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2017 LONG-TERM CAPITAL MARKET EXPECTATIONS “We’ve increased our forecast for developed-market equities in view of an improving growth outlook and moderate inflation expectations.” Contents THE WORLD FROM OUR PERSPECTIVE 2 OUR STRONGEST CONVICTIONS “FOR” 4 OUR STRONGEST CONVICTIONS “AGAINST” 10 OUR CAPITAL MARKET EXPECTATIONS 12 OUR METHODOLOGY AND MODELS 14 APPENDIX: INDEXES AND PROXIES USED 18 About Franklin Templeton Solutions Franklin Templeton Solutions (FT Solutions)1 is a team of multi-asset and alternative investment experts embedded within the global integrated platform of Franklin Templeton—a trusted partner in asset management with clients in more than 170 countries. Our FT Solutions team has been dedicated to managing multi-asset portfolios for over 20 years covering both traditional multi-asset strategies and alternative strategies. In addition to retail investors around the world, our FT Solutions team serves a variety of client types in the institutional arena, ranging from sovereign wealth funds to public and private pension plans. The hallmark of our approach is a disciplined discussion process—with an 80 plus-member global investment forum—that manages assets of over US$40 billion (as at 31 December 2016). BROOKS RITCHEY TOM NELSON, CFA, CAIA CHANDRA SEETHAMRAJU, MBA, PH.D. Senior Vice President, Director of Investment Solutions Senior Vice President, Director of Investment Solutions Vice President, Director of Systematic Modeling 1. Franklin Templeton Solutions is a global investment management group dedicated to multi-strategy solutions and is comprised of individuals representing various registered investment advisory entity subsidiaries of Franklin Resources, Inc., a global investment organization operating as Franklin Templeton Investments. February 2017 We believe the global growth outlook is improving, supported by fiscal stimulus around the world, the pro-growth policies of the incoming US administration and stabilized growth in China. We also see inflation hovering in the moderate zone for the next five to 10 years. After our annual review of the data and themes driving capital markets— current valuation measures, historical risk premiums, economic growth and inflation prospects—we’re pleased to report on our 2017 Capital Market Expectations. Our Strongest Convictions: For Against Global Stocks Global Government Bonds Swedish Krona Swiss Franc Japanese Equity US Infrastructure See appendix for methodology and models used. For Financial Professional Use Only. Not For Public Distribution. 2017 Long-Term Capital Market Expectations 1 THE WORLD FROM OUR PERSPECTIVE Global Growth. Significant Uncertainty. We believe the global growth outlook is improving, supported by fiscal stimulus around the world, progrowth policies of the incoming US administration and stabilized growth in China. China’s economic slowdown appears to have reached its bottom in 2016. The year-over-year Producer Price Index finally nudged into positive territory after almost four years of negative results. The Manufacturing Purchasing • China appears to have navigated 50, which should help to keep the through another difficult trough, however the country’s debt problem has not been solved and appears to be getting worse. momentum.2 positive center stage in 2016 as easy strong dollar trend is also a boost for monetary policies around the world the yuan and Chinese exporters. It’s lost their effectiveness. For example: still too early to predict the outcome stimulus package in August 2016. • Donald Trump, president of the United States, seems certain to introduce significant fiscal stimulus via a combination of tax cuts and infrastructure spending. • European Union (EU) countries are still bound by Maastricht deficit and debt limits, but given the anti-EU populist movement in Europe, it’s hard to rule out fiscal stimulus completely. The new US administration seems likely to bring in fiscal stimulus and de-regulation, which could be another boost for growth. We expect the financial, energy and health care sectors (which combined account for more than a third of the US economy) to benefit the most. to be pricing in Trump’s ambitious plans. Whether his administration can deliver meaningful change to the economy is still unknown, but markets will be disappointed if results fall short of expectations. Managers’ Index also tipped over Stimulus fiscal policies finally arrived • Japan announced a ¥28 trillion • In the United States, markets seem The current of structural reforms in China, but the country appears to be making good progress on moving to a consumer-driven economy from an export-oriented economy, which we also see as a big plus for global growth. Finally, we believe aging population—in China and in developed markets overall—is a powerful demographic factor that may depress global growth. Given the current anti-globalization and anti-trade sentiments, it’ll be even harder to mitigate the impact of Although we’re becoming more these long-term changes. confident about global growth, we Moderate Inflation Ahead need to acknowledge that there are significant uncertainties down the In 2015 and early 2016, deflation road. For example: fears topped the list of risks to the global economy. That concern has • Current populist movements could potentially create strong headwinds in struggling European economies. Based on the outcomes of the Brexit vote and the recent Italian referendum, the integrity of the EU seems likely to face additional challenges ahead before it stabilizes—if it can stabilize. diminished since commodity prices stabilized. Inflation expectations around the world started to notch upward in the middle of 2016, well before Trump’s victory. We believe inflation will normalize faster in the United States than the rest of the world. However, long-term structural 2. Source: Bloomberg. 2 2017 Long-Term Capital Market Expectations For Financial Professional Use Only. Not For Public Distribution. factors such as aging populations Emerging-market equities are less and the savings glut should keep attractive this year primarily because inflation in the moderate zone for the they recovered in 2016 and today’s next five to 10 years. valuations are therefore less Currently, US Personal Consumption Expenditure Core (PCE Core), a price inflation measure that the US Federal Reserve (Fed) emphasizes, is at attractive. On top of that, a rising interest-rate cycle in the United States could make emerging markets vulnerable to significant capital outflows. 