2012 Investment Outlook

2012 Investment Outlook

BlackRock Investment Institute

Divergently
The Year Of LIvIng

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What lies ahead in 2012 for financial markets? a time when emerging economies and asset prices finally come into their own? a descent into an investment nuclear winter? a re-run of 2011, with rudderless, risk-on/ risk-off market forces sidelining many investors? Or a sunny upland where policymakers pull the right levers and growth abounds? We believe we are at an inflection point for economics, asset prices and risk appetite. Signs are everywhere: The euro debt crisis looks to come to a head, China and other emerging markets are easing monetary policy to regain growth momentum and the US economy is showing tentative signs of improvement. We are likely to see a 2012 investing landscape that is very different from last years environment of assets moving in lockstep. We have sketched out scenarios of how things could pan out this year, providing a framework for investors to take advantage of new opportunities and to guard against risks.

What Is Inside
Main Takeaways ........................................................................ 3
Executive Summary

how We See Clearly

More than three dozen leading BlackRock portfolio managers recently gathered at the BlackRock Investment Institutes Outlook 2012 Forum to exchange views. This publication summarizes their ideas. The BlackRock Investment Institute leverages the firms expertise across asset classes, client groups and regions. The Institutes goal is to produce information that makes BlackRocks portfolio managers better investors and helps deliver positive investment results for clients. Executive Director Chief Strategist Executive Editor Lee Kempler Ewen Cameron Watt Jack Reerink

Signposts .................................................................................47
Triggers for Moving Between Investment Landscapes

Scenarios .................................................................................89
Five Scenarios and Their Impact on Markets

Divergence ........................................................................... 1013

Decoupling of Emerging Market Economies and Assets

Nemesis ............................................................................... 1416 Possibility of a Crisis and 2012 Political Risks Hunt for Yield ..................................................................... 1718 Many Want It, Few Have It

The opinions expressed are as of January 2012 and may change as subsequent conditions vary.

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Main Takeaways
Divergence and Nemesis
We see an increasing divergence between faster-growing emerging markets and the debt-ridden developed world. The real economies and asset prices will likely decouple, helped by emerging markets having the room and cash to stimulate growth. In this Divergence scenario, Europe is expected to have a recession followed by a snail-like recovery in 2013. The US economy and Japan muddle through. The biggest risk is the European debt crisis spins out of control and plunges Europe into a deep recession that spreads to the rest of the world. This Nemesis scenario named after the Greek goddess who punishes the proud would be bad because the developed world has little firepower left to fight another crisis.

Probabilities and Signposts

We see Divergence as our main, most probable scenario. The odds for Nemesis are much lower, but still uncomfortably high. Markets have not factored in either scenario, creating opportunities for smart investors. Other scenarios are: The current stagnation continues, inflation surges or global growth resumes. There are big questions this year. Can policymakers pull back the eurozone from the brink? Will China be able to reaccelerate growth? Will smart monetary and fiscal policies offset the effect of global banks shedding assets? Is the US economys recent strength sustainable? The answers to these questions are signposts, and we want to see them clearly before we fully commit ourselves to taking a particular route.

Ewen Cameron Watt Chief Investment Strategist BlackRock Investment Institute

Investment Strategy
In Divergence, we would like equities, investment-grade and high-yield bonds, and metals including gold. We would expect poor returns for safe-haven government bonds, the US dollar and the euro. Within equities, we would focus on emerging markets, and the energy and resources sectors. We would favor most alternative investments. The usual suspects of cash and US, German and Japanese government bonds would dominate in Nemesis. Gold may also work. We would hold US dollars and prefer the yen to the euro. Alternative investments may offer protection if they can stomach a shortterm funding crunch. Within equities, we would like Asia and US defensive stocks while avoiding Europe.

Inflation and a New World

We believe inflation is unlikely in 2012. One caveat: Pretty much everybody backs this idea, and conventional wisdom is often upended. Global monetary easing or another run-up in commodities prices could conceivably spur inflation. Market prices reflect the consensus view, so there are risks. Eventually, we expect a move to sustainable global economic growth at just above historical trends. The question is how we will get there and how fast. In the meantime, markets will be volatile, magnified by elections in key countries. Investors will hunt for safe income in a risky world with low interest rates. And cash will be an important tool to hedge against Nemesis and exploit short-term opportunities.

We believe we are at an inflection point for economics, asset prices and risk appetite.

