Long-term Capital Market Assumptions December 9, 2010 Stu Schweitzer, Global Markets Strategist 212-464-1230, stuart.a.schweitzer@jpmorgan.com Tony Werley, Head of Portfolio Construction 212-464-1650, anthony.d.werley@jpmchase.com
J.P. Morgan view: Moderate growth to send shares and interest rates higher over time The global economy is expected to experience subpar (although possibly improved) growth for a while to come. But the growth shortfall will likely give way to much better conditions over time Inflation is expected to remain subdued in the near term but ultimately to rebound considerably, propelled by policy stimulus, higher service-sector costs and higher commodity prices. Expected average inflation rates have been lowered only marginally Globalization is expected to allow Western companies to improve revenue growth while also keeping them under pressure to continue to cut costs. Corporate profits are expected to continue to outperform home-country economic growth Bond yields are likely to rise considerably from today s levels, although not for a while. Fixed income returns are likely to be hurt as yields rise toward expected higher equilibrium levels Equity returns are likely to benefit from positive surprises over time relative to the widespread pessimism that prevails today. Emerging markets are likely to remain top performers The outlook for real estate returns remains favorable, reflecting the current depressed level of property prices and the likelihood of improved operating fundamentals Opinions, estimates, forecasts, projections and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. There can be no guarantee they will be met. 1
Revised long-term forecasts in context Compound annualized returns (USD terms) 18 16 2000 2010* Last year's projection This year's revised projection 15.71 14 12 Per rcent 10 8 6 4 7.50 7.75 7.75 3.49 7.25 9.50 9.00 6.45 6.49 4.50 3.75 7.50 6.50 2 0 0.81 S&P 500 EAFE EM Equity U.S. Aggregate Fixed Income U.S. High Yield Bonds Source: Bloomberg, MSCI, LehmanLive, J.P. Morgan * As of November-end The charts and/or graphs shown above and throughout the presentation are for illustration and discussion purposes only. Past performance is not indicative future returns. 2
Return methodology Fixed income return equilibrium yield +/- change in bond prices Equity return inflation + real earnings growth + dividend yield +/- impact of valuation changes Alternative asset returns historical return drivers adjusted for the relationship to public markets 3
U.S. household balance sheets were dealt a staggering blow in the past few years Household assets and liabilities f disposable income (%) 4-quarter change as a percent of 100% Household Assets Household Liabilities 50% 0% 0-50% -100% -150% 1970 1975 1980 1985 1990 1995 2000 2005 2010 Source: Federal Reserve, J.P. Morgan. As of Q2 2010. Past performance is no guarantee of future results 4
Fiscal austerity in peripheral Europe, without currency devaluation as an option, is very difficult Real GDP Index, 100 = Q1 2009 Past European currency devaluations during fiscal adjustments Devaluations in USD 106 90 105 104 103 102 101 100 99 98 97 96 95 1Q08 3Q08 1Q09 3Q09 1Q10 Germany, France Portugal, Ireland, Spain, Greece Pe ercent 80 70 60 50 40 30 20 10 0 ITA '75 -'76 POR '76 - '85 DEN '80 - '85 IRL '80 - '85 ESP '81 - '85 BEL '81 - '85 GRE '81 - '85 ITA '92 - '94 GBR '92 - '93 FIN '92 - '93 SWE '92 - '94 AUT '95 - '00 FRA '98 - '00 Source: National sources, J.P. Morgan. As of Q2 2010. Past performance is no guarantee of future results 5
Japan continues to lag in efficiency and profitability Labor productivity Index, 100 = Calendar Year 2000 125 120 United States Corporate profits Indexes, 100 = Q1 2007 120 110 United States 115 100 110 105 100 95 Japan 90 80 70 60 50 Japan 90 40 85 30 80 90 94 98 02 06 10 20 2007 2008 2009 2010 Source: Bureau of Economic Analysis, Bureau of Labor Statistics, ESRI, J.P. Morgan. As of Q2 2010. Past performance is no guarantee of future results 6
Emerging markets: Comparatively strong growth fundamentals Emerging vs. developed economies GDP levels Index,100 = Q1 2005 125 Emerging economies Global consumption share Proportion of consumer spending 40% 120 115 35% United States Emerging markets rcent 110 Per 30% 105 100 Developed economies 25% 95 2005 2006 2007 2008 2009 2010 20% 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 Source: J.P. Morgan Securities LLC. As of Q2 2010. Past performance is no guarantee of future results Source: J.P. Morgan Securities. As of Q2 2010. 7
The U.S. dollar is cheap, but not unprecedentedly so. But beware of easy conclusions about the outlook for the Greenback Real trade-weighted U.S. dollar index Index, 2000 = 100 130 120 110 100 90 80 70 1970 1975 1980 1985 1990 1995 2000 2005 2010 Source: J.P. Morgan. Data as of October 21, 2010 Past performance is no guarantee of future results 8
