Contributors from BlackRock Client Solutions

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2 Contributors from BlackRock Client Solutions Alain Kerneis Head of Strategy & Market Views Vivek Paul Member of Strategy & Market Views John Dewey Member of Strategy & Market Views Jonathan Joiner Member of Strategy & Market Views Simona Paravini- Mellinghoff Head of Chief Investment Office Ben Clissold Chair of the LDI Investment Oversight Group *2+ STRATEGIC PERSPECTIVES

3 Summary Strategic perspectives in three points: CONVERGING TOWARDS SUSTAINABLE GROWTH 1 We have left our central economic scenario unchanged, even as leading economic indicators have pointed to a slowdown in global growth recently. We expect advanced economies to grow at an average annual real rate of 2.0% for the next five years, slightly higher than what was achieved in the past five years. Growth in the advanced economies will be supported, in our view, by ultra-loose monetary policies, a recent improvement in the employment market and by a lower oil price. The emerging world has been hurt by the commodity price implosion and China s slowing growth. We expect growth in emerging economies to converge gradually towards a slower, but probably more sustainable level of 4.5% annually for the next five years. WHY GROWTH ASSETS SHOULD OUTPERFORM BONDS 2 The valuation gap between equities and bonds has widened in favour of equities, following this summer s global equity sell-off. We have increased the allocation to equities in the strategic portfolio by one percentage point, at the expense of bonds, due to our central economic scenario and more attractive valuations. Credit spreads have markedly widened during last quarter, particularly in the energy-related high yield segment. We leave our allocation to credit unchanged despite the stronger valuation signal. We view the downside risk of the high yield segment as too high to justify a larger allocation in our strategic portfolio given the uncertainty around the oil price. SETTING HEDGE RATIOS BEFORE INTEREST RATES START TO RISE 3 We expect bond yields to rise further, over the next five years, than currently priced in forwards and suggest that liability-driven investors run a modest level of interest rate risk in the eurozone and in the UK. We view inflation pricing as more attractive than nominal bonds and favour a moderately higher level of inflation hedge. Contents THE FIVE-YEAR MACRO VIEW 4 Converging towards sustainable growth THE STRATEGIC PORTFOLIO 9 We expect growth assets to outperform INVESTORS WITH LIABILITIES 14 Divergent monetary policies, consistent hedging views PRACTICAL GUIDANCE FOR ASSET ALLOCATION *3+

4 PURCHASING MANAGERS INDEX (PMI) The five-year macro view Converging towards sustainable growth Key points We expect advanced economies to grow at an average annual real rate of 2.0% over the next five years, slightly higher than achieved in the last five years We see growth in emerging economies gradually converging towards a slower, but more sustainable level of 4.5% p.a. for the next five years Inflation in advanced economies is likely to stay below central banks targets The five-year economic scenario that we review every quarter is a key input into how we set our medium-term capital market assumptions and how we dynamically adjust the asset allocation in our model strategic portfolio. We have left our central economic scenario unchanged despite the slowdown in global economic activity, evidenced by several leading indicators of growth during the third quarter of We still see some potential for growth in advanced economies to pick up gradually over the next five years. Within emerging economies the growth prospects for individual countries are diverse. In aggregate, however, we expect growth to exceed the potential for advanced economies, but to converge progressively towards a slower and ultimately more sustainable growth rate. RECENT SLOWDOWN NOT AFFECTING OUR CENTRAL SCENARIO Exhibit 1 shows that economic activity in emerging economies has been declining since the beginning of the year as illustrated by the Purchasing Managers Index (PMI) for emerging markets. The index has now fallen below 50, signalling a higher risk of economic contraction in the near term. By contrast, advanced economies experienced a modest slowdown in activity during the first quarter, but stabilised in the second, with the PMI staying above 50, in the expansion zone. EXHIBIT 1: ECONOMIC ACTIVITY SLOWS, ESPECIALLY IN EMERGING MARKETS Source: Markit Economics, as of October *4+ STRATEGIC PERSPECTIVES