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Signposts
We would only act on these signposts if they are crystal clear: We want to avoid hero trades.
The second half of 2011 was dominated by the risk-on/risk-off theme, whereby assets would move in lockstep on the latest headlines of the European debt crisis. Goethe summed up the prevailing investor psychology well when he coined the phrase Himmelhoch jauchzend, zum Tode betrbt more than 200 years ago. It roughly translates as heavenly joy, deadly sorrow, aptly describing the swings in investor sentiment we saw on a daily basis in 2011. As this drama played out in markets, bank funding the lifeblood of world commerce dried up and key economies started to show cracks. Europe looked headed for a recession and emerging markets lost their growth momentum. We believe we have arrived at an inflection point. The period of stagnation accompanied by violent but highly correlated swings in asset prices simply cannot last. Most likely, we will move to a period whereby emerging economies start diverging from the developed world. We give this Divergence scenario a 40%-50% probability of happening, and will detail it on pages 10-13. At the same time, there is a risk that we will slide into another financial crisis. We put much lower odds of 20%-25% on this Nemesis scenario, but are scared all the same. More on that on pages 14-16. As you see in the chart below, we will eventually slide toward a period of sustainable global growth that is a tad above long-term trends. Do not count on it in 2012, though.

Left or Right?
Moving Into a New Scenario in 2012

Stagnation

Nemesis

Divergence
Global Growth

% Inflation

Source: BlackRock

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It is important to recognize turning points or signposts as we move into Divergence or less likely dive headfirst into Nemesis. We would only act on these signposts if they are crystal clear: We want to avoid hero trades. We are willing to miss the first bite of a potential return because the risks of being wrong are too great and false signals abound.

The European Debt Crisis: Make It Stop!

An obvious signpost is resolution of the European debt crisis. The eurozone tightened monetary policy too rapidly and imposed fiscal austerity too severely in a period when banks worldwide were shedding risky assets. We are now living with the consequences of that technocratic hubris. We saw many attempts at a cleanup in 2011, culminating in the December 9 European summit. It wasnt the hoped for mother of all summits, but it did provide a clearer framework for an eventual solution. And the accompanying actions by the European Central Bank (ECB) to alleviate a dangerous bank funding crunch just might prevent the crisis from spinning out of control, as we argued in Whats Next for the Eurozone. It is crucial to break the buyers strike that at times has paralyzed huge bond markets like Italys, especially because eurozone governments must refinance more than 500 billion euros of debt in the first half alone. The crisis is mostly about the ability to roll over debt, not the ability to pay debt. If we could choose to read one December 2012 headline now, it would be the rate at which Italy rolls over its debt (and in which currency).

Peter Fisher Head of BlackRocks Fixed Income Portfolio Management Team

An Austerity Diet
The ECB has made clear it is the lender of last resort for banks but not for government bonds. This disappointed some investors, but we believe banks can and will pick up some of the slack of buying sovereign debt nobody else wants. Measures such as cutting bank reserve ratios, accepting lower-rated collateral and extending funding have reduced the possibility of a doomsday credit crunch. Eurozone leaders believe they have made progress toward a fiscal union, including automatic sanctions for countries that dont balance their budgets, but many questions remain: Will voters approve plans for centrally run budgets? How will the new fiscal rules be enforced? How exactly will the various rescue funds work? How will Europe cut budget deficits without killing growth and triggering social unrest? The last question goes beyond Europe: Do developed world policymakers have the wherewithal to implement smart policies to reduce long-term drags such as pensions and other benefits while boosting growth in the short term? Policymakers cannot cut near-term spending too deeply or risk plunging their economies into deep recession. Austerity alone starves the patient. All these questions prevent us from calling an end to the European debt crisis no matter how many of us would like to see that happen.

It is crucial to break the buyers strike that at times has paralyzed huge bond markets like Italys.

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China Comes to the Rescue? The bottom line: Do not expect China to bail out the world in 2012.
Another signpost is Chinas response to slowing growth. The country is moving away from its singular focus on pushing down inflation and crushing property speculation. It also has plenty of room for easing in 2012 with an arsenal of growth boosters. The impact of its social housing plans alone is huge. See the chart below. The question is whether China will act on time and effectively to avoid wholesale capital outflows, a property crash and shattering of confidence. Chinas leadership change in late 2012 is a big risk. It will likely give even more prominence to domestic considerations of fighting inflation, keeping a lid on social unrest and furthering employment. We are no panda bears, as we showed in our July 2011 paper Can Chinas Savers Save the World? We dont think a property bust is imminent but see it as an increasing possibility down the road given the current policy mix. The bottom line: Do not expect China to bail out the world in 2012. The best we can hope for are policies that reaccelerate its economy. The good news? The policies could come sooner rather than later in response to an increasing probability for a growth shock. China is different: Economic growth of 6% is not good enough.

