US Perspective on Market Assumptions and Dynamic PERSPECTIVE ON MARKET ASSUMPTIONS AND DYNAMIC...

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    Macro Market Environment All major asset classes posted positive returns in the second quarter. An improving growth outlook and accommodative monetary policy helped to push the MSCI ACWI Index higher and bonds rose as Treasury yields declined and credit spreads tightened further.

    The global economy appeared to regain momentum in Q2, and growth is poised to become more synchronized across the major developed and emerging economies. We remain optimistic on the outlook for the global economy, especially in the developed world. In emerging markets, the outlook is more challenging because of the build-up of imbalances over the last few years. While the Fed remains on track to end QE3 in the fourth quarter, we still consider monetary policy supportive of risky assets as the process of interest rate normalization should be slow.

    Capital Market Assumptions Interest rates declined during the quarter, and credit spreads contracted. The yield curve flattened as yields for maturities up to three years were close to unchanged, while longer-term yields declined. This led to a decrease in expected returns for government bonds and credit. Longer maturity expected returns decreased more than shorter maturity asset classes.

    Within fixed income, we changed the approach for transitioning from initial yields to equilibrium yields to better incorporate market expectations for monetary policy. Given that our equilibrium yield assumptions are higher than current yields, the change resulted in lower expected fixed income returns over a 20 year time horizon due to lower reinvestment rates as it takes longer to reach equilibrium. We lowered the default rate assumptions for high yield bonds over the next two years from 4% and 5% to 3% for both years. The change was made to reflect the expected economic environment over the next two years.

    Equity markets posted solid returns for the quarter, so valuations increased while future return expectations generally decreased. For EM equities, we slightly adjusted the GDP growth assumption from 4.2% to 4.1% to reflect a slowdown in expected growth. Along with an uptick in valuations, this change reduced expected returns by 30 bps.

    Dynamic Asset Allocation Market Views The following summary presents our views on the market outlook and valuations over a medium-term horizon. We have included views for core asset classes relative to Mercers equilibrium expectations. These views are based on conditions as of June 30, 2014. We do not expect clients to make frequent tactical changes to their asset allocation based upon these views. They are provided for discussion purposes and do not provide any assurance or guarantee of future market returns.

    We continue to believe that the environment of solid growth, low inflation and low interest rates is supportive of equity markets and other risky assets. However, equity valuations are elevated, especially in the US. Outside the US, valuations are more reasonable, and there is greater potential upside for earnings due to stabilizing macro conditions in the Eurozone and the possibility of structural reform in Japan.

    Valuations on EM equities appear compelling, although this is driven by a few sectors and countries. While the macro picture has stabilized, it is too early to know if this represents the start of a turnaround in EM fortunes given the uncertainty surrounding the potential for structural reform and the sensitivity to Fed tightening. Nevertheless, for an intermediate-term time horizon, we continue to rate EM equities as attractive and suggest overweighting them relative to developed stocks.

    We expect a gradual normalization in interest rates. The yield curve appears to be a good approximation of future expected interest rates, and we expect intermediate-term Treasuries to earn a similar return as cash. TIPS have appeal relative to Treasuries as there is a risk of an inflation surprise if the Fed is too slow to normalize policy.


    Asset Class Equil Return1

    06/30/2014 20-Yr Current

    06/30/2014 20-Yr Previous


    Global Developed Equities 8.1% 7.5% 7.6%

    US Equities 7.9% 6.6% 6.8%

    International Developed Equities 8.2% 7.8% 7.9%

    Emerging Market Equities 8.7% 9.1% 9.4%

    Global REITS 6.7% 6.7% 6.7%

    US Treasuries 4.7% 3.6% 3.8%

    US TIPS 4.7% 3.6% 3.9%

    US I/G Corp 5.9% 4.7% 5.0%

    US High Yield Bonds 6.6% 5.0% 5.3%

    Non-US Govt bonds 4.1% 3.4% 3.8%

    Emerging Debt Hard Currency 7.5% 6.1% 6.4%

    Emerging Debt Local Currency 5.4% 6.0% 6.4% 1) Equilibrium geometric nominal expected return; assumes inflation of 2.5%.

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    Credit spreads contracted further in 2Q as investors showed signs of reaching for yield. We maintain a slight preference for investment-grade corporate bonds over Treasuries. Given the favorable economic outlook, the downside risk for corporates relative to Treasuries is limited over the short-term. High yield bond spreads are well below normal. Spreads remain reasonable given our base case economic outlook, but with tail risk if the economy disappoints.

    The two key risks to both the global economy and financial markets are (1) the Fed and other central banks tightening monetary policy earlier and more aggressively than expected and (2) instability in some emerging market economies spreads to other parts of the world via trade and financial market linkages.


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