1.7% year-over-year.3 Trump’s fiscal After more than a 30-year run-up, stimulus plan could create jobs and developed-market bond markets increase aggregate demand in the were poised to sell off in the middle short term, which may bring PCE of 2016, even before the US Core back to the Fed’s target of 2% election. Since then, markets seem within the next two years. convinced that the rising-rate cycle Although we believe that most of the potential new US policies are inflationary, if the rest of world does not follow suit—given the openness of our global economy—we do not expect the US inflation rate to differ significantly from those in the rest of the world. Japan and Europe are experiencing an aging population trend, which we believe suppresses aggregate demand and growth potential. Negative interest rates still exist in Japan and some European countries. On top of that, the current account surplus of major exporters such as Germany, China and Japan is now back to 2006–2008 levels and “ in US Treasuries is likely to accelerate regardless of negative interest rates in Japan or quantitative easing (QE) in Europe. Given the current low yields and Long-term structural factors such as aging populations and the savings glut should keep inflation in the moderate zone for the next five to 10 years.” high durations, the expected returns of developed-market bonds are even lower than our last year’s forecast. Long-Term Inflation Forecasts Consensus Economics (10Y) Breakeven Rate (5Y5Y) 2.2% 2.0% 1.9% 2.0% 1.3% 2.5% 1.9% 1.5% 1.2% 3.0% 0.6% 1.9% United States Canada Eurozone United Kingdom Japan Australia Source: Consensus Forecasts, October 2016; Bloomberg, November 2016. There is no assurance that any forecast will be realized. therefore, the excessive supply of Export-Driven Economies Nearing 2006–2008 Current Account Surplus Levels capital is still a depressing factor for Current Account Balance of Germany + Japan + China interest rates and inflation. See chart 1998–2016 Billions USD $900 to the right. Developed-Market Equities Look Attractive, but Developed-Market Bonds Are Shaky $800 $700 $600 $500 $400 We’ve increased our forecast for $300 developed-market equities in view of $200 an improving growth outlook and $100 moderate inflation expectations. $0 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 Source: Bloomberg, International Monetary Fund (IMF), as at 31/12/16. Past performance does not guarantee future results. 3. Source: Bloomberg. For Financial Professional Use Only. Not For Public Distribution. 2017 Long-Term Capital Market Expectations 3 OUR STRONGEST CONVICTIONS “FOR” Global Stocks Could Benefit from Improved Growth and Moderate Inflation Outlook We believe global stocks have believe stocks can benefit more from From a valuation perspective, price- greater performance potential than the expected fiscal stimulus of the to-earnings (P/E) ratios are currently other asset classes in anticipation of new Republican regime in the United below their long-term average, which stimulus fiscal policy and a moderate States. A combination of tax cuts, is favorable for long-term global inflation environment in the next five deficit spending, deregulation and stock return potential. to 10 years. foreign cash repatriation could have As we expected at the beginning of 2016, markets recovered from the initial volatility and ended the year in positive territory. The MSCI World Index was up 8.16%, and the SPX Index was up 11.93%. Markets showed significant resilience given that two so-called “black-swan” a broad boost effect on the economy. At the same time, we believe the structural problems in Europe and Japan will keep global inflation moderate. Although the US dollar (USD) and the US 10-year yield moved up significantly after the election, we expect both markets to slow down in 2017, and the rate hike events occurred during the year: cycle will still be a moderate one. Brexit and Trump’s election. We Our average annual return expectation for global equities is fairly close to the historical average. Overall, we expect global equities to return 7.8% annually over the sevenyear period, with developed markets returning 7.5%, emerging markets 8.7% and global small caps 9.4%. By comparison, we expect global government bonds to return less than 1%. P/E Ratios Favor Long-Term Global Equity Return Potential We Expect Global Equities to Outperform Many Other Asset Classes MSCI All Country World Index P/E Ratio 1988–2016 Comparison of Expected Annualized Returns of Major Stock Indexes vs. Global Government Bonds P/E Ratio 35 As at 30 November 2016 Projected Annualized Returns, 1 January 2017–31 December 2023 Expected Return 10% 30 9.4% 8.7% 9% 8% 25 7.5% 7% Average 20 7.8% 6% 5% 15 4% 3% 10 2% 1% 5 Global Equity 0 1988 1992 1996 2000 2004 2008 2012 2016 Source: Thomson Reuters, Institutional Broker’s Estimate System (I/B/E/S), MSCI, as at 31/10/16. Past performance does not guarantee future results. 4 0.3% 0% 2017 Long-Term Capital Market Expectations DevelopedMarket Equity EmergingMarket Equity Global Small-Cap Equity Global Developed Gov't Bonds Source: FT Solutions. See appendix on page 18 for representative indexes for each asset class. Opinions and beliefs expressed are those of FT Solutions and are subject to change without notice. There is no assurance that any forecast or projection will be realized. For Financial Professional Use Only. Not For Public Distribution. Long Swedish Krona vs. US Dollar We are bullish on the Swedish krona gross domestic product (GDP) to extend its bond purchases in (SEK) from three different growth is one of the most positive. order to support the economy. This perspectives: The growth differential between policy has effectively kept SEKUSD Sweden and the United States has subdued. Amid strengthening reached its widest point in five years economic fundamentals and rising yet the Riksbank, the Swedish house prices in Sweden, however, central bank, maintains its it’s difficult to see how negative accommodative policy. policy rates could continue. The IMF Unemployment has reached an expects inflation in Sweden to reach In our opinion, from a valuation eight-year low, and the economic the central bank’s target of 2% in perspective, the SEK is the most tendency indicator (a survey of 2018, leaving less room for the undervalued relative to other business and consumer views of the central bank to maintain its easy developed-market currencies. economy)4 monetary policy. • valuation • growth prospects • the expected monetary policy environment Sweden’s policy rate relative to its continues to trend higher. We expect the positive trajectory for the Swedish economy to continue. growth trajectory is the most We believe this policy is unlikely to hold over the long term, especially if displaced among developed The Riksbank remains committed to inflation starts to pick up. The markets: While its policy rate is one its easy monetary policy, pledging Riksbank will need to begin its of the most negative, its nominal not to raise rates from its current tightening cycle, ultimately boosting negative level until 2018 and offering SEKUSD. Sweden’s Economy Stronger than Normal Sweden: Economic Tendency Sweden’s Unemployment Rate at Eight-Year Low Indicator4 Sweden: Unemployment Rate 2010–2016 2010–2016 Economic Tendency Indicator 120 Unemployment Rate 9.0% Index above 110: Economy is much stronger than normal 115 110 8.5% 8.0% 105 100 7.5% 95 7.0% 90 Index below 90: Economy is much weaker than normal 85 6.5% 80 2010 2011 2012 2013 2014 2015 2016 Source: Bloomberg, National Institute of Economic Research (Sweden), as at 30/11/16. Past performance does not guarantee future results. 