The Last Keynesian on Earth

China Has Ample Means to Stimulate Growth Chinas Arsenal asset Type Foreign Reserves (Jun 11) Gold Reserves (Jun 11) China Investment Co. (Dec 10) Social Security Fund (Dec 10) Listed SoEs* (Oct 10) Total Source: CLSA Note: Amounts may not add up due to rounding. * State-Owned Enterprises. US $3.2 trillion 33.8m ounces Cash and Investments Total Assets Market Capitalization Trillions of RmB
BILLIONS OF RMB

Social Housing is Another Booster 2500 2000 1500 1000 500 0 2009 2010 2011 2012

5.2 4.0 2.1 0.4

6 5 4 3 2 1 0
PERCENT

20.0 0.4 0.9 0.9 10.0 32.1

Net increased GDP contribution Percentage gross contribution to GDP

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Banks Deleveraging: An Underappreciated Force

A third signpost is how fast the global banking system will shrink or how slowly it will grow. Bank deleveraging is an underappreciated but key force across asset classes. Pressured by new regulations, higher capital standards and more risk-averse investors, global banks have been shedding assets at every opportunity. European banks in particular are under heavy pressure to rid themselves of assets that are either too risky, hard to price or outside the realm of traditional banking. They are much more reliant on money markets for funding than their US counterparts, and need to roll over a mountain of debt in the first half of the year. The global deleveraging trend has capped any gains in risk assets, at least in the short term. Again, policymakers must walk a fine line. Push too hard on bank deleveraging, and they will likely face a fire sale. The result? Bank failures or nationalizations that would plunge the world into deep recession as credit evaporates. We are pretty sure Europe will have a recession in 2012 hardly a help to anemic world growth prospects. A key call between Nemesis and Divergence, therefore, is the degree to which policymakers prevent banks from shedding assets too fast or implement monetary and fiscal policies that offset the effects of deleveraging. On the flipside, gradual bank dispositions open up opportunities to buy choice assets such as real estate securities and infrastructure projects. Nothing really juicy has materialized so far a reminder that there is a big difference between a distressed owner and a distressed asset. Ken Kroner Head of Scientific Active Equity and Head of the Global Markets Strategies Group

Reading US Tea Leaves

A final signpost is whether the surprising resilience of the US economy will hold up. On the one hand, the recent string of strong economic data shows the economy is still anchored by consumer spending and less susceptible to slowing global growth. On the other hand, failure to agree on debt reductions has essentially rendered US Congress impotent until after the elections in November. This means the US economy will lack a stimulus boost in an election year for the first time in decades. And failure to extend employment tax holiday and unemployment benefits would severely handicap the economy. That is not what the doctor ordered. The economys resilience complicated the conundrum for the US Federal Reserve: to ease or not to ease? After its final 2011 meeting in December, the Fed was mum on even the possibility of more quantitative easing. This likely means there is a healthy debate raging within the central bank about whether the economy really needs another boost. We still expect a third round of quantitative easing, likely after the first quarter when we see the US economy run out of steam. This would tilt the balance toward those advocating more easing. It may become easier to read the Fed tea leaves this year as the central bank is rolling out a new communications policy that will likely include setting an inflation target. This would also enable the Fed to update its commitment to keep interest rates low until at least 2013.

Policymakers must walk a fine line. Push too hard on bank deleveraging, and they will likely face a fire sale.

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Helping You See Clearly in 2012

Five Scenarios, Their Probabilities and Impact

Scenario Probability
Ingredients

Divergence 40%50%
A true decoupling: Emerging economies keep outperforming, while the United States and Japan muddle through. Europe has a shallow recession and a recovery at snails pace. Chinas economy reaccelerates. Elections in key countries are major risks. Policy moves halt but dont solve the euro debt crisis. These would likely include a backstop for besieged assets such as Italian bonds and a muddled road map for fiscal responsibility in the developed world. China and other emerging markets ease up on credit.

Nemesis 20%25%
Global recession, credit crunch, social upheaval and steep losses across asset classes around the world. Chinas economy screeches to a halt. The outcome could be worse than the 2008/2009 financial crisis.

Triggers

The most likely trigger is that the European debt crisis spins out of control, leading to a partial breakup of the eurozone and global banks dumping all risk assets. Others include: An Israeli attack on Irans nuclear facilities, a China growth shock or a buyers strike in the US Treasury market. Bond prices may already reflect the chance of this outcome; risk assets such as equities do not.

Probability

Our most likely scenario. Markets are assigning a much lower probability to this scenario judged by the high correlations of most assets. Lots of opportunities to diversify. We prefer equities, investment-grade and high-yield bonds, and metals including gold. Expect poor returns for US, German and Japanese government bonds, the US dollar and the euro. Focus on emerging market equities and bonds, and the energy and resources sectors. Many European equities are priced for disaster and may outperform. We like alternatives, and would move toward shorter-duration bonds. Dividend stocks and US municipal and corporate bonds remain hot as investors hunt for yield.

