The path of least resistance MARKET THOUGHTS OUTLOOK 2016

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1 The path of least resistance MARKET THOUGHTS OUTLOOK 2016

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3 MARKET THOUGHTS OUTLOOK Markets want clarity; investors like to believe they can always distinguish the right investment path to take. Clarity is easy with hindsight; it s rarely as easy on a forward-looking basis. It s interesting how that sometimes gets forgotten in particular at moments of transition for markets and the macro economy. We are at a transition point currently, and transitions are bumpy. We certainly saw market bumps in 2015, and we expect more volatility ahead. As an investor, it s important to determine the implications of being right or wrong about a particular path. What should never be in doubt is the journey the need to stay invested. Richard Madigan Chief Investment Officer J.P. Morgan Private Bank We have entered the later stages of the investment cycle. That will keep markets bumpy and with far less clarity than investors have come to expect from an aging bull market. But to borrow a phrase from Monty Python: It s not dead yet. The outlook is good, not great, and the risks have risen. That will keep visibility curtailed and animal spirits tethered. Each of those observations speaks directly to how we have positioned portfolios, not whether or not to be invested long-term money should be invested. Return expectations, however, need to be managed lower. You ve got to believe a solid base case for moderate growth and tame inflation Global economic growth momentum slowed this past year, as policy mistakes in China raised the specter of a more severe slowdown risk. Inflation expectations rolled over, throwing into doubt the ability of the Federal Reserve to raise policy rates much above current low levels. Lower inflation also added pressure for the European Central Bank (ECB) and Bank of Japan (BoJ) to increase stimulus efforts, causing elevated central bank policy divergence in spite of the Federal Reserve s fluid messaging around lift-off. Energy markets and, by extension, commodity markets remained under pressure as well. FIGURE 1. Global growth and inflation REAL GDP GROWTH ANNUAL % CHANGE INFLATION, CONSUMER PRICES ANNUAL % CHANGE World 3.4% 3.1% 3.6% 3.5% 3.3% 3.4% Advanced Economies 1.8% 2.0% 2.2% 1.4% 0.3% 1.2% United States 2.4% 2.6% 2.8% 1.6% 0.1% 1.1% Euro Area 0.9% 1.5% 1.6% 0.4% 0.2% 1.0% Japan -0.1% 0.6% 1.0% 2.7% 0.7% 0.4% Emerging Economies 4.6% 4.0% 4.5% 5.1% 5.6% 5.1% China 7.3% 6.8% 6.3% 2.0% 1.5% 1.8% Emerging Asia 6.8% 6.5% 6.4% 3.5% 3.0% 3.2% Emerging Europe 2.8% 3.0% 3.0% 3.8% 2.9% 3.5% Latin America 1.3% -0.3% 0.8% 7.9% 11.2% 10.7% Source: International Monetary Fund, PPP weighted. Data as of October 2015.

4 2 MARKET THOUGHTS Global growth slowed last year, stalled by emerging economies and commodity exporters (see Figure 2). Slower global growth also reflects a directed slowdown in China by Chinese policymakers something we have identified as a macro theme since China s lower growth rate isn t new news, regardless of how frequently it s reported. We continue to believe that China is transforming to a more balanced service- and consumption-driven economy. Over the next few years, a +5.5% 6.0% growth target seems reasonable. Whether China succeeds or not in transforming its domestic economy remains to be seen that s the real risk. Its intent to transform, however, should not be in doubt. What China resoundingly proved over the past year is how much it matters to the global economy and outlook policy and communication missteps included. I say that because we are likely to see additional missteps. The most important policy decision that changed how we think about investing in Asia was the August shift in foreign exchange regime by China s central bank effectively giving the People s Bank of China (PBoC) the optionality to weaken its currency at will. Further weakening of the Chinese renminbi may push other Asian currencies lower as well. This FX policy change from the PBoC was a marked change in risk and return asymmetry. As we are predominantly USD, euro, sterling or Swiss franc denominated investors, our investment risks rose significantly, and so we cut Emerging Asia investment positions. The United States and China are the foundation economies for sustainable moderate global growth. If either economy falls into recession, the global economy will as well. I place a 20% 25% probability on that happening in For context, I would have placed a 5% 10% probability on that same recession risk coming into We do not believe that the United States or China will fall into recession in 2016 but a 20% 25% probability isn t zero, and it s certainly higher than 5% 10%. Our investment positioning clearly reflects a no recession base case view. China falling into recession would, in our opinion, be more damaging to global growth than a more aggressive path of Fed tightening. That observation is not part of the mainstream narrative: Pundits may point out that they think China s economy is collapsing, but then quickly add that it won t impact the global economy. That isn t possible China is crucial to global growth. We expect economic growth in the United States to be stuck right around +2.5%. While far from exuberant, slower growth is allowing labor markets to recover without wage inflation overshooting to the upside. Inflation should remain tame in 2016, thanks to a strong USD and low energy prices. The U.S. fiscal deficit continues to improve along with the housing market as FIGURE 2. Emerging markets have detracted from global growth Manufacturing Purchasing Managers Index Developed Markets Emerging Markets Source: Markit, HSBC. Data as of November Purchasing Managers Indices are derived from monthly surveys of private sector firms to determine the current growth environment and expectations.