6.0% 2010 2011 2012 2013 2014 2015 2016 Source: Bloomberg, National Institute of Economic Research (Sweden), as at 31/12/16. Past performance does not guarantee future results. 4. The Economic Tendency Indicator measures overall business and consumer sentiment. It is based on monthly business surveys in the manufacturing, construction, retail trade and private service sectors, as well as monthly consumer surveys. The indicator has a mean value of 100 and a standard deviation of 10. Values between 100 and 110 are equivalent to a stronger-than-normal economy, whereas values above 110 represent a much stronger-than-normal economy. Likewise, values between 90 and 100 show a weakerthan-normal economy and values below 90 are equivalent to a much weaker-than-normal economy. For Financial Professional Use Only. Not For Public Distribution. 2017 Long-Term Capital Market Expectations 5 It’s Time to Go Long on Japanese Equity An improved growth outlook, high positive impact on growth. Real profit margins and attractive GDP increased at an annualized valuations all support Japanese rate of 1.6% in the first three equity. quarters of 2016.5 An ultra-loose monetary policy— Exports were very resilient given massive QE and negative interest significant yen appreciation. After rates—combined with three declining in the first half of 2016, stimulus fiscal budgets in 2016 exports rebounded sharply in the alone have finally resulted in a third quarter.6 After the US election, Japanese Profit Margins Near 20-Year High Japanese Valuations Nearer to Historic Lows TOPIX Profit Margins TOPIX P/E Ratio 1996–2016 2012–2016 Profit Margin P/E Ratio 35 6% 4% 30 2% 25 0% -2% 20 -4% 15 -6% -8% 1996 2001 2006 2011 2016 Source: Bloomberg, as at 30/11/16. Past performance does not guarantee future results. 10 2012 2013 2014 2015 2016 Source: Bloomberg, as at 30/11/16. Past performance does not guarantee future results. 5. Source: Bloomberg. 6. Source: Organisation for Economic Co-operation and Development (OECD) Economic Outlook, Volume 16, Issue 2. 6 2017 Long-Term Capital Market Expectations For Financial Professional Use Only. Not For Public Distribution. “ An improved growth outlook, high profit margins and attractive valuations all support Japanese equity.” the yen reversed its appreciation because of an increasing labor The P/E ratio is around 19, which is trend. Given the US rising rate cycle, shortage and subsequent potential very low compared to its own we expect there is room for wage growth. history. additional depreciation, which could be a further boost for Japanese exports. The profitability of Japanese firms is very favorable. The profit margin of the Tokyo Stock Price Index We believe private consumption is (TOPIX) is at a 20-year high. At the another driver for potential growth same time, valuations are attractive. Among Developed-Market Equities, Japan Offers the Greatest Forward-Looking Opportunity Comparison of Expected Annualized Returns of Various Developed-Market Equities As at 30 November 2016 Projected Annualized Returns, 1 January 2017–31 December 2023 Expected Return 12% 9.6% 10% 8.1% 8% 7.5% 7.3% 6.9% 6.8% Europe ex United Kingdom United Kingdom 8.3% 8.3% Pacific ex Japan Australia 6% 4% 2% 0% Developed-Market Equity United States Canada Japan Source: Calculations by FT Solutions using data sourced from Bloomberg. See appendix on page 18 for representative indexes for each asset class. Opinions and beliefs expressed are those of FT Solutions and are subject to change without notice. There is no assurance that any forecast or projection will be realized. For Financial Professional Use Only. Not For Public Distribution. 2017 Long-Term Capital Market Expectations 7 US Infrastructure Will Benefit from the Coming Fiscal Stimulus Public and private spending in US request is US$98.1 billion, up infrastructure had already been significantly from the FY 2016 trending upward before the election. request of US$72.4 billion (the Combined with strong interest in enacted budget ended up being revamping infrastructure on the part US$76.0 billion). FY 2017 includes of the new administration, we some major expansions of the believe this should bode well for budget—extra spending initiatives investment returns in this category. on pipeline safety, clean energy On the public side, the Department of Transportation’s FY 2017 budget transport, advanced metropolitan planning, cybersecurity Profit Margins for US Infrastructure Higher than Broad US Equities US Infrastructure Valuations Favorable Compared with Broad US Equities Profit Margins: MSCI US Infrastructure vs. MSCI US Equity P/E: MSCI US Infrastructure vs. MSCI US Equity 2012–2016 2012–2016 Profit Margin P/E Ratio 12% 22 10% 20 8% 18 6% 16 4% 14 2% 12 0% 2012 2013 MSCI US Infrastructure 2014 2015 MSCI US Equity Source: Bloomberg, MSCI as at 30/11/16. Past performance does not guarantee future results. 8 2017 Long-Term Capital Market Expectations 2016 10 2012 2013 US Infrastructure 2014 2015 2016 US Equity Source: Bloomberg, MSCI, as at 30/11/16. Past performance does not guarantee future results. For Financial Professional Use Only. Not For Public Distribution. “ Infrastructure, as a real asset, demonstrates inflation-linked pricing power.” and others.7 Election campaign private side valuations and corporate and GDP to increase, we also expect proposals included a US$1 trillion fundamentals also appear to bode asset classes like US infrastructure dollar spending plan to update well for the asset class. Valuations to protect against erosion in infrastructure over the coming are looking more favorable for the purchasing power and to offer decade. These plans will kick off new asset class than US equities, and favorable risk-adjusted returns projects and will require buy-in from corporate profit margins are now compared to other equity sectors private financing, creating many higher than broad US equities. (See less linked to the real economy. opportunities for investment in the charts in this section.) asset class. Infrastructure, as a real asset, also While additional public expenditures demonstrates inflation-linked pricing should boost infrastructure, on the power. As we expect US inflation We Expect Many Opportunities to Arise in US Infrastructure Comparison of Expected Annualized Returns of US Equity vs. US Infrastructure As at 30 November 2016 Projected Annualized Returns, 1 January 2017–31 December 2023 Expected Return 10% 9% 8% 7.9% 7.3% 7% 6% 5% 4% 3% 2% 1% 0% US Equity US Infrastructure Source: FT Solutions. See appendix on page 18 for representative indexes for each asset class. Opinions and beliefs expressed are those of FT Solutions and are subject to change without notice. There is no assurance that any forecast or projection will be realized. 