Investment Strategy

Cash and US, German and Japanese government bonds are the places to be. Gold also may work. Pick the US dollar, yen and sterling over the euro and emerging currencies. Hedge funds, private equity and infrastructure could offer protection if they can stomach short-term funding crunches and regulatory measures such as short selling bans. Within equities, we would focus on US defensive and strong cash flow companies that have the ability to raise dividends. We would also like Asia and avoid Europe. Difficult to hedge as downside protection is very expensive. One possibility is to reduce risk and simultaneously sell the pricey put options and other Nemisis hedges everybody else has put on.

Caveat

The evil twin of divergence is fragmentation: A partial breakup of the eurozone could drive us straight into the arms of Nemesis and roll back trade liberalization.

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Stagnation 15%25%
Sluggish global economic growth and high unemployment. A European recession hits emerging markets but doesnt choke them. Tighter credit conditions but no crunch. Emerging economies cut interest rates to maintain growth or need to do so. The current state of play. A tug of war between seemingly ineffective policymakers and skeptical financial markets. Weekly summits and daily monster moves. Upcoming elections in the United States, France and Russia, and Chinas leadership change add more uncertainty. We believe the world is at an inflection point and see the current status quo as untenable.

Inflation 5%10%
Inflation around the world effectively cuts the developed worlds debt load but also raises the potential for social unrest and knee-jerk policy responses.

Growth 0%5%
Sustainable global growth just above the long-term trend. Fears of a euro debt crisis dissipate and the continents economy rebounds. Emerging markets accelerate without spurring much inflation. The US recovery is real. Developed market policymakers dont just arrest the debt crisis but provide a credible road map for long-term solutions.

The worlds central bankers start running their printing presses day and night, a shortage of commodities leads to big price hikes even with moderate economic growth or a surprise global growth rebound spurs inflation.

Inflation is unlikely to pick up, especially in the developed world. But fixed income markets are likely to move lightening fast once they get a scent of it. US Treasuries and other safe-haven bonds fall off a cliff. Pick high-yield bonds over investment-grade. Income-focused investors switch to risk assets. Choose US, UK, LatAm and Japanese equities, and focus on the energy sector. Alternatives such as real estate/infrastructure (if indexed) and private equity should do okay.

Dream on.

Assets move in lockstep with big price swings from one day to the next as investors buy into the latest policy moves to halt the debt crisis or poke holes in them. Banks shedding risky assets keep a lid on permanent gains in risk assets. Buy long-duration US Treasuries, corporate bonds and emerging Asia debt. Avoid European and Japanese sovereigns. Pick emerging equities and local currency debt, and the yen over European assets.

Most markets rise, especially risk assets such as commodities, high-yield bonds, depressed European sovereigns and financials. US Treasuries, German bunds and other safe-haven investments fall. Pick the euro and emerging currencies over the yen and sterling. Emphasize European and emerging equities and focus on resources, financials and cyclicals.

Volatility and risk are here to stay under any scenario. Whats needed is a new investor mindset, if only to get a good nights sleep.

The market consensus overwhelmingly dismisses the inflation scenario. If history is any guide, this means it actually may happen.

We will eventually end up here. The question is how: Through the doomsday Nemesis scenario or the benign Divergence outcome?

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Divergence
The idea of decoupling is old and often proved wrong.
When we look into our 2012 crystal balls, what jumps out is a decoupling of faster-growing emerging markets and the debt-ridden developed world. We believe this is likely to take place this year, both for the real economies and asset prices. Emerging markets account for almost half of the global economy, and their economies are growing at a much faster clip than the developed world. Research and development spending is keeping pace, with the global shares of US, European and Japanese expected to decline in 2012 due to faster growth in emerging markets led by China, according to a Battelle and R&D Magazine study. Young populations underpin the long-term trend, while urbanization is creating new metropolis powerhouses. See the chart below. We would expect the US economy to muddle through and avoid falling back into recession in Divergence. Europe should have a shallow and short-lived recession, followed by a snail-like recovery in 2013. Japan is a toss-up: It is embarking on a huge stimulus program, but the soaring yen is making life tough for exporters.