5 ANNUAL INFLATION RATE EXHIBIT 2: INFLATION BELOW TARGET FOR NEXT 5 YEARS % Source: BlackRock Client Solutions five-year projections. The inflation measure used is core consumer price inflation (realised core CPI from 2009 to 2014 from National Accounts). Advanced economies: why can growth pick up over the next five years? We see several factors that could help growth in advanced economies reach an average 2.0% p.a. for the next five years, slightly higher than the 1.5% achieved in the past five years: 1. Leading indicators of growth point to economic expansion in western economies. 2. Financial conditions are very accommodative and are likely to remain so for some time in the eurozone and Japan given the low inflation prospects (exhibit 2). This is in part why we expect a larger growth pick-up in the eurozone relative to other regions (exhibit 3). 3. The US and UK economies have strong momentum (though this does put them closer to the start of interest rate rising cycles). 4. Employment has improved in the US, Europe and Japan and is likely to support consumption in the future. 5. Consumers are likely to benefit from lower oil prices and from the relatively low inflation that we expect (exhibit 2). EXHIBIT 3: REAL GROWTH TO PICK UP IN WESTERN ECONOMIES Source: BlackRock Client Solutions five-year projections. Last five-year realised real GDP growth from 2009 to 2014 from National Accounts. PRACTICAL GUIDANCE FOR ASSET ALLOCATION *5+

6 PROBABILITY OF RECESSION Growth in emerging economies to transition to a more sustainable level Several factors contributed to this year s slowdown in emerging economies: Lower oil prices hurt oil exporters, e.g. Russia and the Middle East Chinese trade volumes contracted and investment growth slowed Recession in Brazil and its knock-on effects in Latin America Countries hit by lower commodity prices will, in our view, gradually come out of their recession over the next five years. China is likely to transition progressively towards a lower and more sustainable growth rate than it has experienced in the past five years. This is part of the rebalancing process where China s economic growth will become less dependent on investment and become more driven by consumption. We expect emerging economies to grow at an average annual rate of 4.5% in real terms over the next five years, slower than the 6.2% p.a. achieved over the past five years. WHAT COULD GO WRONG? As illustrated by the IMF staff s Global Projection Model (exhibit 4), the probability of a recession happening in the next four quarters is still well below 50% for advanced economies and emerging Asia. However, the probability has modestly increased since last quarter in the US, the eurozone and Japan, mainly as a result of a softening in leading growth indicators and in global trade volumes. The probability of a recession in Latin America has substantially increased in aggregate given the economic situation in Brazil. EXHIBIT 4: RECESSION REMAINS A RISK Source: IMF staff s Global Projection Model, IMF World Economic Outlook, October 2015 (page 22). Latin America represented by Brazil, Chile, Colombia, Mexico and Peru. The probability of recession is forecast over the next four quarters. *6+ STRATEGIC PERSPECTIVES

7 Exhibit 5 presents the key macro economic scenarios we use to stress test portfolios. These scenarios aim to assess the downside risk in portfolios under a series of tail risk events that deviate from our central economic scenario. Each scenario is associated with a relative likelihood level (low/medium/high) and indicative performance for key asset classes. For avoidance of doubt, a medium or high relative likelihood does not mean we believe the stress is a probable event it merely means that we believe it to be a more likely event than other tail risks. EXHIBIT 5: KEY MACRO SCENARIOS USED FOR STRESS TESTING PORTFOLIOS Scenario Description Relative likelihood Negative growth surprise Emerging market shock Adverse reaction to Brexit Fiscal crisis Credit crunch Sluggish global economic growth with false dawns in the US. Deleveraging throughout the world means growth is contained Emerging markets do not adopt significant structural reforms, preventing sustained growth. China s economic data continues to disappoint relative to expectations The UK exits the European Union, reducing the attractiveness of UK investments for overseas investors. Fears persist over the sustainability of the broader European project, but the impact on US and Asian markets is minimal Mounting debt in developed economies takes its toll and further bailouts and austerity is needed. All markets are affected, and there are few safe havens The world economy is hit by a recession, credit crunch and social upheaval. Developed economies are plunged into another recession and China slows significantly Medium Medium Medium Low Low Demand-driven inflation shock The world economy performs better than expected, pushing demand for certain goods higher to a point where supply is insufficient. Nominal yields rise materially as central banks try to control the situation Low Euro break-up Central bank induced inflation Positive growth surprise The future of the eurozone is thrown into turmoil as a major country (e.g. Spain, Italy, France) exit the currency union Unprecedented monetary easing around the world finally translates into inflation. Central banks lose credibility in their commitment to achieving low stable levels of inflation. The global economy avoids a contraction due to successful fiscal and monetary policies from central banks and governments. Low Low Low Source: BlackRock Client Solutions, as of 30 September PRACTICAL GUIDANCE FOR ASSET ALLOCATION *7+