7. Source: US Department of Transportation, Transforming Communities in the 21st Century: Budget Highlights, Fiscal Year 2017. For Financial Professional Use Only. Not For Public Distribution. 2017 Long-Term Capital Market Expectations 9 OUR STRONGEST CONVICTIONS “AGAINST” Developed-Market Government Bonds: The Pain Shows No End in Sight In spite of a brief improvement after next three to five years. We believe the different economies has changed. the US election, developed-market rising interest rates will offset the Even if the new Republican regime government bond yields remain at already thin carry benefit from yields. can deliver the expected stimulus, the very low levels relative to the last 30 domestic policy changes in the United We maintain our base-case years—largely as a result of QE and expectation of a gradual normalization zero-interest-rate policies around the of rates in the United States. Although world. Given the improved growth outlook and stabilized commodity prices, fears of deflation appear to be diminishing: Inflation is looming in the United States and in the eurozone, and it is gradually nearing the European Central Bank’s 2% target. We expect moderate inflation to return and interest rates to normalize in the States may not be as powerful as might have occurred 30 years ago. the pace of rising rates in the United Overall, given the low starting yields, States might be faster under Trump’s our models suggest that the seven- regime than the market may otherwise year expectations for developed- have expected, we think that given the market government bond returns are situation in Europe, Japan and China, well below what we’ve observed in this is still a gradual shift. We live in a history. more integrated world today than 30 years ago and the relative size of Yields Remain at Historic Lows Developed Government Bonds Likely to Underperform World Government Bond Index Yield to Maturity Comparison of Expected Annualized Returns of Developed Market Bonds vs. Other Bond Types 1984–2016 Yield to Maturity As at 30 November 2016 Projected Annualized Returns, 1 January 2017–31 December 2023 12% Expected Return 7% 10% 5.6% 6% 5.8% 5% 8% 4% 2.4% 2.6% 3% 6% Average since 1984 2% 4% 1% 1.5% 0.8% 0.8% 0.6% 0.9% 0.1% 0% 2% 0% 1984 1988 1992 1996 2000 2004 2008 2012 2016 World Government Bond Index Source: Bloomberg, as at 30/11/16. Past performance does not guarantee future results. 10 2017 Long-Term Capital Market Expectations Source: Calculations by FT Solutions using data sourced from Bloomberg. See appendix on page 18 for representative indexes for each asset class. Opinions and beliefs expressed are those of FT Solutions and are subject to change without notice. There is no assurance that any forecast or projection will be realized. For Financial Professional Use Only. Not For Public Distribution. Short Swiss Franc vs. US Dollar All three components of the longterm currency expectations model are bearish for the Swiss franc (CHF), including valuation, carry and real interest-rate parity. From a valuation perspective, the Swiss franc continues to be the most overvalued relative to other developed-market currencies. Conventional wisdom says that the Swiss franc is a safe haven currency. Recent uncertainties in Europe—the debt crisis, the Greek bailout, Brexit and populist uprisings across the continent—have combined to rattle confidence in the eurozone and drive investors to perceived havens including the Swiss franc. This overbought environment has the potential to reverse with the recent sentiment shift and prospects of global growth and reflation in the United States and Europe. Carry is the second component of the model and takes into account the “ The Swiss franc continues to be the most overvalued relative to other developed-market currencies.” difference in rates between two respective countries. The theory is that assets with higher yields tend to appreciate relative to assets offering lower yields. We expect policy in Switzerland to remain accommodative and the government’s bond yield curve to remain depressed relative to the US yield curve. The Swiss franc is likely to remain a funding currency relative to the US dollar and other developed currencies and therefore we expect the CHF will likely weaken relative to the USD. buoy yields and inflation in the United States. The IMF expects long-term inflation in Switzerland to remain subdued, further allowing the Swiss central bank to maintain negative rates. Swiss inflation is only expected to reach 1% in 2021, substantially below the central bank’s 2% target. This inflation and policy difference will put pressure on the Swiss franc versus the US dollar. Real interest-rate parity takes into account differences in expected inflation between countries. Because of the expected inflation differential, this component of the model forecasts depreciation of the Swiss franc versus the US dollar in the long term. The prospect of global reflation, driven in part by the proposed policies in the United States, may Thumbs Up Swedish Krona; Thumbs Down Swiss Franc Long-Term Expected Change vs. USD Based on Purchasing Power Parity (PPP) Model Long-Term Expected Change vs. USD Based on Real Interest-Rate Parity Model As at 30 November 2016 Projected 1 January 2017–31 December 2023 As at 30 November 2016 Projected 1 January 2017–31 December 2023 Expected Change vs. USD 40% Expected Change vs. USD 4% 33.2% 30% 19.6% 18.3% 20% 10% 2% 2% 0% 8.4% 7.9% 0% -2% 2.5% 0% -4% -10% -6% -1% -4% -8.7% -20% -20.1% -20.5% -30% 2% -1% -1% -4% -8% -9% -10% GBP EUR AUD CAD NZD JPY NOK SEK CHF GBP EUR AUD CAD NZD JPY NOK SEK CHF Source: Bloomberg, FT Solutions. Opinions and beliefs expressed are those of FT Solutions and are subject to change without notice. There is no assurance that any forecast or projection will be realized. For Financial Professional Use Only. Not For Public Distribution. 