Investment Directions DESTINATION UNKNOWN?

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1 FOR PROFESSIONAL CLIENTS/SOPHISTICATED AND QUALIFIED INVESTORS ONLY 2015 Investment Directions DESTINATION UNKNOWN? The magnetic compass was invented by the Chinese around 206 B.C., interestingly, not for the purpose of finding direction. Historians believed it was first used for fortune telling until appropriated by the military for navigation between the 9th and 11th centuries. Today, investors in many ways consider the monetary policies and forward guidance of the U.S. Federal Reserve (Fed) as a sort of compass for global financial markets. In that sense, the Fed holding off the beginning of a tightening cycle in September points to its reservations about where the global economy is going at a time when markets are being destabilized by falls in Chinese stocks. Compass Balancing The Fed s ending zero interest rate policy is easily one of the most highly anticipated and debated central bank decisions since the financial crisis. Falling inflation expectations, though deemed transitory, appear to be one of the key reasons this time why the Fed hesitated in removing monetary accommodation despite a broadly improving domestic economy. While some believe the Fed is already behind the curve on normalizing interest rates, a rate hike before the end of the year is still highly probable. Markets Lack Bearing With the timing of the Fed hike still up for debate, we expect more market volatility ahead. The extraordinary fluctuations that began in late June have somewhat subsided, but tensions about China s decelerating growth and its impact on the overall state of the global economy linger. Economies that depend on commodity exports such as Brazil, Canada and Australia are feeling the effects the most. Chinese policymakers provided some relief with support measures and promises for more, but market calm will probably be tenuous until global growth picks up. Direction Finder For now, we see interest rates rising, though we expect them to climb slowly and remain low for a long time. Staying on our path, we favor a portfolio tilted toward equities, select credit, tax-exempt bonds and inflation protection through Treasury Inflation-Protected Securities (TIPS). Recent selloffs have revealed some pockets of value, such as European equities, but we are cautious toward U.S. Treasuries and commodities. WHAT S NEW: How a Rate Hike Could Impact Stocks Pg. 7 OUTLOOK SUMMARY p OVERWEIGHT q UNDERWEIGHT ADDITIONALLY, FOCUS ON Stocks Japanese & European Equities Cyclical Sectors Munis & High Yield Bonds Bonds U.S. Equities Defensive Sectors Treasuries Consider currency hedged exposure, given continued strength in the U.S. dollar could erode returns in other markets (such as Europe) for U.S. dollar-based investors.

2 Turning Insight Into Action Many measures of U.S. economic activity have improved since the slowdown early in the year. While weakness lingers in some areas, the U.S. economy is regaining speed. Selectivity is important in the U.S. market, where value will vary by sector and individual company. Consider blending opportunities for core market exposure with highconviction active solutions that focus on finding value in the market. United States We are underweight in U.S. stocks. The second-quarter gross domestic product (GDP) growth was revised notably higher (see the chart below), and measures reporting on more recent activity suggest U.S. growth has been stalwart in the face of a slowdown in emerging markets. Evidence can be found in the healthy gains in job creation, consumer spending and construction activities despite unevenness in manufacturing gauges. While inflation expectations have followed commodity prices lower, we do not view deflation as a real risk in the U.S. given the relatively robust growth dynamics. That said, one area that warrants caution is volatility, which we think will stay high. A world marked by slow growth, unstable inflation expectations and U.S. monetary policy normalization possibly around the corner seems incompatible with the low volatility climate of the past few years. Partly because of the relatively solid economic backdrop, U.S. stocks suffered a smaller loss compared with many other major markets in the recent market falls. Even so, valuations are above their long-term average, and that could be problematic given a shift in monetary policy is on the horizon. Low interest rates and wage growth have been key to U.S. companies high profit margins, which have underpinned U.S. stocks high valuation multiples, but those trends are now reversing. Without the tailwind of easy money, U.S. equities will need to rely on revenue growth to generate earnings, of which there has not been much of late and which is pressured by a strong U.S. dollar. We see better opportunities in other parts of the world. U.S. ECONOMY HEADS NORTH After a slow start in the first quarter, second-quarter GDP surged on the back of strong consumption and business spending. 6 CONTRIBUTION TO GDP (%) GDP Investment Net Trade Consumption Government Stocks Sources: Thomson Reuters Datastream, Bureau of Economic Analysis, BlackRock Investment Institute, as of 14 September [2] BLACKROCK INVESTMENT DIRECTIONS

