edward f. keon, jr. managing director and portfolio manager...

EDWARD F. KEON, JR. Managing Director and Portfolio Manager Quantitative Management Associates

Edward F. Keon, Jr. is a Managing Director and Portfolio Manager for Quantitative Management Associates, as well as a member of the asset allocation team. In addition to portfolio management, Keon contributes to

investment strategy, research and portfolio construction.

JOHN PRAVEEN, PhD Managing Director and Chief Investment Strategist Prudential International Investments Advisers, LLC

John Praveen, PhD is managing director and chief investment strategist of Prudential International Investments Advisers, LLC (PIIA), a unit of Prudential Financial, Inc.’s International Investments Division. Praveen

joined Prudential in 2004.

As chief investment strategist, Praveen leads PIIA’s investment strategy team, which undertakes financial market and macroeconomic research and analysis, generates outlook and forecasts, and formulates investment strategy within asset classes, global markets and sectors. The team also provides portfolio management services on an advisory basis.

QUINCY KROSBY Chief Market Strategist Prudential Annuities

Quincy Krosby is chief market strategist for Prudential Annuities. In this capacity, she is a member of the investment management group for the Annuities division, where she provides perspective on the global macro-

economic environment and financial markets.

MICHAEL K. LILLARD, CFA Managing Director and Chief Investment Officer Prudential Fixed Income Management

Michael K. Lillard, CFA, is managing director and chief investment officer for Prudential Fixed Income, responsible for portfolio management and trading for all products and strategies across the firm.

CATHY MARCUS Managing Director and Sr. Portfolio Manager Prudential Real Estate Investors Cathy Marcus is the senior portfolio manager for PREI's flagship core equity real estate fund and is involved in all aspects of managing the fund including portfolio strategy, investment decisions and management of the team.

June 2013

2013 Mid‐Year Turbulent Teens Follow‐Up

What About The Fed?

Ed KeonPortfolio Manager

Rory CummingsAssociate

In the recent QMA White Paper, ”A Different Sort of Turbulence – Brace Yourself for Rapid GDP Acceleration,” we argued that economic growth over the next few years would be much better than consensus expectations, as a lessening fiscal drag would reveal a robust consumer, motivated by pent-up demand, and aided by an improving labor and credit market. One response to that paper has been the simple question:

What About The Fed?

The financial media seem to ascribe every wiggle in equity prices to market perceptions about the timetable and pace of Fed quantitative easing (QE) tapering. Many observers believe that Fed action is primarily responsible for the bull market in equities, citing the striking correlation between the size of the Fed’s balance sheet and the S&P 500 (Figure 1). If they are correct, it would logically follow that a less aggressive Fed could halt or even reverse the rise in prices.

Figure 1: It’s True That The Fed’s Balance Sheet Has Tracked The Market’s Rise But That Doesn’tThere is no doubt that the Fed’s Tracked The Market’s Rise, But That Doesn’t

Necessarily Mean It Caused It

There is no doubt that the Fed s actions have had a profound influence on the economy and the financial markets. Over the past few years, expansive Fed policy has helped offset severe drag from fiscal policy, the combination of 2013 tax increases and lower levels of real government spending at the federal, state, and local levels. Yet we also believe that the Fed’s policies have had less influence on economic growth than some think; the proceeds from a large portion of the Fed’s

2). These reserves represent potential energy for the economy, but until they are used to make loans, their economic impact is muted. In our view, the most tangible impact of Fed policy was to restore the confidence of battered investors. That is, since the 20% peak-to-trough correction in stock prices precipitated by the debt ceiling debate in the summer of 2011, investors have had faith that the Fed will do what it takes to avoid an economic and

portion of the Fed s extraordinary QE purchases sit in deposits held at the Fed (Figure

For more information, please contact:

Stephen BrundageProduct Specialist

Quantitative Management Associates

h

market collapse, whatever happens in other aspects of government policy.

But as we contemplate the eventual change in this unprecedented level of monetary easing, we think that the key influence of the Fed on financial markets will come from the effect of Fed policies on the economy - specifically inflation and economic growth - rather than just on investor sentiment. Although on the surface the relationship between QE and stock prices seems compelling, as any good quant will tell you, correlation does not necessarily mean causality. As we read the historical record, Fed policy can change from being

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accommodative to less so (or even restrictive) without unduly damaging equity markets, as long as inflation remains contained.

4.1%, and rose modestly, in line with inflation, to 4.4%. Rates today are near record lows, of course, so a rise of more than 30 bps might be reasonable to expect. But as long as inflation remains contained, our guess is that rates

September 2012

Figure 2: Reserves Held At The Fed Have Soared, Representing Potential Energy

will not rise tremendously in the next year. We might expect something like 3% a year from now.

Increases in interest rates might provide a bit of a headwind for stocks compared to the 1950s and 60s, but even if valuations do not increase from here, we think it is reasonable to expect equity returns over the next couple of years to be about in line with earnings growth, or perhaps slightly better, with total returns from stocks ranging from roughly 7 – 12%.

So what happened in the 70s and later? Of course there were special factors in some cases like the OPEC embargo and oil price hikes, but the bottom line is that inflation started much higher and accelerated despite Fed action, rising from 4% to 5.5%. It might simply be that the

The evidence is presented in Figure 3. We show tightening cycles as measured by an increase in the Fed funds rate, or for earlier periods, the discount rate. We show equity returns and 10-year Treasury bond rates over the following 6 and 12 months. From the 1970s through 2004, Fed tightening, on average, was associated with weak equity prices over the next year; hence the saying “don’t fight the Fed ” But if we go back further in time in the 1950s and

inflation genie is easier to keep in the bottle than to coax back into the bottle.

As we noted in our prior paper, we are confident that inflation will remain low for at least a year or two, as a still-weak (though recovering) US labor market will combine with secular downshifts in inflationary pressures from energy, health care, and education to keep inflation

d f h h d h d hFed. But if we go back further in time, in the 1950s and 60s, the Fed tightened and stocks soared by an average annual rate of 20%.

So what gives? In the earlier periods, inflation started low, at about 1.6% (around where we are today). A year later, inflation had risen modestly to about 2%. This is also almost exactly what the Fed targets over the next year. Bond yields started at close to historical average levels,

contained for now. The reserves held at the Fed shown in Figure 2 might represent potential inflation as well as potential energy for the economy, but recall that the Fed can pay interest on those reserves if it so chooses. So the potential future inflationary impact of the aggressive policy of the past few years might be easier to contain in the future than it was before the Fed obtained this ability to pay interest on reserves.Bond yields started at close to historical average levels, interest on reserves.

Figure 3: The Stock Market Can Rise After Fed Tightening If Inflation Stays Low

Tightening Periods

S&P 500 Performance 10 Year Treasury Bonds Inflation

3M Prior 6M After 12M After Rate 6M After 12M After Rate 6M After 12M After

4/15/1955 3.29% 9.53% 26.89% 2.75% 2.89% 3.17% ‐0.52% 0.04% 0.52%

9/12/1958 10 07% 16 37% 18 03% 3 74% 3 99% 4 65% 2 23% 0 94% 1 07%9/12/1958 10.07% 16.37% 18.03% 3.74% 3.99% 4.65% 2.23% 0.94% 1.07%

7/17/1963 2.33% 10.44% 20.54% 4.03% 4.18% 4.19% 1.59% 1.84% 1.34%

11/20/1967 ‐4.11% 4.40% 14.11% 5.85% 5.92% 5.71% 3.20% 4.23% 5.04%

Average 2.90% 10.18% 19.89% 4.09% 4.25% 4.43% 1.62% 1.76% 1.99%

3M Prior 6M After 12M After Rate 6M After 12M After Rate 6M After 12M After

1/15/1973 7.52% ‐12.75% ‐21.69% 6.44% 7.05% 7.01% 3.89% 6.00% 10.12%

8/31/1977 ‐3.52% ‐9.69% 7.39% 7.28% 8.04% 8.42% 7.19% 7.33% 8.39%

9/4/1987 12.24% ‐16.34% ‐17.40% 9.28% 8.15% 8.99% 4.65% 4.20% 4.55%

2/4/1994 1 41% 4 64% 0 43% 5 90% 7 10% 7 48% 2 73% 3 11% 3 14%

2

Source: QMA

2/4/1994 1.41% ‐4.64% ‐0.43% 5.90% 7.10% 7.48% 2.73% 3.11% 3.14%

6/30/1999 5.77% 7.86% 7.65% 5.81% 6.43% 6.11% 2.09% 2.86% 3.73%

6/30/2004 1.52% 6.81% 5.60% 4.62% 4.29% 3.99% 3.28% 3.62% 2.92%

Average 4.16% ‐4.79% ‐3.15% 6.94% 7.35% 7.60% 3.97% 4.52% 5.48%

September 2012

If we are correct that inflation is likely to remain relatively low, after a shift in Fed policy to “less accommodating,” we would expect equity returns to look more like the periods above in the 1950s and 60s than like the 1970s forward.

There is no doubt that the global economy is still fragile, and there might well be unanticipated shocks that could damage our outlook. However, we do not believe that recent Fed clarity on intentions to taper QE in 2013 and end it in the middle of next year (subject to incoming data) will present a major headwind for the economy or equity prices in 2013 or 2014.

These materials represent the views, opinions and recommendations of the author(s) regarding the economic conditions, asset classes, securities, issuers or financial instruments referenced herein. Distribution of this information to any person other than the person to whom it was originally delivered and to such person’s advisers is unauthorized, and any reproduction of these materials, in whole or in part, or the divulgence of any of the contents hereof, without prior consent of Quantitative Management Associates LLC (“QMA”) is prohibited. Certain information contained herein has been obtained from sources that QMA believes to be reliable as of the date presented; however, QMA cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. The information contained herein is current as of the date of issuance (or such earlier date as referenced herein) and is subject to change without notice. QMA has no obligation to update any or all of such information; nor do we make any express or implied warranties or representations as to the completeness or accuracy or accept responsibility for errors. These materials are not intended as an offer or solicitation with respect to the

h l f i h fi i l i i i d h ld b dpurchase or sale of any security or other financial instrument or any investment management services and should not be used as the basis for any investment decision. Past performance may not be indicative of future results. No liability whatsoever is accepted for any loss (whether direct, indirect, or consequential) that may arise from any use of the information contained in or derived from this report. QMA and its affiliates may make investment decisions that are inconsistent with the recommendations or views expressed herein, including for proprietary accounts of QMA or its affiliates.

The opinions and recommendations herein do not take into account individual client circumstances, objectives, or needs and are not intended as recommendations of particular securities, financial instruments or strategies to particular clients or prospects. No determination has been made regarding the suitability of any securities, financial instruments or strategies for particular clients or prospects. For any securities or financial instruments mentioned herein, the recipient(s) of this report must make its own independent decisions.

The financial indices referenced herein are provided for informational purposes only. You cannot invest directly in an index. The statistical data regarding such indices has been obtained from sources believed to be reliable but has not been independently verified.

Certain information contained herein may constitute “forward-looking statements,” (including observations about markets and industry and regulatory trends as of the original date of this document). Due to various risks and uncertainties, actual events or results may differ materially from those reflected or contemplated in such forward-looking statements. As a result, you should not rely on such forward looking statements in making any decisions. No representation or warranty is made as to the future performance or such forward-looking statements.

3

Copyright 2013 QMA. All rights reserved

QMA20130620-99

INVESTMENT STRATEGY

AND PORTFOLIO MANAGEMENT

May 2013

Executive Summary

Economic Outlook

• Global economic growth appears to be muddling along at a pace between 2-3%.

• The U.S. economy seems best positioned among the advanced economies with rising housing

market prices and auto industry sales approaching pre-crisis “normal,” household finances in

much better shape, and increasing energy independence.

• The U.S. added 165,000 jobs in April and the unemployment rate fell to 7.5%, continuing an

uninterrupted downturn trend since summer of 2010. Economic growth was 2.5% annualized

for the first quarter, much better than the 0.4% growth of last years fourth quarter.

• Confidence in the Eurozone’s economy declined in April, prompting an anticipated ECB rate

cut in early May.

• The Bank of Japan promised to inject about $1.4 trillion into the nations moribund economy

over the next two years, sending the yen reeling and bond yields to record lows.

• Manufacturing in China expanded at a weaker pace in April, continuing a slowdown in the

performance of the world’s second leading economy.

Market Outlook

• Our general view of economic healing, slowly improving growth prospects, and declining risk

premiums has not changed. Thus, we remain overweight global equities and fixed income risk

assets.

• We have shifted some exposure away from emerging market equities, in light of some

inflation concerns and evidence from recent consumer and business indicators of weaker

growth and deteriorating corporate health in the region.

• We have increased exposure to U.S. equities, and have somewhat increased exposure to

EAFE markets, but remain cautious as European equities are cheap but risks remain. Japan

may be on the verge of a breakout but has disappointed before.

• Despite strong performance last year and so far this year, equities are still attractive relative to

government bonds on a valuation basis.

QMA-20130507-93

Confidential — Not For Further Distribution

ECONOMIC AND MARKET OUTLOOK

ECONOMIC AND MARKET OUTLOOK

2

May 2013

IMPORTANT INFORMATION

These materials represent the views, opinions and recommendations of the author(s) regarding the economic conditions, asset classes, securities,

issuers or financial instruments referenced herein. Distribution of this information to any person other than the person to whom it was originally

delivered and to such person’s advisers is unauthorized, and any reproduction of these materials, in whole or in part, or the divulgence of any of

the contents hereof, without prior consent of Quantitative Management Associates LLC (“QMA”) is prohibited. Certain information contained

herein has been obtained from sources that QMA believes to be reliable as of the date presented; however, QMA cannot guarantee the accuracy of

such information, assure its completeness, or warrant such information will not be changed. The information contained herein is current as of the

date of issuance (or such earlier date as referenced herein) and is subject to change without notice. QMA has no obligation to update any or all of

such information; nor do we make any express or implied warranties or representations as to the completeness or accuracy or accept responsibility

for errors. These materials are not intended as an offer or solicitation with respect to the purchase or sale of any security or other

financial instrument or any investment management services and should not be used as the basis for any investment decision. Past

performance is not a guarantee or a reliable indicator of future results. No liability whatsoever is accepted for any loss (whether direct,

indirect, or consequential) that may arise from any use of the information contained in or derived from this report. QMA and its affiliates may

make investment decisions that are inconsistent with the recommendations or views expressed herein, including for proprietary accounts of QMA

or its affiliates.

The opinions and recommendations herein do not take into account individual client circumstances, objectives, or needs and are not intended as

recommendations of particular securities, financial instruments or strategies to particular clients or prospects. No determination has been made

regarding the suitability of any securities, financial instruments or strategies for particular clients or prospects. For any securities or financial

instruments mentioned herein, the recipient(s) of this report must make its own independent decisions.

Certain information contained herein may constitute “forward-looking statements,” (including observations about markets and industry and

regulatory trends as of the original date of this document). Due to various risks and uncertainties, actual events or results may differ materially

from those reflected or contemplated in such forward-looking statements. As a result, you should not rely on such forward-looking statements in

making any decisions. No representation or warranty is made as to future performance or such forward-looking statements.

The financial indices referenced herein are provided for informational purposes only. You can not invest directly in an index. The statistical data

regarding such indices has been obtained from sources believed to be reliable but has not been independently verified.

QMA affiliates may develop and publish research that is independent of, and different than, the recommendations contained herein. QMA

personnel other than the author(s), such as sales, marketing and trading personnel, may provide oral or written market commentary or ideas to

QMA’s clients or prospects or proprietary investment ideas that differ from the views expressed herein. Additional information regarding actual

and potential conflicts of interest is available in QMA’s Form ADV Part 2A.