New Centers of Power

Top 25 Cities by GDP, 2007 and 2025

Dropouts from 2007

Top 25 in both 2007 and 2025

Newcomers to 2025

Source: McKinsey Global Institute

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This Time Is Different

The idea of decoupling is old and often proved wrong. This is especially true when it comes to asset prices: There is a big difference between great economic performance and great returns. Just look at China. Its economy has notched double-digit growth in most years of the past decade. It has surpassed Japan as the No. 2 economy and has become the worlds top market for new cars. Cities, harbors and roads are being built at breakneck speed. Yet when you look the performance of Chinese equities, as we did in our August 2011 paper Are Emerging Markets the next Developed Markets?, the picture is very different. The Shanghai stock market has barely outperformed Hungary which has grown at a much slower pace. This phenomenon again played out in 2011. Emerging market economies held up pretty well, but asset prices fell off a cliff as investors pulled back on all (perceived) risk in the face of a worsening European debt crisis. Why would 2012 be any different? We see two main reasons: First, emerging market policymakers have plenty of room for both monetary easing and fiscal stimulus. Second, emerging market assets are no longer overvalued compared with developed world securities by historical standards. See chart on page 13. We also believe there is an important long-term trend that makes the case for investing in emerging markets: They are becoming less risky. Their economies are becoming less volatile and dependent on exports. Their fiscal budgets have room for expansion and carry less debt. Dennis Stattman Head of BlackRocks Global Allocation Team

Look Inside the Package

If you believe the developing world will decouple, emerging equities and local currency debt look attractive. Some pointers on each: It is important to zero in on companies benefiting from growing consumption in emerging markets. Global companies, even if theyre domiciled in developed markets, can get a piece of that growth. Many of them are priced reasonably and offer dividend yields at or above yields on government bonds. In other words, have a good look inside the package before you buy it. For example, you could make the case South Koreas Samsung Electronics is a developed market stock in disguise. By contrast, the UKs Burberry or Freeport-McMoRan of the United States are emerging market plays. The chart on the following page shows how companies with big exposure to emerging markets have outperformed ones that have little. The trend has been most pronounced in UK stocks, closely followed by European equities.

Emerging market policymakers have plenty of room for both monetary easing and fiscal stimulus.

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Emerging Safety?
Pure emerging equities did poorly in 2011. Knowing why it came down to tight monetary policy and slowing capital inflows helps answer the question of whether investors should look for direct or indirect emerging markets exposure. We believe looser policies, low valuations and poor sentiment are setting up emerging markets for a rebound in 2012. You could argue emerging market debt is not just higher yielding, but also safer than developed world sovereign bonds. South Korea and Chile, for example, are ranked above the United States and Germany in the BlackRock Sovereign Risk Index. A bevy of countries, including Thailand, Malaysia and Peru, rank higher than the UK. See chart on page 16. Russ Koesterich Chief Investment Strategist, BlackRocks iShares Business A word of caution on emerging market debt: Market stress will often trigger capital flight accompanied by steep drops in local currencies. This can hurt returns much more than declines in actual bond prices, as we showed in our October 2011 paper The Rising Prominence of Asias Debt Markets. In addition, liquidity can dry up fast in emerging markets magnified by government intervention. And an asset you cannot price or trade is worth very little.

Emerging Markets Make All The Difference

Stocks With High Emerging Markets Exposure Outperform 200

EXCESS RETURNS BASIS POINTS

160

120

80 2009 2010
US Returns

2011
UK Returns EUR Returns

We believe looser policies, low valuations and poor sentiment are setting up emerging markets for a rebound in 2012.

Source: BlackRock Note: Emerging market (EM) exposure is based on proprietary BlackRock sell-side survey data. Returns represent the difference between share price returns of the top and bottom deciles of EM exposure in each market. Returns are beta adjusted, based on regional Barra risk models. Returns prior to 2010 are based on static December 31, 2010 EM exposure.

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Opportunities Abound If You Believe in Divergence

Valuations ofVarious Asset Classes by Percentilevs. Historical Norm
100

80

Expensive

PERCENTILE

60 Average 40

20

Cheap

0 US Equities Latin American Equities Eastern European Equities US Ination Expectations UK Ination Expectations European Equities Asian Equities Emerging Market Debt $ UK Real Yield German Bund High Yield Corporate Credit UK Equities US Real Yield

Source: Thomson Reuters, Bloomberg and BlackRock Note: Valuations as of October 31, 2011. Time periods vary for each asset class, depending on when the appropriate indexes were created. Equity valuations are the average of dividend yield, book value and price/earnings ratio. Inflation expectations are 10-year inflation breakeven rates or the difference between the yield on Treasuries/gilts and TIPS/linkers.

Self-Help Stories
Markets are not putting much stock in the possibility of Divergence, as evidenced by assets moving in concert on the latest news from Europe. Indeed, 2011 was a tough year. Many equities lost money without much regional variation. Ostensibly overpriced high-quality bonds once again defied naysayers and racked up great returns. It all came down to macro-economic and confidence factors. The market is being driven by short-term risk aversion for now. This creates anomalies and opportunities for fundamental investors to buy attractive assets at exceptional valuations. If you are a believer in Divergence, opportunities abound. The chart above outlines which assets are mispriced by historical standards. Beyond the investment choices discussed in the scenarios box on pages 8 and 9, some of us are starting to warm to European equities. There is no question they are cheap: Pan-European stocks (including UK equities) traded at around nine times expected earnings at the end of 2011. This is at the bottom end of the 35-year range. The problem is that they are cheap for a reason. Analysts have ratcheted down 2012 profit forecasts for European companies, but are still too optimistic in our view. As a result, we remain cautious and look for self-help stories companies that can withstand a recession or worse. And we still like companies that derive a large proportion of sales and earnings from emerging markets.

