BlackRock

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BlackRock Investment Institute

Portfolio construction

Capital market assumptions

US DOLLAR | AUGUST 2019

FOR INSTITUTIONAL, PROFESSIONAL, QUALIFIED INVESTORS AND QUALIFIED CLIENTS ONLY

Summary

Moves in financial markets in the first half of the year, particularly plunging bond yields, have had a material impact on our capital market assumptions (CMAs). Yet our overall strategic asset preferences are consistent with our prior update in February. Why? Our use of robust optimisation techniques and incorporation of uncertainty dampens the need to make big shifts in portfolio positioning that can occur with a reliance on single-point return estimates. Our paper April 2019 Understanding uncertainty explores this further. Our updated returns take into account our view that the low interest rate environment will persist in the medium term. We will dig deeper into our thinking on asset allocation in an "even lower for even longer" market regime next month, as well as introduce investor-specific strategic asset allocations (SAAs).

? Our strategic asset class views convey our asset class preferences over a 10-year horizon. Based on our

cyclical views and current market valuations, asset classes may be more or less favourable than in a longrun, steady-state environment. We express our views in a whole portfolio context to illustrate our preferences. The views are based on our risk and return expectations and aversion to uncertainty. Our return expectations, updated with data to the end of June, have broadly fallen compared with our previous update in February, largely due to tumbling bond yields and the hefty rally in equities. Yet our broad strategic asset views-- a preference for a barbell approach with allocations to equities and government bonds over credit on a 10-year view -- have not changed materially.

? Government bonds remain among our biggest overweight tilts, if slightly reduced from our last update.

This underscores our belief that the asset class retains a core role as a portfolio diversifier during risk asset selloffs. We trim our overweight due to reduced returns in fixed income after the sharp drop in yields. The drop in expected government bond returns is magnified by the inclusion of forward market pricing of short-term rates over the next few years, reinforcing the even lower for even longer view. We find inflation-linked bonds attractive given our view that markets are significantly underpricing the potential for inflation surprising to the upside over the medium term, especially in Europe, after years of subdued price rises. High valuations and late-cycle concerns tilt us away from global credit. Within private markets, we prefer growth assets over income assets as the latter face similar vulnerabilities as credit. Our long-term allocation to private markets remains sizeable.

? Within developed market equities, we prefer developed market (DM) equities outside the U.S. In the U.S.,

where equities have risen to record highs, richer starting valuations keep us underweight on a strategic time horizon. Yet a better earnings growth relative to other regions spurs us to trim the level of underweight compared to our last update. In Europe, less rosy earnings growth offsets the upside from attractive dividend yields relative to other regions and more appealing starting valuations. We pare our overweight on emerging market (EM) equities as our earnings growth expectations have fallen and valuations have risen. The lower expected return now offers less compensation for the additional risk of the emerging market equities relative to developed market peers, in our view.

Authors

Philipp Hildebrand Jean Boivin

Anthony Chan Paul Henderson Vivek Paul

Contributors

Natalie Gill Christian Olinger Michael Palframan

BLACKROCK INVESTMENT INSTITUTE

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FOR INSTITUTIONAL, PROFESSIONAL, QUALIFIED INVESTORS AND QUALIFIED CLIENTS ONLY

Interpreting our strategic views

We apply our portfolio construction framework to generate our strategic asset allocation tilts on a 10-year horizon relative to a long-term equilibrium portfolio. The chart on the following page summarises our current tilts. This is from the perspective of a local currency investor targeting around 7% volatility on an asset-only basis with few constraints. The strategic views do not account for implementation considerations or practical limitations some investors may face. We will soon start publishing SAAs for different investor types that will account for typical objectives and constraints.

The sharp move lower in rates over the last quarter are central to our views. The plunge in bond yields means that investors are likely facing an environment where interest rates are likely to be even lower for even longer in coming years. The U.S. economy's entry into a late-cycle stage spurs a more cautious stance and heightens the need to build in portfolio resilience. We still believe the diversification offered by global government bonds is still meaningful even as yields have hit historical lows. We prefer a barbell strategy tilting towards global government bonds and non-U.S. developed market equities over credit.

