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Global Asset Allocation Views Themes and implications from the Multi-Asset Solutions Strategy Summit 4Q 2016 AUTHOR IN BRIEF • The growth outlook is brightening a little, but this carries with it fears of a hawkish turn in policy. In our view, these concerns are overstated. We expect the Federal Reserve (Fed) to raise rates only glacially, in turn keeping the U.S. dollar subdued. John Bilton Managing Director Head of Global Multi-Asset Strategy Multi-Asset Solutions • T his environment should underpin carry assets like credit and allow emerging market (EM) assets to recover further. We upgrade stock-bond to a modest overweight, reflecting how expensive government bonds have become; we prefer U.S. and EM equity to Japanese equity and see high yield and EM debt leading credit returns. • A starting point of near-zero yields in the bond market creates a challenge in generating returns. Sharply higher yields are not our base case as demand for duration still outstrips supply, and negative stock-bond correlation offers diversification benefits. Sources of stable carry and an active approach remain key portfolio goals. ASSET CLASS VIEWS CHART (PAGE 3) Asset class Opportunity set Equities/bonds Duration MAIN ASSET CLASSES Credit Commodities Cash U.S. large cap U.S. small cap EQUITIES Europe ex-UK UK Japan Pacific ex-Japan U.S. REITs SOVEREIGN FIXED INCOME U.S. Treasuries Euro, core (Bund) Euro, periphery (BTP) UK Gilts Japanese JGBs Canadian gov’t bonds Australian gov't bonds CREDIT Investment grade U.S. high yield European high yield Emerging markets debt USD FX REGIONAL PREFERENCE BY ASSET CLASS Emerging markets EUR GBP JPY Change Negative Neutral Positive The “sell in May” crowd was out in force at the start of the summer—as muscle memory of the January sell-off, worries about eurozone banks, uncertainty about the Federal Reserve and Brexit fears all pointed to a volatile season. Instead, a stable U.S. dollar, comforting Fed language, reassuring macro data and apparent “containment” of Brexit fallout kept asset markets supported. Between Memorial Day and Labor Day, most major asset classes rallied—global equity up 4.3%, 30-year U.S. Treasuries up 4.1%, EM sovereign spreads 58 basis points (bps) tighter and U.S. high yield spreads 80bps tighter. Among major assets, only oil and pound sterling suffered over the summer. Our base case sees the economic outlook improving into year-end as risks in developed economies become more balanced and the worst of the downturn in emerging economies fades. Yet markets fear that this environment might prompt the Fed to take a hawkish tone. We have sympathy with this concern because valuations are extended and sentiment is fragile, putting greater emphasis than normal on the path of rates. We expect the Fed to strike an accommodative tone—even as it gradually raises policy rates—in turn reassuring asset markets. But as Fed Chair Janet Yellen is discovering, in the field of human endeavor there may be no greater expression of “learning by doing” than the setting of monetary policy. An apparent paradox is at work: The same ultra-loose policy that has mortgaged future returns in sovereign fixed income markets and neutered eurozone bank earnings is underpinning positive momentum in many asset markets. Yet the subtle twist here is that the most damaging aspect of the Fed’s December 2015 rate hike was its contribution to the ASSET ALLOCATION VIEWS crescendo in U.S. dollar strength that sank commodity markets and pushed EM sentiment to 20-year lows. With global growth showing tentative signs of broadening beyond the U.S., one of the planks of dollar strength is fading. Provided the Fed maintains a “first, do no harm” approach and is mindful of the global impact of rate decisions, a gradual rise in rates over the coming months need not wreak the same havoc as the first hike of this cycle. Nevertheless, markets are understandably anxious. The mix of slow but positive growth and extended asset valuations presents a challenge for investors. Economic optimists should accept that equity multiples are quite full and are sensitive to the higher policy rates, which may accompany better growth. Pessimists, meanwhile, must recognize that near-zero bond yields make for lean pickings in cautious portfolios. With stock-bond correlations still negative we see a persistent case for balanced portfolios. In our view, stocks can modestly outperform government bonds, and carry assets like credit, and dollar-sensitive EM assets, can perform well in our base case of