8 We assign a medium relative likelihood to three scenarios which are, in our view, more likely to happen than the other six scenarios: 1. Negative growth surprise 2. Emerging market shock 3. Adverse reaction to Brexit Both negative growth surprise and emerging market shock are associated with a meaningful slowdown in economic activity, led either by advanced economies or emerging markets. Although the likelihood of these scenarios has slightly increased since last quarter, they are still not the basis for our strategic portfolio positioning. For both scenarios we have associated a market sell off of 10% to 20% for developed market equities and up to 30% for emerging market equities, and 15% to 25% for emerging market debt in the emerging market shock scenario. The stress scenario Adverse reaction to Brexit was introduced this quarter as a qualitative assessment of the market reaction to the UK s possible decision to leave the eurozone in the future. While we expect euro and sterling based assets to be negatively affected by this event, the impact on markets at a global level is likely to be less severe than the other two scenarios. We assign a medium relative likelihood as recent opinion poll data suggests that more British people want to leave the EU than remain a member (Source: YouGov September ). For avoidance of doubt, this does not mean we believe Brexit to be a probable event it means that we believe it to be a more likely event than, for example, a credit crunch or a euro break-up. See page 13 for further details on the stress tests we apply to the Strategic Portfolio. *8+ STRATEGIC PERSPECTIVES

9 The strategic portfolio We expect growth assets to outperform Key points We increase our allocation to equities at expense of treasuries Allocations within credit remain unchanged, despite increasing our expected return forecasts We retain our allocation to alternatives, reflecting our positive view on private market assets The valuation gap between equities and bonds has increased in favour of equities following the sharp falls in equity prices over the quarter. Despite recent growth concerns, reflected in the spike in volatility, we maintain our scenario of low, stable global growth with growth assets outperforming global treasuries over the next five years. As such we have modestly increased the strategic portfolio s allocation to equities at the expense of treasuries. Our strategic portfolio (illustrated in exhibit 6) serves as a model strategic asset allocation which represents our five year capital market assumptions as presented in the BlackRock Strategic Assumptions. The portfolio targets an annual return of 4% for 10% risk, over a five year time horizon. We note that investors with liabilities may hold considerably more fixed income assets, and should consider our strategic portfolio as representative of our investment beliefs for the growth or return-seeking portion of their overall assets. We discuss issues affecting investors with liabilities in more detail in the next section. When constructing the strategic portfolio we reflect our views on the relative attractiveness of asset classes. This includes our views on a range of factors including risk and return, diversification and liquidity. EXHIBIT 6: HIGHER ALLOCATIONS TO EQUITIES AT THE EXPENSE OF TREASURIES Source: BlackRock Client Solutions, as at 30 September PRACTICAL GUIDANCE FOR ASSET ALLOCATION *9+

