Capital Markets Update July 2015

2  A recent run of good data suggests that the U.S. economy is not nearly as weak as the first-quarter decline in GDP suggested. In particular, the consumer seems to be reviving, indicating that the long- awaited deployment of oil savings may finally be happening.  In Europe, the growth profile has improved, inflation has clearly bottomed and recent releases emphasized the upward trend in consumer prices. Low oil prices, interest rates and currencies are still stimulative, but slightly less so than before given a recent bounce in oil and yields, and retracement in currencies. Greece’s debt situation remains a major concern and little progress has been made towards reaching a deal.  Emerging-market growth is still generally decelerating, but the latest numbers in China were not quite as weak as expected and the Chinese government continues to roll out additional easing measures.  Overall, we now expect global growth to be slightly weaker in 2015 versus 2014, but to improve in The Economy

3  Economic data generally improved last month. Purchasing managers’ indices (PMIs) moved higher in the U.S., the Eurozone and China.  PMIs in the U.S. and the Eurozone are consistent with moderate growth, and although China’s PMI ticked higher too, it remains slightly below the 50 level which typically indicates a contraction in economic activity.  Data surprise indexes have also shown some improvement. Westpac’s indexes in the U.S. and Eurozone have begun trending higher after having troughed earlier in the spring.  The trend in economic data is behaving similarly to last year, and if 2015 plays out like 2014, we can expect the improvement to continue into the second half of the year. The Economy

4 Short-Term Interest Rates  Short-term interest rates remain low across developed nations.  In some parts of the world, though, the need for ultra-low interest rates is no longer evident. We expect the Fed to hike rates later this year and for the Bank of England (BoE) to do so in the first half of  While initial rate hikes are imminent in these regions, most monetary-policy adjustments are likely to be gradual and well telegraphed as central bankers can be patient in an environment of moderate growth and low inflation. Forecasts as of June 15, 2015

5 Fixed Income  Global bond yields have rebounded sharply, moving closer to level of equilibrium our models suggest.  As a result of the swift upward adjustment in yields, the acute valuation risk that was present in bonds when yields were extremely low is now less obvious.  In some regions, namely the U.S. and the U.K., bond yields are now above the midpoints of their equilibrium ranges.

6  German Bunds rose from 0.05% to over 1.00% in a period of less than two months. This is more than just a reflation story; we are seeing illiquidity and risk premiums reflected in asset prices.  During the bond market sell-off, inflation expectations have only moved slightly higher and growth forecasts have been relatively unchanged, if not lowered.  The Greek crisis is also putting upward pressure on bond yields. While we believe the chance of contagion from the Greek situation is relatively low, French and Belgian bond yields are pricing in this risk, having risen more than German Bund yields.  It appears that we are finally starting to see a return of the fixed-income risk premium that had disappeared during quantitative easing, which held yields low. Fixed Income Forecasts as of June 15, 2015

7  Concerns over Greece and an upcoming initial rate hike in the U.S. have caused equities to waver in recent weeks.  In aggregate, global stocks have become a bit cheaper relative to our composite fair value model.  In European and emerging markets, equities have dropped over 5% from their April peaks, while U.S. stocks have been in more of a sideways moving trend. Equity Markets Fair value is the minimum price level consistent with mild inflation/low interest rates in a growing economy. Above-average price appreciation remains a possibility in an environment where ‘normalcy’ is restored. Moreover, opportunity exists as valuations in some big markets still lie below their minimum expected levels. Corrections are always a possibility and valuations will not limit the risk of damage from systemic shocks, but the outlook for equity market returns is generally superior when stocks lie below fair value at the bands’ midpoint.

8  U.S. stocks have been supported by expanding price-to-earnings (PE) multiples so far this year.  That said, the S&P 500 is up a mere 1% year-to-date as the boost from PEs was almost entirely offset by a reduction in earnings.  Investors seem to be waiting for evidence that earnings will actually pick up later this year.  As valuations are now closer to equilibrium, the need for corporate profit growth becomes that much more important.  Earnings expectations appear to have stabilized, after dropping significantly with the decline in oil prices and the strengthening U.S. dollar in late 2014/early  Looking ahead into 2016, earnings are expected to rise meaningfully. As long as the economy continues to grow at a modest pace, we can expect corporations to deliver that earnings growth, supporting a further move higher in stocks. Equity Markets Forecasts as of June 15, 2015

9  Bond yields have risen considerably, but they are still at historically low levels and there is a risk that they could rise further as the Fed begins hiking interest rates.  Our expectation is for global growth to be moderate and inflation to remain low. In this scenario, yields could still rise, though at a gradual pace over a long period of time.  Increasing bond yields would lead to low or even negative total returns for fixed income investors as capital losses offset coupon income.  We expect a better outcome for stocks, as corporate profits should continue to expand and be supportive of mid-to-high single-digit returns. Thus, we expect stocks to outperform bonds, and trailing 10-year relative returns are consistent with that view.  As a result, we have maintained our underweight in bonds and overweight stocks. For a balanced global investor, we recommend an asset mix of 60% equities, 38% bonds, with the balance of 2% in cash. Asset Mix Asset mix as of June 15, 2015

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