QMA is a wholly-owned subsidiary of Prudential Investment Management, Inc. and an indirect, wholly-owned subsidiary of Prudential Financial,

Inc.

Copyright 2013 QMA. All rights reserved.

QMA-20130507-93

June 2013

2013 Mid‐Year Turbulent Teens

A Different Sort Of Turbulence: Brace Yourself For Rapid GDP Acceleration

Ed KeonPortfolio Manager


Introduction

The U.S. and many global equity markets have recently reached historic highs, recovering all the losses from the financial crisis and Great Recession. Are these gains justified, or is this a kind of “sugar high” induced by easy monetary policy in the U.S. and elsewhere?

In our opinion, the recovery in prices is quite real, and this bull market is likely to have a way to go We think that the U S equity market in particular is anticipating much more robust

Executive Summary

to go. We think that the U.S. equity market in particular is anticipating much more robust economic growth than most expect over the next few years, driving higher profits and equity prices.

After struggling along at around 2% growth for the past few years, by late 2014 we think that the U.S. will start to experience quarters with real GDP growth of 5% or so. Although eventually growth will likely fall back to a more sustainable trend of 3%, we would not be surprised to see above-trend growth persist into 2016 or longer.

Our case is fairly straightforward:

If Government Steps Aside, GDP Growth Could Double. Government policies have been a 1 – 2%+ drag on GDP recently and will continue to be so through 2013 and into 2014. But the drag will drop in time, and by the second half of 2014 and 2015, we would expect a more normal 0.0 - 0.5% contribution to GDP from government spending at all levels. If we are correct, this will be about an incremental 1 - 2%+ boost to GDP by late 2014.

The Resilient U.S. Consumer Is Back And Feeling Better. The household sector has been under siege since 2008, but increased household wealth, a recovery in house prices, a recovering labor market, and better access to credit will allow consumers to satisfy their pent-up demand for housing, autos, and other consumer goods. This could add 1% or more to the current pace of GDP growth in our estimation.

The American Energy Renaissance Has Caught Many By Surprise. The U.S. energy boom is still in its early stages. Over the next few years this will boost GDP directly and indirectly through increased U.S. competitiveness, a lower trade deficit, and a stronger dollar. We guess that this will soon add about 0.5% per year - possibly more - to GDP over several years.

Will Inflation Erupt? Possibly, But Later In The Decade. Although we do expect inflationary pressures to rise starting in about 2015 or so as the labor markets tighten (and financial markets might well begin to anticipate these pressures well before actual inflation emerges), we believe that inflation will stay tame for another year or two. I fl i i h h l h d d i h ll b d l d l b

For more information, please contact:

Stephen BrundageProduct Specialist


h

Inflation in the health care and education sectors has actually abated recently, and labor market inflation, when it comes, well, some folks might say that is “a consummation devoutly to be wished.”

If you sum our rough estimates above and add a 2% current GDP run rate, you would get GDP of 5 –6%. This might seem implausibly high today, but if we are correct, it could be routine in a couple of years.

We will make the argument regarding GDP growth that follows largely with graphs and

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g g g g g y g pcharts, and we welcome comments.

A Primer On GDP Accounting

The National Income and Product Accounts data on which

Government Spending Has Been A Drag On GDP

Figure 2 shows that total government spending (federal as

September 2012

GovernmentIntroduction

GDP calculations are based can be complex and arcane, but the basics of the GDP equation are pretty simple.

GDP is usually reported in real, inflation-adjusted terms, using the GDP deflator as a measure of inflation. Quarterly GDP numbers are based on annualized rates, so if the quarterly GDP report is 2%, that means that if the economy showed the same real growth for a full year as it

g g p g (well as state and local) has been a drag on GDP over the past couple of years, especially the last two quarters. Absent lower levels of government spending, GDP would have been more than 1% higher in the fourth quarter of 2012 and the first quarter of 2013, based on data reported so far. This might seem counterintuitive to readers accustomed to hearing about big government spending and large deficits.

did in that quarter, economic growth would be 2%.

The main elements of GDP are depicted in Figure 1.

Figure 3 shows the levels of federal government spending as well as tax receipts over the past several years, and Figure 4 shows the difference between those two numbers - the federal budget deficit. The data in Figures 3 and 4 are not adjusted for inflation, i.e. they are in nominal dollars.

Figure 3: Federal Spending Has Flatlined Since 2009, While Receipts Are Rising

Figure 1: Basic GDP Accounting Is Straightforward

GDP = + C Consumption Expenditures

+ I Investment Spending

+ GGovernment Expenditures (Goods & Services)

+ Ex ‐ Im Net Exports (Negative Recently)

To assess possible changes in GDP over the next few years, we will directly consider G, government spending, first, then consumer spending, and then shift gears to assess the rise in energy production, which has a direct and indirect impact on all the major components of GDP.

Figure 2: Government Spending Has Been A Big Drag On GDP Growth, But That May Change By Late 2014

2

deficits might make sense in the wake of the financial crisis and Great Recession. Folks in the first camp generally believe that balance should be mostly achieved by reducing spending, while folks in the second camp generally believe

September 2012

Figure 4: The Deficit Is Rapidly Narrowing

that balance should be achieved through tax increases, especially on those with higher incomes. Both sides agree that it would be good if the country achieved faster economic growth, but they have very different views on how to achieve that.

NEWS FLASH: The Federal Government’s Deficit Is Plunging

Federal spending soared in fiscal year 2009, ending

It is well beyond the scope of this paper to cover this debate in any greater detail, but the bottom line is that the spending restraint and tax increases that both parties have accepted have combined with a pick-up in economic growth and asset prices, as well as payments to the government from Fannie (Federal National Mortgage Association) and Freddie (Federal Home Loan Mortgage

September 30, 2009, which included the last four months of the Bush administration with the first eight months of the Obama administration. But since 2009, federal spending has been about flat, and most recently has ticked down a bit, due in part to sequestration. So with spending flat, why hasn’t the GDP impact been close to zero? There are two primary reasons.

T d d

Corporation), to result in a federal budget deficit that is plunging as we write this. Figure 5 shows the latest forecasts from the non-partisan Congressional Budget Office (CBO). The trillion dollar deficits of recent years are gone. For fiscal 2013, ending September 30, the deficit will be about $600 billion - under 5% of GDP - and by next fiscal year the budget deficit will be under 3% of GDP, according to the CBO Further out the deficit is projectedTransfer Payments Have Crowded Out Government

Spending

First, GDP accounts measure production of goods and services; transfer payments are not included. So if the federal government takes money from taxpayers and gives it to Americans who are old or unemployed, that counts as federal spending but does not matter either way to GDP. O h f f h i d

according to the CBO. Further out, the deficit is projected to rise, mostly due to increases in Medicare and Social Security payments (more on this later).

Forecasts can of course be wrong, but if the CBO is right, this will dramatically alter the political debate. The political systems seem to have achieved the lower deficit both sides have sought, even if no one was happy with the mix needed to get there, and no one predicted that we would get thereOver the past few years, transfer payments have increased,

as more Americans have collected Social Security, unemployment insurance, and other benefits. If total government spending is flat but transfer payments are grabbing a bigger share of the pie, then this effectively squeezes spending on government purchases of goods and services that are reflected in GDP.

Th d i i fl i Al h h i fl i i l i

to get there, and no one predicted that we would get there this fast. This means that the still higher taxes sought by

Figure 5: Last Week, The Non‐Partisan Congressional Budget Office Reduced Their Deficit Projections

The second reason is inflation. Although inflation is low, it is not zero. So if spending is flat in nominal terms, it is down a bit in real, inflation-adjusted purchasing power.

Over the past several years there has been a vigorous debate about the role of government in American life, with some thinking that the government is too big and intrusive today and should be cut back, and others believing that the

h ld b d d id d

3

government should be expanded to provide more and better public services. Whichever camp one is in, there is broad agreement that long-term federal spending needs to be closer to taxes collected, even if some degree of high

some are not needed, and it implies that bigger spending cuts are not needed either. The debate about the proper role of government will continue, but without the scary Trillion Dollar Deficit headlines, it is hard to imagine either

that those forecasts will turn out to be correct before the year is out. But at the moment, most economists expect GDP growth of about 2% in 2013. Perhaps the expected impact from the higher taxes and lower spending have not

September 2012

side of the debate getting broad public support for the policies they prefer. Although we suspect that most Americans are not yet aware of how far and how fast the deficit is falling, there have been front-page stories in the Wall Street Journal, the New York Times, and other major publications about this phenomenon over the past month. Public perceptions might change significantly if the CBO turns out to be correct

fully hit yet, or perhaps the impact of more restrictive fiscal policies has been offset by lower gasoline prices and a booming stock market that will stall or reverse later this year. But another possible explanation is that the economy would be growing much faster, perhaps 1 or 2% faster had these changes not been made.

That is, restrictive fiscal policies might be masking a far turns out to be correct.

(Ordinarily, we would not put a paragraph in a white paper entirely in parentheses, but the forecast we are about to suggest is both not central to our main argument in this paper and likely to seem insane to most readers, so we think parentheses are appropriate. If our forecast of economic growth comes true, and if there are no changes to current law we believe it is conceivable that by the 2015 fiscal year

greater underlying economic strength.

So far we have focused on federal policies, but state and local governments have also been a drag on GDP over the past few years (Figure 6). That drag has been diminishing, however. State and local tax receipts come mostly from real estate, sales, and income taxes. Although house prices have started to rise and housing starts are up (more on this later),

law, we believe it is conceivable that by the 2015 fiscal year the U.S. federal government could run a budget surplus. Further economic growth could increase employment, increase paychecks, add to capital gains, and further increase Fannie and Freddie profits to the point where the deficit may be eliminated. You read it here first.)

Tax Increases Are a Drag on 2013 Growth, But That

there will clearly be a further lag before real estate tax receipts rise. But as Figure 7 shows, state and local tax receipts are slowly rising. We would expect that increase to accelerate over the next couple of years. Indeed, on May 20, it was reported that state tax revenues grew 9.7% in real terms in the first quarter of 2013. State and local governments generally spend whatever they take in. If revenue keeps rising we would expect the small GDP dragWill Ease Next Year, Absent Further Increases

Government spending on goods and services directly impacts GDP growth, but of course other government policies also influence GDP, especially taxes. The increase in the payroll tax and the increases in income and other taxes for higher income Americans that became effective at the beginning of 2013 have clearly had a negative influence

GDP f hi Th i i h d i b

revenue keeps rising, we would expect the small GDP drag of state and local governments today to become a slight positive for GDP over the next couple of years.

Figure 6: Local Governments Might Have Been A Drag On GDP

on GDP so far this year. The impact is hard to estimate, but based on research by Romer and Romer1, the GDP hit was probably about -1% or more from what the economy would have done in 2013 absent the tax increases.

If The Government Stops Increasing Taxes and Cutting Spending, GDP Might Increase By 2% Or More

Some observers thought that the government’s fiscal tightening would drive the U.S. back into recession in 2013, based on weak trend growth of 1 – 2% going into 2013 and a roughly 2 – 3% total negative impact from the tax increases and reduced government spending on goods and services. We are writing this in May 2013, and it is possible

4

1. Romer and Romer, “The Macroeconomic Effects of Tax Changes: Estimates Based on a New Measure of Fiscal Shocks,” American Economic Review 100 (June 2010): 763-801

The Resilient U.S Consumer Is Back And Feeling Better

September 2012

Figure 7: State And Local Receipts Are Rising Slowly, But Might Accelerate

Consumption

According to the Federal Reserve’s Flow of Funds report, as of the end of 2012, total U.S. household net worth was back to close to its peak (Figure 8). Given the stock market rally and continued gains in house prices, it seems safe to say that U.S. households as a group are richer than they have ever been as of the spring of 2013.

Figure 8: Household Net Worth Is Back To An All‐Time

If Government Steps Aside, GDP Growth Could

Figure 8: Household Net Worth Is Back To An All Time High

Double

Our point is not to second-guess the policies that have been made or to come down on one side or the other of the political debate. We are looking ahead not backwards. Our points are simple:

1. If the CBO forecasts are roughly correct, and we think they are then the political case for further federal taxthey are, then the political case for further federal tax increases and spending cuts will sharply diminish with the general public.

2. The drag from federal, state and local policies has probably hurt GDP by 2% or more in the first half of 2013, yet the economy still seems to be growing about 2%. If restrictive policy stops soon, and the 2% drag goes to zero over the next two years, it will have about

Of course, the distribution of that wealth has changed, with holders of financial assets back above their old peaks and families whose major asset is their home still well below where they were. According to the Fed’s data, household net worth of real estate was 22% below its peak as of the end of 2012goes to zero over the next two years, it will have about

a 2%+ positive impact on GDP.

OK, enough about the government. Let’s consider how another key element of GDP, Consumption Expenditures might change over the next couple of years.

end of 2012.

However, we think the overall number masks a more important implication of the data. About one-third of U.S homes do not have a mortgage outstanding. For the remaining two-thirds of home owners, we estimate that net worth from real estate fell 80% peak to trough (Figure 9),

Figure 9: House Price Increases Might Have A Much Greater Impact Than Expected Due To LeverageFigure 9: House Price Increases Might Have A Much Greater Impact Than Expected Due To Leverage

Flow of Funds – US Real Estate, $ Trillions

End 2006 End 2009 End 2012 If RE +10%

Household Real Estate 22.7 17.2 17.6 19.4‐Mortgages __9.9__ __10.4__ __9.4__ __9.4__

Net Worth Real Estate 12.8 6.8 8.2 10.0‐ Approx. Houses No Mortgage __7.6__ __5.7__ __5.9__ __6.4__

5

‐80% +100% +60%

Net Worth – Mortgaged Houses 5.2 1.1 2.3 3.6

Source: QMA, Federal Reserve Flow of Funds Q4 2012, March 7, 2013.

though that was not quite as bad as we feared in our 2009 white paper, “Fallout of the Great Recession: How Will Typical Americans React To Having Their Net Worth Nearly Wiped Out?”

growth. We are not predicting another bubble, but we think tight supplies will put upward pressure on house prices for years to come.

September 2012

Figure 10: House Prices Have Risen Modestly From The

As of the end of 2012, however, we estimate from the Fed’s data that the net worth of households with mortgages had doubled from the bottom. Projecting that house prices might be 10% higher than the Fed’s data now or later this year, we project a further 60% gain. True, the net worth of families with mortgages is still below the peak, but the action in economics is always at the margin. Leverage cuts

Figure 10: House Prices Have Risen Modestly From The Bottom, But Still Have Room To Run

Real increase over 30 years =

both ways. The devastating losses suffered as the housing bubble burst might be replaced by dramatic gains which are already underway. This helps families, banks, and the overall economy. Households might be more confident about their financial condition, as well as better positioned to use home equity to finance auto purchases or other consumption expenditures.

0.7% per year

Might Housing Gains Continue? We Think They Will

Figure 10 shows the Case-Shiller house price history in inflation-adjusted terms. Since 1985, house prices have risen by about inflation plus 0.7%, about in line with long-term averages calculated by Shiller.

Note, however, that prices have been both well above (2002 – 2006) and well below (1990 – 1999) that trend.

Figure 11: Inventories Are Down To Levels Last Seen During The Boom

( 00 006) a d we be ow ( 990 999) t at t e d.What explains this? One simple explanation is good old supply and demand. As Figure 11 shows, from the early 1980s until 1998, the supply of existing homes for sale was generally well above six months of sales. By 2000, inventories had dwindled to four months’ sales, and inventories stayed tight until 2006. Over the past few months, inventories have fallen back to about their 2000 –2005 Al h h h i h i k d2005 average. Although housing starts have picked up significantly (Figure 12), they are still near the lowest levels of the past 60 years, without adjusting for population

Figure 12: Housing Starts Are Rising Rapidly, And There Is Evidence Of Pent Up Demand

The gap above trend is smaller than the gap below trendthan the gap below trend,

suggesting pent‐up demand

6

Will Credit Conditions Improve? We Think They Have And Will Continue To Do So

One of the reasons that recoveries from financial crises tend to be slower than normal recoveries is that banks are

September 2012

Figure 15: …Including Mortgage Demand

tend to be slower than normal recoveries is that banks are too weakened to lend. As Figure 13 shows, credit expansion since 2009 has been well below that of other recoveries.