10 IMPLIED EQUITY RISK PREMIUM (ERP) GLOBAL EQUITIES ATTRACTIVE RELATIVE TO BONDS The equity risk premium (ERP) in exhibit 7 shows a measure of forward looking equity valuations compared to bonds, derived from a dividend discount model and current market prices. As can be seen, equities have become cheaper, from already attractive levels relative to bonds. In Europe the difference is now at the highs last seen in A large component of the underperformance of most growth assets over the quarter relates to concerns over weakening Chinese growth and the potential of it leading to a wider global growth slowdown. However, as discussed, we do not believe that these fears pose a significant threat to the global economy and continue to believe bond yields will rise further than market pricing currently implies. Against this backdrop we have increased our allocation to global equities by 1% this quarter at the expense of global treasuries. Within equities our strategic asset allocation is market capitalisation weighted and therefore does not demonstrate a bias between regions. In particular, the split between developed and emerging market equities in our strategic portfolio is based on market cap weights. On a shorter-term (i.e. less than one year) tactical basis, over 2015 we have preferred developed equities to emerging market equities, reflecting the larger effects of a China s slowdown on emerging markets and idiosyncratic risks in some regions, notably Brazil. Within developed equities we have preferred Japan and Europe, due to the more supportive monetary policy environment in these regions. We review our shorter-term tactical views on a frequent basis. EXHIBIT 7: EUROPEAN EQUITIES ARE AT THE CHEAPEST LEVEL VS. BONDS SINCE 2012 % Equities cheaper vs. bonds Source: Goldman Sachs Global Investment Research as at 30 September *10+ STRATEGIC PERSPECTIVES

11 PERCENTILE (RANK VS. HISTORY) BONDS HIGH QUALITY TREASURIES UNATTRACTIVE, WE PREFER CREDIT As discussed above, we are reducing our allocation to global treasuries to fund an increase in equities, reflecting our continued expectation for rates to rise further than is currently priced and the improved valuations within equities. For non-treasury fixed income, 2015 has generally been challenging for credit spreads, which have widened across the credit quality spectrum. High yield has been the worst performer with the spread between government bonds markedly widening over the quarter. The high level of volatility in credit spreads over the past year has created a number of shortterm tactical trading opportunities throughout the year. Where BlackRock Client Solutions run mandates with discretion to trade tactically, we have adjusted our positioning within credit and particularly high yield throughout the year. On a mediumterm strategic basis, in our strategic portfolio we have maintained our 5% allocation to high yield. EXHIBIT 8: CREDIT HAS BECOME CHEAPER % EXPENSIVE INEXPENSIVE Source: BlackRock Client Solutions as at 30 September As can be seen from exhibit 8, valuations for credit, high yield and EMD are lower compared to last quarter and now look cheap relative to their own history. Reflecting this, our expected returns for these asset classes relative to government bonds has increased. For example, over the quarter, our five-year expected return for high yield has seen a notable increase of around 1.5 % p.a. Despite this, we have not increased our allocation to high yield this quarter. Valuations of a wide range of growth assets fell relative to their history over the quarter and many look inexpensive. As a result we have decided to increase the exposure of the portfolio to growth assets through increasing our allocation to equities. We currently hold significant exposure to high yield and while we remain positive on the asset class, we believe it faces some challenges, in particular within the energy sector, which has led to our preference for increasing equity exposure. PRACTICAL GUIDANCE FOR ASSET ALLOCATION *11+

12 DEFAULT RATE OIL PRICE EXHIBIT 9: THE ENERGY SECTOR HAS DRIVEN HIGH YIELD SPREAD WIDENING % $ Source: Bloomberg and Bank of America Merrill Lynch Global Research as at 30 September From exhibit 9 it can be seen that the widening of spreads in high yield has predominantly been driven by the energy sector. Energy constitutes approximately 15% of the high yield universe and is highly correlated with movements in the oil price. In the third quarter oil prices experienced renewed weakness, falling from $60 per barrel to below $40 at the lows, before stabilising around $45. The effects of slowing global demand, continued high levels of supply and high inventories has led to crude prices to more than halving over the past year. Against this backdrop, exhibit 10 shows how default rates in the energy sector have risen to levels last witnessed in 2009, as the fall in oil prices has put significant pressure on the profitability of energy producers. This makes us cautious about increasing exposure to high yield, despite remaining positive about its medium-term prospects. We also think that there are more attractive opportunities in other growth asset classes. EXHIBIT 10: LOW OIL PRICES HAVE LED TO A RISE IN DEFAULTS % Source: Bloomberg and Bank of America Merrill Lynch Global Research as at 30 September *12+ STRATEGIC PERSPECTIVES

