Finance Paper

1 J . P . M O R G A N A S S E T M A N A G E M E N T | L O N G - T E R M C A P I T A L M A R K E T A S S U M P T I O N S

INVESTMENT INSIGHTS

FOR INSTITUTIONAL/WHOLESALE/PROFESSIONAL CLIENTS AND QUALIFIED INVESTORS ONLY – NOT FOR RETAIL USE OR DISTRIBUTION

E Q U I T Y M A R K E T A S S U M P T I O N S

I N B R I E F

• For several years, our equity return assumptions have been lower than history might lead us to expect. This year, we take both developed market (DM) and emerging market (EM) total return expectations down another peg.

• Our DM return assumption reflects our expectation that a low-growth environment will persist, leading to lower real growth and inflation and hence diminished earnings growth. A relatively large share of developed market equity total returns will likely come from a high level of payouts to shareholders rather than from earnings growth.

• Our EM return assumption falls by a slightly larger amount than our DM return assumption in local currency terms, reflecting more severe economic growth downgrades than in developed markets, but also higher valuations that are now a modest drag on our return projections. The return assumption declines by slightly less in U.S. dollar terms, following our expectation of emerging market currency appreciation. Overall, the resulting return gap in favor of emerging markets is the same in U.S. dollar and local currency terms in this year’s assumptions, and continues to be roughly in line with historical experience.

• Our equity return assumptions are based on a methodology that accounts explicitly for specific drivers, including the global composition of corporate revenues—companies have increased their global investment, so we need to take this into account rather than linking revenues only to domestic GDP growth—as well as normalization of profit margins and valuations, and the impact of share buybacks and dilution.

Modest downgrades, disappointing returns Patrik Schöwitz, CFA, Global Strategist, Multi-Asset Solutions

Stephen Macklow-Smith, Portfolio Manager, European Equity Group

Michael Albrecht, CFA, Global Strategist, Multi-Asset Solutions

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E Q U I T Y M A R K E T A S S U M P T I O N S M O D E S T D O W N G R A D E S , D I S A P P O I N T I N G R E T U R N S

COMPARED WITH LAST YEAR, EQUITY RETURNS MOVE LOWER AGAIN

Once again, our equity assumptions deliver a message of low returns relative to history, in particular for developed markets.

We moderately downgrade our assumptions for DM equities compared with last year, to 6.00% from 6.75%. This reflects our expectation of both a lower level of revenue growth and a slight de-rating. Valuation levels remain elevated on a historical basis, and as these revert to mean they are likely to prove a headwind for future returns. In the U.S. and Japan, we anticipate that margins, which are higher than their historical averages, will come under some pressure, while in the eurozone and UK we expect margins to recover.

Our outlook for EM returns remains somewhat brighter than our expectation for DM returns, but it is also reduced by a similar amount. Our aggregate EM equity return assumption falls to 8.75% in local currency terms from 9.75% last year. This takes the gap by which we see emerging markets surpassing DM equity returns down to 2.75 percentage points (ppts) in local currency terms. Our expectations follow from our assumptions of lower economic growth (and thus revenue growth), offset to some degree by a little less dilution than we assumed last year.

At the regional level, our local currency return assumption for EM Asia falls by 100 basis points (bps) to 9.00%, while the return in Europe, the Middle East and Africa (EMEA) declines by 125bps to 8.75%. It falls by 150bps to 7.00% in Latin America. In U.S. dollar (USD) terms, our EM return assumption declines by 75bps to 9.25%, as we see a slightly stronger but still mild appreciation of EM currencies over our horizon. Similarly, the impact of currency assumptions on aggregate DM equity returns boosts the USD return assumption by 50bps to 6.5%. Overall this leaves the return advantage of emerging markets over developed markets in USD terms identical to the return advantage in local currency terms. Foreign exchange (FX) trends thus boost the attractiveness of international equity markets (both EM and DM) to U.S. dollar- based investors, as we expect the USD to weaken gradually over our assumptions horizon.

Despite the undeniable cyclical and structural challenges that lie ahead for emerging markets, we see recovery potential over our long-term horizon. EM return assumptions and drivers vary among specific markets, but we believe that economic growth rates will, in most cases, remain substantially above those in developed markets, while emerging markets do not generally face the same valuation headwinds as developed markets.

BUILDING OUR FORECASTS

We continue to rely on the equity return assumptions methodology we introduced in our 2015 assumptions, summarized in Exhibit 1.