5 OUTLOOK FIGURE 3. Inflation dampened by commodities U.S. Consumer Price Index year-over-year, % 6 All Items All Items Less Food & Energy Source: Bureau of Labor Statistics, Haver Analytics. Data as of October The Consumer Price Index shows monthly data on changes in the prices paid by urban consumers for a representative basket of goods and services. we see further strengthening of household balance sheets. The United States continues to lead the global economy both in stability and strength, but it s important to emphasize that it is relative strength. We said at the start of 2015 that it would be difficult for U.S. 10-year interest rates to get above 2.25% 2.50% before the Fed actually tightens. We believe, given the lack of meaningful inflationary pressure in the economy and moderate growth, even with Fed tightening, it is going to be difficult to see 10-year yields much above a 2.50% 2.75% trading range in Energy prices and the USD will have a lot to do with how quickly we see inflation reappear, or not (see Figure 3). Wages should continue to rise gradually right now, modest wage pressure is coming from lower-skilled labor, which we believe should support steady consumption growth at around +3.0% 3.5%. In Europe, we expect moderate economic growth to hold at around +1.5% in Policy easing, a slow labor market recovery and low energy prices should conspire to keep disinflation a prominent concern for the ECB. The ECB has a single mandate: to manage inflation toward a 2.0% target. Right now, it is failing to deliver on that mandate. Mario Draghi understands perhaps better than any modern central bank governor the efficiency and power of the bully pulpit. He promised to do whatever it takes in July of 2012, but it took until early 2015 before he actually started quantitative easing. Draghi clearly understands that getting markets to do some of the heavy lifting is crucial there is a lesson in there for the Fed. We don t doubt that if inflation expectations move lower in Europe, we will see additional ECB policy action. That means, on the margin, the euro tilting lower. We continue to think the biggest part of the euro s move, in particular against the USD, is behind us. As a starting point, 1.05 seems a fair placeholder versus the USD until the Fed either becomes more assertive in its tightening, and/or the ECB moves further into negative policy rate territory. We are keeping a close eye on negative interest rates across Europe. Japan s recovery appears particularly anemic, but it is the rate of change that matters most in Japan. We expect economic growth to bounce between +0.5% 1.0%. Inflation is not likely to approach the central bank s 2.0% target in the near term. The BoJ remains all-in on quantitative easing. Asset reflation is working, though some of it is forced buying by the government and domestic institutional investors in the local bond and equity markets. The BoJ is buying all of the net new government bonds issued in Japan, which is astounding.