Falling yields have hit our expected returns across a wide swathe of asset classes, notably fixed income. The rally in bonds this year has led to richer starting valuations, dragging down expected returns across all fixed income sub-categories we track. The low absolute level of yields have also dimmed bonds' carry potential. This lower expected return cuts our tilt to global government bonds, yet the asset class still remains one of our biggest overweights due to the portfolio diversification benefits. Inflation-linked bonds, particularly in Europe, hold appeal - both as a ballast to equity selloffs driven by growth shocks and to underappreciated inflation risks. We see market pricing of future inflation as too downbeat relative to our expectations. A blend of nominal and inflation-linked bonds in strategic portfolios can help create resilience to a variety of adverse conditions, in our view.

A sizeable allocation to DM equities, with a preference for developed markets outside the U.S., balances our overweight on government bonds. We also turn less bullish on EM equities than before, as actual earnings growth underwhelms and the potential for above-trend margins to revert lower to their historical average as late-cycle dynamics kick in. Our earnings growth estimates for EM are now below the median growth seen since 1995.

Asset return expectations

We have updated our ve-year mean expected returns using data to end-June. Bond yields have plunged since our last CMA update in February. Risk assets have rallied, with U.S. equities hitting a record peak. These market moves have resulted in several central return expectations falling from our last update, particularly in fixed income markets. Use the chart below to compare different assets.

Equities: Overall expected returns have fallen across the board, with valuations and our estimates for earnings growth the biggest drags. The earnings growth hit is the highest in EM.

Government bonds: Higher starting valuations and lower expected income following the sharp slide in yields drags down our expected returns for DM government bonds. We now see negative returns for eurozone, Japanese, and UK government bonds on a five-year view.

Credit: Lower government bond yields have dampened expected returns for credit assets.

Private markets: We estimate major private markets returns using data and models that capture dynamics in each speci c market (further detail on our return models can be found in our March 2019 private markets paper). In private credit, lower rates and the longer mean reversion time diminishes anticipated yields. Our real estate estimated returns have risen marginally as leverage is a little cheaper now given the drop in yields.

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BlackRock strategic views

Strategic tilt

Hypothetical US dollar 10-year strategic allocation vs. our equilibrium view

June 2019

February 2019

Global governments

DM equity

DM high yield and EM debt

Growth private markets

Mortgage backed securities

EM equity

Global IG credit

Income private markets

10

7.5

5

2.5

0

2.5

5

Underweight

Overweight

7.5 10%

This information is not intended as a recommendation to invest in any particular asset class or strategy or as a promise - or even estimate - of future performance.

Source: BlackRock Investment Institute, August 2019. Data as of 28 June, 2019. Notes: The bar chart shows how our 10-year hypothetical asset allocation for an unconstrained US dollar-based portfolio deviates from our equilibrium view in percentage points. The strategic tilts are rounded to the nearest +/ 2.5%, as a result they may not sum to zero. Income private markets include infrastructure debt, direct lending, real estate mezzanine debt and US core real estate. Growth private markets include US private equity buyouts and infrastructure equity. The hypothetical portfolio may differ from those in other jurisdictions, is intended for information purposes only and does not constitute investment advice.

Asset return expectations and uncertainty

Select return time period (years) 5

25% 20 15 10 5 0 5

Mean expected return June 2019

February 2019

Mean return uncertainty

Interquartile range

Expected annualised return

Long Government bonds Credit (10+ years) Ex US gov. bonds

Ination-linked bonds Government bonds Aggregate bonds Credit Agency MBS Local EM debt USD EM debt High yield

Global 60/40 portfolio EM equities US equities

Europe equities US Small cap

Infrastructure debt US real estate

Hedge funds (global) Direct lending

US private equity (buyout)

This information is not intended as a recommendation to invest in any particular asset class or strategy or as a promise - or even estimate - of future performance.

Source: BlackRock Investment Institute, August 2019. Data as of 28 June, 2019. Notes: Return assumptions are total nominal returns. US dollar return expectations for all asset classes are shown in unhedged terms, with the exception of global ex US Treasuries and hedge funds. Our CMAs generate market, or beta, geometric return expectations. Asset return expectations are gross of fees. For a list of indices used, visit our Capital Market Assumptions website at institutions/en-us/insights/charts/capital-market-assumptions and click on the information icon in the Assumptions at a glance table. We use BlackRock proxies for selected private markets because of lack of sufcient data. These proxies represent the mix of risk factor exposures that we believe represents the economic sensitivity of the given asset class. There are two sets of bands around our mean return expectation. The darker bands show our estimates of uncertainty in our mean return estimates. The lighter bands are based on the 25th and 75th percentile of expected return outcomes ? the interquartile range, for more detail read our recent Portfolio persectives. Indices are unmanaged and used for illustrative purposes only. They are not intended to be indicative of any fund or strategy's performance. It is not possible to invest directly in an index.