3 International Developed Markets We favor eurozone stocks, and it could be a good time to consider taking advantage of market weakness to add to European positions. Europe was among the hardest hit in the recent China-induced global rout, and stocks of companies that are exposed to global trade particularly those in Germany were more harshly punished than the rest. We think the selling is overdone, since China is the destination of only 3.7% of eurozone exports and 5.4% of German exports (see the chart below). More importantly, the eurozone economy is gaining pace as its labor market and credit conditions improve. Corporate profits seem to be in a turnaround, evidenced by solid secondquarter earnings results. In addition, given stubbornly low inflation and concerns over global growth, the prospect for an extension of the current quantitative easing program could provide additional support for the bloc s stocks and economy. We are overweight Japanese equities. Rising risk aversion, rapid yen appreciation and growth concerns about China have led to indiscriminate selling of Japanese equities, yet it has made valuations even more compelling while fundamentals remain attractive. Japanese corporate earnings are growing at an enviable pace, and share buybacks and dividends are on the rise as a result of corporate governance reform. While it is true that the export sectors could be affected by a Chinese slowdown and soft domestic consumption weighs on the inflation outlook, a new government stimulus package appears to be underway. If needed, the Bank of Japan could ease further, which would help keep the yen down and exports competitive. Turning Insight Into Action Earnings growth and valuations of European and Japanese companies are more compelling than for U.S. companies. However, renewed strength in the U.S. dollar could erode returns in international markets for U.S. dollar-based investors, boosting the allure of currency hedged exposure. Consider using an active manager with strong stock selection expertise or be selective with index-based exposures. We hold a neutral view on Canadian and Australian stocks. The fallout of China s growth slump is amplified for these countries that are dependent on commodity exports. As Canada slipped into a recession and Australia barely grew in the second quarter, their central banks have struggled to strike a balance between supporting a flagging economy and risking further inflating property prices. Both stock markets have seen valuations fall to significant discounts to their historical averages. With the Fed's pending rate hike, the U.S. dollar rising and commodity demand waning, we see a period of higher volatility ahead for commodity-related markets. ALL ROADS LEAD TO CHINA Nervousness regarding China s slowdown led to the selling of European exports-related stocks, even though shipments to China make up only a small portion of what Europe exports to the world. Hong Kong Australia Iran Taiwan Korea Chile Iraq N. Zealand Japan Peru Brazil Saudi Arabia Philippines Venezuela Singapore Malaysia Thailand Colombia Vietnam Indonesia Kuwait S. Africa Pakistan Qatar U.S. Russia Argentina Germany U.A.E. Ukraine Finland India Switzerland Israel Canada France U.K. Denmark Sweden Eurozone Italy Nigeria TOTAL EXPORTS TO CHINA IN 2014 (%) Sources: IMF Direction of Trade statistics, IMF, Haver, UBS, as of 14 September DESTINATION UNKNOWN [3]