Our equity assumptions methodology breaks equity returns into easy-to-forecast return drivers

EXHIBIT 1: BUILDING BLOCKS–ANATOMY OF EQUITY TOTAL RETURNS

1. Aggregate revenue growth

• Includes domestic and international growth, as well as any additional expansion of revenues

2. × Aggregate earnings growth / revenue growth (margins) = Aggregate earnings growth

• Reflects normalization in most markets

3. × Earnings per share (EPS) growth / aggregate earnings growth (net dilution) = EPS growth

• Breaks down into: (a) gross dilution; (b) buybacks

4. × Price return / EPS growth (valuations) = Price return

• Consistent with long-term risk-free yields and equity risk premium (ERP)

5. + Dividends (carry) = Total return

• Payout ratio consistent with sustainable growth rate

Similar to DuPont analysis, this methodology allows us to decompose total returns structurally into easy-to-forecast ratios as drivers of return. It enables us to account explicitly for the global composition of corporate revenues—and how fast different regions are growing—as well as the normalization of profit margins and valuations, and the impact of share buybacks and dilution. Finally, we tie together complex interrelationships among these factors by ensuring that they are consistent with expected return on equity (RoE), based on an index-level adaptation of Robert Higgins’s sustainable growth rate (SGR) concept—which we further refined this year. This framework makes certain that total payouts to shareholders (dividends plus buybacks) and resulting net dilution are sustainable and consistent with earnings growth and expected RoE (for the latter we use a DuPont-style decomposition to shape our expectations).

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E Q U I T Y M A R K E T A S S U M P T I O N S M O D E S T D O W N G R A D E S , D I S A P P O I N T I N G R E T U R N S

DEVELOPED MARKET EQUITY RETURN ASSUMPTIONS

As we have noted, at the aggregate DM level our total return assumption falls again slightly this year, to around 6.00% in local currency terms. All major DM markets continue to see small downgrades in their top-line aggregate sales estimates, reflecting reductions in our economic growth expectations. We see RoEs remaining high relative to earnings growth, consistent with payouts (dividends plus buybacks) contributing proportionally more to total returns compared with history. Valuations will remain a headwind, dragging on expected total returns across all major developed markets. The composition of equity return assumptions across the major developed markets is illustrated in Exhibit 2.

The makeup of equity return projections differs across developed markets

EXHIBIT 2: CONTRIBUTION TO TOTAL RETURNS, % ANNUAL, FOR G4 LARGE CAP EQUITIES

-4

-2

0

2

4

6

8

10

12

U.S. large cap Eurozone UK Japan

Dividend yield Valuation impact Buybacks Gross dilution Margins impact Revenue growth Total return

Source: J.P. Morgan Asset Management; data as of September 30, 2016.

For the U.S., our return assumption declines modestly to 6.25%, mostly reflecting a lower level of revenue growth. Margins appear to have less far to fall than we were projecting last year. Valuations should provide a similar drag, although we have slightly raised target P/E assumptions for European and U.S. equity markets to reflect an expected environment of lower for even longer bond yields.

In contrast, our return expectation for U.S. small caps ticks down only marginally to 7.00% from 7.25% last year. Earnings growth should be somewhat faster than for large caps, even though we assume a larger decline in margins from current record levels than for large caps, and in spite of lower exposure to fast-growing emerging markets. Lower RoE continues to imply higher dilution

than for large caps. The key change from last year, however, comes from valuations—while valuations for large caps have risen further since last year, they have actually declined mildly for the small cap index, leading to a fairly substantial positive return contribution. Overall the small cap return premium expands to 0.75% from 0.25% last year.

Our eurozone assumption decreases 100bps to 6.00%. Revenue growth continues to decelerate in line with our expectations for global growth, but we expect valuations to present less of a headwind, given the market’s decline since last year. We still project that margins will recover, but we have lowered our assumed rate of recovery. This largely reflects the ongoing pressures on European bank profits, as very low interest rates will continue to squeeze net interest margins. We have also embedded an expectation of a continued need for more capital in the European financial sector, reflected in the relatively high ongoing dilution numbers compared with pre-crisis levels.