Figure 13: Slow Credit Growth Post‐Financial Crisis Has Restrained Growth…

60%

A Slower Rebound – Increase in Debt Outstanding: Domestic

Non‐Financial, As of 12/31/12

And families are in good position to take on some additional debt as suggested by the Fed’s Financial10%

20%

30%

40%

50%

Based on Capital Economics 5/14/13 Housing Market Update

But Figure 14 suggests some “green shoots” of change. A

additional debt, as suggested by the Fed s Financial Obligations Ratio (Figure 16). This measures the costs of servicing mortgages, credit card payments, car loans, etc. relative to disposable personal income. Thanks to low interest rates and household de-leveraging, this level is at a generational low, back to levels not seen since the early 1980s.

0%

10%

1 2 3 4 5 6 7 8 9 10 11 12 13 14

1975 1982 1991 2001 2009

Quarters after recovery’s start

Source: Thomson Reuters Datastream, QMA, Based on WSJ 5/8/13

ut F gu e 4 suggests so e g ee s oots o c a ge.few years ago, credit conditions were dramatically tightening and credit demand was falling. Now credit demand is rising and credit terms are slowly loosening. There is a long way to go, and no one is advocating a return to anything close to the wild lending of a decade ago, but we think the thaw in credit that has started has a long way to run. Mortgage applications have started to increase (Fi 15) b h ill h lf h l l f d d

Figure 16: It Is Relatively Easier For Consumers To Pay Their Bills Today

(Figure 15), but they are still at half the level of a decade ago.

Figure 14: …But Credit Conditions Are Starting To Loosen As Credit Demand Rises…

Mortgage Lenders Tightening Credit & Reporting Stronger Demand (% Balance)

We Think That U.S. Consumers Have A Ton Of Pent-Up Demand

Figure 17 shows U.S. auto sales over the past two decades. In the nine-year period from about the middle of 1998 to

7

y pthe middle of 2007, car sales consistently ran 16 – 18 million units annually. At the low in 2009, car sales fell below 10 million units. Americans have been holding on to

Source: Capital Economics 5/14/13 Housing Market Update, Federal Reserve

the labor market getting better (Figure 18), we think Americans will want to spend again. We have foregone but not foresworn consumption.

Indeed the U S consumer has kept GDP growing in 2013

Figure 17: Pent‐Up Demand Is Substantial, E.g. Auto Sales Have Rebounded, But Might Have More To Go – Still

Below 1999‐2007 Levels

September 2012

Indeed, the U.S. consumer has kept GDP growing in 2013 despite the headwinds from government. Personal consumption expenditures (PCE) account for about 70% of GDP. Despite higher taxes and anxiety about the sequester, PCE accelerated from 1.8% in the fourth quarter of 2012 to 3.2% in the first quarter of 2013. If we are right that those headwinds will diminish during 2014, we expect consumption to increase sharply from current levels, adding

Roughly a 20 million car “gap”

their cars longer, and the average age of cars on the road

perhaps a percentage point or more to GDP growth by 2015.

Energy

Figure 19: After A Long Decline, U.S. Energy Production Is Soaring

has crept up over the past couple of years, in part due to economic conditions, but perhaps also due to higher quality and longevity. Car sales have rebounded from the low to about 15 million, still about 2 million units below the 1998 – 2007 average. If we make the simplistic assumption that Americans would have liked to have continued to buy cars at the 17 million rate if they could, we have about a 20 million car gap to make up There has clearly been some

Oil And Natural Gas Production (1980‐ Feb 2013)

million car gap to make up. There has clearly been some demand destruction: miles not driven to jobs lost or vacations foregone. But our guess is that Americans have not lost their love of cars. We would expect sales to continue to increase. A level of 20 million units a couple of years from now seems reasonable to us as Americans try to make up for lost time.

Data on car sales are easy to come by but we suspect that aSource: EIA, Capital Economics

Data on car sales are easy to come by, but we suspect that a similar pattern exists for other consumer goods. We did not buy in the aftermath of the financial crisis because we couldn’t. But with credit conditions starting to improve and

The American Energy Renaissance Has Caught Many By Surprise

As Figure 19 shows, after a long decline, U.S. oil production has jumped about 2 million barrels a day over the past two years and it continues to rise rapidly. Natural gas production is also soaring. New production techniques to release “tight energy” sources, a.k.a. fracking, have enabled

Figure 18: The Labor Market Is Recovering

g gy , g,energy companies to reclaim sources that had long been uneconomical.

We first discussed this issue in the year-end 2011 Turbulent Teens, and a detailed analysis of this issue is beyond the scope of this paper. Although the impact on GDP is unlikely to be as fast or dramatic as that of a shift in government policies or a rebound in robust consumer

8

g pspending, the implications could have a greater longer-run impact on the economy. Those impacts are likely to manifest themselves in multiple ways:

1. The hundreds of billions of dollars of equipment and infrastructure needed to extract this energy with minimal environmental damage will boost investment spending for years to come.

Will Inflation Erupt? Possibly, But Later In The Decade

September 2012

Inflation

2. U.S. manufacturing will benefit from lower cost, secure energy resources.

3. The U.S. trade deficit is due roughly half to energy and half to trade with China, as seen in Figure 20. If most forecasts are correct, the U.S. could be self-sufficient in energy in about a decade. A manufacturing renaissance could cut the bilateral trade deficit with China Both

Some investors might wonder whether the faster GDP growth we expect might combine with easy Fed policy to reignite inflation. Since in the short run, unexpected increases in inflation tend to hurt equity market returns, what growth giveth the market might inflation take away?

We argued back in our 2010 year-end Turbulent Teens installment that demographics would eventually lead to a could cut the bilateral trade deficit with China. Both

these factors could boost net exports, helping GDP and the dollar.

sta e t t at de og ap cs wou d eve tua y ead to atighter labor market and higher inflation, and we still think that is likely eventually. But as we wrote in a late 2009 white paper (“Is Inflation Likely To Accelerate Soon?”), we think the short-term outlook for inflation remains benign. As we showed in that white paper, inflation in the U.S. comes through the labor market (Figure 21), and unit labor costs remain tame. In addition, if energy production continues to

h ill h l lid i fl i A d ll

Figure 20: Excluding Oil And China, The U.S. Has Had A Trade Surplus

soar, that will help put a lid on inflation. A stronger dollar would also help hold inflation in check. So a tighter labor market might lead to wage increases, inflationary pressures, and higher interest rates. But after the past few years, that seems like a high-quality problem to have.

Figure 21: U.S. Inflation Is Driven By Labor Costs, Which Are Still Low

Five By ’15!

When we consider the cumulative effect of a change in government taxing and spending behavior, an increase in consumption, and the multiple long-term positive implications of an energy boom, we get excited about prospects for GDP growth over the next few years. The CBO forecasted 1.4% in 2013, 3.4% in 2014, and 4.4% in , ,2015. We suspect that actual growth will be about a percentage point higher in each year.

(Though we don’t have access to the model the CBO uses to forecast the deficit, we would guess that if they used our GDP forecasts they would get a surplus in 2015. OK, moving on, not a big deal, lede safely re-buried, closing parenthesis now.)

In addition, the two big drivers of inflationary pressures over the past several decades have quietly abated in the past few years. As Figure 22 shows, inflation in the health care and education sectors has fallen dramatically from the rate of a few years ago.

The health care inflation rate drop might be cyclical a

9

p ) The health care inflation rate drop might be cyclical, a consequence of tough economic times forcing consumers with co-pays or limited/no insurance to postpone care. It

remains to be seen whether the advent of “Obamacare” will cause costs to re-accelerate or remain quiescent. But if the current trend were to continue, it would have important long-term effects on U.S. competitiveness and the federal

September 2012

Figure 23: Stocks Are About Fairly Valued By Historical Standards

budget deficit. All the long-term projections assume continued rapid health care price increases. Though it is premature to draw any definitive conclusions, if those assumptions turn out to be overly pessimistic, the long-term budget outlook might be much better that the conventional wisdom believes.

Figure 22: Health Care And Education Inflation Rates igu e ea a e A E u a io I a io a eHave Been Falling

Figure 24: Earnings Estimates Are Risingg g g

We Think The Bull Market Has A Way To Run

W h b i ll d h i h ill b

Conclusion

We have basically argued that economic growth will be better than the consensus forecast over the next few years. At least in part, the 2013 equity rally might mean that our thinking is already being reflected in stock prices. So does that mean the rally is already overdone? We think not.

The outlook for equity returns is basically driven by earnings and valuations. As Figure 23 shows, valuations as

d b f d P/E ti b t ith

The tone of this Turbulent Teens series has been cautiously optimistic since we started in 2009. Although we recognize that there are plenty of exogenous shocks that could invalidate our forecast, we are ready to drop the “cautiously.” We are optimistic about the next few years,

d h b h fmeasured by forward P/E ratio are about average, neither high nor low.

We suggest that bull markets end when stocks become overvalued; we are still far away from that, in our opinion. Earnings expectations suggest continued growth (Figure 24). In the long run, earnings growth has been about equal to nominal GDP growth. If we are right that GDP growth might be better than expected those earnings expectations

and we suspect the turbulence over the next few years will be of the sort you get when you slam down the accelerator of a powerful sports car. The new turbulence might be less frightening and more exhilarating.

10

might be better than expected, those earnings expectations have a good chance of being realized or even exceeded.

September 2012

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11

Copyright 2013 QMA. All rights reserved

QMA20130524-97

1 *Prudential International Investments Advisers, LLC. (PIIA) is a business of Prudential Financial, Inc., (PFI),

which is not affiliated in any manner with Prudential plc, a company headquartered in the United Kingdom.

For informational use only. Not intended as investment advice. See “Disclosures” on the last page for

important information.

Global Investment Outlook

PRUDENTIAL INTERNATIONAL INVESTMENTS ADVISERS, LLC.

July 2013

Financial Market Outlook: Stocks Likely to Struggle in Near-term on Fed

QE Taper Fears, Japan Policy Uncertainty & Growth Concerns.

However, Stocks Remain Supported by Low Rates & Liquidity, Improving

Growth, Healthy Earnings & Attractive Valuations. Equity Rally Likely to

Resume with Bernanke Reassurance on QE Continuation & Abe-Kuroda

Deliver Next Tranche of Stimulus & Policy Reforms in Japan.

Bond Yields Range Bound as Upward Pressure on Yields from QE Taper

Fears & Improving Growth Offset by Low Inflation & QE Buying.

John Praveen’s Global Investment Outlook - July 2013 expects global markets to

continue to struggle and remain volatile in the near-term with Fed QE taper chatter,

Japan policy uncertainty, and global growth concerns. However, the global equity rally

is likely to resume as current liquidity and policy uncertainties ease with the Fed

reassuring about QE continuation, Abe-Kuroda deliver the next tranche of stimulus and

policy measures in Japan, and global growth picks-up in H2 2013.

In the near-term, stocks are likely to continue to struggle and volatility is likely to

remain high with: 1) Fears about premature QE taper by the U.S. Fed and policy uncertainty in Japan; 2) Emerging central banks remain slow to cut rates; 3) Growth concerns persisting with the U.S. on track to a Q2 slowdown, Eurozone remains in recession, Emerging markets growth yet to gain traction; and 4) Risk that Turkey’s political tensions could escalate into a destabilizing crisis.

However, strategically, global equity markets remain supported by: 1) Low interest rates and plentiful liquidity; 2) Improving global growth with Abenomics fuelling Japan’s recovery, U.S. GDP rebound after the Q2 soft patch, Eurozone recession ending, and Emerging Economies recovery strengthening; 3) Improving risk appetite as Eurozone continues to re-stabilize with resolution of the crises in Italy and Cyprus; 4) Healthy earnings rebound; and 5) Valuations have become more attractive with the recent correction and market multiples remain well below long-term averages.

Bond yields are likely to remain range bound after the recent spike. Yields are likely to

remain under upward pressure from: 1) Lingering fears about premature “tapering” of QE asset purchases by the Fed, and uncertainty about the next tranche of BoJ stimulus; 2) Improving growth in the U.S. & Japan; and 3) Bond valuations remain expensive relative to stocks. However, bonds remain supported by: 1) Inflation in the Developed Economies remaining in a downtrend; 2) Renewed increase in risk aversion with escalating political tensions in Turkey; 3) Growth disappointment in China and Eurozone remaining in recession.

John Praveen, PhD

Chief Investment Strategist

FOR MORE INFORMATION CONTACT:

Lisa Villareal Phone: 973-367-2503 Email: Lisa.villareal@ prudential.com

2 For informational use only. Not intended as investment advice.


Market Outlook: Equity Rally Ends in Mid May on Fed QE “Taper” Fears, BoJ Disappointment & Global

Growth Concerns. Stocks Likely to Struggle in Near-term on Fed QE Taper Fears & Japan Policy

Uncertainty. Bernanke & Abe-Kuroda Reassurances Needed to Calm Markets & Resume Rally.

Bond Yields Rise on QE Taper Chatter. Yields Likely to be Range bound as Upward Pressure on Yields

from QE Taper Fears & Improving Growth Likely to be Offset by Low Inflation & Central Bank Buying.

Stock Market Outlook (July 2013): After defying expectations of a correction for several months, the liquidity-driven equity rally ended in late May as Fed QE “taper” chatter spooked markets. In addition, disappointment over Abe’s “third arrow” and the BoJ refraining from undertaking fresh reflation measures after the aggressive stimulus announced in early April, and downward revision to Global and China’s GDP growth outlook added fuel to the market sell-off.

Stocks posted strong gains until mid-May with the ECB cutting rates, easing risk aversion with a new government in Italy and resolution of the Cyprus crisis, and surprisingly solid US jobs report in May. In the U.S., the S&P 500 soared to a new all time high of 1687 and the Dow hit 15,542. Meanwhile, the Japanese Nikkei surged 50% YTD at the May peak.

However, the stock rally ended in late May as comments by Fed Chairman Bernanke and minutes of the May Fed

meeting suggested that QE 3 asset purchase could be tapered “in the next few meetings" if economic conditions

warrant. While the Fed was quick to clarify that current U.S. economic activity is still far from the conditions under which it would begin to taper-off asset purchases, chatter about QE taper grew in intensity and alarm. Assurances from the BoJ and the ECB that their reflationary policies would remain in place did little to calm markets.

The equity sell-off gathered steam in early June on disappointing economic data with the U.S. ISM unexpectedly dropping below 50. Further, reports that China's new leadership has a greater tolerance for slower growth and that GDP could slow to as much as 7% before triggering fresh stimulus, added to the negative sentiment. Growth concerns increased with the World Bank cutting its forecast for the year, citing a deeper Eurozone recession and slowdown in China and India. Further, the Gezi park protests in Turkey and the government’s aggressive response increased risk aversion offsetting other positive news flow such as the upgrade of U.S. sovereign outlook to stable and the upward revision to Japanese Q1 GDP growth to 4.1%. Through mid-June (15th) the Developed Market index fell -2%, further trimming

YTD gains to 11%. The Emerging Market index fell -6.2% taking YTD losses to -7%.