2017 Long-Term Capital Market Expectations 11 OUR CAPITAL MARKET EXPECTATIONS Traditional Beta: Equity Traditional Beta: Fixed Income As at 30 November 2016 Seven-Year Annualized Return Capital Market Expectations (in Local Terms), Projected 1 January 2017–31 December 2023 As at 30 November 2016 Seven-Year Annualized Return Capital Market Expectations (in Local Terms), Projected 1 January 2017–31 December 2023 Seven-Year Capital Market Expectations 20-Year Annualized Return Global Equity 7.8% 6.8% 0.3% 4.6% Developed-Market Equity Global Developed-Market Government 7.5% 6.8% US Government 1.3% 4.9% United States 7.3% 8.3% Canadian Government 0.5% 5.7% Canada 8.1% 9.0% Europe ex UK Government 0.4% 4.7% Europe ex UK 6.9% 7.6% UK Government 0.1% 6.7% United Kingdom 6.8% 6.4% Japanese Government -0.7% 2.6% Japan 9.6% 1.1% Australian Government 1.7% 6.6% Pacific ex Japan 8.3% 5.4% Global Corporate High Yield 4.0% 6.7% Australia 8.3% 8.6% US High-Yield USD 4.3% 7.2% Pan-European EUR 2.4% 5.9%* Global Natural Resources 8.3% 7.3% Pan-European GBP 3.9% 11.0%* Global Gold Miners 3.1% 0.1% US Listed Infrastructure 7.9% 2.2%* Global Real Estate Investment Trusts (REITs) 5.9% 9.8% Specialty Equity *Data not available for full 20-year period. Returns calculated using data since inception of the representative index, beginning 31/12/98. Seven-Year Capital 20-Year Annualized Market Expectations Return *Data not available for full 20-year period. Returns calculated using data since inception of the representative index, beginning 31/1/99. Seven-Year Capital 20-Year Annualized Market Expectations Return Global Investment-Grade Credit 3.0% Issued in USD 2.7% 5.8% Issued in GBP 2.1% 5.8%* 5.1% Seven-Year Capital Market Expectations 20-Year Annualized Return Issued in JPY 0.4% 1.1%* Emerging-Market (EM) Equity 8.7% 8.9% Issued in EUR 1.7% 4.9%* EM Europe, Middle East, Africa (EMEA) 8.3% 5.1% Issued in CAD 2.1% 5.7%* EM Latin America 8.8% 12.1% Issued in AUD 3.3% 6.6%* EM Asia 8.8% 3.5% EM Debt Composite (36% Hard, 39% Local, 25% EM Corp) 3.7% 8.6% Global Small-Cap Equity 9.4% 7.9% EM Debt–Government (Hard) 4.2% 10.1% US Small Cap 9.2% 8.5% EM Debt–Government (Local) 6.3% 8.5%* EM Corporate (Hard) 2.9% 6.6%* Inflation-Linked Bonds 0.7% 5.9%* US Securitized 1.5% 5.2% US Mortgage-Backed Securities 1.5% 5.2% Other Fixed Income *Data not available for full 20-year period. Returns calculated using data since inception of the representative indexes: Global Corp IG Credit GBP beginning 31/12/99; Global Corp IG Credit JPY beginning 31/7/00; Global Corp IG Credit EUR beginning 31/7/98; Global Corp IG Credit CAD beginning 31/10/02; Global Corp IG Credit AUD beginning 30/6/04; EM Debt Government (Local) beginning 31/12/02; EM Debt Government (Hard) beginning 31/1/03; Inflation-Linked Bonds beginning 31/1/02. Expected Return Source: Franklin Templeton Solutions. Past performance does not guarantee future results. There is no assurance any forecast or projection will be realized. See appendix on page 18 for representative indexes for each asset class. 12 2017 Long-Term Capital Market Expectations For Financial Professional Use Only. Not For Public Distribution. Traditional Beta: Commodities Alternatives As at 30 November 2016 Seven-Year Annualized Return Capital Market Expectations (in USD), Projected 1 January 2017–31 December 2023 As at 30 November 2016 Seven-Year Annualized Return Capital Market Expectations (in USD), Projected 1 January 2017–31 December 2023 Seven-Year Capital Market Expectations 20-Year Annualized Return Commodities 4.0% 1.4% Alternatives Oil 6.2% 4.7% Gold 1.1% 5.2% Precious Metal 8.9% 5.5% Agriculture 7.5% -1.4% Traditional Beta: Currency As at 31 December 2016 Seven-Year Forecasts Capital Market Expectations, 31 December 2023 Seven-Year Capital Market Expectations Spot as at 31/12/16 FX Rate USD CAD 1.34 1.34 EUR USD 1.01 1.05 GBP USD 1.25 1.23 USD JPY 114.69 116.96 AUD USD 0.73 0.72 Seven-Year Capital Market Expectations 20-Year Annualized Return FT Solutions Risk Premia Composite* 3.2% 7.6% US Private Equity 9.3% 13.9%** Hedge Fund 6.0% 7.5% *Risk premia strategy (and sub-strategy) historic composite returns are simulated based on third-party data we pull from Bloomberg and aggregate using a proprietary methodology. See “Risks of Assumptions for Risk Premia and Other Alternatives” on page 17 for important information about risk premia composite calculation methodology. **US Private Equity return calculated through 30/6/16. Economic As at 30 November 2016 Seven-Year Annualized Return Capital Market Expectations (in Local Terms), Projected 1 January 2017–31 December 2023 Seven-Year Capital Market Expectations Policy Rate as at 31/12/16 USD Cash 2.2% 0.5% CAD Cash 2.1% 0.5% EUR Cash 1.4% 0.0% GBP Cash 1.9% 0.3% JPY Cash 0.5% 0.1% AUD Cash 2.8% 1.5% Cash Expected Return Expected Return Source: Franklin Templeton Solutions. Past performance does not guarantee future results. There is no assurance any forecast or projection will be realized. See appendix on page 18 for representative indexes for each asset class. For Financial Professional Use Only. Not For Public Distribution. 2017 Long-Term Capital Market Expectations 13 PROCESSES OUR METHODOLOGY AND MODELS AND MODELS This section provides an overview of the methodology and models we use to develop long-term capital market expectations (CMEs) for various asset classes, including equities, fixed income, commodities and alternatives. In total our 2017 CMEs cover 66 asset classes including 19 in equity, 25 in fixed income, seven in commodities, five within currency and four in the alternative beta and alpha spaces. In terms of economic expectations, we deliver six expectations of regional three-month cash returns. Our CMEs are intended to provide annualized seven-year return expectations. However, the time horizon can be generalized to the next five to 10 years, and we update our models annually. This period coincides with the model (a form of the dividend average length of a US business discount model) as well as cycle, as defined by the National regressions on economic scenarios Bureau of Economic Research. for equity expectations and stressing Since 1945, there have been 11 US the yield curve for fixed income business cycles with an average expectations. duration of 69.5 months. The timeframe also historically corresponds to the average duration of aggregate fixed income indexes that we use. We base our CMEs more on forward-looking assumptions rather than a long-term historical average return for an asset class. Using forward-looking returns is an Our long-term return expectations important distinction since past are driven by current valuations, performance should not necessarily analyst expectations, expected be an indication of future returns, growth rates and expected economic especially in times of changing environments. We use inputs and macroeconomic environments. We model techniques specific to each build our return expectations using asset class within a process that informed forward estimates of blends quantitative analysis with fundamentals and economic regimes fundamental research. The process over the next five to 10 years rather includes using the residual income than simply relying on historical “ Our long-term return expectations are driven by current valuations, analyst expectations, expected growth rates and expected economic environments.” performance. 