6 4 MARKET THOUGHTS There is a great deal more on the reform agenda that needs to happen in Japan, but like China s commitment to transform, we view Japan s commitment to change as equally determined. Two years ago, we said we viewed our equity investments in Japan as a short-term rental, made on the back of a currency trade. Today, we feel those investments are more like a medium-term lease. As investors, we are willing to commit longer to Japan because of the progress we see, especially around corporate governance. Policymakers believe they have no choice but to fight deflation with every option they have, but the amount of debt being created is simply staggering. FIGURE 4. Profitability in EM has deteriorated Last 12 months earnings per share in USD, index 12/31/2009 = MSCI World (Developed Markets) Emerging markets should look better in 2016, but the dispersion across regions is likely to be pronounced. Most emerging economies will look better because of a lower starting point not because they are necessarily through the worst. External conditions are more difficult with regard to access to, and the cost of, capital. Should commodity market rebalancing get worse, the nonlinear effects of lower commodity prices may lead to a significant rise in financial stress, defaults and possible contagion. Latin America, the Middle East and Africa stand out as concerns. Asia continues to look better positioned to navigate the year ahead, but we expect local currency markets to be a great deal more volatile and pressured. From an investment perspective, we prefer developed over emerging markets (see Figure 4). The United States is furthest along in expansion, with Europe and Japan in recovery but disappointing in momentum. Emerging markets are recovering from a credit crunch and an overextended investment boom that is especially the case for countries dependent on commodity exports for growth. We have had meaningful debate on the CIO Team about whether emerging markets will be the tipping point that stalls the global economy in While not our base case, we remain concerned that there may be additional spillover effects from developing economies that can weigh on broader risk premia as we saw in the third quarter of Source: MSCI, FactSet. Data as of November Fixed income markets fading fears, lingering doubts, greater divergence MSCI Emerging Markets We ve seen more than 600 unique central bank interest rate cuts since the failure of Lehman Brothers, along with over $12 trillion of central bank asset purchases. It has also been the longest period of zero interest rate policy in the history of the U.S. Federal Reserve. In Europe, the ECB has even adopted negative policy rates. Negative interest rates are troubling (see Figure 5). They distort how risk is taken and measured across all asset classes globally. Negative rates can push investors to overreach for returns across risk assets, but we are not seeing much evidence of this today. In fact, we continue to see generally rational behavior. The majority of investors have taken advantage of opportunities as they ve presented themselves, but with a clear understanding that valuations are no longer low across almost every asset class. Nothing is cheap enough to make investors feel there is a value cushion that warrants taking on a lot of additional risk. That s a healthy observation about market behavior investor caution continues to trump complacency.

7 OUTLOOK Notwithstanding the Fed s expected slow normalization of policy rates ahead, we see interest rates across developed markets staying low. We own core bonds across portfolios, but we own less fixed income than we normally would because yields are low and volatility is too high. That said, over the past 18 months we have extended fixed income portfolio duration by around 1.5 years to a target of approximately years. We have done so by allocating to strategies both in credit and core bonds that can also take advantage of opportunities across global rates. Income enhancement and diversification against rising rates are the main focus within our fixed income allocations. We expect that core bonds will see another year of modest returns and high volatility. Gradually rising policy rates in the United States are creating a complicated market environment for global bonds. Therefore, how you invest in fixed income is particularly important. We prefer higher-quality bonds and targeted duration positioning over broad bond market exposure. That is true for everything from government bonds to credit markets. We strongly prefer active management to passive index-linked strategies across fixed income markets. For investment grade credit, we are targeting low-single-digit returns with potentially modest spread tightening. Credit returns will predominantly come from interest carry, minus defaults. While issuance remains strong, the bulk of activity has come from higher-quality companies in sectors like tech, healthcare and consumer discretionary. Corporate balance sheets and cash flows are healthy, though we ve passed peak levels of strength. We continue to watch absolute levels of leverage and rating trends closely. We expect, on the margin, to see both fundamental and technical conditions weaken across extended credit markets. Current credit spreads appear fair, though what happens to energy and, more broadly, the commodity complex will continue to have an exaggerated effect on global high yield markets (see Figure 6). We expect mid-single-digit returns and favor higher-quality issuers. High yield markets can absorb modest Fed tightening, though they may exhibit stress if the Fed ends up having to tighten more aggressively. That isn t our base case view. FIGURE 5. Aggressive policy and low expectations 2-year sovereign yield, % 6 United States 5 Germany United States 3 2 Switzerland 0.0 Japan Germany 0-1 Japan -1.0 Switzerland Source: Bloomberg. Data as of December 2015.