History suggests a risk of renewed inflation after the current slump U.S. consumer prices 10 inflation rates (%) Annualized 10 year 8 6 4 2 0-2 -4 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 Sources: U.S. Bureau of Labor Statistics, Robert J. Shiller ( Irrational Exuberance, Princeton University Press, 2005), J.P Morgan. Data as of October 2010. Past performance is no guarantee of future results. 9
Commodities might start the inflationary process, but they won t necessarily feed through to core prices Consumer vs. commodity price inflation Core CPI inflation 20 Core CPI CRB All Commodities Spot Index (right axis) Commodity inflation 70 60 15 10 5 0 50 40 30 20 10 0-10 -20-30 -5 65 70 75 80 85 90 95 00 05 10-40 Source: U.S. Bureau of Labor Statistics, Bloomberg, J.P Morgan. Data as of October 2010. Core inflation equals Consumer price inflation excluding food and energy Past performance is no guarantee of future results. 10
The pressure to cut costs to persist for a long while to come Hourly compensation costs for production workers 60 50 40 $ U.S. 30 20 10 0 Norway Denmark Sweden Euro Area Australia U.K. Canada U.S. Japan Korea Singapore Hungary Taiwan Brazil Hong Kong Mexico China Philippines Vietnam Source: Bureau of Labor Statistics, Empirical Research Partners. J.P. Morgan. United States and China as of 2009 other countries as of 2007 or 2008. Euro Area includes Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain. 11
Interest rates likely to be the deciding factor Interest rates vs. inflation 20 Core CPI Fed Funds 10-yr Treasuries 18 Percent change vs. year ago 16 14 12 10 8 6 4 2 0 65 70 75 80 85 90 95 00 05 10 Source: U.S. Bureau of Labor Statistics, Federal Reserve, J.P Morgan. Data as of October 2010 Past performance is no guarantee of future results. 12
Developed market economic outlook Compound 10 15 year growth and inflation United States (%) Headline inflation 3.00 Core inflation 2.50 GDP 2.50 Europe (%) Headline inflation 2.00 Core inflation 1.75 GDP 1.50 U.K. (%) Japan (%) Headline inflation 2.75 Core inflation 2.25 GDP 2.00 Headline inflation 0.75 Core inflation 0.50 GDP 1.00 Source: J.P. Morgan Asset Management estimates The assumption chart is for illustrative purposes only. This chart should not be relied upon as a recommendation 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. References to specific asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as recommendations. 13
Fixed income Equilibrium fixed income assumptions Current yield (%)* Equilibrium yield (%) Return (%) U.S. Core Inflation 2.50 2.50 U.S. Cash 2.50 2.50 U.S. Municipal bonds 2.76 4.00 3.00 U.S. Government bonds 2.51 4.50 3.00 U.S. 10-yr Treasury 2.80 4.75 3.00 U.S. TIPS (real yield) 0.88 1.50 3.75 U.S. Corporate bonds 3.79 6.25 4.75 U.S. High Yield bonds 8.20 8.75 6.50 Non-U.S. WGBI (USD) 2.12 3.00 2.50 Emerging Market debt (USD) 5.99 7.25 6.25 Local Sovereign EM debt (USD) 6.66 6.50 6.50 Corporate EM debt (USD) 5.92 7.50 6.50 U.S. inflation Low nearer term inflation given economic slack; inflation may rise as economy recovers headline inflation expected to outstrip core U.S. fixed income higher rates and subdued spreads central banks likely to keep real policy rates close to zero government bond yields should rise from historic lows credit spreads close to equilibrium Non-U.S. fixed income relatively low developed world government bond returns with boost from currency EMD spreads close to equilibrium Source: J.P. Morgan Asset Management estimates. Equilibrium fixed income yields have been rounded to the nearest 25 bps. * As of November 30, 2010. Opinions, estimates, forecasts, projections and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. There can be no guarantee they will be met. 14
Credit spreads still look attractive, but far less so than in recent years Corporate debt spreads 700 600 500 High yield debt spreads 2,000 1,800 1,600 1,400 Basis points 400 300 Basis points 1,200 1,000 800 200 600 100 400 200 0 90 94 98 02 06 10 0 90 94 98 02 06 10 Source: Barclays Capital, J.P. Morgan. Data as of November 19, 2010. Source: Barclays Capital, J.P. Morgan. Data as of November 19, 2010. 15
Equity Compound (IRR) 10 15 year returns Equity returns (%) U.S. Core Inflation U.S. GDP 2.50 2.50 U.S. large cap U.S. small cap 7.75 8.25 EAFE (USD) 7.25 Europe ex-u.k. (local) 7.75 Japan (local) 4.50 U.K. (local) 8.00 U.S. equity EPS growth slightly above nominal GDP small rise in dividend yields from current levels valuations unlikely to rise materially given uncertainties over deleveraging and future price inflation Non-U.S. equity Europe, Japan, U.K. EPS growth above nominal GDP deflationary pressures likely to persist in Japan, limiting nominal returns emerging markets likely to outperform developed Canada (local) EME (USD) 8.25 9.00 Source: J.P. Morgan Asset Management estimates Opinions, estimates, forecasts, projections and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. There can be no guarantee they will be met. 16