The market is being driven by shortterm risk aversion for now. This creates anomalies and opportunities.

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nemesis
If the European debt crisis were to spin out of control, it would likely plunge Europe into a deep recession that would spread to the rest of the world, including China. The result would not be a simple addition of problems, but a multiplication. It could be bad because the developed world has used up much of its firepower to fight another credit crunch and deep recession. We call this scenario Nemesis, after the Greek goddess who wreaks havoc and vengeance on the prideful. Some would argue creating a European monetary union without a fiscal union was an act of hubris with punishment long overdue. The European debt crisis already has dented business confidence and capital spending, not just in Europe but around the world. Expectations for growth in key economies have already taken a hit. See the chart below. Against this gloomy backdrop, it would not take much to set off Nemesis: Policymakers could fail to stabilize government bond and credit markets. Banks could dump risky assets en masse. Developed world governments could impose austerity measures that trigger recessions and social unrest. And there is a possibility of a partial breakup of the eurozone the evil twin of our Divergence scenario. There is also a chance we are focusing too much on the European crisis. Other potential Nemesis triggers include an Israeli strike on Irans nuclear facilities that causes oil prices to hit $150 a barrel, a growth shock in China due to bad policy choices or a buyers strike in the US Treasury market on renewed fears of a fiscal train wreck. And then there is the stuff we have not thought about yet: The shell you hear is not the one that hits you.

Richard Urwin Head of Investments, Fiduciary Mandates

Getting Gloomier
Fund Manager Expectations of Economic Performance 120% 80 40 0 -40 -80 -120

PERCENT CHANGE

Some would argue creating a European monetary union without a fiscal union was an act of hubris with punishment long overdue.

2002

2003

2004

2005

2006
Japan

2007

2008

2009

2010

2011

United States

Eurozone

Asia Pacic

Source: BofA Merrill Lynch Fund Manager Survey Note: Based on the question: How do you think the regions economy will develop over the next 12 months? Data as of November 10, 2011.

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Hedging or Dodging Nemesis

It is tough and expensive to hedge against Nemesis. Beyond the investment choices discussed in the scenarios box on pages 8 and 9, alternative investments can offer protection for long-term investors if: 1. The underlying investment can withstand a deep recession, short-term funding crunch or regulatory crackdown. Examples are companies that have the ability to keep paying dividends and interest payments in a depression. Or hedge funds that can stomach short-selling bans, a sudden cut-off in credit and mass redemptions. 2. The investor can afford to take a long-term view. This means not being forced to sell when the investments value tumbles or its credit rating drops off a cliff. There is a third prerequisite: The investment should yield an attractive return. This is much easier said than done these days, which we will discuss on pages 17 and 18. Alternative investments work well in pretty much any scenario if they live up to their promise of delivering superior, uncorrelated returns. For hedge funds as a group, this did not happen in 2011. This once again brings home the message of how important it is to pick the right manager in alternative investing. It is crucial to hold cash, both to guard against Nemesis and to take advantage of opportunities. Nemesis, however horrible it would be for most people, would represent a fantastic buying opportunity much like equities, high-yield bonds and resources were great buys in early 2009. While we believe Nemesis would really hurt, three factors could mitigate its impact: Corporate cash coffers are filled to the brim. Banks are in much better shape than in 2008, especially in the United States. And emerging markets have plenty of room for boosting growth, both through monetary easing and stimulus spending. Bob Doll Chief Equity Strategist

A Big Election Year

How do you really feel about the economy and the widening gap between the haves and have-nots? It depends who you are and where you are. Country, region, age group, ethnicity and residency make all the difference. And the gap between rich and poor has reached its highest level in more than 30 years in the industrialized world, according to a recent study of the Organization for Economic Co-operation and Development. These differences have caused political stress and soul searching on both sides of the Atlantic as well as in emerging markets. You could argue policymaking is almost antiseptic: It is about making a few good, rational choices and avoiding a lot of bad choices. Politics, by contrast, can have unexpected twists and turns. Politics can be emotional. Politics can be ugly. To financial experts, some political decisions may make no sense whatsoever. Politicians are not stupid, though. And their decisions or lack thereof may make all the sense in the world in a political context. The fact is that policymaking and politics are intertwined. This is why it is important to track and understand domestic politics. This has long been the case in emerging markets investing, but it is a newish concept in the developed world.