Looking ahead, strategically, global equity markets remain supported by low interest rates and liquidity,

improving growth, healthy earnings rebound and attractive valuations:

Interest Rates & Liquidity Tailwinds turn into Uncertainty but Likely to Ease: The interest rate and liquidity tailwinds that fuelled the equity market rally thus far in 2013 turned into uncertainty with increased chatter about Fed tapering QE in the near-term, the BoJ withholding further stimulus, and Emerging central banks remaining slow to cut rates despite lackluster growth. However, the interest rate uncertainty is likely to ease with: 1) The Fed reassuring that QE asset buying will continue through late 2013 and that fears of early tapering are exaggerated; 2) The BoJ delivers further monetary stimulus; 3) The ECB take concrete measures to improve credit flow to SMEs; 4) Emerging central banks take advantage of the easing of inflationary pressures and step up rate cuts and other easing measures.

Modest GDP Growth in H1, Growth Gains Traction in H2: Global growth remains modest in the near-term but is

likely to strengthen over H2 2013. While U.S. GDP growth is on track to a Q2 slowdown, growth is likely to rebound in H2 as sequestration cuts will be a smaller drag. Japan’s GDP growth is expected to continue at a solid pace in coming quarters led by consumption and housing investment after the strong 4.1% Q1 GDP growth. Eurozone economy continues to struggle in H1 but recent developments are positive as the ECB cut rates and measures to improve credit



flow to the SMEs combined with improving financial conditions should begin to help Eurozone GDP growth to turn positive in H2 2013. The Emerging Economies remain on a modest growth path but growth is likely to gain traction in H2.

Valuations – Even more attractive after recent correction: Equity market P/E multiples remained stable in May as modest price gains were offset by healthy earnings growth. While developed markets posted solid gains year to date, P/E multiples have remained below historical averages, and the recent correction has improved valuations further. Emerging Markets have struggled and underperformed and are down -7% YTD. Consequently their valuations are even more attractive. Given their underperformance, Emerging market stocks trade at a discount relative to developed market stocks and have the potential to re-rate given the likelihood of EM central bank rate cuts.

Improving Earnings Outlook: Global earnings growth expectations for 2013 have been revised higher to 12%. Japan earnings outlook has been revised sharply higher in order to reflect the boost to the Japanese economy from the Abe government’s aggressive reflationary policies and the BoJ stimulus. Further, the sharp yen depreciation should boost exporter’s earnings. U.S. Q1 earnings season ended on a stronger than expected note suggesting earnings are likely to surprise on the upside. Emerging Markets are still expected to post solid earnings growth for 2013, around 12%. U.S. earnings are expected to post 8% growth in 2013. Japan is expected to surge 54% in 2013 after -11% decline in 2012 while Eurozone earnings growth expectations for 2013 have been revised down to 5%.

Bottom-line: After defying expectations of a correction for several months, the liquidity-driven equity rally

ended in late May as Fed QE “taper” chatter spooked markets. In addition, the BoJ refraining from undertaking fresh reflation measures after the aggressive stimulus announcement in early April, and downward revision to China’s GDP growth outlook added fuel to the market sell-off. Between the mid-May high and mid-June (June 15), developed markets are down -5.4% with Japan down -18.8%. YTD, the Developed Market index is up 10.9%. Emerging Market stocks corrected -5.6% and continued to underperform, down -6.4% YTD.

In the near-term, stocks are likely to continue to struggle and volatility is likely to remain high with: 1) Fears about premature QE taper by the Fed, and uncertainty about further BoJ stimulus and Abe’s “third arrow” to reflate Japan; 2) Emerging central banks remain slow to cut rates; 3) Growth concerns persist with the U.S. on track to a Q2 slowdown, Eurozone remains in recession, Emerging markets growth yet to gain traction, and growth forecasts being downgraded; 4) Risk that Turkey’s political tensions could escalate into a destabilizing crisis.

However, strategically, global equity markets remain supported by: 1) Low interest rates and plentiful liquidity with the Fed continuing QE through late 2013, the BoJ likely to inject fresh stimulus, the ECB taking steps to improve credit flow to SMEs, and further rate cuts likely by Emerging central banks; 2) Improving global growth with Abenomics fuelling Japan’s recovery, U.S. GDP rebound after the Q2 soft patch, Eurozone recession ending, and Emerging Economies recovery strengthening; 3) Improving risk appetite as Eurozone continues to re-stabilize with resolution of the crises in Italy and Cyprus; 4) Healthy earnings rebound with earnings expectations being revised higher after the stronger than expected U.S. Q1 earnings season and Japanese earnings outlook revised higher; and 5) Valuations have become more attractive with the recent correction and market multiples remain well below long-term averages.

While Fed QE chatter, Japan policy uncertainty and global growth concerns are likely to keep markets volatile in

the near-term, the global equity rally is likely to resume as the liquidity and policy uncertainties ease with the Fed

reassuring that it is unlikely to “taper” QE buying until late 2013/early 2014, Abe-Kuroda deliver the next tranche

of stimulus and policy measures in Japan, and global growth picks-up.



Bonds: Yields Likely to Remain Range Bound as Upward Pressure on Yields from QE Taper Fears &

Improving Growth Likely to be Offset by Low Inflation & Central Bank Buying.

Global Bond yields rose sharply in May on uncertainty about the path of future central bank asset purchases,

especially increased chatter about Fed’s QE taper, and easing risk aversion in Eurozone.

Looking ahead, bond yields are likely to be range bound in the near-term. Yields are likely to remain under

upward pressure from: 1) Lingering fears about premature “tapering” of QE asset purchases, and uncertainty about the next tranche of BoJ stimulus; 2) Improving GDP growth in the U.S. & Japan; and 3) Bond valuations remain expensive relative to stocks.

However, bonds remain supported by: 1) Inflation in the Developed Economies remaining in a downtrend; 2) Renewed increase in risk aversion with escalating political tensions in Turkey; 3) Growth disappointment in China and Eurozone remaining in recession.

Investment Strategy: Reduce Equity Overweight as Stocks Likely to Struggle & Remain Volatile in

Near-term on QE Taper Fears & Japan Policy Uncertainty

Asset Allocation: Stocks vs. Bonds

Stocks – Reduce Equity Overweight: We tactically reduce equity overweight as stocks are likely to continue to struggle in the near-term with fears about premature QE taper by the Fed, uncertainty about further BoJ stimulus and Abe’s “third arrow” to reflate Japan, and continued political tensions in Turkey.

We expect the equity rally to resume on Bernanke reassurance about Fed QE continuation, Abe-Kuroda delivering the next tranche of stimulus and policy measures in Japan, and global growth picking-up.

Strategically, global equity markets remain supported by low interest rates and plentiful liquidity, improving growth, healthy earnings rebound and attractive valuations. Hence we keep stocks at modest overweight.

Bonds – Neutral on Bonds as bond yields are likely to remain range-bound after the recent spike. Bond yields are likely to be under upward pressure from QE taper fears, easing of Eurozone risks and improving growth. However, this is likely to be offset by low inflation in the developed economies (U.S. and Eurozone headline inflation under 1.5%) and continued central bank buying, even with Fed QE taper.

Global Equity Markets:

After surging 50% YTD, Japan stocks correct sharply on uncertainty about further BoJ stimulus and Abe’s “third

arrow”. Reduce Japan Overweight.

Modest Overweight: Japan; Neutral: Eurozone, Emerging Markets, U.S.; Modest Underweight: U.K.

Modest Overweight – Japan

1) Japan – Reduce to Modest Overweight: After surging over 50% through mid-May, Japanese stocks fell around 20% through mid-June on Fed QE taper fears, BoJ remaining on hold in May-June and disappointment about Abe’s “third arrow” to reflate Japan. Japan stocks are likely to remain volatile in the near-term until fresh policy moves by the BoJ and the Abe administration. However, Japanese stocks remain supported by solid GDP and earnings rebound and the rally is likely to resume once BoJ injects fresh stimulus and Abe announces structural reforms (third arrow).



Neutral – U.S., Eurozone & Emerging Markets:

1) Eurozone – Downgrade to Neutral: While Eurozone risks have declined with easing of Cyprus and Italian crises, concerns of Fed QE tapering, sluggish Chinese growth, and Eurozone recession continuing into Q2 are fresh concerns. While prospects for ECB improving credit flow to SMEs, and recession ending in H2 are positives for Eurozone stocks, they are likely to remain volatile in the near term due to Fed Taper fears, Japan policy uncertainty and weaker growth in China. Hence, reduce to neutral.

2) Emerging Markets - Remain Neutral: Emerging Market stocks continued to struggle as fears about premature QE taper resulted in significant capital outflows. Escalation of Turkey tensions is a fresh negative. GDP growth outlook remains sluggish with China disappointing and India struggling. However, EM central banks have room to ease with decline in commodity and oil prices dampening inflationary pressures. EM stock valuations are attractive. Earnings expected to rebound 12% in 2013.

3) U.S. – Upgrade to Neutral: U.S. likely to provide a defensive hedge amidst increased market volatility. U.S. stocks have given up some of their gains, improving valuations. GDP growth on track to slow in Q2 but rebound in H2 as sequestration cuts are likely to be a smaller drag. Earnings growth expected to slow in Q2 but recover in H2.

Underweight – U.K.:

1) U.K. - Remain underweight: U.K. stocks remain under pressure with weak GDP growth and modest earnings growth. BoE remains on hold and has less room to adopt further easing measures due to inflation overshoot. Earnings expected to rise just 3% in 2013.

Global Bond Markets

• Overweight: Eurozone Bonds; Modest Overweight: U.S. Treasuries

• Neutral: Japanese JGBs

• Underweight: U.K. Gilts

Global Sectors

• Overweight: Financials, Information Technology; Modest Overweight: Industrials, Telecoms & Healthcare

• Neutral: Consumer Discretionary

• Underweight: Energy, Materials, Consumer Staples & Utilities

Currencies

• Overweight: U.S. Dollar • Neutral: Euro & Sterling • Underweight: Yen

The U.S. dollar is likely to strengthen against the yen and be range bound against the euro.

The yen strengthened sharply after the BoJ remained on hold in May and June after the aggressive reflationary measures in April. The BoJ is likely to undertake further monetary reflationary measures in conjunction with the Abe government’s reform policies which should resume the yen downtrend, pushing the yen back above ¥100/$.

In the Eurozone, economic activity remains depressed currently but there are signs that growth will turn positive in H2. In addition, Eurozone risks have eased with resolution of the Cyprus crisis and a new government in Italy. These are positive for the euro. However, further ECB rate cuts are negative for the Euro.

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Disclosures: Prudential International Investments Advisers, LLC. (PIIA), a Prudential Financial, Inc. (PFI) company, is an investment adviser registered with the Securities and Exchange Commission of the United States. Pramerica is a trade name used by PFI and its affiliated companies in select countries outside of the United States. PFI, a company incorporated and with its principal place of business in the United States of America is not affiliated in any manner with Prudential plc, a company headquartered in the United Kingdom. The commentary presented is for informational purposes only, and is not intended as investment advice. This material has been prepared by PIIA on the basis of publicly available information, internally developed data and other third party sources believed to be reliable. However, no assurances are provided regarding the reliability of such information. All opinions and views constitute judgments of PIIA as of the date of this writing, and are subject to change at any time without notice. There can be no assurance that any forecast made herein will be realized. Distribution of this information to any person other than the person to whom it was originally delivered and to such person’s advisers is unauthorized and no part of this material may be reproduced or distributed further without the written approval of PIIA. These materials are not intended for distribution to, or use by, any person in any jurisdiction where such distribution would be contrary to local law or regulation. The companies, securities, sectors and/or markets referenced herein are included solely for illustrative purposes to highlight the economic trends, conditions, and the investment process, but may or may not be held by accounts actually managed by PIIA. The strategies and asset allocations discussed do not refer to any service or product offered by PIIA or by its affiliates The global asset and strategy allocation models presented are hypothetical allocation models shown for illustrative purposes only, and do not necessarily reflect the management of any actual account. Following the allocation recommendations presented will not necessarily result in profitable investments. Past performance is not an assurance of future results. Nothing herein should be viewed as investment advice to adopt any investment strategy, nor should it be considered an offer to provide investment advisory or other allocation services. © 2013 Prudential Financial, Inc. and it related entities. Prudential, the Prudential logo and the Rock symbol are service marks of Prudential Financial, Inc. and it related entities, registered in many jurisdictions worldwide.

1 *Prudential International Investments Advisers, LLC. (PIIA) is a business of Prudential Financial, Inc., (PFI),

which is not affiliated in any manner with Prudential plc, a company headquartered in the United Kingdom.

For informational use only. Not intended as investment advice. See “Disclosures” on the last page for

important information.

Global Investment Strategy

PRUDENTIAL INTERNATIONAL INVESTMENTS ADVISERS, LLC.

July 2013

Investment Strategy: Tactically Reduce Equity Overweight as Stocks Struggle

on Fed QE Taper Fears, Japan Policy Uncertainty & Global Growth Concerns.

Bernanke Reassurance on QE Continuation & Abe-Kuroda Delivering Next

Tranche of Stimulus & Policy Reforms Needed to Calm Markets.

Bond Yields Range Bound as Pressure on Yields from QE Taper Fears &

Improving Growth Offset by Low Inflation & QE Buying. Raise Bonds to Neutral.

John Praveen’s Global Investment Strategy for July 2013 reduces the equity market

overweight on a tactical basis as stocks are likely to continue to struggle and volatility

remains high in the near term with fears about Fed QE taper, uncertainty about further

BoJ stimulus and Abe’s “third arrow” to reflate Japan, global growth concerns, and

continued political tensions in Turkey.

Strategically, global equity markets remain supported by: 1) Low interest rates and plentiful liquidity; 2) Improving global growth; 3) Improving risk appetite as Eurozone continues to re-stabilize with resolution of the crises in Italy and Cyprus; 4) Healthy earnings rebound; and 5) Valuations have become more attractive with the recent correction.

While Fed QE taper fears, Japan policy uncertainty and global growth concerns are likely to keep markets volatile in the near-term, the equity rally is likely to resume as the liquidity and policy uncertainties ease with the Fed reassuring about QE buying continuing through late 2013, Abe-Kuroda deliver the next tranche of stimulus and policy measures in Japan, and global growth picks-up. Hence we see the equity correction as a buying opportunity.

We raise bonds to neutral as yields are likely to remain range bound with upward pressure on yields from QE taper fears, easing of Eurozone risks and improving growth offset by low inflation in the developed economies and continued central bank buying, even with QE taper.

Among global stock markets, we reduce overweight in Japan as market likely to remain volatile until fresh BoJ stimulus and Abe outlines “third arrow”. Reduce Eurozone to Neutral on Fed taper fears. Remain neutral on EM stocks with sluggish growth and slow rate cuts. We raise U.S. to neutral as it is likely to be a defensive hedge amidst increased volatility.

Among global bond markets, we remain overweight in Eurozone bonds as the economy remains in recession and inflation remains low. Raise U.S. Treasuries to modest overweight on Q2 GDP slowdown and low inflation. Remain Neutral on JGBs. Remain Underweight U.K. Gilts.

Among global sectors, we are Overweight on Financials and Information Technology; Modest Overweight on Industrials, Healthcare and Telecoms; Neutral on Consumer Discretionary; Underweight on Energy, Materials, Consumer Staples and Utilities.

Among currencies, the U.S. dollar is likely to strengthen against the yen and be range bound against the euro. Further BoJ stimulus and Abe government’s reform measures should push the yen back above ¥100/$.