Equities still appear historically cheap, especially relative to bonds Compound (IRR) 10 15 year returns U.S. equity risk premium Estimated Dividend Discount Rate minus corporate bond yield 6 5 2009 market bottom 4 2003 market bottom Perce ent 3 2 1 0-1 -2 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 Source: J.P. Morgan. Data as of November 2010. A dividend discount rate (DDR) is the discount rate which equates the present value of the estimated stream of future dividends to the current market price. The J.P. Morgan DDR is a bottom-up, sector-neutral and capitalization weighted average of dividend discount rates (DDRs) on large-capitalization stocks as estimated by J.P. Morgan Asset Management equity research analysts. A DDR does not represent a stock's expected actual return in any given time period. Bond yield used in the risk premium calculation is average yield on A and Baa rated long-term corporate bonds. Past performance is no guarantee of future results. 17
The global not domestic economy is the key influence on U.S. and European corporate revenue growth United States Annual growth rate 10 9 8 1996-2010 Q2 2010E Euro Area Annual growth rate 12 10 1996-2010 Q2 2010 Perc cent 7 6 5 Perc cent 8 6 4 3 4 2 1 2 0 S&P 500 Core Revenues World GDP U.S. GDP 0 Euro Area Core Revenues World GDP Euro Area GDP Source: Standard & Poor's, U.S. Department of Commerce, International Monetary Fund, Corporate Reports, Empirical Research Partners, J.P. Morgan. Core revenue excludes energy, financials and utilities. Source: Eurostat, International Monetary Fund, Corporate Reports, Empirical Research Partners, J.P. Morgan. Core revenues exclude energy, industrial commodities, financials and utilities. 18
U.S. equity building blocks Equity return components Expected total return = 7.75% Valuation impact: Zero Dividend yield: 2.50% Real earnings growth: 2.75% Inflation (core): 2.50% Valuations still slightly below historical averages, but unlikely to rise materially given uncertainties over deleveraging and future price inflation Moderate increase in preference for dividend payouts as companies remain conservative over investment and hiring outlays Earnings growth slightly above nominal GDP as companies maintain cost discipline and continue to benefit from foreign-sourced revenues Low inflation in the nearer term, but nearzero real rates and eventual economic recovery mean upside risk in the longer-term Source: J.P. Morgan Opinions, estimates, forecasts, projections and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. There can be no guarantee they will be met. 19
Real assets U.S. dollar-based assumptions. Compound (IRR) 10 15 year returns Real assets (%) REITs 6.50 REIT returns slight shortfall versus direct real estate, given less attractive valuation after price run-up U.S. direct real estate (unlevered) U.S. value added real estate European direct real estate (unlevered, local) Global Infrastructure Commodities 7.00 8.25 6.75 8.00 7.00 Real estate and infrastructure returns typically less than equity, more than fixed income but U.S. property valuations remain depressed value added boosted by acquisition expertise European property slightly boosted by lower liquidity, but valuations are less attractive Infrastructure likely to benefit from exposure to regulated utilities and leverage Commodities returns in line with global nominal GDP Source: J.P. Morgan Asset Management estimates Opinions, estimates, forecasts, projections and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. There can be no guarantee they will be met. 20
Alternative assets U.S. dollar-based assumptions. Compound (IRR) 10 15 year returns Alternative assets* (%) Private equity 8.25 Hedge funds Event Driven 7.00 Long Bias 7.50 Relative Value 5.00 Macro 7.50 Diversified 6.25 Private equity returns industry medians slight premium to large cap public markets expect wide differentials between managers Hedge fund returns industry medians Event Driven: expected returns between equities and credit Long Bias: expected to return a small discount to global equities Relative Value: expected to return a premium to global bonds Macro: derived from risk-taking in global equity, fixed income, commodities, and currency Diversified: expected returns are a blend of global equity and fixed income betas expect wide performance differential Source: J.P. Morgan Asset Management estimates * Industry medians Private Equity and Hedge Funds are unlike other asset classes shown above, in that there is no underlying investible index. The return estimates shown above for these assets are our estimates of industry medians; the dispersion of returns among different managers in these asset classes is typically far wider than in traditional assets. Given the complex risk-reward tradeoff in these assets, we counsel clients to rely on judgment rather than quantitative optimization approaches in setting strategic allocations to these asset classes. Opinions, estimates, forecasts, projections and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. There can be no guarantee they will be met. 21