8 6 MARKET THOUGHTS FIGURE 6. Energy has been an important driver of high yield spreads Spread, bps 1,200 High Yield Energy 1,100 1, High Yield Source: Bloomberg. U.S. high yield market shown. Data as of December Equity markets back to basics As dependence on quantitative easing (QE) has extended across developed markets, risk assets have adopted a somewhat perverse response mechanism to macro headlines: rallying on bad news and selling off on good news for fear that the stimulus punch bowl will be taken away. We have seen several market tantrums over the past few years, where good fundamental news has been met with market sell-offs. Bad news somehow became good for risk assets. We hope the year ahead takes us back to basics where good news is good, bad news is bad, and markets respond accordingly. It s easy to point to QE and the drumbeat for Fed tightening as culprits behind a challenging year for global equity markets. In reality, high valuations, as well as disappointing sales and earnings, had a lot more to do with it. Developed markets held up better than emerging markets a trend we expect to continue into the first half of Japan and the Eurozone have continued to benefit from the pass-through effects of weaker currencies and improving operating leverage. Being a global equity investor remains incredibly important. The phrase profit recession has been used to characterize what was a particularly challenging period for U.S. earnings over the past year. Sales growth was negative and earnings in aggregate about flat driven by energy, materials and industrials. Those three sectors make up about 20% of the U.S. equity market. While we are not overly concerned about current valuation levels, we have said repeatedly that U.S. equity market returns need to be driven by earnings growth. Earnings have been disappointing. Unlike in Europe, we see little scope for margin expansion in the United States. Some margin contraction, if it is due to higher wage pressure, would be welcomed. That means sales growth and financial engineering will continue to drive earnings growth and market returns. As our base case, we expect valuations to hold steady. We are taking U.S. consensus earnings of 8% 10% for 2016, and cutting them in half, as a starting point for our outlook. USD strength will weigh on sales growth and margins are likely to modestly contract, in line with rising wages. In turn, steadily rising wages should help support top-line sales growth. Financial engineering, whether in the form of robust merger and acquisition (M&A) activity, buybacks or higher payout ratios, will continue to play an important role supporting equity market returns in 2016.

9 OUTLOOK We continue to see stronger earnings growth for mid-cap versus large-cap stocks. In the United States, we continue to have exposures in equities that are lower on the market-cap spectrum. Mid-caps benefit from less direct exposure to foreign sales (they are more insulated from USD strength) and a higher weighting to financials. With this capitalization tilt, we reflect constructive views on M&A activity, USD strength, rising rates and domestic-led growth. Earnings dispersion was an important driver of sector returns in 2015, and we expect that to continue. But the year ahead is going to be more nuanced it is likely to be far more company-specific. That should favor active managers. We remain concerned about earnings growth in energy, materials and industrials commodity prices need to stabilize before we revisit any of these sectors. Initial earnings growth from these sectors is likely to be baseeffect driven very similar to emerging markets. While sales and earnings in Europe have been disappointing, that disappointment is driven predominantly by the United Kingdom and Switzerland, not the Eurozone. Eurozone sales and earnings have been solid, reflecting the benefits of a weaker currency and operating leverage, as margins slowly recover. The dispersion we see in underlying fundamentals across Europe is one of the reasons we re starting to see a better opportunity for active managers in Europe. What and where you invest in Europe matters it isn t about simple momentum. As our base case, we expect to see high-single-digit earnings growth in 2016 across the Eurozone. Unlike the United States, we see upside for margin improvement across the Eurozone. The upside argument for Eurozone equity markets is operating leverage; it isn t because valuations are cheap. Relative to their own history, as well as other developed markets, European equities are not cheap. High valuation is the one constant, looking across almost every market currently. It reflects where we are in the investment cycle (see Figure 7). Financial engineering is already playing an important role globally, and it should play an increasingly important support role in Europe. Buybacks have amounted to 1.0% 1.5% of market capitalization over the past 12 months and, on the margin, we see them increasing. M&A activity is accelerating (see Figure 8). We have seen a meaningful increase in mega-deals (greater than $10 billion in size) and inbound M&A activity from U.S. as well as Asian buyers especially China. We expect to see increased M&A activity from European buyers in Earnings growth in Japan will come down from the lofty double-digit levels we saw in 2015, as the translation benefits to earnings from a weaker currency dissipate. That said, for our base case we see earnings growth in high-single digits. Financial engineering will also play a stronger supporting role for Japanese equity markets. With the government s commitment to enhancing shareholder value through corporate governance and a focus on return on equity, we expect buybacks to increase. Japanese equity markets have the greatest capacity for multiple expansion across developed markets in The pause we have seen in re-rating came from investors questioning whether Japan can be more than a currency trade. The next 12 months are going to be pivotal. They will be watched carefully by global investors to see if Japan can deliver on far more than a weak currency. Right now, we believe momentum is on its side. FIGURE 7. Global valuation and profitability metrics FORWARD PRICE TO EARNINGS PRICE TO BOOK PRICE TO CASH FLOW RETURN ON EQUITY REGIONAL EQUITY MARKET CURRENT 10-YEAR AVERAGE CURRENT 10-YEAR AVERAGE CURRENT 10-YEAR AVERAGE CURRENT 10-YEAR AVERAGE United States % 15.6% Europe % 13.5% Japan % 7.4% Emerging Markets % 14.4% Source: FactSet, MSCI. Data as of November Forward price to earnings: ratio of price to next 12 months estimated earnings. Price to book: ratio of price to book value. Price to cash flow: ratio of price to last 12 months cash flow. Return on equity: last 12 months earnings as a percent of shareholder s equity.

