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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

F I X E D I N C O M E A S S U M P T I O N S

I N B R I E F

• We expect a significantly slower and shallower path of global interest rate normalization, with lower terminal rates for both the cash rate and 10-year yields. In turn, this all but wipes out duration premium and drives returns on longer-dated bonds down to the level of cash returns.

• U.S. government yields should settle modestly below nominal GDP, with the aggregate “true economic borrowing rate”1 a little above nominal GDP.

• Credit still shines as the bright spot in fixed income. We take into account market concern about a persistent liquidity premium in high yield but anticipate that any additional gain from spread will accrue to investors, as we expect average default rates and recovery rates to be stable over the long term.

• Emerging market (EM) debt faces some structural challenges, but we see current spreads on corporate and sovereign debt as broadly fair compared with their long-term equilibrium.

G4 government bonds: A slower and shallower path to normalization John Bilton, CFA, Head of Global Multi-Asset Strategy, Multi-Asset Solutions

Thushka Maharaj, DPhil, CFA, Global Strategist, Multi-Asset Solutions

Michael Feser, CFA, Portfolio Manager, Multi-Asset Solutions

Jonathon Griggs, Head of Applied Research, Global Fixed Income, Currency and Commodities

Grace Koo, PhD, Quantitative Analyst and Portfolio Manager, Multi-Asset Solutions

1 We define the true economic borrowing rate as the rate that, on average, the economy as a whole (government, consumers and corporations) is financed at; this is approximated from 0.2 x treasury yield + 0.4 x mortgage rate + 0.4 x corporate yield.

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The last 12 months witnessed the start of the U.S. rate normalization process while, simultaneously, negative interest rate policies expanded elsewhere around the globe. Overall, weighted average G10 cash rates remained static as rate cuts in several key economies effectively offset the U.S. rate hike. More significant, the expected pace for future rate hikes slowed sharply over the same period, with the weighted average G10 two-year yield falling by more than half to just 14 basis points (bps). At the time of writing, 70% of 10-year developed market sovereign bonds yield less than 1%. But while this era of ultra-easy monetary policy and ultra-low bond yields may persist for some time longer, it won’t last forever. Ultimately, we still expect policy rate normalization to occur in all economies, but the path of policy normalization will be both slow and shallow. We also believe that the potential for interest rates to fall is limited, especially in regions such as the euro area and UK. As a result, the outlook for interest rates is asymmetric. This has important consequences for liability-relative investors, who should be aware of the risks of locking in liabilities at current low rates.

Our changes to the path of normalization are a direct consequence of our reduced expectations for global growth and inflation and result also in a lower level of equilibrium cash and 10-year yields. We expect U.S. monetary policy to normalize very gradually over the next four years. In the eurozone, we expect the current negative rate environment to persist for another three years, followed by a glacial four-year normalization period (Exhibit 1). In both regions, we see equilibrium cash rates converging toward the respective region’s rate of inflation—implying negative real returns on cash over our assumptions horizon.

Our fixed income assumptions methodology constructs equilibrium yields from simple building blocks BUILDING BLOCKS–ANATOMY OF FIXED INCOME YIELDS AND SPREADS

1. Equilibrium cash rate • The level of cash rates consistent with our long-run growth

and inflation forecasts by country

2. + Curve (equilibrium long-dated yield) • Additional yield to compensate investor for holding long-

term bonds (term premium)

3. + Credit spread • Additional credit spread, incorporating rating migration

assumptions for investment grade and credit/liquidity risk premia and expected default loss for high yield

4. Return calculation • Reflects normalization path to equilibrium interest rate,

annual roll-down and rebalancing to a constant maturity index, plus coupon accrual and any defaults/losses

A shallower path to normalization by the Fed will result in a still- lower level of equilibrium cash yields

EXHIBIT 1: EXPECTED PATH OF DEVELOPED MARKET CASH RATES OVER OUR ASSUMPTIONS HORIZON (%)

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

20 16

20 17

20 18

20 19

20 20

20 21

20 22

20 23

20 24

20 25

20 26

20 27

20 28

20 29

20 30

U.S. 2017 3-month cash EUR/Fr 2017 3-month cash

UK 2017 3-month cash Japan 2017 3-month cash

Source: J.P. Morgan Asset Management estimates; data as of September 30, 2016. The terminal rate represents the average equilibrium rate.

Along with the eurozone, Japan, Denmark, Sweden and Switzerland are currently pursuing negative interest rate policies. We believe these policies are approaching their limits as the adverse impact on credit availability from falling banking profitability effectively offsets a diminishing increase in credit demand from even lower rates. Monetary policy authorities globally are therefore increasingly eager for fiscal authorities to pick up the baton of providing stimulus to the economy, which should in time facilitate the normalization of rates.