Policymaking is almost antiseptic: It is about making a few good, rational choices and avoiding a lot of bad choices. Politics can be emotional. Politics can be ugly.

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Politics Matter More Than Ever

Scheduled 2012 Elections in Countries Tracked by the BlackRock Sovereign Risk Index

Finland
Presidential 1st Round: Jan 22 2nd Round: Feb 5

USA
Presidential Nov 6

Greece Russia
Presidential Mar 4 Parliamentary Feb 19

Mexico France
Presidential Jul 1

Egypt
Presidential March

2.0

S. Korea
1.0 SEPTEMBER BSRI
Presidential Dec 19

Presidential 1st Round: Apr 22 2nd Round: May 6

China
Leadership Oct/Nov

Venezuela
Presidential Oct 7

0.0

-1.0

-2.0 Norway China Israel Chile Brazil Japan Spain Peru UK Austria Colombia New Zealand Netherlands S. Africa Croatia Switzerland Czech Republic Hungary Italy Venezuela Indonesia S. Korea Germany Malaysia Philippines Argentina Australia Denmark Thailand Portugal Belgium Turkey Sweden Canada Finland Mexico Ireland Greece Poland France Russia Egypt USA India

Source: BlackRock Note: The BlackRock Sovereign Risk Index ranks selected countries sovereign debt using a set of fiscal, financial and institutional metrics.

The possibility of social unrest is high in many nations at a time of power shifts or vacuums in key countries. A flurry of elections could magnify risks or usher in scenarios we have not yet contemplated. Governments could change in about a quarter of the countries tracked by the BlackRock Sovereign Risk Index. See the graphic above. Taiwan kicks off the elections calendar in January with a close race that will determine its economic linkage with China and the likelihood of a blow-up between the two. Finland, which has played the Scrooge in the European debt drama, is next. The outcome of Russias March election is a given, even if selected billionaire oligarchs jump into the fray. The scale of Vladimir Putins victory, however, will determine the probability of needed economic reforms and the likelihood of stability. Russia may appear less relevant today than in the cold war era, but a Russia that is not doing well is dangerous. Onto Paris in the spring, where the weaker half of the Merkozy duo is trying to crawl out of a deep unpopularity hole. Nicolas Sarkozy faces a struggle to get through the first round, let alone kick sand in the face of socialist opponent Franois Hollande in the final. Chinas formal leadership handover in the autumn is likely to turn the countrys focus even more inward in the run-up. The grand finale is US President Barack Obamas bid for an Act 2. And we have not even talked about Greece, Mexico, South Korea and others.

A flurry of elections next year could magnify risks or usher in scenarios we have not yet contemplated.

B L a C k R O C k I n v e S T m e n T I n S T I T U T e [ 17 ]

hunt for Yield

Erstwhile safe havens are no longer there. Many top-rated bond yields are either at record lows or negative. Others are too good to be true or too scary to touch. At the same time, retirees live longer and are growing in numbers. Many of these people and their pension funds are looking for income. Two long-term demographic trends are driving investor appetite for income: an explosion in the number of pensioners and higher life expectancies around the world. The global retirement population will almost triple to 2 billion by 2050, the United Nations estimates. See the chart below. Pensioners are also far more active in retirement than in previous decades and have higher expectations for living standards. Inflation has a devastating impact on the real value of savings over longer periods of time. And people are living longer in retirement: For every US couple aged 65, for example, there is a 50% chance one of them will live to be 92. This is great for the couple if they get along, that is but it is a strain on society. The numbers translate into increased demand for pension payments and medical benefits. This will put stress on government finances at a time budgets are already in horrible shape and pension investment returns have lagged projections. This is old news but it gets more important each year.

The big opportunity in 2012 and beyond is: Where do I clip yield?

Few Choices
Top-rated sovereign bonds, long investors prime choice for safe income, return very little or actually lose money after factoring in inflation. That leaves investment choices such as high-yield corporate bonds, dividend stocks, Asian debt, alternative investments such as private equity, infrastructure and real estate, and options strategies from covered call writing to volatility spreads.

World Retirement Boom

The Number of 60+ers Is Expected to Triple to 2 Billion by 2050

Asia 400 mln Europe 159 mln North America Latin America Africa Oceania 63 mln 57 mln 54 mln 5 mln

1236 mln 236 mln 125 mln 186 mln 213 mln 12 mln

2009
738 Million Retirees
Source: United Nations Population Ageing and Development 2009

2050
2 Billion Retirees

[ 18 ] 2 0 1 2 : T h e Y e a R O f L I v I n g D I v e R g e n T L Y

Many real estate securities look pricey after a big run-up in 2011. High-yield bonds have appreciated but still offer value as a potential hedge against a recession. Historically, high-yield bonds have performed well in periods of negative economic growth. Dividend stocks are another avenue, but some are starting to look relatively expensive. The valuation gap between high- and low-payout US stocks is currently at a record low, suggesting companies with strong free cash flows are better buys at this time. These companies can raise dividends, and the key with equities is dividend growth, not yield.

