SSgA Long-Term Asset Class Forecasts

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1 SSgA Long-Term Asset Class Forecasts As of June 30, 2014 Investment Solutions group (ISG) Market commentary Please find attached the nominal asset class return forecasts projected by the SSgA Investment Solutions Group (ISG) as of June 30, Our longer-term forecasts are forward-looking estimates of total return generated through combined assessment of current valuation measures, income payouts, economic growth, and inflation prospects, as well as historical risk premia. We also include shorter-term return forecasts that incorporate output from our tactical asset allocation models. Outlined below is the process we use to arrive at our return forecasts for the major asset classes. Inflation by Dan Farley Senior Managing Director of SSgA, and Chief Investment Officer for ISG The starting point for our nominal asset class return projections is an inflation forecast. We incorporate both consensus estimates of long-term inflation and the inflation expectations implied in current bond yields. US Treasury Inflation Protected Securities (TIPS) provide a market observation of the real yields that are available to investors. The difference between the nominal bond yield and the real bond yield at longer maturities furnishes a marketplace assessment of long-term inflation expectations. During the second quarter of 2014, long-term government yields continued their fall. The Federal Reserve continued to taper bond purchases, and despite having the end of quantitative easing in sight, yields moved lower, in part due to the Fed s expressed willingness to keep rates low even after tapering is complete. For the second quarter as a whole, longer-term nominal yields decreased by 20 basis points, while real yields at similar maturities fell about 30 basis points. The net result was a small increase in long-term US inflation expectations, which shifted up slightly to 2.35% 1 as of the end of the second quarter. This modest inflation projection is consistent with steady but sluggish global expansion. While output gaps persist in many countries, growth estimates have been coming down since the first quarter of The Fed s commitment to keep rates low for longer, coupled with the ongoing Japanese commitment to lift inflation, reflects continuation of a highly accommodative central bank environment. In the expectation that central bank largesse will eventually lead to greater upward pressure on consumer prices, we retain a long-term assumption of 2.5% inflation for our analyses. Cash Our long-term forecasts for global cash returns incorporate what we view as the normal real return that investors can expect to earn over time. Historically, cash investors have earned a modest premium over inflation, but by design, current monetary policy priorities are dictating that cash returns stay below prevailing inflation rates. We expect that short-term interest rates will one day normalize, but without any clear indication on the timing, our long-term cash return forecast is 2.2% for the US and 2.1% for the Eurozone, reflecting a discount from our long-term inflation projection. Our short-term outlooks for cash returns derive from observed interbank rates, which exhibited modest variation around minimal levels during the first quarter. Due to the accommodative tone of much central bank commentary, we continue to model a suppressed pace of convergence between our near-term cash return expectations and our longer-term forecasts.

2 Bonds Our return outlooks for fixed income derive from current yield conditions together with expectations as to how real and nominal yield curves will evolve relative to historical averages. For corporate bonds, we also analyze credit spreads and their term structures, with separate assessments of investment-grade and high-yield bonds. While most government bond yields fell during the first quarter, our updated longer-term return expectations for fixed income reflect only modest adjustments, as increased reinvestment income still plays a large role over the long term. On shorter horizons, our tactical allocation models remain broadly cautious towards government bonds. As a result, most of our one-year bond forecasts show slight decreases relative to our projections three months ago. As is the case with our cash return forecasts, our bond return models continue over the next several years to incorporate a suppressed pace of convergence to the higher longer-term yields that we expect at more distant horizons. Spreads on high-yield bonds narrowed further during the second quarter. The yield on the Barclays US High Yield Index fell to 4.91%, 2 more than 30 basis points below its level at the end of the first quarter. Corresponding yields in Europe declined by 24 basis points. Our short-term return projection for US high-yield bonds has dropped to 1.3%; but because we expect yields below investment-grade to normalize over time, we expect that reinvestment effects will help to maintain income levels over the longer haul, for which we are projecting a 5.0% return. In the near term, we expect real yields to match the behavior of nominal yields and rise modestly. Our resulting one-year return forecast for US TIPS is 1.7%. Still, to the extent that governments in developed countries want to keep borrowing costs down while they pursue strategies intended to reinvigorate economic growth, they may seek to keep real yields depressed. Over the longest time frames, we are modeling increases in real yields, but we expect that inflation protection will provide enough income to produce a long-term return on US TIPS of 3.0%. Equities Our long-term equity forecasts begin with expectations for US large cap stocks, and we then build our projections for other equity