10 8 MARKET THOUGHTS FIGURE 8. Global merger and acquisition volume acceleration Rolling fourth-quarter sum in billions (USD) 5,000 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1, Source: Bloomberg. Data as of Q We are constructive on Japanese and European equities across portfolios globally. In USD-denominated portfolios, we are hedging one-third to one-half of the underlying euro and yen currency exposure back into USD. In euro-denominated portfolios, we continue to hold tactical overweights to USD. Alternative investments a glass half full We generally saw strong first-half 2015 performance across our alternative investments. Alpha generation stalled in the second half of the year, as markets corrected and then quickly recovered. Hedge funds didn t lose as much as equity markets did on the way down in the correction, but they also didn t rally as much on the way back up. This is how we expect them to behave. We do not own hedge funds for directional equity market beta. If we want beta, we hold higher allocations to stocks where we are already overweight. Hedge funds allow us to allocate to risk assets without overreaching for directional market risk. Because of where we are in the investment cycle, and recognizing the fact that valuations aren t low, we like hedge funds as an intermediate allocation somewhere between stocks and credit. We invest in hedge funds in our portfolios for asymmetric returns. Depending on the market environment, hedge funds can behave like a 50/50 stock-bond mix in one setting, and a 20/80 mix in another. What we expect from hedge funds is performance that isn t driven purely by market direction we expect alpha as well as beta. Historically, a market environment in which directional risk assets are generating lower returns is a good environment for hedge funds. Hedge funds have also managed to perform well in rising interest rate environments. Both of these backgrounds reflect the investment environment we believe we face in the year ahead. We reduced allocations to event-driven hedge funds this past year, and prefer long-short equity and relative value strategies in our current allocation mix. We favor strategies with lower net exposures and more dynamic tactical positioning. Those strategies should be able to adapt and navigate what we expect to remain a choppy market. We have focused on exposure diversification, mixing activist exposure with trend followers. Hedge funds are doing what we need them to be doing in our allocation mix. That said, we want to see a more consistent and steady stream of alpha generation. We believe the dispersion across strategies over the past year reflects an erratic market environment, not a breakdown in the ability of hedge funds to generate alpha.

11 OUTLOOK Commodity markets a glass half empty We focus a great deal as a team on investment discipline both as it pertains to a market outlook, as well as portfolio design and our actual investment tool kit. Given the innovation we see continuously across financial markets, we want to make sure we re not missing something we could be using in portfolios, and that we re revisiting asset allocation design and challenging it. Each year, we evaluate the benefits of the asset classes that comprise long-term asset allocation. We consider allocation adjustments to calibrate portfolio goals in line with our forward expectations by monitoring asset class returns, volatility and correlations. While we have tactically been underweight commodities for several years now, this past year we challenged whether commodities continue to make sense as a risk diversifier in portfolios. After careful review, we have decided to remove them from our allocations. Eliminating commodities from our portfolios is a significant shift and rethinking of the tool kit we use to invest across markets globally. We did something similar last year as we reconsidered how best to use passive investment vehicles like ETFs strategically and tactically across regions. From a portfolio construction perspective, commodities have historically been attractive as a risk diversifier. They have shown low correlation both to equities and fixed income, and an ability to generate roll-yield. This roll-yield comes primarily from a declining sequence of asset prices in the forward market, also referred to as backwardation. We typically see it when producers hedge their price risk by selling the commodity in the forward market, creating a continuous source of pressure at longer-dated maturities and a tendency for the commodity forward prices to roll up the curve over time. We believe there has been a marked structural change in the commodities market over the past few years. Both the carry component and diversification benefits from holding commodities in a portfolio have been eroded as speculators have played a more important role in trading activity. The roll-yield we traditionally have counted on from backwardation has been diminished. We also see commodities challenged in their ability to generate strong returns as an asset class. That is particularly the case as global growth remains moderate and excess supply continues to be worked off across the global commodity complex. To put perspective and some numbers around this, the long-term expected returns that we use to set strategic allocations for commodities were revised lower to 3.0%, from a decade peak of 7.0% per annum. The volatility we forecast, using the same capital market assumptions, is 19% it was less than 10% a decade ago. Given our views on the medium-term headwinds facing the asset class, we are taking commodities out of traditional multi-asset portfolios that own them. We will continue to watch commodity markets closely for tactical investment opportunities. Additionally, allocations to macro hedge funds will continue to allow us to capture tactical opportunities across commodity markets.