4 Emerging Markets Turning Insight Into Action It may be time to consider a benchmark exposure in emerging markets, but investors should remain very selective. Consider accessing specific countries or regions, or use an active manager with expertise to identify potential opportunities. We are neutral in emerging markets. Weak domestic demand and trade growth, an appreciating U.S. dollar and slumping commodity prices have already taken a toll on emerging-market (EM) assets. Although China s one-off currency devaluation may represent a modest contribution to its exports, losing the anchor of a near-fixed exchange rate could at least mean more volatility, if not further weakness in the yuan and more rounds of competitive EM currency depreciation. Given other challenges, such as dwindling corporate profits, declines in productivity and a dispirited investor base, we think it is too soon to turn positive on EM. We have a benchmark weight in China with a preference for H-shares. This past month brought more evidence of Chinese deceleration: manufacturing growth languished to its weakest in three years and services sectors sharply retreated. Growth worries along with the surprise yuan devaluation (see the chart below) sent the Hong Kong-traded H-shares almost a third of the way down from their peak in April, leaving stock valuations at a 12-year low.* Currently, H-shares' price-to-book and price-to-forward earnings ratios are significantly below their historical averages. Still, unless there is better economic data or a more convincing policy response, the murky growth outlook and prospects for further yuan depreciation amid continued capital outflow are keeping many value investors at bay. Within emerging markets, we hold a regional overweight in Asia. At the expense of other EM regions, the slump in commodity prices has benefited Asia s mostly commodity-importing economies. Although cheap energy prices alone are unlikely to revive growth, they help strengthen Asia s fundamentals by increasing their current account surpluses, widening profit margins, lowering inflation and freeing up fiscal resources. In addition, strong current accounts and ample foreign exchange reserves make Asia more resilient to capital outflow as the Fed looks to shift policy, leaving the region s currencies less volatile relative to other EM currencies. SURPRISE YUAN DEVALUATION LEFT MARKETS DISORIENTATED The yuan has been trending stronger for a decade, and the one-off currency repricing in August created market uncertainty and more skepticism regarding China s policy responses. 7.0 YUAN PER USD Stronger Yuan Weaker Yuan Source: Bloomberg, as of 14 September Yuan per USD * A-shares are domestic Chinese stocks traded in Shanghai or Shenzhen, mainly available to domestic Chinese investors, although select qualified foreign institutional investors and Hong Kong retail investors also participate through regulated channels, but with collective ownership in the low single digit percent. H-shares broadly reference stocks of Chinese companies listed in Hong Kong, available for trading for all investors globally. [4] BLACKROCK INVESTMENT DIRECTIONS

5 Global Sectors We favor cyclical sectors that are reasonably priced and have good earnings dynamics, including information technology and European financials. We are however, underweight U.S. consumer discretionary and more cautious on U.S. industrials given higher valuations, modest earnings growth and falling investment in energy and mining equipment. We are underweight in dividend-rich defensive sectors such as consumer staples and U.S. utilities. We are overweight global financials with a preference for European financials. Banks bore the brunt of the global market falls in the past month, but the selling has provided a better entry point for investors who missed the rally early in the year. Compared to their U.S. counterparts, we think European financials offer more potential and should benefit from the continent s recovery and rising credit growth due to European Central Bank (ECB) efforts. Turning Insight Into Action Consider cyclical sectors over defensive and dividend-oriented sectors. Consumer staples and U.S. utilities look particularly unattractive and are vulnerable to rising rates. Look into potential opportunities in the technology and financials sectors and consider a long/short approach to potentially benefit from any continued market volatility. We have a preference for information technology (IT). An improving U.S. economy will likely provide a boost to the IT sector as companies increase capital spending to replace antiquated technology infrastructure. The sector offers one of the fastest earnings growth rates, while valuations are roughly in line with their historical average. More corporate actions backed by ample liquidity is another catalyst. We are underweight U.S. consumer discretionary and global consumer staples. U.S. consumer discretionary stocks are trading at a hefty premium, both relative to their own history and to other sectors. The question remains whether or not these companies can maintain their current profitability level if consumption remains soft. Consumer staples stocks are also expensive, and their bond-like characteristics make them vulnerable to even a modest pickup in yield. We have a benchmark weight in energy and materials but see relative value in select industries. Given the subdued global growth outlook and a rising U.S. dollar (see the chart below), we do not expect an imminent or strong rebound in commodity prices. We see oil prices leveling off in the absence of a significant reduction in non-u.s. production. That said, the better opportunity may be in commodity-related stocks, rather than the commodities themselves. We see some value opportunities in discounted U.S. drillers, U.S. refiners as well as metals and U.S. DOLLAR INTERFERENCE A rising dollar could stall a commodity rebound, which does not bode well for energy and materials companies INDEX LEVEL Source: Bloomberg, as of 14 September U.S. Dollar Index DESTINATION UNKNOWN [5]