asset classes using appropriate risk premia. The foundation for the US large cap forecast is an estimate of the real return potential, derived from the current dividend yield, real earnings growth rates, and potential for expansion or contraction of valuation multiples. Since the current dividend yield on the S&P 500 is 1.95% 3 and we also anticipate a real earnings growth rate of roughly 2.0%, we forecast a real return of 4.0% for large cap US equities. Combining this with our inflation forecast, we see long-term equity returns in the 6.4% range. The trailing price/earnings ratio for the S&P 500 rose to 17.93x 4 during the second quarter, a level that remains broadly consistent with historical norms. We are therefore not factoring in any expansion or contraction of this multiple over the long haul. Still, amid a fragile economic recovery as we prepare to exit the latest quantitative easing program, we expect real earnings may grow at a pace slower than long-term historical averages. To envision a meaningful multiple expansion from current levels, we would like to see greater caution in earnings growth expectations, consistent with the economic environment. In the absence of this kind of conservatism, we do not feel an upward adjustment in our longer-term equity forecast is appropriate. Our forecasts for other equity markets (both within the US and elsewhere) are based on the US large cap estimate and methodology. Over the long term, we expect US mid cap and small cap markets each to earn a modest premium of 0.25% to 0.50% over large cap stocks. Since we believe that long-term economic and earnings growth, as well as inflation, should not vary significantly across the developed world, our global large cap forecast is similar to that for US large cap. Non-US small cap and emerging markets should both provide higher earnings growth rates than developed large cap markets and we therefore project that these asset classes will earn higher returns. It is important to note that we are not making an explicit currency call as part of our non-us forecasts. Over the long term, the effects of near-term currency fluctuations should cancel out, producing limited impact on returns. Furthermore, for our forecasts to be useful globally, we want to avoid a US-centric bias. On a one-year horizon, our equity outlook has remained largely unchanged since the end of the first quarter. Our signals on momentum and earnings sentiment suggest that central bank accommodation will continue to flatter equity markets. In addition, although European shares have seen multiples increase over the second quarter, the ECB s continued accommodative policy should leave room for expansion. We are forecasting one-year returns of 8.5% for large cap US equities, and 8.8% in local currency terms for developed equity markets outside the US. 2

3 Private Equity Our long term forecast for private equity is based upon past performance patterns of private equity funds relative to listed equity markets and our extrapolation of these performance patterns on a forward basis. According to several academic studies 5,6 the annualized rate of return of private equity funds over the long term appears to be largely in line with that of listed equities, with outperformance relative to listed equities before fees, but relative underperformance after fees. Before fees, we believe that an average private equity fund can outperform large-cap listed equities by perhaps 1% over the long run. All else equal, this makes our long-term forecast for private equities reasonably comparable to our projections for small capitalization stocks, but we also consider additional factors, including financial conditions and capital availability. Since private equity currently seems to have ready access to capital, we have tempered our return forecast slightly to reflect a more competitive return environment. Because private equity funds tend to use ample leverage and can often prove much less liquid than publicly traded investments, we rate the long-term risk level of private equity as higher than that of small-cap equities. REITs REITs have historically earned returns between bonds and stocks due to their stable income streams and potential for capital appreciation. Because low yields are keeping our return forecasts for bonds under pressure, our long-term forecast for US REITs is 4.8%. In the shorter term, our expected return models suggest that REITs look attractive, and the appeal of their income features seems likely to foster continued support for the asset class in the current low-yield environment. Our one-year expected return of 4.7% for US REITs has increased from last quarter, still falling short of our long-term REIT forecast. Commodities Our long-term commodity forecast is based on the level of world GDP, as a proxy for consumption demand, as well as on our inflation outlook. Additional factors affecting the returns to a commodities investor include how commodities are held (e.g. physically, synthetically, or via futures) and the various construction methodologies of different commodity benchmarks. Our forecasts are based on the approach and weightings used in the S&P GSCI Commodity Index, which reflects investing through futures and is heavily weighted to the energy complex. Futures-based investors have the potential to earn a premium by providing liquidity and capital to producers seeking to hedge market risk. This premium is greatest when the need for hedging is high, driving commodities to trade in backwardation, with future prices that are lower than spot prices. When spot prices are lower, however, the market is said to be in contango, and futures investors may realize a negative premium. Our long-term return forecast for commodities remains 6.0%, but on a one-year horizon, continued sluggish global growth is tempering the demand outlook as several commodity markets are currently in contango. Overall, we are forecasting a one-year commodity return of 5.3%. 1 Factset as of 6/30/ Ibid. 3 Ibid. 4 Bloomberg as of 6/30/ Phalippou, Ludovic and Olivier Gottschalg, 2009, the Performance of Private Equity Funds. Review of Financial Studies, vol. 22, no 4 (April): Kaplan, Steven N, and Antoinette Schoar Private equity Performance: s, Persistence and Capital Flows. Journal of Finance, vol. 60, no 4 (August):

