -10 Prior Trough Peak 1953 1957 1981 1990 At Potential 1960 2000 1969 2007 Peak 1973 50 Prior Peak 1953 1981 Trough At Potential 1957 1990 1960 2000 1969 2007 Peak 225 200 175 150 125 100 75 50 Prior Peak 1953 1973 1981 Trough 1957 1960 At Potential 1969 1990 2000 2007 Peak 1973 … and the curve will flatten more from here… UST 10s30s spread 150 Federal debt (% GDP), change from peak 50 Budget deficit (% GDP) change since peak Credit market debt as % GVA, change 10 75 …but complicating the process for the Fed (and more so the ECB and BOJ) is the need for deliberate tightening given government leverage… Ultimately though, deficit-financing will push US rates higher… 20 15 250 150 Business IP investment (precrisis peak = 100) 175 IP Investment, relative to pre-crisis peak Spread (bp) Business investment (pre-crisis peak = 100) 200 Business structure investment (precrisis peak = 100) 225 IP spending is on a good path, and as we have described in the past, it is actually multiples of this because of the rapidly declining cost of that IP, thereby making it cheaper to buy… 40 30 20 10 100 50 0 -50 0 -100 -10 Prior Trough Peak 1953 1981 At Potential 1957 1990 1960 2000 1969 2007 Peak 1973 Prior Trough Peak 1953 1957 1981 1990 At Potential 1960 2000 Peak 1969 2007 1973 Takeaways: • CMBS supply should be muted, with some growth, but it still generally remains attractive… • Consolidation of cash flows continues along the technology-innovation lines… • Fed keeps moving albeit deliberately, especially with the balance sheet… • Other developed market rates move higher but central banks try to mute those moves… • Curves flatten… Source: NBER, BLS, BEA, NFIB, Federal Reserve, Bloomberg as of 3/31/17 For Professional, Permitted, Institutional, Qualified and Wholesale Investors/Professional Clients Only. Not for Public Distribution – Please Read Important Disclosures 20170517-160346-445949 21 These other medium-cycle trends are incredibly profound… Households (consumers) are in great shape, driving housing markets with it, and the banks have historic levels of dry-powder to promote further velocity here (and elsewhere)… FHFA House Prices, relative to pre-crisis peak Residential Investment, relative to pre-crisis peak 170 150 House prices (pre-crisis peak = 100) Business investment (pre-crisis peak = 100) 160 125 100 75 50 Prior Peak Trough 1953 1981 1960 2000 1969 2007 Interest and principal as % of typical household income 130 120 110 100 90 80 Prior Peak Trough 1953 1981 1973 1957 1990 Construction employment (pre-crisis peak = 100) 0.5 110 25 0.0 100 20 15 10 5 0Prior Peak 1953 1981 Trough At Potential 1957 1990 1960 2000 1969 2007 Peak 1973 1973 1.0 Risk ratio, change since cycle peak 30 1969 2007 1.5 120 35 1960 2000 Change in risk ratio since start of cycle 130 40 Peak At Potential Construction employment, peak =100 45 Mortgage payments as % of typical income 140 Peak At Potential 1957 1990 150 -0.5 90 -1.0 80 -1.5 70 Prior Trough Peak 1953 1981 At Potential 1957 1990 1960 2000 Peak 1969 2007 1973 Prior Trough Peak 1953 At Potential 1957 1960 1969 Peak 1973 Takeaways: • We are very comfortable with securitized assets focused around the consumer… • We are comfortable with housing-related debt and equity, particularly non-agency mortgages. • We are comfortable with Agency Mortgages, respectful of the supply-growth potential. While this will be muted somewhat by rate volatility, and we have to keep an eye on the Fed, but we love buying these as an IG/credit substitute when they get cheap on Fed balance-sheet reduction fears. Source: NBER, BLS, BEA, NFIB, Federal Reserve, Bloomberg as of 3/31/17 For Professional, Permitted, Institutional, Qualified and Wholesale Investors/Professional Clients Only. Not for Public Distribution – Please Read Important Disclosures 20170517-160346-445949 22 … although we are impressed with global growth, it clearly could moderate from here, but we believe it should stabilize around generous levels of growth for the balance of the year, buoying equity valuations… We have shown before how equities are not high until these bars invert like ‘06 and ‘07, which would require much higher rates, higher prices, or deteriorated FCF… 1 2.5 Index Level Present Value S&P 500 Index Price 2,500 % Difference (rhs) 100% 2,000 50% 1,500 0% 1,000 -50% 500 2018 Est (1) 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 2005 2004 -100% 2003 0 To come back to equilibrium: 1. S&P’s rally 25% 2. FCF drops 12.8% 3. 