6 Turning Insight Into Action With interest rates likely to rise in the United States in 2015, fixed income investors could face challenges yet again this year. Manage Interest Rate Duration Consider a flexible strategy with the ability to actively manage duration. Manage Interest Rate Risk Seek to reduce interest rate risk through time by using a diversified bond ladder and matching term maturity to specific investing needs. Seek Income Cast a wider net for income while seeking to carefully balance the tradeoffs between yield and risk. Build a Diversified Core Consider using core bonds for potential diversification benefits and possible protection from unforeseen shocks to equity markets. Fixed Income We have an underweight in U.S. Treasuries and a benchmark weight in TIPS. While investors piled into safe-haven bonds during the recent market turbulence, this dynamic subsided when the focus shifted back to economic fundamentals. Longer-term Treasury yields returned to a narrower range, and yields of shorterdated securities most vulnerable to changes in the Fed s policy continued to drift upward. Although we think yields could drift higher over the remainder of the year, the increase will likely be constrained at the longer end of the curve, given the already relatively high level of Treasury yields as compared with other developedmarket sovereign bond yields. Despite inflation being near its recent lows, and inflation expectations half a point lower than a year ago (see the chart below), we still prefer duration exposure from TIPS rather than traditional Treasuries. We are underweight non-u.s. developed-market debt. The notion that the ECB could expand its bond-buying program due to lowered growth and inflation projections pressured the region s government bond yields lower, making them even less attractive than higher-yielding alternatives. We are overweight high yield. When volatility was most pronounced last month, high yield bonds were trading at their largest premium over Treasuries in three years before stabilizing early in September. Declining energy and materials prices posed a headwind, though corporate defaults are at 2.4%, well below their historical levels. High yield debt, offering a combination of attractive yields and lower volatility relative to equities, has historically performed well under a modestly rising rate scenario. Despite the recent volatility, high yield still generated a positive total return year-to-date. While some value has returned to investment grade credit, a wait-and-see approach could be prudent until there is a clearer picture on supply later in the year. INFLATION EXPECTATIONS POINT SOUTH Inflation expectations have followed commodity prices lower in the past several months, but deflation is an unlikely scenario for the U.S. given the relatively robust growth dynamics BREAKEVEN RATE (%) Nov 14 Jan 15 Mar 15 May 15 Jul 15 Sep 15 U.S. 10-Year Treasury Breakeven Inflation Rate Source: Bloomberg, as of 15 September [6] BLACKROCK INVESTMENT DIRECTIONS

7 Hot Topic: How a Rate Hike Could Impact Stocks A key question on investors minds even with the Fed delaying interest-rate liftoff: What impact will a rate hike have on stocks? To gauge this, the past can be helpful. When you examine S&P 500 performance during rate cycles going back to the 1970s, a clear pattern emerges: The start of a tightening cycle typically causes some rise in volatility, but rarely a bear market. Regardless of the period, three-month returns following the start of a steady tightening period were on average negative and more volatile. However, looking 6 or 12 months out, markets rebounded and generally produced positive, albeit subpar, returns (see the chart below). The extent of the impact was also influenced by changes in equity valuations and the direction of inflation. In the past, U.S. equity markets have been more resilient to tightening monetary conditions if valuations were flat or falling over the preceding 12 months. If valuations had been rising in the previous year, however, the S&P 500 has historically performed much worse following the start of a tightening cycle. To the extent the recent correction has resulted in a modest contraction in multiples, this should help mitigate the impact of a rate hike. The other key variable to watch is real, or inflation-adjusted, rates. Here, the news is less good. With inflation expectations down significantly from their recent highs, real rates are rising even before a Fed hike. In the past, rising real rates have been associated with more severe corrections. However, should inflation expectations begin to stabilize, this would also likely dampen the volatility around a rate hike. Of course, the pace of monetary tightening will likely be gradual, and this will be a very different tightening cycle than previous instances. Rates have never been this low for so long, and the Fed will need a new set of monetary tools to wind down its bloated balance sheet. As a result, it is hard to predict the stock market s reaction to tightening. Still, a normalization in U.S. monetary policy is likely to herald more volatility, not a catastrophe. RATE HIKES DO NOT IMPLY END TO LONG-TERM PERFORMANCE Following an initial change in the Federal Funds target rate, data showed that stock returns were negative and volatile after three months but improved after six months and longer. S&P 500 PRICE RETURN (%) Average Since 1970s 3-month 6-month 12-month Source: Bloomberg, as of 14 September Note: S&P 500 Price Return (%) after the start of a tightening cycle. Index returns are for illustrative purposes only. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results. DESTINATION UNKNOWN [7]