14 2017 Long-Term Capital Market Expectations For Financial Professional Use Only. Not For Public Distribution. Traditional Equities Building Blocks Model We use several models for our The building blocks model forecasts equity return expectations. The returns by summing three forecasts: benefit of using several different 1. Dividend yield sourced from models is that we take into account Bloomberg analyst estimates both the absolute and relative forecasts (as in the residual income 2. Earnings-per-share (EPS) model). To develop our 2017 CMEs growth rates, which are the within traditional equities, we used average of bottom-up analyst the “residual income” model and the forecasts from the I/B/E/S and “building blocks” model. top-down long-term GDP and inflation forecasts Residual Income Model The residual income model uses the 3. P/E expansion, which assumes relationship between price-to-book that P/E will converge to its long- (P/B) ratios, historical return of term average. equity (ROE), and forward-looking (one-year and two-year) ROE to Specialty Equities “ We build our return expectations using informed forward estimates of fundamentals and economic regimes over the next five to 10 years rather than simply relying on historical performance.” determine expected returns. A higher To develop our expectations for forward ROE tends to contribute to a specialty equities, we use regression higher return expectation. A lower models. The models identify relevant P/B ratio typically indicates a higher equity and commodity factors that return expectation. In addition, we drive the expected returns for each found that comparing expected asset class. Based on the historic returns relative to their own histories betas and alphas we construct miners, we also consider the gold provides insightful information. The forward-looking views that determine price to be a factor in the model. For percentile of current expected return our expectations. We believe that infrastructure, oil prices are a in relation to historical expectations within the specialty equity category, relevant explanatory factor. indicates major bullishness or the returns in natural resources, gold Therefore, main inputs to our bearishness relative to history. Our miners, listed infrastructure and real specialty equity long-term return analysis shows that rank-adjusted estate investment trusts (REITs) models is the relationship between results provide strong guidance in should be in line with traditional those factors and the asset class forecasting returns. equity indexes. With regard to gold indexes. Risks of Assumptions for Equity Return Expectations The residual income model relies on the theory that a company’s equity value is equal to the sum of its current book value and its expected future cash flows. Actual equity returns may deviate from the expected returns if the theory does not hold or if realized return on equity differs substantially from the analyst estimates used in the modeling. Unforeseen macroeconomic shocks (such as strong shocks to inflation or GDP) or major changes in the structure of the equity markets could also cause actual returns to differ from the expected returns. In addition, actual returns may deviate from expected returns if one or more of the forecast components comprising the building blocks model turn out to be different from actual dividend yields, EPS growth or P/E expansion. Risks of Assumptions for Specialty Equity Return Expectations Actual returns may differ from the expected returns for specialty equity if our forward-looking assumptions of the relationships between asset classes differ from reality. For Financial Professional Use Only. Not For Public Distribution. 2017 Long-Term Capital Market Expectations 15 Fixed Income Commodities Interest-Rate Differential Yield Curve Shift Model Spot Return and Roll Yield Currencies in countries with high The main input to our fixed income We based our expected returns from interest rates tend to appreciate return expectation is our yield curve commodities on two sources: spot relative to currencies in countries shift (YCS) model. Principal return and roll yield. For spot return, with lower interest rates. We use our component analysis (PCA) of we apply an inflation-adjusted model own forecast short-term cash rates historical data has shown that the to forecast spot price. We first for given countries as inputs. expected returns for bonds are calculate historical real commodity Real Interest-Rate Parity mainly driven by current yield level prices given their historical inflation Real interest-rate differential and parallel shift scenarios. Given a rates, and forecast real commodity between two countries drives the parallel shift scenario, the YCS price targets given the long-term exchange rate between model assumes current yield curve macroeconomic outlook, then add them. We use our own forecasts for will shift gradually to the target over back the inflation expectation to get long-term inflation for given seven years. The model also the final target spot price. For roll countries. involves stressing the yield curve on yield, we estimate historical roll yield a monthly basis using a random walk for each commodity and take the approach. The results include long-term average for our forecasts. expected returns and the confidence intervals of the expected returns for Currency the fixed income asset classes. We base our long-term foreign Major inputs into the model include: exchange assumptions on equalweighting forecasts from three well- 1. Term structure (the shape of the yield curve) documented theories: purchasing power parity, interest-rate differential 2. Yield volatilities and real interest-rate parity. 