13 ALTERNATIVES PRIVATE MARKETS REMAIN ATTRACTIVE Although we have increased our expected return for equities over the quarter, they remain low relative to recent history. Our core view for listed assets, over the medium term, expects lower returns than achieved in the past five years. Against this backdrop, the premium earned for holding alternatives, in particular private market assets, remains attractive. We believe that investors should consider broadening their investment universe and maintain a 25% allocation to alternatives. Within alternatives, we are positive on private equity, although note that significant levels of unemployed capital (dry powder) requires investors to be selective. In the current ultra-low yield environment, the rental yields available in real estate and spreads in areas of illiquid credit are also attractive. We are neutral on infrastructure equity and debt given the spread compression we have witnessed. In private markets the dispersion of returns between managers is significantly higher than is typical in public markets, opening up opportunities to improve investor returns through asset selection, sourcing and management of credit deterioration. WHAT COULD GO WRONG Exhibit 11 details the effects of applying our stress tests on the strategic portfolio from the point of view of a US dollar investor. Unsurprisingly the portfolio is expected to perform most poorly in the fiscal crisis and credit crunch scenarios, where growth assets performance is sharply negative. The stress tests are decomposed into their underlying macro-economic drivers (risk factors). It can be seen that the largest driver of performance within these scenarios is the equity factor, highlighting the portfolio s bias towards equities. The scenarios we believe to be most likely, as discussed in section one, are the negative growth surprise and emerging market shock scenarios. Each lead to portfolio losses of between 5 and 10%. From the perspective of a euro investor, performance is expected to be slightly positive in two scenarios - euro break-up and our new adverse reaction to Brexit scenario - due to non currency hedged assets performing positively when the euro weakens sharply. EXHIBIT 11: STRATEGIC PORTFOLIO STRESS TESTS - US DOLLAR BASIS Source: BlackRock Client Solutions as at 30 September PRACTICAL GUIDANCE FOR ASSET ALLOCATION *13+

14 PROJECTED CENTRAL BANK RATES Investors with liabilities Divergent monetary policies, consistent hedging views Key points Market expectations remain for divergence in monetary policy across developed nations We expect that bond yields will rise further than currently priced, which supports liability-driven investors running a moderate level of interest rate risk We view inflation pricing as more attractive and therefore suggest a moderately higher inflation hedge Bloomberg s survey of economists still suggests that the Federal Reserve and Bank of England will enter into a hiking cycle in the coming months, even though recent market -implied pricing suggests it could be slightly later. Historically government bonds have performed poorly in the aftermath of the start of a rate rising cycle, particularly in the US. Coupled with the current unattractive level of yields, we still expect yields to rise further than currently priced in the US and UK over the next five years. In the eurozone, the focus is on potential further policy easing, with a rate increase extremely unlikely in the near future. Nevertheless, the extreme low level of yields means that we anticipate that yields will rise over the medium term. The US Federal Reserve (Fed) decided against raising rates in its 17th September meeting, despite having set expectations for this earlier in the year. In the press conference, Fed Chair Janet Yellen cited international risks, dollar strength and belowpar inflation as the key drivers for maintaining base rates at their record lows. Despite the perceived dovish tone of the speech, economists still anticipate the first rate hike to occur in the coming six months, as shown in exhibit 12. Closely following the Fed is likely to be the Bank of England, with the Governor, Mark Carney, recently indicating that continued strength in the UK s economy probably means a decision on rates would become clearer at the beginning of next year. EXHIBIT 12: ECONOMISTS EXPECT US AND UK TO BEGIN HIKING CYCLE IN COMING MONTHS Source: Bloomberg as at 15 October Average economists projections of central bank rates. *14+ STRATEGIC PERSPECTIVES