A side effect of the simultaneous pursuit of dovish monetary policies globally is the globalization of yield curve slopes (the difference between the yield on long-term bonds and cash) now that curve slopes owe more to global factors than to more domestically driven ones. As a result, we expect the path of normalization of long-term bond yields to be much more globally synchronized than that for cash rates. In other words, we expect the U.S. yield curve slope only to fully normalize once monetary policy tightening is close to starting in the eurozone and Japan, rather than solely following the path of U.S. monetary policy.

A final consideration in our framework for the equilibrium level of long-term government bond yields is their level relative to our long-run nominal growth expectations. Prior to 2000, 10-year U.S. Treasury yields consistently exceeded the rate of nominal GDP growth, but since then they have consistently tracked below. The combination of the global savings glut, the income needs of an aging population, increased regulation and ongoing financial repression, as well as sluggish global growth and inflation, will in our view prevent a return to the relationship we observed

F I X E D I N C O M E A S S U M P T I O N S G 4 G O V E R N M E N T B O N D S : A S L O W E R A N D S H A L L O W E R P A T H T O N O R M A L I Z A T I O N

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before 2000. Even with Treasury yields modestly below the rate of nominal GDP growth, however, the aggregate “economy-wide” borrowing yields will remain consistently above it (Exhibit 2).

As current government bond yields are reflecting an even more pessimistic near-term outlook than our longer-term assumption of sluggish global growth and muted inflation, the outlook for government bond returns is not compelling. Early in our forecast horizon, returns are impaired by low or even negative yields. Subsequent returns struggle to offset the negative mark-to-market impact incurred while rates normalize, due to the low level of our equilibrium yields. Over the full horizon, our return assumptions across the yield curve and regions are paltry indeed.

Credit still shines as a relative bright spot even after taking account of the change in liquidity risk, and we expect attractive spread returns to accrue to investors, as our fundamental expectations for defaults and recoveries remain unchanged.

U.S. RATES

U.S. rates have started to normalize at a much slower pace than we had initially expected. We therefore extend our time horizon to arrive at the equilibrium rate of 2.25% from three years to four. This rate is 25bps lower than last year’s assumption and suggests a close to zero real rate in equilibrium for cash. To reflect the anchoring effect of global policy, this year we extended the normalization period for 10-year yields to five years (Exhibit 3),

Even with Treasury yields modestly below the rate of nominal GDP growth, the aggregate “economy-wide” borrowing yields will remain consistently above it

EXHIBIT 2: PATH OF U.S. NOMINAL GDP AND ECONOMY-WIDE BORROWING COSTS (%)

-2

1990 1991 1993 1995 1997 2001 2003 2005 2007 2009 2011 2013 2015

Spread (economic borrowing cost - U.S. 10-year average nominal GDP growth) U.S. nominal GDP growth (10-year average) Estimated economic borrowing cost*

1999

Source: Bloomberg, Haver Analytics. *Estimated borrowing cost is approximated from 0.2 × Treasury yield + 0.4 × mortgage rate + 0.4 × corporate yield.

A weaker nominal growth outlook relative to last year leads us to reduce our 10-year equilibrium yield assumptions

EXHIBIT 3: EXPECTED PATH OF DEVELOPED MARKET 10-YEAR GOVERNMENT BOND YIELDS OVER OUR ASSUMPTIONS HORIZON (%)

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031

UK 2017 10-year

U.S. 2017 10-year

EUR/France 2017 10-year

Japan 2017 10-year

Source: J.P. Morgan Asset Management estimates; data as of September 30, 2016. The terminal rate represents the average equilibrium rate.

F I X E D I N C O M E A S S U M P T I O N S G 4 G O V E R N M E N T B O N D S : A S L O W E R A N D S H A L L O W E R P A T H T O N O R M A L I Z A T I O N

4 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

Lower equilibrium yield and return assumptions are a direct consequence of our reduced expectations for global growth and inflation

EXHIBIT 4: EQUILIBRIUM YIELD AND RETURN ASSUMPTIONS FOR U.S., UK AND EUROZONE FIXED INCOME MARKETS (%)

U.S. UK Euro

Equilibrium yield Return Equilibrium yield Return Equilibrium yield Return

Inflation 2.25 - 2.00 - 1.50 -

Cash 2.25 2.00 2.25 1.75 1.75 1.00

10-year bond 3.50 2.25 3.00 1.50 3.00 1.25

Gov’t bond market* 3.50 2.25 3.00 1.00 3.00 1.25

Investment grade credit** 4.75 3.25 4.50 2.50 3.75 2.00

High yield 8.25 5.75 6.75 4.25

Emerging market debt† 7.00 5.50

Source: J.P. Morgan Asset Management estimates; data as of September 30, 2016. * U.S intermediate Treasuries, UK Gilts, euro government bond index. ** Investment grade corporate bonds, †EM sovereign debt; UK Gov’t: UK: Gilts; IG corporate bonds; Euro:

Government Bond Index; IG corporate bonds.

implying that the normalization phase lasts for roughly one third of our forecast horizon. In keeping with our reduced expectations for long-run U.S. nominal growth rates, we have further reduced the equilibrium yield by 50bps to 3.50%. Compared with last year, this implies a modestly flatter curve slope between cash and 10-year yields in equilibrium. We maintain the 25bps yield curve premium assumption for the slope between 10-year and 30-year yields. Our macro forecasts for inflation are modestly higher than the current market expectations implied by TIPS breakevens; hence we see room for better inflation-linked returns in our 2017 assumptions.

EUROZONE RATES

In the eurozone, we anticipate that significant output gaps and negative rates will persist for some time. Cash rates will therefore only begin to normalize in 2019 and reach their equilibrium rate of 1.75% four years later, implying a significantly negative real return on cash over our assumption horizon. We use as our reference point 10-year French government bonds, which we expect to trade close to the weighted average 10-year government bond yield of the eurozone as a whole. A weaker growth and inflation outlook relative to last year leads us to reduce our 10-year yield assumption by 50bps to 3.00%. We expect eurozone 10-year yields to normalize in seven years—two years later than the U.S.—with a curve slope between cash and 10-year rates of 125bps in equilibrium. This is a palpably steeper slope than today but rather flat in a historical context. In line with the U.S., we see upside risks to European inflation breakevens, as our macro forecasts for inflation are modestly higher than current market expectations.

UK RATES

Historically, the UK economy tended to be relatively synchronized with the U.S. growth cycle; as such, the monetary policy of the Bank of England (BoE) typically followed that of the Federal Open Market Committee (FOMC), with a modest time lag. An irony of Brexit, however, is the significant realignment of UK monetary policy—and our assumption of UK rate normalization—toward the eurozone. We now expect BoE monetary policy to remain ultra-easy until 2018, before cash rates rise over a period of four years to reach their equilibrium level of 2.25%. Real returns over our assumptions horizon are close to zero, reflecting the high sensitivity of the UK economy to the level of short-term rates. Our equilibrium yields for 10-year UK Gilts are sharply lower from last year, reflecting a lower trajectory for nominal growth as well as persistent demand for longer-duration bonds. In line with other global bond markets, UK Gilt yields are expected to normalize over seven years, with a modestly steeper yield curve slope than current levels in equilibrium.

JAPANESE RATES

Japanese cash rates will follow a similar trajectory to the eurozone’s but level out at an even lower equilibrium yield of just 1.00%. To ensure ongoing debt sustainability, Japan’s equilibrium 10-year government bond yields will have to remain well below the nominal GDP growth rate. We expect 10-year yields to reach their equilibrium level of 1.25% after a seven-year normalization period, resulting in the flattest yield curve slope of all the major economies. This forecast reflects the profound demographic challenges the country faces and their impact on the long-run growth and inflation outlook. Also implied in our forecast is a more moderate level of success of Abenomics over the assumptions horizon.

F I X E D I N C O M E A S S U M P T I O N S G 4 G O V E R N M E N T B O N D S : A S L O W E R A N D S H A L L O W E R P A T H T O N O R M A L I Z A T I O N

5 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

GLOBAL CREDIT MARKETS: THE PICK OF THE FIXED INCOME UNIVERSE

Over the long term, credit spreads tend to strongly mean revert, as both default rates and recovery rates have remained remarkably stationary over the long term. While both the frequency of default and the recovery rate vary somewhat across cycles, there is no evidence of a trend in these factors over multiple cycles. Although readers using our work to consider shorter horizons may want to factor in the recent dip in recovery rates, we assume that over the assumptions horizon credit spreads will remain in line with the long-run mean (Exhibit 5).

Credit investors may also be concerned that the “extraordinary” monetary policies that followed the global financial crisis (GFC) suppressed defaults compared with what the economic contraction would have justified. With monetary policy still far from normal, this level of policy accommodation might not be available were another crisis to occur in the near term, and future credit losses should therefore be expected to be higher. While we believe this is a valid near-term concern, we do not consider it sufficient to raise the expected credit loss amount over our assumptions horizon.

There are, however, two recent developments in credit markets that we expect to have a longer-term structural impact: extended duration and leverage in the investment grade sector and a liquidity premium in high yield.