John Praveen, PhD

Chief Investment Strategist

FOR MORE INFORMATION CONTACT:

Lisa Villareal Phone: 973-367-2503 Email: Lisa.villareal@ prudential.com

PRUDENTIAL INVESTMENTS » MUTUAL FUNDS



Investment Strategy: Tactically Reduce Equity Overweight as Stocks are Likely to Struggle in the Near Term on Fed QE Taper Fears, Japan Policy Uncertainty & Global Growth Concerns. Bernanke Reassurances & Abe-Kuroda measures Needed to Calm Markets & Resume Rally

Asset Allocation: Stocks, Bonds & Cash

Stocks – Reduce to Modest Overweight: After defying expectations of a correction for several months, the liquidity-driven equity rally ended in late May as Fed QE “taper” chatter spooked markets. In addition, the BoJ refraining from undertaking fresh reflation measures, and downward revision to global growth outlook added fuel to the market sell-off.

Strategically, global equity markets remain supported by: 1) Low interest rates and plentiful liquidity with the Fed continuing QE though late 2013, the BoJ likely to inject fresh stimulus, the ECB taking steps to improve credit flow to SMEs, and further rate cuts likely by some Emerging central banks; 2) Improving global growth with Abenomics fuelling Japan’s recovery, U.S. GDP rebound after the Q2 soft patch, Eurozone recession ending, and Emerging Economies recovery strengthening; 3) Improving risk appetite as Eurozone continues to re-stabilize with resolution of the crises in Italy and Cyprus; 4) Healthy earnings rebound with earnings expectations being revised higher after the stronger than expected U.S. Q1 earnings season and Japanese earnings outlook revised higher on weaker yen; and 5) Valuations have become more attractive with the recent correction and market multiples remain well below long-term averages.

However, in the near-term stocks are likely to continue to struggle and volatility remain high with: 1) Fears about early QE taper by the Fed, and uncertainty about further BoJ stimulus and Abe’s “third arrow” to reflate Japan; 2) Emerging central banks remain slow to cut rates; 3) Growth concerns persist with the U.S. on track to a Q2 slowdown, Eurozone remains in recession, Emerging markets growth yet to gain traction; 4) Risk that Turkey’s political tensions could escalate into a destabilizing crisis.

Given the elevated risks, we have tactically reduced the equity overweight as stocks are likely to struggle and

remain volatile. We remain strategically positive on global equity markets as they remain supported by low

interest rates and liquidity, improving growth, healthy earnings rebound and attractive valuations. We expect the

global equity rally to resume as the liquidity and policy uncertainties ease with the Fed reassuring that it is

unlikely to “taper” QE buying until late 2013, Abe-Kuroda deliver the next tranche of stimulus and policy

measures in Japan, and global growth picks-up. We thus see the equity correction as a buying opportunity.

Bonds – Raise to Neutral: Global Bond yields rose sharply in May/June on increased chatter about Fed’s QE taper, and easing risk aversion in Eurozone. After the recent spike, bond yields are likely to remain range-bound, hence we raise bonds to neutral from modest underweight. Yields are likely to remain under upward pressure from: 1) Lingering fears about early “tapering” of QE buying by the Fed, and uncertainty about the next tranche of BoJ stimulus; 2) Improving GDP growth in the U.S. & Japan; and 3) Bond valuations remain expensive relative to stocks. However, bonds remain

supported by: 1) Inflation in the Developed Economies remaining in a downtrend; 2) Renewed increase in risk aversion with escalating political tensions in Turkey; 3) Growth disappointment in China and Eurozone remaining in recession.

Investment Strategy within Global Markets:

Global Equity Market Strategy:

Reducing Japan Overweight on Uncertainty about further BoJ stimulus and Abe’s “third arrow”.

• Reduce Japan to Modest Overweight;




• Reduce Eurozone to Neutral;

• Remain Neutral Emerging Markets;

• Raise U.S. to Neutral;

• Remain Underweight in U.K.

Global Bond Markets:

• Overweight: U.S. Treasuries, Eurozone Bonds;

• Neutral: Emerging Market Bonds & Japanese JGBs;

• Underweight: U.K. Gilts.

Global Sectors:

• Overweight: Financials, Information Technology;

• Modest Overweight: Industrials, Healthcare & Telecomms;

• Neutral: Consumer Discretionary;

• Underweight: Energy, Materials, Consumer Staples & Utilities.

Currencies:

• Overweight: U.S. Dollar & EM Currencies;

• Neutral: Euro & Sterling;

• Underweight: Yen.

The U.S. dollar is likely to rebound against the yen and be range bound against the euro.

The yen strengthened sharply after the BoJ remained on hold in May and June after the aggressive reflationary measures in April. The BoJ is likely to undertake further monetary reflationary measures in conjunction with the Abe government’s reform measures which should resume the yen downtrend, pushing the yen back above ¥100/$.

Eurozone economic activity remains depressed currently but there are signs that growth will turn positive in H2. In addition, Eurozone risks have eased with resolution of the Cyprus crisis and a new government in Italy. These are positive for the euro. However, further ECB easing measures are negative for the Euro.

Global Equity Market Strategy

Japan - Reduce Overweight: After surging over 50% through mid-May, Japanese stocks fell over 20% through mid-June on Fed QE taper fears, BoJ remaining on hold in May-June and disappointment about Abe’s third arrow to reflate Japan. However, Japanese stocks remain supported by solid GDP and earnings rebound. Japan’s Q1 GDP has been revised higher to 4.1% and GDP growth momentum remains solid in Q2. Earnings outlook has been sharply revised higher to around 54% YoY for 2013. While the yen has appreciated recently on concerns about further BoJ bond buying, the yen has depreciated -8.2% since the beginning of the year and is a positive for Japanese exporters and earnings. Japan stocks are likely to remain volatile in the near-term until fresh stimulus by the BoJ and policy measures by the Abe administration. However, the rally is likely to resume once BoJ reassures with further stimulus and Abe announces structural reforms (third arrow).




Eurozone – Reduce to Neutral: While risk aversion has declined with easing of Cyprus and Italian crises, concerns of Fed QE tapering, sluggish Chinese growth, and Eurozone recession continuing into Q2 are fresh concerns. Eurozone GDP is expected to decline -0.7% in Q2. However, recent developments are positive for Eurozone growth outlook. The ECB cut rates in May and is exploring measures to improve credit flow to the small and medium-sized companies (SMEs) in the Periphery. This combined with improving financial conditions should begin to help the Eurozone recovery and GDP growth is expected to turn positive in H2 2013. While prospects for ECB improving credit flow to SMEs, and recession ending in H2 are positives for Eurozone stocks, they are likely to remain volatile in the near term due to Fed Taper fears and BoJ stimulus concerns, and weaker growth outlook for China. Hence, reduce to neutral.

Emerging Markets (EM) – Remain Neutral: Emerging Market stocks continued to struggle as fears about early Fed QE taper resulted in significant capital outflows. Escalation of Turkey tensions is a fresh negative. GDP growth outlook remains sluggish with China disappointing and India struggling. However, EM central banks have room to ease with the decline in commodity and oil prices dampening inflationary pressures. EM stock valuations are attractive after underperforming significantly year to date. EM earnings growth is expected to rebound a solid 12% in 2013 after declining -2% in 2012.

U.S. - Upgrade U.S. stocks to neutral as the U.S. is likely to provide a defensive hedge amidst increased market volatility. U.S. stocks have given up some of their gains which has improved the valuations. GDP growth on track to slow in Q2 but rebound in H2 as sequestration cuts are likely to be a smaller drag, while housing remains robust and consumer spending solid. Earnings growth expected to slow in Q2 but recover in H2.

U.K. - Remain modest underweight as GDP growth outlook remains weak and the BoE remains on hold. GDP growth rose 1.3% in Q1 after the -1.2% contraction in Q4 2012. However, there are risks to Q2 growth outlook. Inflation remains elevated, though has edged down recently. The BoE remains on hold and has not adopted additional easing measures despite inflation easing recently. Earnings expectations have been revised lower with earnings expected to rise just 3% in 2013 after the -9% decline in 2012.

Global Bond Market Strategy

Eurozone: The outlook for Eurozone bonds remains positive. Eurozone economy continues to struggle with GDP contracting -0.8% QoQ annualized in Q1 and is on track to decline -0.7% in Q2. While ECB rate cuts and improving financial conditions are positive for Eurozone growth outlook and GDP is expected to turn positive in H2 for Eurozone as a whole, the periphery is likely to remain in recession. Further, headline & core inflation is low, both well below ECB’s 2% target. Weak growth and low inflation and scope for further ECB rate cuts are likely to keep downward pressure on yields. There had been a temporary reduction in Eurozone sovereign risks as the Cyprus crisis was resolved and Italian political uncertainty eased. However, spreads have widened again, largely due to a general increase in financial market volatility as equity markets corrected rather than renewed risks in the Periphery. Wider spreads and market uncertainty point to downward pressure on Eurozone yields. Remain Overweight in Eurozone Bonds.

U.S. Treasuries: The outlook for U.S. Treasuries is positive. Treasury yields spiked in May, rising to a high of 2.17% on solid Q1 GDP growth and expectations of early tapering of Fed’s QE asset purchases. However, U.S. GDP growth is on track for a Q2 slowdown while the Fed is expected to reassure markets that QE asset buying will continue through late 2013 and that fears of early tapering are exaggerated. Further, inflation remains in a downtrend. All these positives are likely to keep Treasury yields in a modest downtrend in the near-term. Upgrade U.S. Treasuries to Overweight.

Emerging Markets: The outlook for Emerging Market bonds is neutral. EM bond performance remains largely driven by the changes in risk appetite. Following the resolution of crises in Cyprus and Italy, risk appetite improved, a positive for




EM bonds. However, fears of premature Fed QE taper led to a reversal of capital flows into EM and a negative for EM bonds. However, the recent decline in commodity prices has taken pressure off EM inflation giving room for central banks to cut rates. Further, growth is expected to improve in H2, a positive for EM bonds. Remain Neutral in EM Bonds.

Japan JGBs: The outlook for JGBs is neutral. Yields are back up to pre-April levels after plunging following the April stimulus announcement. While the BoJ remains committed to aggressive reflation, the bank remained on hold in May and June in order to evaluate the impact of the stimulus announced in April. However, uncertainty about the next tranche of BoJ reflation measures are likely to keep JGB yields range bound in the near-term. Further, while BoJ buying is likely to keep downward pressure on JGB yields, the growth rebound and easing of deflationary pressures are likely to put upward pressure on yields. Hence, JGB yields are likely to be range bound. Remain Neutral JGBs.

U.K. Gilts: The outlook for U.K. Gilts remains negative. U.K. inflation remains higher than in other developed economies, despite easing recently. As a result, the BoE remains constrained from expanding its asset purchase program, though the new BoE Governor Carney is expected to be more dovish than out-going Governor King. While U.K. Q1 GDP surprised on the upside, Q2 growth is expected to slow, a positive for U.K. Gilts. Remain Underweight Gilts.

Global Sector Strategy

We expect Financials Info Tech, Industrials, Healthcare and Telecoms to outperform other sectors. We remain

Overweight in Financials & Information Technology; Modest Overweight in Industrials, Healthcare & Telecoms;

Neutral in Consumer Discretionary; Underweight in Energy, Materials, Consumer Staples & Utilities.

• Financials: Improvement in capital market activity and improving growth outlook are positives. Likelihood of further asset purchases in Japan and low rates in general are supportive of Financials. Asset price improvements in the US leading to healthier bank balance sheets. Financials trade at a discount to long term average P/E and P/B. Remain

Overweight.

• Information Technology: Software & Services continue to post strong gain with a broadly positive outlook for H2 2013 on improving revenue trends driven by an increase in contract renewals and business confidence. Relatively strong profitability and cheap valuations. Earnings are expected to grow 6% in 2013. Raise to Overweight.

• Industrials: The global manufacturing sector eked out further modest expansion in production and new orders during May. Japanese industrials are likely to benefit from the weakening Yen. Industrials with EM exposure remain under downward pressure. Earnings are expected to grow 10% in 2013 after 3% in 2012. Remain Modest Overweight.

• Healthcare: The sector remains the best performer year to date. US Pharmaceuticals and Biotech stocks continue to outperform on strong pipeline and profitability. The sector is trading at a modest discount to long term trailing P/E despite strong gains in 2012 and early 2013. Remain Modest Overweight.

• Telecomm Services: Increased exports of smart phones from Korea and Taiwan are a positive for the sector leading to an increase in mobile browsing revenue. Increasing capex budgets towards network roll-outs putting pressure on margins. Earnings expected to grow 4% in 2013. Raise to Modest Overweight.

• Consumer Discretionary: Japanese consumer spending is likely to continue to strengthen as the Abe reflation boosts consumer confidence. U.S. consumption spending is likely to pick up further in H2 2013. Eurozone retail sales remain weak. Sector valuations are relatively attractive. Earnings expected to grow 18% in 2013. Remain Neutral.




• Materials: Commodity price weakness likely to continue in the near term. Industrial commodities likely to see continued price declines as emerging market demand remains weak amidst a sluggish growth recovery. Earnings expected to rebound 5% after declining -21% in 2012. Remain Underweight.

• Energy: Sluggish growth recovery in emerging economies and lower demand from Europe continues to weigh on the sector. Continued weakness could keep prices low in the near term. However, any increase in risk aversion due to geopolitical developments would boost oil prices. Sector valuations remain attractive. Remain Underweight.

• Consumer Staples: The sector has performed strongly against a favorable commodity backdrop. However, valuations have become expensive following strong gains. Earnings are expected to grow 6% in 2013. Remain

Underweight.

• Utilities: Increased risk appetite with improving macro environment is a negative for the sector. Sector valuations at par with the overall market after the 2012 gains. Margins remain weak with soft pricing power and higher input costs. Remain Underweight.

Investment Strategy Summary

Asset Allocation: Reduce Equity Overweight; Raise Bonds to Neutral; Underweight Cash.

Global Equities: Reduce Overweight in Japan; Reduce Eurozone to Neutral; Remain Neutral on Emerging Markets; Raise U.S. to Neutral; Remain Underweight U.K.

Global Bonds: Remain Overweight Eurozone bonds; Raise U.S. Treasuries to Overweight; Remain Neutral Japanese JGBs; Remain Underweight U.K. Gilts.

Global Sectors: Overweight: Financials, Information Technology; Modest Overweight: Industrials, Healthcare & Telecoms; Neutral: Consumer Discretionary; Underweight: Materials, Energy, Consumer Staples & Utilities.

Currencies: Overweight: U.S. Dollar & EM Currencies; Neutral: Euro & Sterling; Underweight: Yen.

Follow us on Twitter: www.twitter.com/prustrategist

Disclosures: Prudential International Investments Advisers, LLC. (PIIA), a Prudential Financial, Inc. (PFI) company, is an investment adviser registered with the Securities and Exchange Commission of the United States. Pramerica is a trade name used by PFI and its affiliated companies in select countries outside of the United States. PFI, a company incorporated and with its principal place of business in the United States of America is not affiliated in any manner with Prudential plc, a company headquartered in the United Kingdom. The commentary presented is for informational purposes only, and is not intended as investment advice. This material has been prepared by PIIA on the basis of publicly available information, internally developed data and other third party sources believed to be reliable. However, no assurances are provided regarding the reliability of such information. All opinions and views constitute judgments of PIIA as of the date of this writing, and are subject to change at any time without notice. There can be no assurance that any forecast made herein will be realized. Distribution of this information to any person other than the person to whom it was originally delivered and to such person’s advisers is unauthorized and no part of this material may be reproduced or distributed further without the written approval of PIIA. These materials are not intended for distribution to, or use by, any person in any jurisdiction where such distribution would be contrary to local law or regulation. The companies, securities, sectors and/or markets referenced herein are included solely for illustrative purposes to highlight the economic trends, conditions, and the investment process, but may or may not be held by accounts actually managed by PIIA. The strategies and asset allocations discussed do not refer to any service or product offered by PIIA or by its affiliates The global asset and strategy allocation models presented are hypothetical allocation models shown for illustrative purposes only, and do not necessarily reflect the management of any actual account. Following the allocation recommendations presented will not necessarily result in profitable investments. Past performance is not an assurance of future results. Nothing herein should be viewed as investment advice to adopt any investment strategy, nor should it be considered an offer to provide investment advisory or other allocation services. © 2013 Prudential Financial, Inc. and it related entities. Prudential, the Prudential logo and the Rock symbol are service marks of Prudential Financial, Inc. and it related entities, registered in many jurisdictions worldwide.