a “do no harm” Fed. Our “low growth, no recession” view of the world continues to drive portfolio allocation following our September Strategy Summit. The improved trajectory of growth and full valuations of government bonds are reflected with a mild overweight (OW) to stocks vs. bonds. The U.S. remains our preferred equity market. We add an OW to UK equity, based on currency support, and an OW to EM equity based on receding economic risks and stable dollar; our least favored equity market is Japan. In fixed income, we lean further into credit with an OW to U.S. and European high yield, as well as to EM debt, all funded out of investment grade; we maintain a neutral duration view with a preference for U.S. Treasuries over UK Gilts and German Bunds. While we do adopt a slight pro-growth tilt, we are under no illusions that asset returns will be anything but meager. Returns are capped either by rich valuations or limits to plausible global growth—or both. Yet we do believe that this economic expansion has further to run and, more important, that policymakers are acutely aware of their role in making this happen. KEY THEMES AND THEIR IMPLICATIONS EMERGING MARKETS MACRO THEMES DEVELOPED MARKETS MACRO THEMES GLOBAL MACRO THEMES Theme Macro and asset class implications Low inflation Low inflation but not no inflation; threat of deflation is passing, but global spare capacity limits inflation risks Global policy divergence Path of Fed normalization affected by global policy, which in turn keeps U.S. yields in check even as rates rise Supply-side weakness If productivity and labor become binding constraints, inflation pressure could build and force Fed action U.S. economic strength U.S. in the middle of a long and relatively flat business cycle; lends support to U.S. high yield credit and equities Europe: gradual growth recovery Europe’s recovery continues, but monetary policy a negative for bank earnings; prefer to play via credit and EUR Japan: beyond Abenomics Japanese economic risk becoming more binary; policy shifting from monetary to fiscal; may see yen rise further Emerging markets rebalancing EM data are improving and USD helps stabilization; EM assets could extend run despite structural challenges China in transition Financial liberalization gives scope for further CNY downside; additional rounds of mini-stimulus are feasible Source: J.P. Morgan Asset Management Multi-Asset Solutions; data as of September 7, 2016. For illustrative purposes only. 2 J . P . MO R G A N A S S ET M ANAGEM ENT ASSET ALLOCATION VIEWS Active allocation views These asset class views apply to an intermediate-term horizon (that is, 12 to 18 months). Up/down arrows indicate a positive ( ) or negative ( ) change in view since the prior quarterly Strategy Summit. This summary of our individual asset class views shows absolute direction and strength of conviction but is independent of portfolio construction considerations. Max negative Asset class Opportunity set SOVEREIGN FIXED INCOME FX CREDIT REGIONAL PREFERENCE BY ASSET CLASS EQUITIES MAIN ASSET CLASSES Change Negative Neutral Positive Neutral Max positive Rationale Equities/bonds Improved growth and near-zero yields see stocks outperform sovereign bonds Duration Better growth puts pressure on bonds, but strong bid for duration persists Credit Credit still a good alternative to stocks as loose policy supports carry assets Commodities Past the lows in commodities, but still a long way off a renewed supercycle Cash Negative and near-negative rates a disincentive to holding cash U.S. large cap High-quality bias, better nominal GDP and stable USD support EPS rebound U.S. small cap Better domestic growth justifies an upgrade, but valuations are a headwind Europe ex-UK Supportive data, margins and operating leverage; bank outlook a constraint UK Sharp weakening in GBP a big boost for UK stocks; oil rebound also helpful Japan Strong yen and fading hope for stimulus remove scope for earnings boost Pacific ex-Japan Concerns over China persist, but market is underheld and macro is steady Emerging markets Stable dollar and commodity outlook could see EM outperformance run further U.S. REITs Vulnerable to any rise in U.S. bond yields; prefer core real estate U.S. Treasuries Attractive on real yield terms against other sovereigns despite rising rates Euro, core (Bund) Zero or negative nominal yield; starting to hit limits on ECB policy Euro, periphery (BTP) Risks surround Italian referendum, but ECB QE supports periphery spreads UK Gilts Scope for inflation to rise as GBP falls, further undermining UK real