3. Market structures (weights for Purchasing Power Parity different durations) Exchange rates should change to create equilibrium ensuring that the 4. Expected shift scenarios For corporate bonds and emergingmarket debt instruments, we assume credit spreads will revert to their own long-term averages over a seven- same set of goods will cost the same if purchased with two different currencies. Inputs include OECD purchasing power parity and IMF calculations. year horizon. We estimate corresponding default and recovery rates based on the averages of their long-term history. Risks of Assumptions for Fixed Income Return Expectations Actual fixed income returns may deviate from the expected returns if the actual shift in the yield curve over seven years deviates substantially from the types of shifts and stresses applied to the yield curve in the model. Unforeseen macroeconomic shocks or major changes in the market structure or term structure could also cause actual returns to differ from expected returns. Risks of Assumptions for Commodities Actual returns may differ from the expected returns if the spot return and roll yield deviate from realized values. Risks of Assumptions for Currency Expectations Long-term currency expectations depend on the accuracy of the theories (purchasing power parity, interest-rate differential and real interest-rate parity) and on the long-term projections for yields and inflation rates. If reality deviates from the theory, or if realized yields and inflation rates differ significantly from the projections, we may see that actual currency rates differ from the expected rates. 16 2017 Long-Term Capital Market Expectations For Financial Professional Use Only. Not For Public Distribution. Alternatives To determine our expectation for Economic Forecasts We base our long-term forecasts for private equity, we assumed an We collected GDP and inflation rates alternatives on efficiency and illiquidity premium of 200 basis from multiple sources, including the illiquidity premium assumptions. We points, which is generally in line with World Bank, OECD, IMF and other consider the historical trend of the the average of a sample of third parties. Our portfolio managers Sharpe ratio on risk premia and institutional private market forecast also make their own forecasts. Our hedge funds. We base all historical assumptions. final forecasts comprise all the data related to the risk premia For our hedge fund return external and internal forecasts. To strategies on data from third parties expectation, we combined our determine the short-term (three- and do not represent the actual efficiency assumption and multi- month) cash rate, we build out a performance of any portfolio or factor models to forecast long run forward rate model and use the index. Using the forward-looking returns that determine a seven-year Taylor rule based cash forecast Sharpe ratio, cash rate and historical CME for hedge funds. model. We include the current risk, we construct our long-term risk government bond yield curve, premia return expectations. current inflation and GDP, long-term GDP and inflation expectations as inputs. Risks of Assumptions for Risk Premia and Other Alternatives Risk premia strategy (and sub-strategy) historic composite returns are simulated based on third party data sourced from Bloomberg that we aggregate using a proprietary methodology. We divide the various strategies by type, rank them through a quantitative and qualitative process, and weight them by risk. Because these composites are determined based on our own assessments and calculations, these composites represent our own views and analysis and may vary from the methodologies and conclusions of others. Although we believe the composite data is accurate and reasonable, we cannot guarantee it, nor can we guarantee that implementation of any of the specific strategies would attain the performance or target of any composite mentioned in this paper. Actual performance of a specific strategy may differ substantially from the composite performance shown. All composite data is hypothetical and for illustrative purposes only. It does not represent the results of any actual portfolio or index. We created the composite data with the benefit of hindsight and knowledge of factors that could have positively affected the results. We have presented all composite and index data gross of fees and expenses. Fees and expenses would lower a managed portfolio’s returns. Actual returns may differ from the expected returns if our efficiency assumptions or multi-factor models deviate from reality. For example, we have assumed a decreasing Sharpe ratio trend over the long term. Actual returns may not match expected returns if the Sharpe ratio instead increases or remains constant over the next seven years. Risks of Assumptions for Economic Forecasts The forward cash rate may deviate from the expected cash rate if the yield curve deviates substantially from the one that we applied in the model. Unforeseen macroeconomic shocks, changing government policies or major changes in the term structure would also cause the actual cash rate to differ from the expected cash rate. For Financial Professional Use Only. Not For Public Distribution. 2017 Long-Term Capital Market Expectations 17 APPENDIX: INDEXES AND PROXIES USED Asset Class Equity Global Equity Global Developed US Equity Canadian Equity UK Equity Europe ex UK Equity Japanese Equity Pacific ex Japan Equity Australia Global Small Cap US Small Cap Emerging Markets EM EMEA EM Latin America EM Asia Specialty Equity Global Natural Resources Global Gold Miners US Listed Infrastructure Global REITs Fixed Income Global Developed-Market Government US Government Canadian Government Europe ex UK Government UK Government Japanese Government Australian Government Global Investment-Grade Credit Issued in USD Issued in GBP Issued in JPY Issued in EUR Issued in CAD Issued in AUD Global Corporate High Yield US High-Yield USD Pan-European High-Yield in EUR Pan-European High-Yield in GBP Emerging-Market Debt Aggregate EM Debt–Gov’t (Hard) EM Debt–Gov’t (Local) EM Corporate Hard Other Fixed Income Inflation-Linked Bonds US Securitized US Mortgage-Backed Securities 18 2017 Long-Term Capital Market Expectations Market Proxy MSCI All Country World Index TR MSCI Daily TR Gross World Local MSCI Daily TR Gross USA Local MSCI Daily TR Gross Canada Local MSCI Daily TR Gross UK Local MSCI Daily TR Gross Europe ex UK Local MSCI Daily TR Gross Japan Local MSCI Daily TR Gross Pacific ex Japan Local MSCI Daily TR Gross Australia Local MSCI Small Cap All Country World Russell 2000® MSCI Daily TR Gross Emerging Markets EM Local MSCI Emerging Markets Europe Middle East Africa Local MSCI Daily TR Gross Emerging Markets EM Latin America Local MSCI Daily TR Gross Emerging Markets EM Asia Local Morningstar Natural Resources Category (31/12/88–31/8/96) S&P Natural Resources Sector (31/8/96–30/11/02) S&P Global Natural Resources (30/11/02–Present) DJGI World (ALL)/Gold Mining (31/12/91–30/9/98) FTSE Gold Mines TR (30/9/98–Present) MSCI US Infrastructure Total Return Index (29/7/11–Present) S&P Global REIT Citigroup World Government Bond All Bloomberg Barclays US Aggregate Government IMF