We continue to believe that future returns in Japan depend significantly on the success of corporate governance reform, a critical and as yet unfinished piece of Abenomics. As Japanese equity fundamentals (notably profit margins and RoE) remain at record levels by local standards, we are reluctant to assume either a wholesale reversion to historically lower mean values or a surge to the much better levels that are normal in the rest of the developed world. We take the middle road, projecting that fundamentals will remain relatively close to current levels, and introducing the assumption of a mild downward trend in margins. We make that move seeing little evidence of underlying margin improvement absent further foreign exchange help, which we do not believe is forthcoming. (Our FX assumptions continue to envision yen appreciation from here.)

The prevailing high level of profitability translates in our framework into pressure for higher shareholder payouts in order to sustain it. However, absent stronger earnings growth, sustaining the current level of profitability would imply unrealistically high payout rates to shareholders. We have therefore chosen to cut our RoE assumption and thereby cap implied buybacks in our framework at a still-high 2.5% per annum. Abenomics encourages companies to put their reserves to work, but recent evidence suggests that issuance still outweighs buybacks. We cut our Japanese equities return assumption, in local currency terms, to 4.75%, due to the aggregate impact of a decline in growth, falling margins and capped buybacks, compensated for by a higher dividend yield. Given that Japan’s economic and political environments are in a state of flux, we will continue to reassess our assumptions.

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E Q U I T Y M A R K E T A S S U M P T I O N S M O D E S T D O W N G R A D E S , D I S A P P O I N T I N G R E T U R N S

In the UK, our equity return assumption falls 1ppt to 6.25%. Two important factors point in opposing directions: Normalization of margins should boost returns going forward, while high valuations should act as a drag. UK earnings have suffered from the commodity cycle, given the heavy weighting of commodity-related sectors in the UK index. This is before any impact from Brexit—in fact, UK equities have performed relatively well post-Brexit, only adding to the rise in valuations. On balance, we expect that the negative drag from valuations will outweigh the lift from improving margins. This comes, in part, from cutting our target level for margins again this year to take account of the likely headwind from Brexit-related uncertainty. Across markets, the share of revenue from international sources varies widely (Exhibit 3) and is particularly high for the UK. In the near term, a weaker sterling should help boost the revenues (in GBP terms) and margins of UK exporters, but this impact has not yet been seen in financial data and so does not affect our starting point; in the longer run, recovery in sterling means any boost to earnings should be only temporary, and there is little impact to our long- term equilibrium projections.

While U.S. companies generate 72% of their revenue in North America, UK companies rely on domestic markets for just 31% of their revenue

EXHIBIT 3: INTERNATIONAL REVENUE BREAKDOWN FOR G4 MARKETS

North America Europe United Kingdom Japan Asia Pacific ex-Japan Central & South America Australasia Middle East & Africa Eastern Europe India/Bangladesh/Pakistan Other (or data unavailable)

0

10

20

30

40

50

60

70

80

90

100

U.S. large cap Eurozone UK Japan

Source: Thomson Reuters Datastream, J.P. Morgan Asset Management; data as of September 30, 2016.

EMERGING MARKET EQUITY RETURN ASSUMPTIONS

We derive our aggregate EM equity assumption—8.75% in local currency terms and 9.25% in U.S. dollars —by applying the same methodology to nine large emerging markets and aggregating by market capitalization weight. The countries we include account for more than 85% of the market capitalization in the MSCI Emerging Markets Index. Data history in emerging economies is generally shorter, and data quality less robust, so our confidence in the resulting assumptions is by nature somewhat lower than for developed markets. Despite this reservation, and the variety of cyclical and structural crosscurrents moving through the emerging market universe, we identify a few common themes.

Top-line growth in most EM countries remains much higher than in developed markets, despite a downgrade in our assumptions again this year. While Taiwan and South Korea are the obvious slower-growing outliers in the EM universe, the aggregate EM growth rate is still stronger than the DM rate by more than 3ppts. This feeds through to faster aggregate EM earnings growth, although at the moment we expect the pace will be slowed a little by pressure on profit margins. An offset to faster aggregate earnings growth is the generally higher level of net shareholder dilution, although at current levels it is modest relative to history.

On the valuation front, the picture is mixed across emerging markets. Valuations look low in China, as they do in South Korea and Taiwan to a lesser degree. In contrast, Mexico, India, Brazil and South Africa appear to be at the expensive end of the spectrum. Overall, in the wake of a recovery that began at the start of 2016, EM equity valuations no longer look low, resulting in a modest drag on returns of around 40bps.