yields Japanese JGBs More attractive on roll-down and real yield, but BoJ seeking to steepen curves Canadian gov’t bonds Spread to U.S. bonds now fair; data slowing Australian gov't bonds Attractive yield and carry plus further rate cuts keep support for AUD bonds Investment grade Further into credit cycle than HY; primary supply still relatively high U.S. high yield Spreads nearer fair value, but carry still attractive European high yield ECB action keeps bid in place for EU IG, which will spill over into HY Emerging markets debt EM balance sheet strength improving, attractive carry vs. G4 bonds USD Consolidation persists; USD balances Fed hikes and broadening global growth EUR ECB moves away from rate cuts; growth above trend GBP Fundamental outlook poor; further pressure likely as Brexit realities bite JPY Moving from monetary to fiscal stimulus; little scope for further JPY weakness Source: J.P. Morgan Asset Management Multi-Asset Solutions; data as of September 7, 2016. Diversification does not guarantee investment returns and does not eliminate the risk of loss. Diversification among investment options and asset classes may help to reduce overall volatility. J.P. MORGAN ASSE T MA N A G E ME N T 3 MULTI-ASSET SOLUTIONS NEXT STEPS J.P. Morgan Multi-Asset Solutions manages USD $178 billion in assets and draws upon the unparalleled breadth and depth of expertise and investment capabilities of the organization. Our asset allocation research and insights are the foundation of our investment process, which is supported by a global research team of 20-plus dedicated research professionals with decades of combined experience in a diverse range of disciplines. For more information, contact your J.P. Morgan representative. Multi-Asset Solutions’ asset allocation views are the product of a rigorous and disciplined process that integrates: • Qualitative insights that encompass macro-thematic insights, business cycle views and systematic and irregular market opportunities • Quantitative analysis that considers market inefficiencies, intra- and cross-asset class models, relative value and market directional strategies • Strategy Summits and ongoing dialogue in which research and investor teams debate, challenge and develop the firm’s asset allocation views As of June 30, 2016. Important Disclaimer Investing in foreign countries involves a greater degree of risk and increased volatility. Changes in currency exchange rates and differences in accounting and taxation policies in foreign countries can raise or lower returns. Also, some markets may not be as politically and economically stable. The risks associated with foreign securities may be increased in countries with less developed markets. These countries may have relatively unstable governments and less established market economies than developed countries. These countries may face greater social, economic, regulatory and political uncertainties. These risks make securities from less developed countries more volatile and less liquid than securities in more developed countries. Equity securities are subject to “stock market risk”. The price of equity securities may rise or fall because of changes in the broad market or changes in a company’s financial condition, sometimes rapidly or unpredictably. Fixed Income/Bonds are subject to interest rate risks. Bond prices generally fall when interest rates rise. The views contained herein are not to be taken as an advice or a recommendation to buy or sell any investment in any jurisdiction, nor is it a commitment from J.P. Morgan Asset Management or any of its subsidiaries to participate in any of the transactions mentioned herein. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own professional advisers, if any investment mentioned herein is believed to be suitable to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yield may not be a reliable guide to future performance. J.P. Morgan Asset Management is the brand for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide. 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Morgan S.A.; in Canada for institutional clients’ use only by JPMorgan Asset Management (Canada) Inc., and in the United States by JPMorgan Distribution Services Inc. and J.P. Morgan Institutional Investments, Inc., both members of FINRA/SIPC.; and J.P. Morgan Investment Management Inc. In APAC, distribution is for Hong Kong, Taiwan, Japan and Singapore. For all other countries in APAC, to intended recipients only. Copyright 2016 JPMorgan Chase & Co. All rights reserved. II-AA-VIEWS-4Q16 | 0903c02a8170c199