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NOTHING below this line

0171117-00016-00 Ed. 04/2013

dr. quincy KrosbyChief Market Strategist, Prudential Annuities®

banking on itWhile a quick glance of popular magazines, globally, highlights the comings and goings of Justin Bieber, Adele, and our own Taylor Swift, not to mention the ubiquitous Kardashian/Jenner clan, the financial world has its mega stars. They can walk through airports without the paparazzi lying in wait. The average world citizen has no idea who they are, what they look like, or what they do. Yet, their actions affect our lives in every way, from the price of our most basic food, to our mortgage rates and the interest paid on our checking accounts. Above all else, they move markets — all markets: stocks, bonds, commodities, currencies and real estate. Nearly everything. From what they say, and especially what they don’t say, central bankers have become the most powerful force in today’s financial landscape.

There’s Ben Bernanke, of course, the Financial Times’ 2012 person of the year, Mario Draghi, and the latest entrant to central bank super stardom, Haruhiko Kuroda. In financial circles, and increasingly in political circles, they are viewed as the power brokers underpinning the global economy. As the recovery expands and sputters, these Three Financial Tenors will be heralded and defamed alike as they resort to extraordinary measures in an equally extraordinary chapter in financial history.

The uniTed sTaTes — The VirTuous circleAs the U.S. markets closed the books on the best first quarter in 15 years and continued to make new highs into the second quarter, investors didn’t know whom to thank: corporate CEOs for engineering strong profits, or Ben Bernanke for orchestrating the ultra low interest rate environment which has ultimately offered little in the way of attractive yielding investment choices outside of stocks. On March 28th it didn’t matter as the S&P 500™ erased the losses wrought by the unleashing of the sub-prime induced crisis and set a new record. Bernanke could point to an ever closer fulfillment of his outline for the all-important economic “virtuous circle.”

In November 2010, as the Federal Reserve’s quantitative easing program was being expanded, an op-ed piece penned by Chairman Bernanke appeared in the Washington Post, explaining “what the Fed did and why.” This outreach effort was to become an integral part of the Chairman’s push towards transparency and communication. Moreover, it was designed to allay growing fears that the Fed’s

q2 2013 ediTion

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expansionary policies were going to lead to the hyper-inflationary environment suffered in Germany during the 1920s, or more recently in Zimbabwe.

According to the article, the purchases of Treasury securities and mortgage-backed assets eased financial conditions and allowed stock prices to rise and interest rates to fall. “Easier financial conditions will promote economic growth,” wrote Bernanke. “For example, lower mortgage rates will make housing more affordable and allow homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.” For the Federal Reserve, economic expansion is consummate with full employment.

if only iT were ThaT easyThe road towards the virtuous circle has been obstructed along the way by euro zone-related fears, a slowing Chinese economy, and a host of self-inflicted Washington-based concerns and confusion.

Although we’ve seen a marked improvement in the labor market with job openings reaching the highest level since 2008 and unemployment claims down substantially, under the surface, the employment picture raises the basic question of why aren’t more Americans being hired. Is the problem cyclical or more short term in nature, or is it reflective of a deeper, structural change in the U.S. economy? And are the measures being employed by the Federal Reserve encroaching on fiscal policy rather than remaining clearly within the distinct realm of monetary policy?

Total employment is currently three million below where it was before the recession began, while the labor force participation rate suggests that potential job seekers are dropping out of the job pool. This has allowed the headline unemployment rate to edge comfortably below 8%. The broader measure of unemployment, which includes “marginally attached” workers, accounts for those who take part-time positions out of necessity and those who stop looking temporarily. At just under 14%, this figure has remained stubbornly high.

To be sure, household wealth has been restored, thanks in large measure to a rising stock market and gains in home prices. Based on Federal Reserve figures, household worth fell to $51.4 trillion in 2009 after reaching $67.4 trillion in 2007. Projections suggest that the numbers could reach $68 trillion by the second quarter of this year. However, it is the top 5% of Americans who hold more than 80% of the individual stocks and bonds in the U.S. while the average American has seen wages moving only slightly. Based on Census Bureau data, annual median household income fell to $45,000 in 2012, down from approximately $51,000 in 2010.

As the Federal Reserve adheres to its 1977 congressional mandate to create an environment of sustainable economic growth, or the full employment mandate, along with its original mandate to keep inflationary pressures under control, the Federal Open Market Committee (FOMC) announced at its December 12, 2012, meeting that it would maintain its zero-interest-rate policy until unemployment falls to 6.5%, as long as inflation doesn’t climb higher than 2.5%. At a recent press

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conference, Bernanke said the FOMC will continue to monitor a range of indicators that include wages, jobless claims and the hiring rate. The bond purchases, he emphasized, could be “calibrated” depending on “meaningful changes in economic conditions that can be sustained for a number of months.”

In the meantime, the Fed’s monthly purchases, bringing the Fed’s balance sheets closer and closer to $4 trillion, are designed to propel the stock market, the housing market, and the auto industry, in addition to prompting a cash-rich corporate America to accelerate spending on goods and services, all lending support to economic expansion and the creation of more jobs — thus completing the elusive “virtuous circle.” Until then, members of the FOMC debate whether or not the program is ensuring healthy job growth and at what cost and risk.

Vice Chairman of the Federal Reserve Janet Yellen, the leading candidate to replace Bernanke in early 2014, has focused on the need for an expansionary policy given the still high rate of unemployment, warning that “prolonged economic weakness could harm the economy’s productive potential for years to come.” And placing her squarely in the “dove” camp at the Fed, Yellen noted that “with employment so far from its maximum level and with inflation running below the Committee’s 2% objective, I believe it’s appropriate for progress in the labor market to take center stage in the conduct of monetary policy.”

low raTes aT whaT cosT — The uninTended consequencesMuch of the debate regarding quantitative easing has been shrouded in political or at times philosophical polemics, evolving into a right versus left debate. Nobel Prize laureate Paul Krugman, a staunch defender of the policy, recently summed up his position in his New York Times column: “Unemployment, not excessive money printing, is what ails us now — and policy should be doing more, not less.” David Stockman, the budget director under President Reagan, lambasted Fed policy in an op-ed piece for The New York Times: “Sooner or later — within a few years — this latest Wall Street bubble, inflated by an egregious flood of phony money from the Federal Reserve rather than real economic gains, will explode.”

Certainly, the deliberately flattened interest rates are forcing a global search for yield whether for pension funds, endowments or the average investor. The search for yield is forcing money into deeper and more esoteric crevices of the market, with the risk/reward ratio skewed towards risk. Products are being created utilizing ever higher leverage and easily being sold as yield becomes a cherished commodity. What was easy to achieve just a few years ago now involves intricate formulas. Savers are being punished. The distortions and lack of discovery in markets have made policy announcements by Federal Reserve, the Bank of Japan and the European Central Bank seemingly more important than the most basic fundamentals.

Still, the unconventional monetary policies being implemented have helped erase the losses suffered during the downturn. But as risk garners higher returns, more risk will be taken. Such is the nature of market behavior. While we continue to depend on monetary easing, it would be wise to focus on fundamentals, for it is fundamentals that you can truly bank on in the long run.

4/ 40171117-00016-00 ORD203077 Ed. 04/2013[WO# 588201]

To help her analyze current market conditions, Dr. Quincy Krosby’s sources include: The Bureau of Labor Statistics, Bloomberg.com, The U.S. Department of Commerce, The Economist, The Federal Reserve, the Financial Times, Goldman Sachs, Morgan Stanley, The New York Times, The New Yorker, and The Wall Street Journal.

The views and opinions are those of the author at the time of publication and are subject to change at any time due to market or economic conditions. This document has been prepared solely for informational purposes. This 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.

Annuities are issued by Prudential Insurance Company of America and Pruco Life Insurance Company (in New York, by Pruco Life Insurance Company of New Jersey), all located in Newark, NJ, and distributed by Prudential Annuities Distributors, Inc., Shelton, CT. All are Prudential Financial companies and each is solely responsible for its own financial condition and contractual obligations. Prudential Annuities is a business of Prudential Financial, Inc.

© 2013. Prudential Annuities, Prudential, the Prudential logo, the Rock symbol, and Bring Your Challenges are service marks of Prudential Financial, Inc. and its related entities, registered in many jurisdictions worldwide.

Christine C. MarcksPresident, Prudential Retirement

Margaret G. McDonaldSenior Vice President & Actuary, Prudential Retirement

LONGEVITY RISK AND INSURANCESOLUTIONSfor U.S. corporate pension plans

0227989

Table of contents

Introduction ..................................................................................................................................1

Employers face unprecedented defined benefit pension liabilities and volatility....................................2

Plan sponsors rethinking risk ..........................................................................................................5

Insurance solutions for the pension market ......................................................................................7

Longevity, aging and the pension market ........................................................................................14

References ..................................................................................................................................16

1

Rapidly changing demographics and increases in life expectancy pose a serious challenge to the health of

corporations, potentially impacting their ability to compete. For American corporations, the impact of aging can

be seen most clearly through the lens of their employer‑sponsored retirement plans.

In this report we focus on the U.S. corporate pensions market, where there is broad consensus that the risk

position of corporate pension plans is not sustainable. Yet, despite this recognition, U.S. plan sponsors lack

awareness of the impact of improved life expectancy on their pension liabilities, and focus almost exclusively

on investment risk. It is our position that a true understanding of longevity risk is the needed catalyst for U.S.

corporate pension plans to more actively adopt de‑risking strategies.

Defined benefit pension plans have grown to enormous proportions, with some dwarfing the size of their sponsoring

organizations. Unprecedented pension deficits are front‑and‑center and the cash required to close them is straining

free cash flow. Having endured significant market downturns over the past several years, sponsors are now keenly

aware of how volatile that cash call can be. Transferring pension risk through an insurance solution offers a sponsor

the opportunity to remove these risks from their balance sheet and focus on their core business.

The challenges are not limited to corporations that sponsor defined benefit plans. As members of the baby boom

generation approach retirement, their ability to retire with security is also becoming the focus of corporations that

sponsor defined contribution plans as the main source of retirement benefits. When uncertainty about the ability to

make account balances last throughout retirement causes these older employees to postpone retiring, the normal

course of promotion and hiring that keeps a corporate culture vibrant and motivated is disrupted. Lifetime income

solutions can provide needed security to this generation of workers and support workforce management strategies.

Introduction

2

Employers face unprecedented defined benefit pension liabilities and volatility

Pension plan liabilities have increased dramatically over the past few decades, due to both an aging workforce

and increased longevity of retirees. The recent market crisis diverted employers from these risks as they struggled

to address the challenges to their core business. Now the focus is squarely on pension plans, as many corporations

have pension liabilities that exceed 25% of their market capitalization, with some businesses owing more than

their net worth (CNBC, 2012). The investment community is keenly focused on pension plan financials as a major

driver of free cash flow and earnings.

As of year‑end 2011, the average ratio of plan assets to liabilities for the 100 largest U.S. pension plans stood at

73%, meaning that U.S. sponsors will face onerous funding requirements over the next several years as they fund

a deficit of approximately $0.5 trillion (Milliman, 2011). Even more troublesome to employers than the current

poor‑funded status is the volatility of that funded status. A recent poll of plan sponsors indicates that their highest

priority for 2012 is “controlling funded status volatility” (Mercer, 2011). The graph below shows that despite

hundreds of billions in pension contributions, the funded status of most plans has not significantly improved since

the depths of the recent economic crisis. What’s more, twice in the last 10 years plan sponsors have lost over 35%

of their funded status. It is imperative for plan sponsors to find relief from this volatility.

2000 2002 2004 2006 2008 2010

100%

Twice in the past 10 years,US sponsors of defined benefit planshave lost over 35%of funded

statusin market downturns

Source: Prudential. Illustrates approximate funded status of US corporate pension plans.*Standard & Poor’s, “S&P 500 2010: Pensions and Other Post-Employment Benefits (OPEBs),” May 26, 2011.

$215Bin contributions weremade between 2008-2011*

Despite Pension Contributions, Funded Status Remains LowFunded Status

12/31/2011

72.4%

FIGURE 1

3

7/1/2011

Source: Aon Hewitt, “Aon Hewitt Global Pension Risk Tracker,” as of 9/30/2011, https://rfmtools.hewitt.com/PensionRiskTrackerNote: Cumulative assets (in billions USD) and liabilities of all pension schemes in the S&P 500 index on the accounting basis.

Volatility Caused by Asset & Liability Mismatch3rd Quarter 2011

Funded Status

Liabilities

Assets

13.4%funded statusin 3 months

decline90.9%

77.5%

9/30/2011

-6.2%

+10.0%

Equitydecline

15%AA Rate

decline78bps

FIGURE 2

Pension liabilities, once calculated under long‑term investment return assumptions, are now calculated at discount

rates based on high‑quality corporate debt, while the majority of pension fund assets are still invested in equities

and other risk assets. The result is a poor correlation of asset and liability returns. An example of this divergence

can be seen in the third quarter of 2011, when discount rates dropped 78 basis points, increasing liabilities by

10%. Simultaneously, investments in the average pension fund lost more than 6%, due in large part to a 15%

drop in equities. The result was a 13.4% drop in funded status in just one quarter (Aon Hewitt, 2011). To a plan

sponsor with funding requirements and a pension earnings charge that is based on a snapshot of funded status on

one day each year, this volatility in untenable.

4

Based on Society of Actuaries report: “The Rising Tide of Pension Contributions Post-2008: How Much and When.” Year 1 asset return variance: -18% to 19%. Year 1 is equal to 2011 for this analysis.

Impact of One Year’s Asset Return on Contribution RequirementsSensitivity analysis for year 1 return. Return is constant in all other years.

0

50

150

100

250

200

1 2 3 4 5 6 7 8 9

ProjectedContribution

in $ Billions

7.4% year 1 return on assetsRange of contributions if year 1 return on assets is between -18% and 19%

Years

$234B

$140B

FIGURE 3

Funding rules under the Pension Protection Act (PPA) of 2006 resulted in a more direct correlation between

pension plan funded status and cash flow requirements. The combination of the current poor funded status of most

plans and the new PPA funding rules will dramatically increase funding requirements of corporate U.S. pension

plans over the next several years. In stark contrast to the 10 years ending in 2009 when minimum contribution

requirements fluctuated between $9 billion and $22 billion, projections for the period between 2010 and 2019

average $90 billion per year, with a peak amount of $140 billion needed in 2016 (Society of Actuaries, 2011a).

While these amounts are staggering, consider how dramatically the picture changes if plans experience one year of

poor asset returns. A scenario in which the first year asset return is assumed to be ‑18% increases the peak year

contribution to $234 billion, a 67% increase over the baseline scenario (Society of Actuaries, 2011a).