12 10 MARKET THOUGHTS Portfolio positioning the path of least resistance is higher We remain constructive in our outlook, but we see more bumps ahead. Return expectations need to be lowered. Lower returns with higher volatility simply reflect where we are in the investment cycle. We ve seen several strong double-digit-return years since the financial crisis of That somehow gets forgotten the longer a bull market runs on. Higher than normal returns simply become expected; they shouldn t be. Market valuations have recovered back to what we would consider to be the fair-plus side of long-term normal depending on the market. It is interesting to note that portfolio diversification becomes more important the later we get in a cycle there is less of a value cushion to allow for being wrong. That puts greater emphasis on the need for diversification of investment risk across a portfolio. Asset allocation, at its core, is about measuring and managing investment risk. The further along in a cycle, the more important it becomes. Currently, we believe that argues for staying invested, but not overreaching for risk. We believe we are in a world where investors should expect, at best, low-single-digit returns from fixed income and, hopefully, mid-to-high-single-digit returns from equity markets. Equity market returns will be driven by earnings growth and dividends. If earnings disappoint, valuations will be under pressure as investors demand a higher risk premium for a less certain earnings stream. We saw that happen in the August and September market correction, as earnings and growth momentum stalled on the back of fears that China might be pulling the global economy into recession. A lack of clarity is discounted by markets in the form of higher risk premia whether wider credit spreads or lower equity multiples. We saw both of these in the market correction, and we may see them again. However, for our broader asset allocation, we prefer to see things trough before we reenter those markets. We don t believe we are there yet. Across developed markets, growth and quality should remain investment trends that will resonate across equity markets as we enter So should carry in the form of higher-dividend-paying equities. We continue to invest in hedge funds across portfolios that can own them, for the asymmetry of the return stream. We view hedge funds as an active allocation to alpha and less directional market risk. They are an important portfolio diversifier. We continue to favor long-short and relative value managers as complements to the more directional risk we are taking elsewhere in portfolios. In Balanced and Conservative portfolios, we are overweight funding overweights from fixed income. However, it is important to note that in Balanced and Growth portfolios, we have reduced exposure to the asset class over the past 12 months. Geopolitical risks are rising. That is likely to further weigh on sentiment. We have presidential elections in the United States to distract us as central bank policy divergence increases across developed economies. Anything that markedly influences interest rates will affect the price of all risk assets. That means higher volatility, greater sector and security dispersion and, on the margin, a little less certainty for the first half of Markets are rarely as extreme, or clear, as investors would like them to be. It s human nature. Corrections inevitably run longer than we expect, and we ve certainly seen that across global markets over the past six months. Market and macro expansions also tend to run longer. As I mentioned at the start of this note, we believe we ve entered the later stages of the investment cycle. That is an important transition point. That said, we believe the path of least resistance for markets, looking into 2016, is to move higher but at a slower and bumpier pace. Across portfolios, we are overweight global equities and alternatives versus fixed income. Coming into 2016, the size of our equity overweight versus benchmarks will be lower. We are overweight developed equity markets and avoiding emerging markets for now. I can t recall when I have not owned emerging markets in a portfolio. For long-term value investors with patient and stable hands, there are already interesting pockets of value.

13 OUTLOOK Biography Richard Madigan Chief Investment Officer J.P. Morgan Private Bank Richard Madigan is Chief Investment Officer and Head of Investment Strategy for J.P. Morgan Private Bank. In his role he is responsible for the development of investment strategy, tactical and strategic asset allocation for $1 trillion in high-net-worth and institutional client assets, including the firm s Global Access Portfolios. Richard is Chair of the Private Bank s Global Investment Committee. The CIO Team comprises market strategy, portfolio construction and a dedicated quantitative research and analytics team that also oversees investment risk. The team is global, with senior CIO Team members based in New York, London, Geneva, Hong Kong, Singapore and São Paulo. Strategy and Portfolio Construction for Latin America are based in New York. Richard brings over 20 years of experience in portfolio management and international capital markets to the firm. Prior to his current role, Richard held the title of CIO, Global Access Portfolios. Before joining J.P. Morgan, he was Managing Director, Head of Emerging Markets Investments and Senior Portfolio Manager at Offitbank, a New York based wealth management boutique, where he managed peak assets in excess of $1 billion in both domestic and offshore portfolios, including the firm s flagship emerging markets mutual fund. He was also a senior member of the firm s investment committee. Before joining Offitbank, Richard worked for J.P. Morgan s Investment Banking division in New York in the emerging markets securities business. He previously spent six years with Citicorp, first as a banker in Mexico, and then in the firm s international corporate finance division in New York. Richard s commentaries have appeared in the Financial Times, The New York Times, The Wall Street Journal, Bloomberg and Reuters. He is a frequent guest speaker on CNBC, and has also appeared on CNN and Bloomberg News, as well as various industry conferences. Richard holds a master s degree from New York University, where he majored in Finance and International Business. He has lived both in Europe and Latin America and currently resides with his wife and children in New York City.