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Once again, our equity assumptions deliver a message of low returns relative to history, in particular for developed markets

EXHIBIT 4: SELECTED DEVELOPED MARKET EQUITY RETURN ASSUMPTIONS AND BUILDING BLOCKS

Equity assumptions U.S. large cap Euro area UK Japan

Revenue growth 5.3 4.3 4.5 3.3

+ Margins impact -0.3 0.9 2.6 -0.4

Earnings growth 5.0 5.2 7.3 2.9

+ Gross dilution -2.0 -2.0 -2.0 -2.0

+ Buybacks 2.1 0.5 0.3 2.5

EPS growth 5.1 3.7 5.5 3.4

+ Valuation impact -0.9 -0.7 -2.7 -0.6

Price return 4.1 2.9 2.6 2.8

+ Dividend yield (DY) 2.0 3.0 3.5 2.0

Total return, local currency 6.25% 6.00% 6.25% 4.75%

Source: J.P. Morgan Asset Management; estimates as of September 30, 2016.

EXHIBIT 5: SELECTED EMERGING MARKET EQUITY RETURN ASSUMPTIONS AND BUILDING BLOCKS

Equity assumptions China Korea Taiwan India South Africa Brazil

Revenue growth 8.2 6.8 5.3 12.3 8.9 9.6

+ Margins impact -0.2 -1.8 0.5 0.1 -0.1 1.0

Earnings growth 8.1 5.0 5.9 12.4 8.8 10.7

+ Gross dilution -2.2 -0.2 -1.3 -2.7 -2.2 -4.7

+ Buybacks 0.3 0.8 0.5 0.5 1.0 0.5

EPS growth 6.0 5.5 5.1 9.9 7.4 6.0

+ Valuation impact 0.7 0.8 0.1 -2.5 -2.3 -2.2

Price return 6.7 6.4 5.2 7.1 4.9 3.7

+ Dividend yield (DY) 2.8 1.5 3.5 1.5 3.0 3.5

Total return, local currency 9.75% 8.00% 9.00% 8.75% 8.00% 7.50%

Source: J.P. Morgan Asset Management; estimates as of September 30, 2016.

E Q U I T Y M A R K E T A S S U M P T I O N S M O D E S T D O W N G R A D E S , D I S A P P O I N T I N G R E T U R N S

In Exhibits 4 and 5 below, we present the building blocks that form the foundation of our DM and EM equity assumptions.

INVESTMENT INSIGHTS

FOR INSTITUTIONAL/WHOLESALE/PROFESSIONAL CLIENTS AND QUALIFIED INVESTORS ONLY – NOT FOR RETAIL USE OR DISTRIBUTION

NOT FOR RETAIL DISTRIBUTION: This communication has been prepared exclusively for institutional/wholesale/professional clients and qualified investors only as defined by local laws and regulations.

JPMAM Long-Term Capital Market Assumptions: Given the complex risk-reward trade-offs involved, we advise clients to rely on judgment as well as quantitative optimization approaches in setting strategic allocations. Please note that all information shown is based on qualitative analysis. Exclusive reliance on the above is not advised. This information is not intended as a recommendation to invest in any particular asset class or strategy or as a promise of future performance. Note that these asset class and strategy assumptions are passive only–they do not consider the impact of active management. References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Assumptions, opinions and estimates are provided for illustrative purposes only. They should not be relied upon as recommendations to buy or sell securities. Forecasts of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material has been prepared for information purposes only and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. The outputs of the assumptions are provided for illustration/discussion purposes only and are subject to significant limitations. “Expected” or “Alpha” return estimates are subject to uncertainty and error. For example, changes in the historical data from which it is estimated will result in different implications for asset class returns. Expected returns for each asset class are conditional on an economic scenario; actual returns in the event the scenario comes to pass could be higher or lower, as they have been in the past, so an investor should not expect to achieve returns similar to the outputs shown herein. References to future returns for either asset allocation strategies or asset classes are not promises of actual returns a client portfolio may achieve. Because of the inherent limitations of all models, potential investors should not rely exclusively on the model when making a decision. The model cannot account for the impact that economic, market, and other factors may have on the implementation and ongoing management of an actual investment portfolio. Unlike actual portfolio outcomes, the model outcomes do not reflect actual trading, liquidity constraints, fees, expenses, taxes and other factors that could impact future returns. The model assumptions are passive only—they do not consider the impact of active management. A manager’s ability to achieve similar outcomes is subject to risk factors over which the manager may have no or limited control.

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