5

With corporate cash and earnings at risk, many plan sponsors have chosen to close their plans to new entrants

or even freeze benefit accruals to curtail the growth of plan liabilities. According to a recent Mercer study, more

than two‑thirds of U.S. corporations participating in the survey have either closed or frozen their defined benefit

plans (Mercer, 2011). However, while freezing or closing a plan signals an employer’s intent to shed pension risk,

this has only a minimal impact on funded status and the related cash flow and earnings volatility in the short

term. Plan sponsors need effective longer‑term solutions. Corporations sponsoring defined benefit pension plans

assume the real risk of participants living longer than anticipated by valuation mortality tables. For those with

large plans, it could be said that these employers are running a substantial life insurance operation alongside their

stated business. Population data shows that the retired lifetime—that is, the period from retirement to death—for

the average U.S. male has increased 27%, or four years, in the past three decades.1 As shown below in Figure 4,

pension valuation tables have typically lagged actual experience, resulting in a significant increase in pension

liability in every recent decade as these tables were updated. While most plan sponsors have become attuned to

the investment risk that is inherent in their pension plans, longevity risk is a significant yet often ignored risk which

cannot be addressed through investment strategy alone. It is not a risk most plan sponsors would choose to hold

but one that can be very efficiently managed through insurance products.

Plan sponsors rethinking risk

1Prudential Analysis based on published mortality tables, GAM 71, GAM 83, and RP 2000.

FIGURE 4 US Pension Plan Sponsors Face Increasing Longevity RiskIncrease in Liability due to Mortality Table Updates

14.6 16.2 17.1 18.6 20.1

0

5

15

10

25

20

1980s 1990s 2000s Proposed 2014Currently

65-Year-Old MaleLife Expectancy

7.5%LiabilityIncrease




Source: Prudential calculations. 1980s using GAM 71 Mortality Table, 1990s using GAM 83 Mortality Table, 2000s using RP 2000 Mortality Table, Current using RP 2000 Mortality Table with PPA improvements, and Proposed 2014 using RP 2000 with Scale BB improvements.

US Pension Plan Sponsors Face Increasing Longevity RiskIncrease in Liability due to Mortality Table Updates

14.6 16.2 17.1 18.6 20.1

0

5

15

10

25

20

1980s 1990s 2000s Proposed 2014Currently

65-Year-Old MaleLife Expectancy





Source: Prudential calculations. 1980s using GAM 71 Mortality Table, 1990s using GAM 83 Mortality Table, 2000s using RP 2000 Mortality Table, Current using RP 2000 Mortality Table with PPA improvements, and Proposed 2014 using RP 2000 with Scale BB improvements.

65-Year-Old Male Life Expectancy

25

20

15

10

5

01980s 1990s 2000s Current Proposed 2014

6

Asset management strategies such as liability‑driven investing (LDI) techniques, which seek to match the cash

flow needs of the pension plan with those of the pension portfolio, can offer plan sponsors meaningful relief from

volatility. As the chart below indicates, the majority of corporate plan sponsors say they have adopted an LDI

approach for at least a portion of their plan. However, the recent funded status volatility described above indicates

that most still have large allocations to risky assets. It is evident that, in the face of substantial underfunding,

many sponsors are still hoping to close the gap between assets and liabilities with returns from riskier assets.

However, along with this aspiration comes significant volatility, which can result in a level of cash requirement that

is unacceptable to shareholders.

Currently implement LDIPlan to implement LDINo plans to implement LDI

Source: aiCIO “Survey of Geography and Asset Allocation Series: LDI Edition,” September 2011. Respondents drawn from aiCIO’s readership from the U.S. that met two criteria: they (a) were a senior investment official at (b) a corporate or public defined benefit pension plan.

Corporate Pension Plans Implement Liability-driven Investment Strategies

Liability Under $5B

80%

5% 15%15%

Liability Over $5B

60%30%30%

10%

FIGURE 5

7

Insurance solutions for the pension market

Buy‑outs and buy‑ins The insurance industry is well‑suited to offer solutions to defined benefit plan sponsors who want to eliminate

longevity and/or investment risk. Multi‑line insurers have broadly diversified risks reflecting diverse sources of

business risks and earnings across products, markets and geographies. Managing the risk of longevity through

retirement annuities is a desirable complement to mortality risk, providing a valuable source of diversification.

Additionally, the insurance industry has a long history of managing assets on the basis of matching liabilities and is

therefore well‑equipped to manage pension risk (Haefeli and Liedtke, 2012).

A pension buy‑out is a transaction which has been used for decades to transfer liabilities and associated assets for

a specified set of pension participants to an insurance company under a group annuity contract. It is designed to

shrink the size of the pension plan on the corporation’s balance sheet and to relieve the sponsor permanently of

the risks associated with the settled participants. A buy‑out is often seen in plan termination scenarios, in which

annuities are purchased for all participants. For plans that are less than 100% funded, a buy‑out can also be used

for certain groups of participants, such as retirees. It is the only solution for plan sponsors who want to completely

relieve their balance sheet from some or all of their pension burden.

Unless the plan is fully funded, a buy‑out will result in a deterioration of funded status, because the plan must

pay more to effect the transaction than is held on the company’s balance sheet as a liability. This has been a

particular concern for plan sponsors under PPA regulations due to the administrative and funding requirements

associated with falling below certain funded percentage levels. Plan sponsors who have the cash available may

contribute additional funds in order to maintain funded status. A transaction for only a portion of the plan would

be another way to mitigate the funded status impact. The retiree population, which is already in receipt of monthly

pension payments, typically is the population identified for a partial transaction such as this. Plan sponsors who

want to minimize the transaction further, or who want to dollar‑cost‑average the transaction in various interest rate

environments, may consider a series of transactions over a period of several years.

A buy‑out, unless it is de minimis in size, will also trigger settlement accounting under Accounting Standards

Codification 715, which requires the immediate recognition in earnings of a proportional share of Unrecognized

Net Losses. As the current Unrecognized Net Loss for the average plan sponsor in the Dow 30 is approximately

38% of liability, this is a significant factor for sponsors concerned about the earnings impact of a buy‑out.

However, many pension‑heavy plan sponsors are less concerned about this particular event, as they believe that

the investment community will reward them for completing the transaction and that recognition will outweigh the

one‑time earnings hit.

8

Although popular in the U.K. for some time, buy‑in transactions are new to the U.S. market, with Prudential

completing the first U.S. buy‑in transaction in May 2011. The transaction is similar to the buy‑out, except the liability

and associated assets for the transaction group remain in the plan. A buy‑in is designed to provide the same risk

protection offered by a buy‑out without deteriorating funded status or triggering settlement accounting. The buy‑in

is revocable and provides for a transfer to a buy‑out at any time. In short, it combines a near perfect liability‑driven

investment strategy with longevity protection.

Longevity insurance: an emerging solutionFor plan sponsors who want to shed longevity risk without a transfer of investment risk to an insurance company,

longevity insurance is an option. This solution has emerged in the U.K. where pension plans offer a Cost of Living

Adjustment (COLA) that magnifies the impact of improved longevity. As such, longevity insurance has been

embraced by several large plan sponsors in the U.K. The transaction exchanges a series of actual benefit payments

for a series of fixed benefit payments. This longevity protection is typically used alongside a LDI asset strategy to

offer a plan sponsor additional risk mitigation. Although longevity risk is less apparent in the U.S., the risk is real.

Longevity insurance will be an attractive alternative for risk‑conscious plan sponsors who realize that despite having

effective investment strategies, they have no solution for longevity risk.

Buy‑outs and buy‑ins: diminishing tail risks—illustrative scenario To demonstrate the benefits of buy‑outs and buy‑ins and their impact on de‑risking, we consider a subset of the

plans sponsored by corporations that form the Dow 30. Twenty‑five of these corporations sponsor defined benefit

plans, for a total of $0.5 trillion in assets, or approximately 25% of the U.S. corporate pension market. These

plans mirror the larger U.S. market in several ways: on average their funded status is below 80% and retirees

account for about half of the liabilities.

Insurance Solution Comparison

Buy-in Buy-out Remain in Plan Assets & Liabilities Transferred to Insurer De-risk Plan Sponsor Goal Decrease Plan Size or Exit No Settlement Accounting Yes No Impact Impact on Funded Status Declines None Contribution Impact Accelerates, If Underfunded

FIGURE 6

Insurance Solution Comparison

Buy-in Buy-out Remain in Plan Assets & Liabilities Transferred to Insurer De-risk Plan Sponsor Goal Decrease Plan Size or Exit No Settlement Accounting Yes No Impact Impact on Funded Status Declines None Contribution Impact Accelerates, If Underfunded

9

Buy-out Reduces Contribution VolatilityStochastic Analysis with Current Mortality Table

No Buy-out Buy-out

Future Valueof Contributionsfrom 2012 - 2017

in $ Billions $130B $127B

$176B$214B$211B

$281B

0

50

100

150

200

300

350

250

95th-99th 75th-95thPercentiles

Stochastic analysis results from 2,000 trials. Assuming funding to 100% by 12/31/2016, 80% minimum funding requirement, 5% accumulation rate, and 10% Buy-out purchase premium. Based on the 16 companies from the Dow 30 with funded status greater than 80% as of 12/31/2010.

FIGURE 7

We modeled the assets and liabilities for each of the 16 plans in the Dow 30 that are at least 80% funded in order

to provide an analysis that best relates to the average corporate plan sponsor considering a risk transfer solution.

We have assumed that the sponsor will contribute enough to reach 100% funded status at the end of five years.

We used a stochastic analysis with 2,000 trials to consider the impact that a pension risk transfer for the retired

population would have on plan‑funded status and required cash flow.

Impact of a pension buy‑out Most sponsors considering risk transfer are primarily interested in mitigating tail risk, or the probability of highly

negative results. In this analysis, that would likely be those scenarios with the very lowest investment returns and/or

lowest corporate bond rates since these together result in the highest cash contribution requirements. The graph below

shows the impact that a buy‑out for the retired population would have on funding requirements for the 16 companies

over the next five years, with a focus on the results for the 25% of scenarios which produce the highest contribution

requirements. Those 25% of trials are illustrated below, with the lighter blue band representing the range associated

with the worst 5% of results, and the darker blue representing the next 20% of the highest contribution outcomes. The

results show that, for the 5% of the trials that result in the highest contribution requirements, contributions would be

reduced by between $35 billion and $67 billion. For the next 20% of trials, a buy‑out would reduce the present value

of contributions by $3 billion to $35 billion. Already facing sharply increased funding requirements, plan sponsors are

rightly concerned about the possibility of the enormous contributions associated with tail events, and this concern is

what leads them to consider insurance solutions.

10

The analysis above does not incorporate any improvements in life expectancy beyond what is anticipated in currently

prescribed mortality tables. If these tables were updated to reflect a continuation of the longevity improvement

indicated by the Society of Actuaries (2011b) study, the need for additional protection becomes even more apparent.

Figure 8 compares the results in Figure 7, shaded in gray, with those that include these improvements. Under this

new scenario, the contribution requirements over the five‑year period associated with the 5% of trials with the worst

results is reduced between $47 billion and $80 billion, with a reduction of $14 billion to $47 billion for the next

20% of trials. For sponsors who have been ignoring longevity risk, it is time to recognize the magnitude of this risk

they bear and to consider whether it is a risk they are rewarded for holding or whether it is a risk that should be

transferred to an insurer.

Impact of a pension buy‑inPlan sponsors considering a buy‑in transaction are similarly interested in reducing tail risk. However, because the

assets and liabilities remain in the plan, they are also interested in making sure the funded status at the time of the

buy‑in transaction is protected over time. To demonstrate this benefit of the buy‑in, we have tracked the funded status

of a hypothetical buy‑in, transacted on Jan. 1, 2010. As of the transaction date, the covered population was 110%

funded; that is, the assets allocated to the buy‑in were 110% of GAAP liability. We have tracked the market value of

the buy‑in asset and accounting liabilities for two years. As Figure 9 indicates, in spite of market turbulence during

2010 and 2011, there is only a slight variation in funded status for the transacted group. For plan sponsors looking

for nearly perfect protection from funded status volatility, the buy‑in is the solution.

Buy-out Reduces Longevity RiskStochastic Analysis with Modification to Mortality Improvement Rate*

No Buy-out Buy-out0

50

100

150

200

300

350

250

$130B $127B

$176B$214B$211B

$281B

$158B $144B

$195B$232B$242B

$312B

Stochastic analysis results from 2,000 trials. Assuming funding to 100% by 12/31/2016, 80% minimum funding requirement, 5% accumulation rate, and 10% Buy-out purchase premium. Based on the 16 companies from the Dow 30 with funded status greater than 80% as of 12/31/2010.*Improvement rate modified from scale AA currently required for US funding to experience for U.S. population during 2000-2007 in SOA June 2011 study “Global Mortality Improvement Experience and Projection Techniques.”

95th-99th 75th-95thPercentiles

Future Valueof Contributionsfrom 2012 - 2017

in $ Billions

FIGURE 8

11

Defined benefit regulatory reformThe current regulatory environment in the U.S. does not encourage plan sponsors to de‑risk their defined benefit

pension plans with insurance products. Regulators must reevaluate established regulations and systems to help

plan sponsors meet their challenges. Consider the following:

•For plan sponsors seeking to de‑risk their plan through a buy‑in, Department of Labor regulations present

a roadblock because they are designed to ensure that the sponsor selects an annuity provider among the

safest available at the time of a buy‑out transaction. Because of these rules, buy‑in transactions must have a

revocability provision, so that the plan sponsor has recourse if the insurer chosen for the buy‑in is no longer

considered a safest available provider at the time of conversion to buy‑out. Allowing plan sponsors to perform

the required due diligence at the time of the buy‑in would provide both transaction certainty and more

favorable pricing.

•As regulations stand now, full flat‑rate Pension Benefit Guaranty Corporation (PBGC) premiums must be paid

on behalf of participants who are part of a buy‑in, even though the risk for that cohort has been substantially

eliminated. A reduction in this premium would incent plan sponsors to de‑risk without posing any additional risk

burden on the PBGC.

Assets determined using PBGC fair value methodology. Liabilities determined using Citigroup pension liability index.

Buy-in Assets Highly Correlated to Liability

1/1/2010 4/1/2010 7/1/2010 10/1/2010 1/1/2011 4/1/2011 7/1/2011 10/1/2011 1/1/2012

AssetsLiabilities

Preserves Funded Status for Transacted Group

FIGURE 9

12

Shifting investment and longevity risks to employeesMany plan sponsors have shifted the focus of their retirement program from defined benefit to defined contribution

plans. This shift transfers both investment and longevity risks from employer to employee. Individuals under defined

contribution plans face the risk of outliving their retirement savings if they fail to accumulate the necessary funds

in their plans or if they live beyond their life expectancy. While significant progress has been made with respect to

offering a broad range of investment options to enable diversification of investment risk, there has been relatively little

focus on longevity risk or the need for lifetime income protection.

Facing this risk, coupled with the recent financial crisis, many employees have elected to postpone their

retirement. A 2012 study conducted by the Employee Benefits Research Institute (EBRI) found that the age at

which workers expect to retire continues a slow upward trend. In particular, the percentage of workers who expect

to retire after age 65 has increased, from 11% in 1991, to 17% in 1997, 18% in 2002, 24% in 2007, and

37% in 2012 (EBRI, 2011). The effects of delayed retirement extend beyond the individuals to employers. Many

workers choose to work beyond 65, and their maturity and experience can be a positive factor for the workplace.

However, it can become problematic for an employer if a large number of retirement‑age employees remain on the

job because they simply cannot afford to retire. There is a tipping point where employers may be concerned about

higher medical costs, decreased opportunity for younger workers or limited availability to acquire new talent.

It is in the interest of employers to provide risk‑mitigating tools that help those ready to retire to do so with

greater security.

Calculations based on UP94 mortality table with scale AA improvements to the year 2000 and generational improvements using scale BB after the year 2000.

How Long Will I Live After Retirement?Probability a 65-year-old will be alive at given ages.