14 12 MARKET THOUGHTS Index Definitions All index performance information has been obtained from third parties and should not be relied on as being complete or accurate. Indices are shown for comparison purposes only. While an investor may invest in vehicles designed to track certain indices, an investor cannot invest directly in an index. Barclays 10-Year Municipal Bond Index To be included in the Barclays 10-Year Municipal Bond Index, bonds must be rated investment grade (Baa3/BBB- or higher) by at least two of the following ratings agencies: Moody s, S&P, Fitch. If only two of the three agencies rate the security, the lower rating is used to determine index eligibility. If only one of the three agencies rates a security, the rating must be investment grade. They must have an outstanding par value of at least $7 million and be issued as part of a transaction of at least $75 million. The bonds must be fixed rate, have a dated-date after December 31, 1990, and must be at least one year from their maturity date. Remarketed issues, taxable municipal bonds, bonds with floating rates, and derivatives are excluded from the benchmark. Barclays Capital Global Aggregate Index This index provides a broad-based measure of the global investment grade fixed-rate debt markets. The Global Aggregate Index contains three major components: the U.S. Aggregate (USD 300mm), the Pan-European Aggregate (EUR 300mm), and the Asian-Pacific Aggregate Index (JPY 35bn). In addition to securities from these three benchmarks (94.1% of the overall Global Aggregate market value as of December 31, 2009), the Global Aggregate Index includes Global Treasury, Eurodollar (USD 300mm), Euro-Yen (JPY 25bn), Canadian (USD 300mm equivalent), and Investment Grade 144A (USD 300mm) index-eligible securities not already in the three regional aggregate indices. The Global Aggregate Index family includes a wide range of standard and customized subindices by liquidity constraint, sector, quality, and maturity. A component of the Multiverse Index, the Global Aggregate Index was created in 1999, with index history backfilled to January 1, (Source: Barclays Capital.) Dow Jones/UBS Commodity Index A broadly diversified index that allows investors to track commodity futures contracts on physical commodities. J.P. Morgan Corporate EMBI Global Index The J.P. Morgan Corporate EMBI Global Index includes U.S. dollar-denominated Brady bonds, Eurobonds, traded loans and local market debt instruments issued by sovereign and quasi-sovereign entities. J.P. Morgan Domestic High Yield Index The J.P. Morgan Domestic High Yield Index is an index designed to track the performance of the investable universe of the U.S. dollar domestic high yield corporate debt market. J.P. Morgan Global FX Volatility Index The J.P. Morgan Global FX Volatility Index is a benchmark for implied volatility across the global FX market. The VXYs are liquidity-weighted baskets of 3-month at-the-money implied volatilities based on FX options turnover reported in the BIS Triennial Central Bank Survey. The minimum daily turnover threshold is USD 300mm. The VXY Global covers 23 USD-based currency pairs. J.P. Morgan U.S. Liquid Index ex EM (JULI ex EM) The JULI ex EM measures the performance of the investment grade dollar-denominated corporate bond market excluding emerging markets. The JULI ex EM focuses on the most liquid instruments with the objective of making the index a fair and true representation of the investable market. The HFRI Fund of Funds Index includes multiple managers through funds or managed accounts. The strategy designs a diversified portfolio of managers with the objective of significantly lowering the risk (volatility) of investing with an individual manager. The Fund of Funds manager has discretion in choosing which strategies to invest in for the portfolio. A manager may allocate funds to numerous managers within a single strategy, or with numerous managers in multiple strategies. The minimum investment in a Fund of Funds may be lower than an investment in an individual hedge fund or managed account. The investor has the advantage of diversification among managers and styles with significantly less capital than investing with separate managers.