4 Figure 1: SSgA Tactical/Strategic Asset Allocation Forecasts June 2014 Asset Class 1 Year (%) 3 Years (%) 5 Years (%) 10 Years (%) 30 Years (%) Long-term Risk (Std Dev) (%) Large US Stocks Large Growth Large Value Mid-cap stocks Small/Mid-Cap Stocks Small US Stocks Global Developed ex US Euro Europe Asia-Pacific Global ex US Small Cap Global Developed (World) Global Equities (ACWI) ACWI ex USA Emerging Markets Stocks EM Asia EM LatAm EM EMEA US Government Bonds Broad US Investment Grade Bonds US TIPS Non-US Government Bonds Eurozone Government Bonds UK Government Bonds Japanese Government Bonds Global Government Bonds Global Investment Grade Bonds US High Yield Bonds Emerging Markets Bonds Hedge Funds (market neutral) US Real Estate (REITs) Private Equity Commodities US Cash UK Cash EMU Cash The forecasted returns are based on SSgA s Investment Solutions Group June 30, 2014 forecasted returns and long-term standard deviations. The forecasted performance data is reported on a gross of fees basis. Additional fees, such as the advisory fee, would reduce the return. For example, if an annualized gross return of 10% was achieved over a 5-year period and a management fee of 1% per year was charged and deducted annually, then the resulting return would be reduced from 61% to 54%. The performance includes the reinvestment of dividends and other corporate earnings and is calculated in the local (or regional) currency presented. It does not take into consideration currency effects. The forecasted performance is not necessarily indicative of future performance, which could differ substantially. 4

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Registered Number: Member of the Irish Association of Investment Managers Telephone: +353 (0) Facsimile: +353 (0) Italy: State Street Global Advisors Italy, Sede Secondaria di Milano, Via dei Bossi, Milan, Italy Telephone: Facsimile: State Street Global Advisors Italy is a branch office of State Street Global Advisors Limited. State Street Global Advisors Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom. Japan: State Street Global Advisors (Japan) Co., Ltd., Akasaka, Minato-ku, Tokyo Telephone: Financial Instruments Business Operator, Kanto Local Financial Bureau (Kinsho #345). Japan Investment Advisers Association, Investment Trusts Association Japan, Japan Securities Dealers Association. Netherlands: State Street Global Advisors Netherlands, Adam Smith Building, Thomas Malthusstraat 1-3, 1066 JR Amsterdam, Netherlands Telephone: +31 (0) State Street Global Advisors Netherlands is a branch office of State Street Global Advisors Limited. State Street Global Advisors Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom. Singapore: State Street Global Advisors Singapore Limited, 168, Robinson Road, #33-01 Capital Tower, Singapore (Company Registered Number: D) Telephone: Facsimile: Switzerland: State Street Global Advisors AG, Beethovenstr. 19, CH-8027 Zurich Telephone: +41 (0) Facsimile: +41 (0) United Kingdom: State Street Global Advisors Limited. Authorised and regulated by the Financial Conduct Authority. Registered in England. Registered Number: VAT Number: Registered Office: 20 Churchill Place, Canary Wharf, London, E14 5HJ Telephone: Facsimile: United States: State Street Global Advisors, One Lincoln Street, Boston, MA Telephone: (617) Web: ssga.com Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income. Investing in futures is highly risky. Futures positions are considered highly leveraged because the initial margins are significantly smaller than the cash value of the contracts. The smaller the value of the margin in comparison to the cash value of the futures contract, the higher the leverage. There are a number of risks associated with futures investing including but not limited to counterparty credit risk, currency risk, derivatives risk, foreign issuer exposure risk, sector concentration risk, leveraging and liquidity risks. Investing in foreign domiciled securities may involve risk of capital loss from unfavorable fluctuation in currency values, withholding taxes, from differences in generally accepted accounting principles or from economic or political instability in other nations. Investments in emerging or developing markets may be more volatile and less liquid than investing in developed markets and may involve exposure to economic structures that are generally less diverse and mature and to political systems which have less stability than those of more developed countries. Generally, among asset classes, stocks are more volatile than bonds or short-term instruments. Government bonds and corporate bonds generally have more moderate short-term price fluctuations than stocks, but provide lower potential long-term returns. US Treasury Bills maintain a stable value if held to maturity, but returns are generally only slightly above the inflation rate. Investing in commodities entail significant risk and is not appropriate for all investors. Commodities investing entail significant risk as commodity prices can be extremely volatile due to wide range of factors. A few such factors include overall market movements, real or perceived inflationary trends, commodity index volatility, international, economic and political changes, change in interest and