A market-driven approach to projecting hedge fund returns HFRI Equity Long Bias hedge fund returns and factor description for July 2005 to June 2010 Factors contributing to equity long bias returns Risk taking volatility contribution (%) -12 70 60 50 40 30 20 10 0 4 0-4 -8 Jul-05 U.S. Equities Int'l Equities Commodities Volatility Credit Governments Cash FX Manager Actual monthly HFRI returns plotted with the combined returns of its market exposures as identified by the Factor Model 8 HFRI Equity Hedge Returns Expected Factor Returns Percent Sep-05 Nov-05 R 2 = 98% Jan-06 Mar-06 May-06 Jul-06 Sep-06 Nov-06 Jan-07 Mar-07 May-07 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 Jan-10 Mar-10 May-10 Source: Hedge Fund Research, J.P. Morgan. Past performance is no guarantee of future results. It is not possible to invest directly in an index. 22
Concluding comments Economic recovery likely to remain intact, but multi-year deleveraging in the developed world to keep global growth below prior trend rates; markets may deliver only moderate overall returns Today s high levels of spare economic capacity are likely to persist for years, keeping inflation and interest rates low, but aggressive central bank stimulus should eventually push inflation and yields higher as conditions in the global economy normalize Emerging economies should remain on a strong secular growth trend, with emerging markets outpacing developed markets by a wide margin Alternative investments and real assets important for their diversification benefits, ability to capitalize on distressed opportunities and lower susceptibility to the volatility of traditional risk assets It is near-impossible for quantitative optimization techniques to arrive at recommended portfolios that account for asset liquidity or illiquidity and its impact on real-world investment results. There is no substitute for judgment Opinions, estimates, forecasts, projections and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. There can be no guarantee they will be met. Diversification does not guarantee investment returns and does not eliminate the risk of loss. 23
Important information Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The views and strategies described may not be suitable for all investors. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. Note: 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 to all the above asset classes. 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 as a promise of future performance. Note that these asset class assumptions are passive only they do not consider the impact of active management. References to future returns for either asset allocation strategies or asset classes are not promises or even estimates of actual returns a client portfolio may achieve. J.P. Morgan Asset Management Long-term Capital Market Return Assumptions are developed each year by our Assumptions Committee, a multi-asset class team of senior investors from across the firm. The Committee relies on the input and expertise of a range of portfolio managers and product specialists, striving to ensure that the analysis is consistent across asset classes. The final step in the process is a rigorous review of the proposed assumptions and their underlying rationale with the senior management of J.P. Morgan Asset Management. Our capital market assumptions are used widely by institutional investors including pension plans, insurance companies, endowments and foundations to ensure that investment policies and decisions are based on real-world, consistent views and can be tested under a variety of market scenarios. 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. J.P. Morgan Asset Management is the marketing name for the asset management businesses of JPMorgan Chase & Co. Those businesses include, but are not limited to, J.P. Morgan Investment Management Inc., Security Capital Research & Management Inc. and J.P. Morgan Alternative Asset Management Inc. Copyright 2009 JPMorgan Chase & Co. Copyright 2010 JPMorgan Chase & Co. 24
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