Other Hunting Grounds

The US municipal bond market has been prime territory for yield hunters. It has held up well, despite Cassandra-like warnings of defaults and some high-profile bankruptcies. We see regulatory risk as a bigger potential scourge. The Feds admission it underclubbed the size of the market by some $800 billion is more than an oops. It may bring regulation, scrutiny and attacks on the tax-exempt market as a shelter for the wealthy. Alternative investments such as private equity are other options for long-term investors. Private equity should do well in most scenarios as long as it is not dependent on funding. The big challenge these days is eking out synergies in target companies: There is not a lot of corporate fat left after the recession. Infrastructure is good for stable, long-term income as long as returns are indexed against inflation and investors have enforceable claims on the hard assets. This includes renewable energy projects, which now make up roughly half of new power generation. The main challenge here is a dearth of investable projects. With so much demand for income, our longtime investment theme of the structural bid for yield holds true more than ever. We expect it to play out this year in particular because it has become so tough to find safe and stable income. The big opportunity in 2012 and beyond is: Where do I clip yield?

Rick Rieder Chief Investment Officer, Fixed Income, Fundamental Portfolios

Got Income?
Real Bond Yields Have Turned Negative in Many Developed Markets

United States
6 6

Japan
6

United Kingdom

3
PERCENT PERCENT

3
PERCENT

-3 01 03 05 07 09 11

-3 01 03 05 07 09 11

-3 01 03 05 07 09 11
Inflation Rate 10-Year Government Bond Yield Stock Index Yield

Source: Thomson Reuters Note: Stock index dividend yields based on S&P 500, TOPIX and FTSE All Shares.

B L a C k R O C k I n v e S T m e n T I n S T I T U T e [ 19 ]

We hope this publication has given you a framework to navigate the investing landscape and recognize signposts along the road. To see clearly in 2012, five points are worth remembering: } expect a decoupling of fast-growing emerging economies and the developed world. emerging market assets would outperform in this Divergence scenario. } The odds of a nemesis crisis are much lower, but still uncomfortably high. The biggest potential trigger is an escalating european debt crisis. } Investors will scrounge for income in a risky world with ultra-low interest rates. a global retirement boom and longer life expectancies underpin this trend. } market volatility is here to stay, magnified by elections and power handovers in key countries. Politics matter more than ever in investing. } Inflation is unlikely to pick up. This market consensus view could be upended by a global monetary easing or a run-up in commodities prices.

This paper is part of a series prepared by the BlackRock Investment Institute and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of January 2012 and may change as subsequent conditions vary. The information and opinions contained in this paper are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. This paper may contain forward-looking information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this paper is at the sole discretion of the reader. This material is being distributed/issued in Australia and New Zealand by BlackRock Financial Management, Inc. (BFM), which is a United States domiciled entity. In Australia, BFM is exempted under Australian CO 03/1100 from the requirement to hold an Australian Financial Services License and is regulated by the Securities and Exchange Commission under US laws which differ from Australian laws. In Canada, this material is intended for permitted clients only. BFM believes that the information in this document is correct at the time of compilation, but no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BFM, its officers, employees or agents. International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation, and the possibility of substantial volatility due to adverse political, economic or other developments. In Latin America this material is intended for Institutional and Professional Clients only. This material is solely for educational purposes and does not constitute an offer or a solicitation to sell or a solicitation of an offer to buy any shares of any fund (nor shall any such shares be offered or sold to any person) in any jurisdiction within Latin America in which an offer, solicitation, purchase or sale would be unlawful under the securities law of that jurisdiction. If any funds are mentioned or inferred to in this material, it is possible that they have not been registered with the securities regulator of Brazil, Chile, Colombia, Mexico and Peru or any other securities regulator in any Latin American country and no such securities regulators have confirmed the accuracy of any information contained herein. No information discussed herein can be provided to the general public in Latin America. The information provided here is neither tax nor legal advice. Investors should speak to their tax professional for specific information regarding their tax situation. Investment involves risk. The two main risks related to fixed income investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments. Any companies listed are not necessarily held in any BlackRock accounts. International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation, and the possibility of substantial volatility due to adverse political, economic or other developments. These risks are often heightened for investments in emerging/developing markets or smaller capital markets.

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