15 OUTLOOK MOVE Index Merrill Option Volatility Estimate. This is a yield curve weighted index of the normalized implied volatility on 1-month Treasury options. It is the weighted average of volatilities on the CT2, CT5, CT10 and CT30. MOVE is a trademark product of Merrill Lynch (weighted average of 1m2y, 1m5y, 1m10y and 1m30y Treasury implied volumes with weights 0.2/0.2/0.4/0.2, respectively). MSCI EAFE Index (Europe, Australasia, Far East) This is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the United States and Canada. As of June 2007, the MSCI EAFE Index consisted of the following 21 developed market country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom. MSCI World Index The MSCI World Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global developed markets. It captures large- and mid-cap representation across 23 developed market countries. The index covers approximately 85% of the free float-adjusted market capitalization in each country. S&P 500 Index The S&P 500 is a capitalization-weighted index of 500 stocks from a broad range of industries. The component stocks are weighted according to the total market value of their outstanding shares. The impact of a component s price change is proportional to the issue s total market value, which is the share price times the number of shares outstanding. S&P 500 is a trademark of Standard and Poor s Corporation. MSCI Emerging Markets (EM) Asia Index The MSCI EM Asia Index captures large and mid-cap representation across eight emerging market countries (China, India, Indonesia, Korea, Malaysia, the Philippines, Taiwan and Thailand). With 534 constituents, the index covers approximately 85% of the free float-adjusted market. MSCI Emerging Markets Index The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. MSCI Europe Index The MSCI Europe Index is a capitalization-weighted index that monitors the performance of stocks listed in the continent of Europe. MSCI Japan Index The MSCI Japan Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in Japan.

16 14 MARKET THOUGHTS IMPORTANT INFORMATION JPMorgan Chase & Co. and its affiliates do not provide tax advice. Accordingly, any discussion of U.S. tax matters contained herein (including any attachments) is not intended or written to be used, and cannot be used, in connection with the promotion, marketing or recommendation by anyone unaffiliated with JPMorgan Chase & Co. of any of the matters addressed herein or for the purpose of avoiding U.S. tax-related penalties. Each recipient of this presentation, and each agent thereof, may disclose to any person, without limitation, the U.S. income and franchise tax treatment and tax structure of the transactions described herein and may disclose all materials of any kind (including opinions or other tax analyses) provided to each recipient insofar as the materials relate to a U.S. income or franchise tax strategy provided to such recipient by JPMorgan Chase & Co. and its subsidiaries. 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17 OUTLOOK Conflicts of interest will arise whenever JPMorgan Chase Bank, N.A. or any of its affiliates (together, J.P. Morgan ) have an actual or perceived economic or other incentive in J.P. Morgan s management of its clients portfolios to act in a way that benefits J.P. Morgan. Conflicts will result, for example (to the extent the following activities are permitted in your account): (1) when J.P. Morgan invests in an investment product, such as a mutual fund, structured product, separately managed account or hedge fund issued or managed by JPMorgan Chase Bank, N.A. or an affiliate, such as J.P. Morgan Investment Management Inc.; (2) when a J.P. Morgan entity obtains services, including trade execution and trade clearing, from an affiliate; (3) when J.P. Morgan receives payment as a result of purchasing an investment product for a client s account; or (4) when J.P. Morgan receives payment for providing services (including shareholder servicing, recordkeeping or custody) with respect to investment products purchased for a client s portfolio. Other conflicts will result because of relationships that J.P. Morgan has with other clients or when J.P. Morgan acts for its own account. Investment strategies are selected from both J.P. Morgan and third-party asset managers and are subject to a review process by our manager research teams. From this pool of strategies, our portfolio construction teams select those strategies we believe fit our asset allocation goals and forward-looking views in order to meet the portfolio s investment objective. As a general matter, we prefer J.P. Morgan managed strategies. We expect the proportion of J.P. Morgan managed strategies will be high (in fact, up to 100%) in strategies such as, for example, cash and high-quality fixed income, subject to applicable law and any account-specific considerations. While our internally managed strategies generally align well with our forward-looking views, and we are familiar with the investment processes as well as the risk and compliance philosophy of the firm, it is important to note that J.P. Morgan receives more overall fees when internally managed strategies are included. We offer the option of choosing to exclude J.P. Morgan managed strategies (other than cash and liquidity products) in certain portfolios. Should you have any questions regarding the information contained in this material or about J.P. Morgan products and services, please contact your J.P. Morgan private banking representative. Additional information is available upon request. If you no longer wish to receive these communications, please contact your usual J.P. Morgan representative. Past performance is no guarantee of future results. Additional information is available upon request.