While both the frequency of default and the recovery rate vary across cycles, there is no evidence of a trend in these factors over multiple cycles

EXHIBIT 5: LONG-RUN DEFAULT AND RECOVERY RATES FOR U.S. HIGH YIELD (%)

’82 ’83 ’84 ’85 ’86 ’87 ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09 ’10 ’11 ’12 ’13 ’14 ’15 ’16

Domestic high yield default rate, last 12 monthsBond issuer-weighted recovery rates

Long-term average 3.76%Long-term average 41.0%ç è

Source: Moody’s Investors Service, JPMorgan Chase & Co.; data as of June 30, 2016.

The average post-default spread of U.S. high yield is currently markedly higher than the pre-financial crisis average—some, but by no means all, of this can be attributed to reduced liquidity

EXHIBIT 6: U.S. HIGH YIELD EXCESS SPREAD OVER LAST 20 YEARS AND THE 20 YEARS LEADING UP TO THE GFC (BPS)

-300

300

600

900

1,200

1,500

1,800

’86 ’88 ’90 ’92 ’94 ’96 ’98 ’00 ’02 ’04 ’06 ’08 ’10 ’12 ’14 ’16

U.S. high yield default rate, last 12 months

Loss given default

Excess spread*

Average excess spread (pre-GFC)

Average excess spread (last 20 years)

Source: Moody's Investors Service, JPMorgan Chase & Co.; data as of June 30, 2016. * Excess spread = level of spread available after accounting for credit loss.

F I X E D I N C O M E A S S U M P T I O N S G 4 G O V E R N M E N T B O N D S : A S L O W E R A N D S H A L L O W E R P A T H T O N O R M A L I Z A T I O N

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As investment grade issuers—especially large cash-generative firms with higher quality balance sheets—extend duration and leverage, it is likely to exert some upward pressure on the equilibrium credit spread. We estimate that an additional 25bps of spread for long-duration corporate credit will be required to generate sufficient investor compensation for the increased spread duration and credit risk. We raise our equilibrium spread assumption to 175bps over duration-equivalent treasury yields.

In high yield credit, we acknowledge the lower level of secondary market liquidity that has accompanied tighter regulation of broker-dealers. However, we believe this is only one element in the market narrative of a liquidity premium. A more critical consideration is that high yield investors tend to have not just a relative return requirement but also a fairly anchored minimum total return requirement, which needs to be met to generate demand. Consequently, when risk-free rates are relatively low, credit spreads will remain wider to overcome this minimum expected return hurdle. Even after years of ultra-low rates, investors have only slightly lowered this hurdle compared with the past. As we anticipate equilibrium yields for risk-free assets to remain well below their historical norm, we also expect to see a moderate widening in equilibrium high yield credit spreads.

The long-run average excess (post-default) spread of U.S. high yield credit has risen significantly post-GFC. In the 20 years before the GFC, it averaged 275bps, whereas over the last 20 years—a period that captures the credit crisis and the post-GFC environment fully—the average excess spread is almost 400bps (Exhibit 6). We do not believe that this entire differential reflects a permanent shift in liquidity; indeed, we would expect that much of the additional spread will erode as risk-free rates normalize and as default rates and recovery rates revert toward long-term averages. Nevertheless, we would expect some residual liquidity- linked spread to remain in place over our assumptions horizon and estimate this to be around 25bps. To reflect this, we raise our equilibrium spread assumption (before accounting for default losses) by 25bps to 500bps for U.S. high yield.

GLOBAL EMERGING MARKET DEBT: SIGNS OF STABILIZATION, BUT DELEVERAGING RISKS REMAIN

Emerging market debt faces a number of headwinds in the coming years from deleveraging and a slowing pace of credit quality improvements. Nevertheless, the absolute level of debt is likely to be manageable, and we believe the risk of an acute crisis, as seen in the late 1990s, is small. The post- global financial crisis average spread level on the J.P. Morgan U.S. dollar-denominated diversified emerging market bond index (EMBI) of around 325bps reflects a fair balance of the risks, as well as the persistent demand for EM debt that is likely to result from low yields in developed markets. The structural challenges, aggregate debt levels and challenges to credit quality improvement probably prevent spreads on EM hard currency debt from tightening significantly toward the extremes seen immediately before the financial crisis.

Corporate EM debt has a number of pockets of vulnerability and may face some near-term challenges should an EM deleveraging cycle get underway. We believe that the J.P. Morgan diversified corporate emerging markets bond index (CEMBI) has an equilibrium fair value spread of 375bps over our forecast horizon. This compares with a post-GFC average of around 360bps. While EM corporate debt is often compared with developed market high yield debt, the index itself is roughly two-thirds investment grade and one-third high yield. Thus our forecast of a 375bps spread, we believe, amply reflects the structural challenges generally facing EM debt, with the credit quality embedded in corporate EM debt indices.

F I X E D I N C O M E A S S U M P T I O N S G 4 G O V E R N M E N T B O N D S : A S L O W E R A N D S H A L L O W E R P A T H T O N O R M A L I Z A T I O N

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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