15 AVERAGE YIELD CHANGE AVERAGE YIELD CHANGE By contrast, in the eurozone and Japan, loose monetary and quantitative easing programmes remain in full flow. Over the quarter the ECB president, Mario Draghi, opened the door for extensions of the current QE programme, referencing the continued weak inflation releases and concerns on growth. Similarly the governor of the Bank of Japan, Haruhiko Kuroda, commented on being ready to further adjust policy if needed to meet the inflation target of 2%. For investors with liabilities, it is movement in long-term interest and inflation rates, as opposed to short-term base rates, that typically have the largest effect on liability values. However, monetary policy and the level of short-term interest rates are important factors for assessing bond valuations, particularly in the current extraordinary monetary policy environment. Over the past seven years, the combination of low base rates, quantitative easing and large investor demand has driven bond yields to record lows across developed markets. As we draw close to the potential start of a rate hiking cycle, could we see an end to the bull market for sovereign bonds? History suggests that this may be the case in the immediate aftermath of rate rises (though not necessarily in the long run). Exhibit 13 tracks the average moves of domestic government bond yields following the first rate rise. It shows that government bond yields have displayed sustained weakness for up to three years, as markets adjust to the change in policy. EXHIBIT 13: FIRST HIKE HISTORICALLY COINCIDES WITH WEAKER 10-YEAR GOVERNMENT BOND YIELDS OVER THE NEAR TERM % % Source: Deutsche Bank, Global Financial Data. Data based on rate hiking cycles since 1950 in the US and 1914 in the UK (10-year government bond yields). PRACTICAL GUIDANCE FOR ASSET ALLOCATION *15+

16 BOND YIELDS TO RISE FURTHER THAN CURRENTLY IMPLIED History may not be a good guide for future performance and there are a number of important differences to consider when comparing this cycle to previous ones, such as the starting position of extraordinarily low policy rates. Nonetheless, we do anticipate bond yields will rise further than currently implied over the coming five years, reflecting the extraordinarily low level of government bond yields. Our strategic views on the level of long-dated bond yields incorporate our expectations of long-term inflation, real rates and term premia. For short-dated tenors, real and nominal yields are low or negative in most developed nations, which we feel reflects the combination of low central bank rates, very low inflation and the continuation of quantitative easing in some regions. However, over the longer term we expect base rates to rise, central banks to meet their inflation targets and, importantly, real yields to rise closer to our expectations of real global growth. Exhibit 14 details the assumptions that drive our expectations for 10-year yields over the long term - depending on region we expect 10-year nominal yields to be between 3.0% and 4.25%, significantly above current nominal yields. Investors with long-term liabilities are likely to be more concerned about 20 or 30 year yields than ten-year yields - see sidebox below for further discussion. EXHIBIT 14: HOW WE DERIVE OUR YIELD ESTIMATES Nominal yield (10 yr) Eurozone US UK Japan Long-term CPI estimate % +2.25% +2.0% +2.0% Inflation risk premium +0.25% +0.25% +0.25% +0.25% Real rate +1.75% +1.75% +1.75% % Long-term target +3.75% +4.25% +4.0% +3.0% Source: BlackRock Client Solutions as at 30 September Our CPI estimate over the next five years is lower than our long-run estimate, as discussed in section one and later. 2 Assumes a difference of 1.0% between RPI and CPI i.e. assumes an RPI-real rate (comparable to the real rate implied by UK index-linked gilts) of 0.75% OUR EXPECTATIONS FOR TERM PREMIA If the expectation of future interest rates were constant, one would still expect long-dated bonds to have higher yields than shorter-dated bonds under normal conditions. This term premium is to compensate investors for the longer period until capital is repaid, larger exposure to interest rate moves and, for nominal bonds, the greater risk of changes in future inflation expectations eroding real returns. In most developed markets our assumptions for bond returns includes an allowance for a positive term premium. In the US and Europe our estimates include a 25bp yield differential between 10-year and ultra-long government bonds reflecting this term premia for both nominal and real government bonds. In the UK however, this is not the case. We anticipate a significant supply/demand imbalance for long-dated government bonds. This reflects the continued significant demand we anticipate from LDI investors hedging their UK liabilities. We therefore assume no term premium for ultra-long-dated nominal bonds vs. ten year bonds in the UK. For index-linked government bonds the supply and demand imbalance is even more acute. A large proportion of UK pension schemes liabilities are linked to inflation. Reflecting this, we expect UK real yields to have a negative term premium, with ultra-long real yields being 25bps below ten-year yields. This is equivalent to expecting the inflation levels implied by ultra-long-dated bonds to be higher than short-dated bonds and above central bank *16+ STRATEGIC PERSPECTIVES