currency exchange rates. Risk associated with equity investing include stock values which may fluctuate in response to the activities of individual companies and general market and economic conditions. Bonds generally present less short-term risk and volatility than stocks, but contain interest rate risk (as interest rates rise bond values and yields usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss. Increase in real interest rates can cause the price of inflation-protected debt securities to decrease. Interest payments on inflation-protected debt securities can be unpredictable. Investing in REITs involves certain distinct risks in addition to those risks associated with investing in the real estate industry in general. Equity REITs may be affected by changes in the value of the underlying property owned by the REITs, while mortgage REITs may be affected by the quality of credit extended. REITs are subject to heavy cash flow dependency, default by borrowers and selfliquidation. REITs, especially mortgage REITs, are also subject to interest rate risk (i.e., as interest rates rise, the value of the REIT may decline). Asset Allocation is a method of diversification which positions assets among major investment categories. Asset Allocation may be used in an effort to manage risk and enhance returns. It does not, however, guarantee a profit or protect against loss. Companies with large market capitalizations go in and out of favor based on market and economic conditions. Larger companies tend to be less volatile than companies with smaller market capitalizations. In exchange for this potentially lower risk, the value of the security may not rise as much as companies with smaller market capitalizations. Hedge funds are typically unregulated private investment pools made available to only sophisticated investors who are able to bear the risk of the loss of their entire investment. An investment in a hedge fund should be viewed as illiquid and interests in hedge funds are generally not readily marketable and are generally not transferable. Investors should be prepared to bear the financial risks of an investment in a hedge fund for an indefinite period of time. An investment in a hedge fund is not intended to be a complete investment program, but rather is intended for investment as part of a diversified investment portfolio. Currency Risk is a form of risk that arises from the change in price of one currency against another. Whenever investors or companies have assets or business operations across national borders, they face currency risk if their positions are not hedged Investments in small/mid-sized companies may involve greater risks than in those of larger, better known companies. Investing in high yield fixed income securities, otherwise known as junk bonds, is considered speculative and involves greater risk of loss of principal and interest than investing in investment grade fixed income securities. These Lower-quality debt securities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer. Investing involves risk including the risk of loss of principal The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSgA s express written consent. The MSCI ACWISM Index is a trademark of MSCI. The financial products described herein are indexed to an MSCI index. The financial products referred to herein are not sponsored, endorsed or promoted by MSCI, and MSCI bears no liability with respect to any such financial products or any index which such financial products are based. The prospectus contains a more detailed description of the limited relationship that MSCI has with SSgA and any related funds. 5

6 This document contains certain statements that may be deemed to be forward-looking statements. All statements, other than historical facts, contained within this article that address activities, events or developments that SSgA expects, believes or anticipates will or may occur in the future are forward-looking statements. These statements are based on certain assumptions and analyses made by SSgA in light of its experience and perception of historical trends, current conditions, expected future developments and other factors it believes are appropriate in the circumstances, many of which are detailed herein. Such statements are subject to a number of assumptions, risks, uncertainties, many of which are beyond SSgA s control. Readers are cautioned that any such statements are not guarantees of any future performance and that actual results or developments may differ materially from those projected in the forward-looking statements. This material is solely for the private use of SSgA clients and is not intended for public dissemination. The views expressed in this commentary are the views of Dan Farley of the SSgA Investment Solutions Group through the period ended June 30, 2014 and are subject to change based on market and other conditions. The opinions expressed may differ from those of other SSgA investment groups that use different investment philosophies. All material has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy of, nor liability for, decisions based on such information. Past performance is no guarantee of future results. S&P GSCI is a trademark of Standard & Poor s Financial Services LLC and has been licensed for use by Goldman Sachs & Co. Standard & Poor s S&P 500 Index is a registered trademark of Standard & Poor s Financial Services LLC. Source: Barclays POINT/Global Family of Indices Barclays Inc. Used with permission. State Street Global Advisors is the investment management business of State Street Corporation (NYSE: STT), one of the world s leading providers of financial services to institutional investors. ssga.com 2014 State Street Corporation. All Rights Reserved. 6 ID1633-INST Exp. Date: 7/31/2015