8 DRILLING DOWN: EQUITY AND FIXED INCOME OUTLOOKS CURRENT ENVIRONMENT Risk/ Global Region Valuations Growth Profitability Sentiment DEVELOPED MARKETS North America United States + Canada + Europe Eurozone + + Switzerland + United Kingdom + Asia Pacific Japan Australia + EMERGING MARKETS Asia Pacific China + India South Korea + Latin America Brazil + Mexico Emerging EMEA Russia + South Africa + + Global Sector & Style Valuations Growth Profitability Risk/ Sentiment CYCLICAL SECTORS Consumer Discretionary Energy + Financials + + Industrials Information Technology Materials + DEFENSIVE SECTORS Consumer Staples + Health Care Telecommunications Utilities STYLES U.S. Small/Mid Caps + U.S. Mega/Large Caps + Fixed Income Sector Valuations Economics Risk/ Sentiment U.S. Treasuries + U.S. TIPS U.S. Investment Grade Credit + + U.S. High Yield Credit + + U.S. Municipals + U.S. Mortgage-Backed Securities + Non-U.S. Developed Markets Emerging Markets Inflation Hedge Demand Supply & Demand Opportunity Holding Cost Safe Haven Demand Gold* OUR VIEW AND OUTLOOK Price Trend underweight neutral overweight Price Trend underweight neutral overweight Price Trend underweight neutral overweight Price Trend underweight neutral overweight unattractive neutral + attractive underweight outlook slightly underweight outlook current neutral outlook slightly overweight outlook overweight outlook Underweight: Potentially decrease allocation Neutral: Consider benchmark allocation Overweight: Potentially increase allocation * See the appendix for an explanation of the methodology for our gold views and other outlooks. Note that the time frame for these views is generally three to 12 months. Please note that the views expressed above in the factor table are for time frames of at least three months. This material represents an assessment of the market environment at a specific time and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research, investment advice or a recommendation regarding the ishares Funds or any security in particular. This information is strictly for illustrative and educational purposes and is subject to change. This information does not represent the actual current, past or future holdings or portfolio of any BlackRock client. [8] BLACKROCK INVESTMENT DIRECTIONS