17 YIELD While we have similar long-term expectations for yields across most developed markets, a key variable in assessing bond valuations and deriving expected returns is the speed at which they revert to the long-term expected level. We expect monetary policy to diverge, with US and UK rate rises imminent, but for monetary easing to continue in the eurozone. Against this backdrop we have a longer reversion period for euro government bond yields of ten years as compared to seven years in the US and UK. Therefore while European yields are notably far lower than the US and UK, we do not see the same level of disparity in our five year return assumptions for government bonds. Exhibit 15 displays the cumulative effect of these assumptions on our expected range for 20-year yields in five years. It can be seen that across the eurozone, the UK and the US markets we anticipate nominal and real yields to rise significantly more than currently implied. EXHIBIT 15: BY 2020, WE EXPECT LONG-DATED YIELDS TO BE HIGHER THAN THE MARKET CURRENTLY IMPLIES % Market implied 5-year forward 20-year yield - Jun 2015 Source: BlackRock Client Solutions as at 30 September PRACTICAL GUIDANCE FOR ASSET ALLOCATION *17+

18 INFLATION EXPECTATIONS LONG-DATED EURO AND US INFLATION PRICING IS ATTRACTIVE RELATIVE TO CENTRAL BANK TARGETS Given the weakness witnessed in commodity pricing, we expect short-term inflation to remain below central bank targets. Over the medium to long term, however, our central estimate is for central banks to manage inflation in line with targets, though we note that tail risks exist around this view as illustrated by some of the stress tests discussed in previous sections. Exhibit 16 removes the effects of low inflation in the short term by showing the expected 15-year inflation swap rate in five years time that is implicit in inflation-swap pricing. This 15-year swap rate 5-years forward, is compared against central bank inflation targets over recent history. It can be seen that long-term inflation swap levels have fallen over the past year and in the US and eurozone currently trade below central bank targets. We consequently view these levels as attractive for hedging inflation risk. Long-dated UK inflation swap rates, however, show a significant premium to central bank targets. Since Q1 we have seen a notable increase in long-dated inflation swap EXHIBIT 16: NOW IS A REASONABLE TIME TO REMOVE INFLATION RISK % Source: BlackRock as at 30 September Source: Bloomberg and BlackRock Client Solutions as at 30 September Inflation expectations relative to central bank target. rates in the UK to levels more consistent with recent history. While the premium relative to the Bank of England s inflation target is significant, we anticipate this will remain over the medium term. As discussed in the sidebox, this reflects our expectation of a significant supply/demand imbalance for long-dated UK inflation linked assets. *18+ STRATEGIC PERSPECTIVES

19 TARGET HEDGE RATIO WE CONTINUE TO SUPPORT RUNNING SOME INTEREST RATE RISK We continue to believe that long-dated nominal and real yields could rise somewhat further than markets currently price over a medium-term time horizon. However, investors should not lose sight of the potential risk of being under-hedged. While an individual investor s circumstances will always influence the optimum hedge ratio, we continue to believe most liability-driven investors should target hedging between 60 and 75% of their liability interest rate risk, as illustrated in exhibit 17. For investors with inflation-linked liabilities, we suggest a moderately higher inflation hedge when compared to their interest rate hedge. Investors should be aware that hedging materially more inflation than interest rates can increase model-based measures of risk/var, though for most long-term investors this is not a primary concern. In the US and the eurozone long-dated inflation expectations are below or in line with central bank targets and support a higher inflation hedge ratio. In the UK, while long-dated inflation expectations are at a significant premium to central bank targets, we anticipate this premium will persist over the longer term, supporting a higher inflation hedge ratio. EXHIBIT 17: FOR A TYPICAL PENSION FUND WE ASSUME A HIGH HEDGE RATIO FOR BOTH INTEREST RATES AND INFLATION % > 75% > 80% 60 TO 75% 65 TO 80% < 50% < 50% Source: BlackRock Client Solutions as at 30 September Target hedge ratio for 80% funded investor, PRACTICAL GUIDANCE FOR ASSET ALLOCATION *19+

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