5yr TSY backs up 98bps 4. Market valuewtd avg. IG/HY spreads back up 98bps 5. Some weighted combination of all of these. REAL GDP GROWTH (%) S&P 500 Index - Index FCF Discounted Using IG/HY Yield to Worst 3,500 150% 3,000 Our internal indicators may be stabilizing, but still point to decent global growth… 2 2.0 1.5 Jan 15 Jul 15 Jan 16 GPS Jul 16 Jan 17 12m Forward Consensus … while exports are moving smartly higher (but probably can’t hold this growth pace)… 3 EM : Export Nominal 40% 30% 20% 10% 0% -10% -20% -30% 01.14 07.14 01.15 07.15 01.16 07.16 01.17 40% 30% 20% 10% 0% -10% -20% -30% -40% 01.14 Asia : Export Nominal 70% Latam : Export Nominal 50% 30% 10% -10% 07.14 01.15 07.15 01.16 07.16 01.17 -30% 01.14 07.14 01.15 07.15 01.16 07.16 01.17 Last Month Last Month Last Month EM Export Nominal (USD) SA 3m/3m annualized Asia Export Nominal (USD) SA 3m/3m annualized Latam Export Nominal (USD) SA 3m/3m annualized Export Nominal (USD) NSA yoy Export Nominal (USD) NSA yoy Export Nominal (USD) NSA yoy Takeaways: • We like owning equity upside and are not worried that we are too high already today with growth being strong alongside a moderate central bank tightening, and a strong bid for yield products (keeping the appropriate discount rate for equities low)… All of this also continues to support our EM vs. DM rate-convergence forecast… Source: 1) Bloomberg, as of 5/2017; 2) BlackRock BII, as of 5/2017; 3) Haver, as of 5/2017 For Professional, Permitted, Institutional, Qualified and Wholesale Investors/Professional Clients Only. Not for Public Distribution – Please Read Important Disclosures 20170517-160346-445949 23 … and with current volatility still being priced too low, why not own the beta risk in upside convexity instruments (like equity calls), in case of exogenous downside shock, especially with such generous carry-availability still from places like EM (while developed markets rates move moderately higher)... Not only is spot vol low, but longer-dated points on the vol curve are also historically low, meaning the market is willing to offer cheap vol for longer-terms, in virtually all products… 80 70 40 35 30 50 Level Level 60 40 30 25 20 20 15 10 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 0 Minimum Level 10yr Japan 10yr Germany 10yr France Spread 10yr Spain Spread 10yr Italy Spread 10yr Portugal Spread 10yr UK 10yr Canada 10yr Australia 10yr US Munis MBS OAS US IG OAS US Long Credit OAS US HY OAS Global EM 10yr Mexico 10yr Russia 10yr Indonesia 0.05% 0.38% 0.84% 1.56% 2.16% 3.21% 1.07% 1.45% 2.47% 2.22% 2.30% 0.23% 1.12% 1.61% 3.75% 4.17% 7.14% 7.58% 7.04% 5Y Percentile 18% 28% 28% 22% 42% 36% 7% 24% 15% 54% 59% 24% 13% 13% 12% 7% 91% 23% 26% VIX 6-month Median EURUSD USDJPY AUDUSD GBPUSD USDBRL USDSGD USDKRW USDCAD 3M Implied Vol Percentile – Today vs. Last 5 Years 0% 18% 1% 3% 2% 1% 13% 3% 2Y UST 5Y UST 10Y UST 30Y UST 10Y DE 10Y JP 2% 3% 0% 0% 0% 2% 1% S&P 500 VIX 2% 0% 12.0 11.0 10.0 8.0 23% 0% 13.0 9.0 21% 15% Oil Eurostoxx Nikkei MSCI EM 14.0 Vol VIX 10 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 7.0 6.0 03/16 50% 100% 06/16 09/16 12/16 03/17 EURUSD 1m ATM Vol Takeaways: • Treasury vol is cheap to preserve some of the rate risk inherent in all of these trades, including holding some longer-end duration.. • Muni’s are priced ok, particularly with the ability to manage some of this duration risk with cheap rate-optionality. • HY spreads seem full and global developed markets core rates are too low, but could stay that way for a bit of time, but it is a good deal of beta to get the existing income…… Source: Bloomberg, as of 5/17/2017 For Professional, Permitted, Institutional, Qualified and Wholesale Investors/Professional Clients Only. Not for Public Distribution – Please Read Important Disclosures 20170517-160346-445949 24 3) Short-term news or noise – we think that it is news that the (scheduled) major vol events have passed (like the French election), and that the focus now should be on following the cash-flow across the major secular and mediumterm trends in efforts to generate consistent return with contained levels of risk, with a very healthy respect for the seriousness of the potential news out of Washington… Short-term dynamics: most participants take risk down into events (or don’t invest) and then pile-in after… like now… 1 … some of the best trades have been to fade the short-term noise being promulgated through the market… 1 Headlines before French Election Round 2: “Buy the EUR & European banks! The ECB will start raising rates once Macron wins” [EUR / European banks subsequently trade lower] 150 1.10 Euro STOXX Banks Index 1.05 1.00 0.95 0.90 T-60 T-50 S&P (Election) T-40 T-30 T-20 T-10 T T+10 T+20 S&P (Election Overnight) 1.12 130 1.10 Headlines after Brexit: “Sell the EUR & European banks! The Eurozone can’t grow and is slowly breaking up” [EUR / European banks subsequently trade higher] 120 110 100 1.04 Headlines before French Election Round 1: “Sell the EUR & European banks! They are up 50% since Brexit, and not pricing in election risk” [EUR / European banks subsequently trade higher] 80 1.00 4% 2% 0% -2% 08/16 09/16 10/16 11/16 12/16 01/17 02/17 03/17 04/17 History does not always repeat itself, but the explosion in market cap in tech seems to be following the cash flows… 1 Cash Flows Structurally Shrinking 3,500 Cumulative Free cash Flow Population Growth through 2022E 6% 07/16 4,000 Cash Flows Structurally Growing 8% 06/16 Events SX7E EURUSD (rhs) Euro STOXX Banks Index 12% 10% 1.02 70 CAC 40 (French Election) Demographics tell us something about the sustainability of cash flows (growth) 2 1.06 90 05/16 FTSE (Brexit) 1.08 EURUSD Index (1=Day of Event) 140 1.14 3,000 2,500 2,000 1,500 1,000 500 (500) (1,000) 2012 Q1 2012 Q3 2013 Q1 2013 Q3 2014 Q1 2014 Q3 2015 Q1 2015 Q3 2016 Q1 2016 Q3 -4% Consumer Discretionary Financials Information Technology Utilities Source: 1) Bloomberg, as of 5/2017; 2) World Bank, as of 12/31/16 For Professional, Permitted, Institutional, Qualified and Wholesale Investors/Professional Clients Only. Not for Public Distribution – Please Read Important Disclosures Consumer Staples Health Care Materials Energy Industrials Telecommunication Services 20170517-160346-445949 25 While on the surface it doesn’t look like reasonable returns can be generated in “fully-valued capital markets”, we would argue that this isn’t true if you focus on who you are and what should be the drivers (long, intermediate, and short-term) of your return toolkit… Yield 7% 6% 5% 4% 3% 2% 1% 0% -1% 1985 Real Risk-Free Yield (US 10Y - Core CPI) 1990 1995 2000 2005 2010 2015 No Term Premium Yield per Unit of Duration Yields vs. Risks Across Asset Classes No Real Risk-Free Yield Still Yield, Less Beta, Some Duration for Now MBS Muni 5% APAC Credit US Term Premium US Agency US IG Int. TSY Long TSY S&P German 10Y 4% US HY ABS EM Hard FX MSCI World CMBS EM Local Russell 2000 Global Agg France 10Y Euro IG Yield per Unit of 12mo Vol Yield 3% 2% 1% 0% -1% 1985 1990 1995 2000 2005 2010 2015 No Credit Premium 20% HY OAS Yield 15% 10% 5% 0% 2000 2005 2010 2015 Source: Bloomberg, as of 5/17/2017 For Professional, Permitted, Institutional, Qualified and Wholesale Investors/Professional Clients Only. Not for Public Distribution – Please Read Important Disclosures 20170517-160346-445949 26 Important Notes This document contains general information only and does not take into account an individual’s financial circumstances. An assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a professional adviser before making an investment decision. Reference to any security, holding or company is for discussion purposes only. The issuers referenced are examples of issuers BlackRock considers to be well known and that may fall into the stated sectors. BlackRock may or may not own any securities of the issuers referenced and, if such securities are owned, no representation is being made that such securities will continue to be held. Index Index performance is shown for illustrative purposes only. It is not possible to invest directly in an index. Past performance is not indicative of future returns. Manager Opinion The opinions expressed may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by BlackRock, Inc. and/or its subsidiaries (together, “BlackRock”) to be reliable, are not necessarily all inclusive and are not guaranteed as to accuracy. There is no guarantee that any of these views made will come to pass. Any investments named within this material may not necessarily be held in any accounts managed by BlackRock. Reliance upon information in this material is at the sole discretion of the reader. Outlook Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions. Outlook and strategies are subject to change without notice. Risk Investment involves risk. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. 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International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation, and the possibility of substantial volatility due to adverse political, economic or other developments. These risks are often heightened for investments in emerging/developing markets or smaller capital markets. © 2017 BlackRock, Inc. All Rights Reserved. BLACKROCK, iSHARES, and the stylized i logo are registered and unregistered trademarks of BlackRock, Inc. or its subsidiaries in the United States and elsewhere. All other trademarks are those of their respective owners. For Professional, Permitted, Institutional, Qualified and Wholesale Investors/Professional Clients Only. Not for Public Distribution – Please Read Important Disclosures 20170517-160346-445949 28 20170517-160346-445949