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Assumptions at a glance

Asset

Return expectations (geometric, gross of fees)

5 year

10 year

15 year

20 year

US government (10+ years)

0.4% 0.3% 1.0% 1.4%

US credit (10+ years)

0.6% 1.9% 3.2% 4.1%

Global ex US government bonds 1.1% 1.6% 2.0% 2.3%

US ination-linked government bonds

1.3% 1.7%

2.1%

2.4%

US government bonds (all maturities)

1.4% 1.7% 2.1% 2.3%

US aggregate bonds

1.6% 2.0% 2.4% 2.7%

US credit (all maturities)

1.6% 2.3% 3.0% 3.4%

US agency MBS

1.6% 2.0% 2.2% 2.4%

US cash

1.8% 2.1% 2.3% 2.4%

Local currency EM debt

2.7% 3.0% 3.2% 3.3%

USD EM debt

2.9% 3.5% 4.1% 4.5%

US high yield

4.5% 4.7% 4.9% 5.1%

Emerging large cap equities

5.5% 6.4% 7.3% 7.9%

US large cap equities

5.5% 6.0% 6.5% 6.8%

Europe large cap equities

5.7% 6.2% 6.7% 7.1%

US small cap equities

5.8% 6.3% 6.8% 7.1%

Global ex US large cap equities 5.9% 6.4% 6.7% 7.0%

Developed infrastructure debt

2.3% 3.1% 3.8% 4.2%

US Infrastructure debt

4.0% 4.7% 5.3% 5.7%

Real estate mezzanine debt

4.9% 5.3% 5.8% 6.1%

US core real estate

5.1% 5.3% 5.4% 5.5%

Hedge funds (global)

5.5% 5.8% 6.1% 6.2%

Global infrastructure equity

6.9% 7.1% 7.3% 7.4%

Global direct lending

7.3% 7.7% 8.0% 8.2%

US private equity (buyout)

13.1% 13.2% 13.2% 13.1%

Long-term expected volatility

14.2% 12.1% 3.3%

5.7%

5.0%

4.0% 5.8% 2.1% 0.0% 12.2% 9.1% 7.8% 22.4% 16.0% 18.3% 19.2% 16.4% 8.5% 9.6% 10.9% 14.6% 7.1% 17.8% 13.4% 30.0%

Long-term correlation

Global equities

30% 24% 22%

Global government bonds 77% 55% 100%

1%

49%

38%

16% 15% 25% 0% 52% 36% 62% 80% 88% 89% 87% 91% 25% 20% 61% 43% 80% 63% 74% 80%

77%

76% 61% 57% 0% 7% 35%

6% 13% 18% 15% 19% 15% 47% 49% 5% 6% 27% 2% 22% 24%

This information is not intended as a recommendation to invest in any particular asset class or strategy or as a promise - or even estimate - of future performance.

Source: BlackRock Investment Institute, August 2019. Data as of 28 June, 2019. Notes: Return assumptions are total nominal returns. US dollar return expectations for all asset classes are shown in unhedged terms, with the exception of global ex US Treasuries and hedge funds. Our CMAs generate market, or beta, geometric return expectations. Asset return expectations are gross of fees. Forecasted future performance is not a reliable indicator of future results. We use long-term volatility and correlation expectations. We break down each asset class into factor exposures and analyse those factors' historical volatilities and correlations over the past 18 years. Correlations with global equities and bonds are based on global measures excluding domestic equities and bonds. We combine the historical volatilities with the current factor makeup of each asset class to arrive at our assumptions. This approach takes into account how asset classes evolve over time. Example: Some xed income indices are of shorter or longer duration than they were in the past. Our expectations reect these changes, whereas a volatility calculation based only on historical monthly index returns would fail to capture the shifts. Indices are unmanaged and used for illustrative purposes only. They are not intended to be indicative of any fund or strategy's performance. It is not possible to invest directly in an index. For a list of indices used, visit our Capital Market Assumptions website at institutions/en-zz/insights/charts/capital-market-assumptions and click on the information icon in the Assumptions at a glance table.

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