9 Appendix The analysis behind our equity views: Our approach in deriving country/sector views is both quantitative and qualitative. In the quantitative framework, we take into account valuation, profitability, growth, risk/sentiment and price trend, among other factors, in deciding how attractive or unattractive a country or sector is. In the qualitative approach, we consider economic/political/policy event catalysts that can have a potential impact on financial market conditions. The variables included in the table are indicative of key considerations behind our investment views, and should not be viewed in isolation. Valuations: We measure a country s price-to-book ratio premium/discount to its own trading history, and compare the premium/discount to that of other emerging or developed countries. If a country s valuation is at a discount to its own historical average and the discount is greater than that of other countries, we assign "+," and vice versa. Growth prospects: We assign a + to countries that are growing faster (as measured by leading indicators and earnings growth prospects) than their past trends and a - to countries growing slower. Corporate sector profitability: A country with a relatively profitable corporate sector (as measured by ROA) is assigned a + and we give a - to countries growing more slowly. Risk/Sentiment: A country that is perceived as relatively safe (according to historical volatilities and credit default swap (CDS) spreads) is assigned a + ; a risky country is assigned a -. Price Trend: An asset with a relatively good return performance within the previous year is assigned a + ; an asset with relatively poor returns is assigned a -." The factors are not equally important in driving returns at a given point in time. As a result, when it comes to formulating our final views, the various factor readings are not additive. For example, a + value factor may overshadow negative readings in other factors, leading us to still like the country. We use a similar methodology for coming up with our sector and style views, focusing on valuations (P/B and P/E), profitability (ROA), risk / sentiment (historical volatilities and sector spreads) and momentum. In addition, we consider the global growth outlook for cyclical and defensive sectors. In addition, our view on gold is similarly based on the macroeconomic factors that historically impact gold returns. These include the opportunity cost of holding gold (real interest rates); supply and demand; inflation (gold as a real asset tends to act as an inflation hedge); safe haven demand (during periods of high financial stress, demand for gold tends to increase) and momentum. The analysis behind our fixed income views: In general, when formulating our fixed income views, we put more weight on the Valuations bucket than on either the Economics or Risk/Sentiment buckets. Valuations: We focus on discounted risk-adjusted cash flows relative to market prices. When a sector exhibits market prices well above what our model sees as fair, we assign the sector a - ; we assign a + when the opposite is true. Economics: In general, when the overall economic environment (as measured by basic economic and/or aggregate balance-sheet fundamentals) is particularly favorable for a given fixed income sector, we assign a + ; we assign a - when the opposite is true. Risk/Sentiment: When a sector has exhibited strong positive returns/risk appetite (as measured by trailing returns) over the previous several months, we score it a + ; we assign a - when the opposite is true. Price Trend: An asset with a relatively good return performance within the previous year is assigned a + ; an asset with relatively poor returns is assigned a -." Less Risk Risk Appetite Index RISK APPETITE DIAL last month Investor appetite for risk has worsened significantly as a potential Fed interest rate increase got closer and concerns about China s growth intensified. Global stocks retreated sharply in the past month as volatility spiked. While the U.S. and European economies are gaining pace, growth in emerging markets has flagged with a notable slowdown in China. Spreads between low-quality and high-quality U.S. corporate debt continued to widen. More Risk DESTINATION UNKNOWN [9]

10 Contributors Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock, and Chief Investment Strategist for ishares. He is a founding member of the BlackRock Investment Institute, delivering BlackRock s insights on global investment issues. Stephen Laipply is Product Strategist for BlackRock s Model-Based Fixed Income Portfolio Management Group. Shannon Morton, CFA, is a Global Investment Strategist for BlackRock, where her responsibilities include relating the Investment Strategy Team s research and investment views to key institutional and financial advisor clients. Nelli Oster, PhD, is a Global Investment Strategist for BlackRock, where her responsibilities include relating the Investment Strategy Team s research and investment views to key institutional and financial advisor clients, and developing the tactical country, sector and asset allocation models. Kurt Reiman is a Global Investment Strategist for BlackRock, where his responsibilities include relating the Investment Strategy Team s research and investment views to key institutional and financial advisor clients. Heidi Richardson is a Global Investment Strategist for BlackRock and Head of Investment Strategy for U.S. ishares. Terry Simpson, CFA, is a Global Investment Strategist for BlackRock, where his responsibilities include relating the Investment Strategy Team s research and investment views to key institutional and financial advisor clients. Matt Tucker, CFA, is the Head of North American Fixed Income ishares Strategy within BlackRock s Fixed Income Portfolio Management team. Ruiling Zeng, CFA, is an Investment Strategist and Researcher for BlackRock, where her responsibilities include researching and communicating investment views across countries, sectors and asset classes. LET US KNOW How do you use this market commentary and do you find it useful? Please share your feedback and any questions or concerns you have at blackrockinvestments@blackrock.com. You also can find the latest market commentary from the Investment Strategy Group at BlackRockblog.com, BlackRock.com and ishares.com. [10] BLACKROCK INVESTMENT DIRECTIONS

11 WHY BLACKROCK BlackRock helps people around the world, as well as the world s largest institutions and governments, pursue their investing goals. We offer: } A comprehensive set of innovative solutions, including mutual funds, separately managed accounts, alternatives and ishares ETFs } Global market and investment insights } Sophisticated risk and portfolio analytics We work only for our clients, who have entrusted us with managing $4.72 trillion, earning BlackRock the distinction of being trusted to manage more money than any other investment firm in the world.* Want to know more? blackrock.com * AUM as of 30 June DESTINATION UNKNOWN [11]

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