Canada LT Government Total Return (31/1/75–31/12/84) Canada Government Bond Index All Maturities (31/12/84–Present) World Government Bond Index Europe All (31/1/85–31/1/99) Citigroup Economic and Monetary Union Government Bond Index All (31/1/99–Present) Citi Government Bond Index UK Local Citigroup Japan Government Bond Index All Citi Government Bond Index Australia Local Bloomberg Barclays US Aggregate Corporate (31/1/90–31/12/96) Merrill Global Broad Market Corporate (31/12/96–29/9/00) Bloomberg Barclays Global Aggregate Credit (29/9/00–Present) Bloomberg Barclays US Aggregate Corporate Bloomberg Barclays Aggregate Corporate GBP Bloomberg Barclays Aggregate Corporate JPY Bloomberg Barclays Aggregate Corporate EUR Bloomberg Barclays Aggregate Corporate Canada Bloomberg Barclays Aggregate Corporate AUD Bloomberg Barclays Capital US Corporate High Yield (31/12/25–31/12/00) Bloomberg Barclays Global High Yield Corporate (31/12/00–Present) Bloomberg Barclays Capital US Corporate High Yield Bloomberg Barclays Pan-European High Yield EUR Bloomberg Barclays Pan-European (Non-Euro) High Yield GBP (36% EMD Hard Currency, 39% EMD Local, 25% EMD Corporate) JP Morgan Emerging Market Bond Index+ JP Morgan Gov’t Bond Index – Emerging Markets Global Diversified Composite Local Bloomberg Barclays Emerging Markets Corporates Total Return Index Value Unhedged USD Bloomberg Barclays Global Inflation-Linked Bonds (11/30/97–Present) Bloomberg Barclays US Securitized: MBS/ABS/CMBS Total Return Index Value Unhedged USD Bloomberg Barclays US MBS Index Total Return Value Unhedged USD For Financial Professional Use Only. Not For Public Distribution. Asset Class Market Proxy Fixed Income (cont’d.) Commodities Oil (57% WTI + 43% Brent Oil) Precious Metal GSCI Precious Metals Total Return (31/1/73–31/1/91) Bloomberg Precious Metals Sub-Index Total Return (1/2/91–Present) S&P GSCI Gold Index (28/2/78–31/1/91) Bloomberg Gold Sub-Index Total Return (1/2/91–Present) Gold Agriculture Bloomberg Agriculture Sub-Index Total Return Alternatives US Private Equity FT Solutions Proprietary Monthly Adjusted – Cambridge Associates US Private Equity Index (31/1/86–30/6/16) Risk Premia* HFRI Fund of Fund Composite (31/12/89–30/11/97) HFRX Global Hedge Fund Index (31/12/97–31/12/09) FTS Systematic Beta Enhanced Composite (29/1/10–Present) Hedge Fund HFRI Fund Weighted Composite Index Cash USD CAD EUR Encorr 90-Day T-Bill (31/12/74–31/1/97) JPM Cash Index USD 3-Month (31/1/97–Present) Canada DEX 90-Day Bill (31/1/75–1/97) JPM CAD Cash Index 3-Month (2/97–Present) IMF Germany Deposit Rate (De-Annualized) (to 31/12/95) Germany Cash Indexes – Libor Return 3-Month (31/1/96–31/1/99) JPM Cash Index Euro Currency 3-Month (28/2/99–Present) GBP JPM Cash Index GBP 3-Month JPY JPM Cash Index JPY 3-Month Bloomberg AusBond Bank Index (31/3/87–31/1/97) JP Morgan 3-Month AUD Cash Index (31/1/97–Present) AUD *Risk premia strategy (and sub-strategy) historic composite returns are simulated based on third-party data we source from Bloomberg and aggregate using a proprietary methodology. See “Risks of Assumptions for Risk Premia and Other Alternatives” on page 17 for important information about risk premia composite calculation methodology. MSCI makes no warranties and shall have no liability with respect to any MSCI data reproduced herein. No further redistribution or use is permitted. This report is not prepared or endorsed by MSCI. CFA® and Chartered Financial Analyst® are trademarks owned by CFA Institute. Important data provider notices and terms available at www.franklintempletondatasources.com. For Financial Professional Use Only. Not For Public Distribution. 2017 Long-Term Capital Market Expectations 19 WHAT ARE THE RISKS? conditions. In other words, the future performance and All investments involve risks, including possible loss of correlations of risk premia strategies may differ, principal. potentially significantly, from historical performance and Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Bond prices generally move in the opposite direction of interest rates. Thus, as the prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in developing markets involve heightened risks related to the same factors, in addition to those associated with their relatively small size, lesser correlations. In addition, because the risk premia composites in this paper are determined based on FT Solutions’ own assessments and calculations, these composites represent solely the views and analyses of FT Solutions and may vary from the methodologies and conclusions of others. Although FT Solutions believes that the composite data is accurate and reasonable, there is no guarantee of such, that implementation of any of the specific strategies would attain the performance, or target of any composite mentioned in this paper. Actual performance of a specific strategy may differ substantially from the composite performance shown. liquidity and lack of established legal, political, business, Investing in the natural resources sector involves special and social frameworks to support securities markets. risks, including increased susceptibility to adverse Such investments could experience significant price economic and regulatory developments affecting the volatility in any given year. Derivatives, including currency sector—prices of such securities can be volatile, management strategies, involve costs and can create particularly over the short term. Some strategies, such as economic leverage in a portfolio, which may result in hedge fund and private equity strategies, are available significant volatility and cause the portfolio to participate only to pre-qualified investors, may be speculative and in losses (as well as enable gains) on an amount that involve a high degree of risk. An investor could lose all or exceeds the portfolio’s initial investment. a substantial amount of his or her investment in such Because some risk premia strategy signals are built using historical market events, the risk premia strategies can be subject to model risk, whereby the strategies perform differently than the model would expect for various strategies. Real estate securities involve special risks, such as declines in the value of real estate and increased susceptibility to adverse economic or regulatory developments affecting the sector. reasons, including but not limited to market and economic 20 2017 Long-Term Capital Market Expectations For Financial Professional Use Only. Not For Public Distribution. IMPORTANT LEGAL INFORMATION This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as at publication date and may change without notice. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market. 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