Age

95%100% 93% 89%83% 80%

71%66%

55%49%

37%28%

18%9% 5%

65 70 75 80 85 90 95 100

FemaleMale

FIGURE 10

13

Guaranteed income: an insured solution Lifetime income products are solutions that provide a certainty of retirement income which can help employees

retire with confidence. These products help participants accumulate assets and convert those assets into

guaranteed income at retirement. Additionally these products are cost‑effective as they are designed to pool

mortality risk through insurance wrappers, thereby allowing providers to price the products at institutional rates as

opposed to higher individual rates. Finally, unlike traditional annuities, newer lifetime income products typically

provide a death benefit, flexibility and control—all of which are attractive features to participants who have spent

decades accumulating their retirement wealth.

Defined contribution regulatory reform To encourage employers to offer lifetime products to their employees, a fiduciary safe harbor regulation for

employers is recommended. This would allow employers to offer a lifetime income option that satisfies the necessary

requirements without fiduciary concern.

Regulations allowing plan sponsors to use lifetime income products as the qualified default investment option for

their plans (the automatic investment choice for those who do not elect otherwise), would also encourage greater

product adoption.

Lastly, providing a tax advantage to employees who elect a minimum percentage of their account balance to be

paid as a lifetime benefit would spur an increase in election rates for this product feature.

14

Longevity, aging and the pension market

The aging of the U.S. population requires new tools to manage retirement plans. The size and volatility of defined

benefit pension obligations have become visible and unwieldy for a number of reasons; chief among these is the

impact of longevity risk. Plan sponsors must de‑risk in order to preserve their corporation’s ability to compete and

prosper.

Momentum is building in the U.S. for insurance solutions. A CFO Magazine survey conducted in 2011 found that

among the financial executives surveyed, 45% were considering defined benefit risk transfer or have initiated

discussions regarding defined benefit risk transfer solutions with their board of directors (CFO Publishing LLC (c),

2012).

Defined contribution plans have now become the dominant retirement vehicle for most U.S. companies, shifting

the investment and longevity risks to employees. Employers need to take steps to ensure that these plans provide

the retirement security that workers need to retire with confidence.

Insurance solutions, incorporating the vast investment and life contingency capabilities of the insurance industry,

are ideally suited to help employers meet these challenges. Having the necessary experience in managing longevity

and investment risk, along with a regulatory framework that requires maintenance of adequate capital reserves

to meet long‑term obligations, insurance companies are uniquely suited to provide pension de‑risking solutions.

Buy‑outs and buy‑ins for defined benefit plans and lifetime income products for defined contribution plans offer

the certainty of outcomes that the market needs. The industry should continue to work with regulators to promote

these solutions because they offer the promise of retirement security to American workers.

16

References

Aon Hewitt (2011) “Aon Hewitt Global Pension Risk Tracker,” September 30.*

CFO Publishing LLC (c) (2012) The Future of Retirement and Employee Benefits: Finance Executives Share Their Perspectives, a study with Prudential.

CNBC (2012) Pension Threat: The Looming Crisis Facing Investors, February 2.*

EBRI (Employee Benefit Research Institute) (2011) 2012 Retirement Confidence Survey, March,

Washington, DC: EBRI.*

Haefeli, D. and Liedtke, P.M. (2012) Insurance and Resolution in Light of the Systemic Risk Debate: A contribution to the financial stability discussion in insurance, Geneva: The Geneva Association.*

Mercer (2011) Redefining Pension Risk Management in a Volatile Economy, sponsored by CFO Research Services,

CFO Publishing LLC.*

Milliman (2011) “The Milliman 100 Pension Funding Index”, March 6, Seattle, WA: Milliman.*

Society of Actuaries (2011a) The Rising Tide of Pension Contributions Post 2008: How Much and When,

Schaumburg, IL: Society of Actuaries.

_____ (2011b) Global Mortality Improvement Experience and Projection Techniques, June,

Schaumburg, IL: Society of Actuaries.

* Available on the Internet.

© 2012 Prudential Financial, Inc. and its related entities. Prudential, the Prudential logo, the Rock symbol and Bring Your Challenges are service marks of Prudential Financial, Inc., and its related entities, registered in many jurisdictions worldwide.

0227989-00002-00 RSBR825Exp. 01/23/2014 07/2012

280 Trumbull Street Hartford, CT 06103

www.prudential.com

Perspectives June 2013

We believe a well-

diversified absolute return

portfolio with a constrained

duration band represents

the best approach to

keeping the alpha

associated with fixed

income relative value

security selection while

limiting the structural

interest rate beta.

Robert Tipp, CFA

Managing Director,

Chief Investment Strategist,

and Head of Global Bonds

and Foreign Exchange

Prudential Fixed Income

Michael Collins, CFA

Managing Director, Senior Investment Officer Prudential Fixed Income

Absolute Return Fixed Income Strategies

What, How, and Why Now? After a three decade bull market in interest rates, the vast majority of appreciation from declining

rates in developed countries is behind us. Given the recent rise in interest rates, some fixed income

investors may now be looking for strategies that can provide higher yields than cash, and also

guard against a further rise in rates. One alternative, an ‘absolute return’ fixed income strategy,

may meet both of these objectives. In the following Q&A we sit down with Prudential Fixed Income's

Robert Tipp, Chief Investment Strategist, and Michael Collins, Senior Investment Officer and

Portfolio Manager, to discuss different types of absolute return fixed income portfolios and how a

well-diversified, duration-constrained portfolio can take advantage of the alpha-generating

opportunities available in today’s market environment while avoiding systematic exposure to rising

interest rates.

Q) What is an ‘absolute return’ fixed income strategy?

Absolute return fixed income strategies go by a number of different names: absolute return,

unconstrained, real return, strategic alpha, and even ‘go-anywhere’ or ‘GA’ fixed income.

Regardless of the name, these strategies generally share two common traits. First, they strive to

deliver positive absolute returns over a specified period regardless of the direction of interest rates.

Second, unlike traditional fixed income strategies, they are not managed against a market-

capitalization weighted bond index. Rather, they are managed against a cash-based benchmark

such as 3-month LIBOR, 3-month Treasury bill, or any country’s money market (‘risk-free’) rate. The

defining feature of these types of strategies is that they are opportunistic. In most cases, they can

select from a broad array of security types and ‘go-anywhere’ within the fixed income market in

search of attractive returns.

Beyond these two traits, absolute return strategies can vary widely in terms of eligible sectors and

security types, absolute alpha objectives, and risk parameters. Asset managers, in large part, each

have their own concept of ‘absolute return’. Some may limit exposure to non-investment grade

securities or to the credit and ‘spread’ sectors, some may aggressively adjust duration or use

modest leverage, and others may invest heavily in privately issued (vs. publicly-issued) securities.

There are global multi-sector absolute return portfolios, single-sector absolute return portfolios, and

even regionally-based portfolios.

In addition, while traditional long-only fixed income strategies have

the luxury of being able to underweight positions versus their

benchmarks, many absolute return fixed income strategies need

to tactically ‘short’ specific bonds or sectors of the market—often

through the use of derivatives—to implement a negative view.

Accordingly, these strategies can at times have a negative

duration (e.g., go ‘short’ interest rates) which can directly benefit

investors when interest rates rise.

A key point to note is that absolute return fixed income strategies

are not typically hedge funds. Some strategies may use small

amounts of leverage but many generally do not. In addition, the

vehicle and fee structures for most absolute return strategies are

similar to other institutional and retail fixed income portfolios. For

example, there are typically no lock-up periods or gates.

Perspectives—June 2013

Page 2

While traditional fixed income strategies managed

against a market index attempt to maximize the

information ratio, or risk-adjusted excess return,

absolute return strategies, in contrast, attempt to

maximize the Sharpe ratio, or ‘absolute’ risk-

adjusted return.*

Traditional multi-sector fixed income strategies

usually underweight and overweight positions

relative to a market capitalization-weighted

benchmark. These benchmarks may be inefficient

because by definition they are comprised of issuers

with the most debt outstanding and can have

significant exposure to developed country interest

rates. Moving to an absolute return fixed income

strategy can systematically reduce interest rate risk

while focusing on the best risk-adjusted return

opportunities.

* The higher a portfolio's Sharpe ratio, the better its risk-adjusted

performance. A negative Sharpe ratio indicates that a riskless

asset, such as cash, would perform better than the portfolio.

Absolute Return Fixed Income

Seeks to maximize risk-adjusted abso lutereturn over a cash-based benchmark

Traditional Fixed Income

Seeks to maximize risk-adjusted excess return

over a market index

Q) How would you categorize the different types of absolute return strategies?

Broadly speaking, we view absolute return fixed income strategies as falling

into three categories. The first category takes a macro-based approach that

expresses top-down views on interest rate, currency, country, and sector

exposures. The second category takes a concentrated approach, investing

either across the broad fixed income market or specializing in a single sector

or region. These portfolios tend to hold larger positions in a fewer number of

issues, sectors, currencies, and/or countries. The third category is a blended

macro and micro approach that uses both top-down and bottom-up investment

styles. These portfolios are generally well diversified and invest in the full

spectrum of global fixed income sectors, rate markets, and currencies.

In our view, a blended approach that actively manages duration within a

modest, specified band represents the best approach to keeping the alpha

associated with fixed income security selection while limiting the structural

interest rate beta. Actively managing a diversified portfolio across sectors,

security types, rates, and currencies in both developed and emerging countries

provides the strongest base to consistently generate alpha, respond to

changing market conditions, limit idiosyncratic risk, and manage downside

risk.

The duration constraint, achieved by limiting interest rate risk within a modest,

specified band relative to a near zero duration cash benchmark, not only

reduces interest rate risk, but focuses a portfolio’s risk allocations on those

areas that can provide the greatest value per unit of risk: country, sector,

industry, and issue selection. By comparison, portfolios with wider duration

bands (e.g., up to 5 years) may result in a return series that is inconsistent with

an investor’s objective since the portfolio may drift into an intermediate or long

duration ‘style box’, possibly at an inopportune time.

Another benefit of a blended, duration-constrained absolute return strategy is

that it tends to have a low correlation to traditional fixed income portfolios. In

fact, during periods of rising government bond yields, an absolute return portfolio with a near zero duration has the potential to post

positive returns as the interest rate hedge—created via interest rate futures or swaps—may generate a positive return on a mark-to-

market basis.

Q) What is an appropriate alpha target for an absolute return fixed income strategy?

Depending on an investor’s risk appetite, in the current investment environment we believe an alpha target in the range of +100 to

+400 bps over 3-month LIBOR or a government cash-equivalent rate is reasonable over a full market cycle, assuming the portfolio is

unlevered and focuses on public securities. The appropriate alpha target is a function of a client’s return objective and risk constraints,

with a key driver being the extent to which they are willing to invest in the ‘plus’ sectors of the fixed income market—below investment

grade securities, emerging markets debt, and foreign currencies. A universe that is limited to high quality bonds and allows for only

limited FX and interest rate risk would naturally have a lower alpha objective, while those with the greatest flexibility have the potential

to achieve a much higher alpha target.

Sample Absolute Return Fixed Income Portfolios

Alpha Target Over Cash Benchmark

(Annualized Over Full Market Cycle) Investment Criteria

+100 bps Investment grade quality with only modest allocation to ‘plus’ sectors

+ 300 bps Broadly diversified with up to 50% in ‘plus’ sectors

+400 bps Significant (as much as 100%) exposure to ‘plus’ sectors and/or modest leverage

There is no guarantee these objectives will be achieved.

Q) How is the alpha generated in an absolute return fixed income strategy?

Alpha is generated primarily by identifying fundamentally undervalued fixed income sectors and securities across the global markets,

and capitalizing on temporary mispricings and relative value trading opportunities. Portfolios should be actively managed with both

strategic and tactical allocations. Today the global credit sectors, both investment grade and non-investment grade, still offer attractive

opportunities, especially given the current, relatively low level of default risk. Government bonds and currencies can also add value.


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Evaluating the economic cycles across countries helps identify mispricings—whether interest rates truly reflect the fundamentals in a

specific country or if they are unduly influenced by technical factors.

Currencies can offer a range of opportunities at any given time. There will always be some currencies that are appreciating and others

that are depreciating. Capitalizing on those changes can create macro trading opportunities where alpha can be added in a risk-

controlled manner.

The positive fundamental trends of emerging market countries can also create opportunities for fixed income investors. Many

emerging market sovereign bonds offer higher yields than developed country sovereigns, and the stronger economic growth in

emerging countries and accompanying rise in productivity should make their currencies appreciate over time. The quasi-sovereign and

corporate bond markets in emerging countries are growing rapidly, providing both tactical and strategic opportunities.

Q) What is the expected volatility of an absolute return fixed income portfolio?

With respect to volatility, we would expect a Sharpe ratio generally between 0.5 and 1.0, given the expected Sharpe ratios and

correlations of the underlying alpha-generating activities. For example, a portfolio with an alpha target of +300 bps over LIBOR and an

expected Sharpe ratio of 0.67 (or 2/3) would have an expected volatility of 450 bps. The expansion of the investment opportunity set

as alpha targets increase should allow the portfolio’s Sharpe ratio to remain fairly consistent even as the risk budget expands.

Q) What are the downside risks and how are they managed?*

While most absolute return strategies strive to deliver a positive absolute return and may aggressively hedge different risk exposures,

they cannot theoretically hedge all risks or their return would be close to the cash-based benchmark. All portfolio decisions, including

sector allocation, issue selection, interest rate anticipation, and currencies can lead to positive or negative absolute performance. As in

traditional fixed income strategies, the key risks in an absolute return fixed income portfolio are interest rate risk, credit risk, and

currency risk. And just like traditional fixed income strategies, each of these risks must be actively monitored and managed to mitigate

downside risk.

At the portfolio level, risk budgets with thresholds on systematic risk (yield curve, currency, sector, quality) and tail risk (country,

industry, and issuer) can provide a framework for determining risk allocations and proactive monitoring. In addition, individual issuer

exposure must also be actively monitored to identify improving/or and deteriorating credits, especially in portfolios with spread

exposure to investment grade corporate bonds, high yield corporate bonds, emerging markets debt, sovereign debt, and asset-backed

securities. Active risk and sector allocation, including tactical shifts along the credit spread curves, selling bonds and going to cash,

and moving up and down an issuer’s capital structure, are other ways an asset manager can tactically increase or decrease overall

credit risk. Finally, tail-risk hedging/mitigation strategies utilizing interest rates, currencies, and credit derivatives can allow asset

managers to quickly reduce overall portfolio systematic risk.

* Note: No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment.

Q) How is interest rate risk hedged and what is the ‘cost’ of hedging?

The interest rate hedging process uses a combination of U.S. and other global (e.g., German, Japanese) interest rate futures contracts

and interest rate swaps to hedge the interest rate risk of the underlying bonds in a portfolio. Futures and swaps can also be used to

implement active duration and yield curve positions within specified bands. The ‘cost’ of the hedge in yield terms is essentially the

difference between the yields on the hedging instrument and cash. For example, to hedge the duration of a 5-year corporate bond

using U.S. Treasury interest rate swaps, the cost is the yield of the 5-year swap minus 3-month LIBOR. At the end of May 2013, the

cost of this hedge would have been 0.94% (1.21% yield on 5-year U.S. Treasury interest rate swap less 0.27% for 3-month LIBOR)*.

In practice, however, interest rate risk is hedged at the portfolio level, rather than on a bond-by-bond basis.

Investing in a portfolio with essentially a zero duration (relative to longer duration portfolios) is subject to other potential costs, as well.

First, since the yield curve is normally (and currently) positively sloped, reducing duration results in a lower portfolio yield, all else being

equal. To profit from a shorter duration posture, interest rates would have to rise more rapidly than what’s already priced into the

forward yield curve. Second, the portfolio may be subject to a loss on an interest rate hedge if government bond yields decline,

especially in scenarios in which credit quality deteriorates and the yields on other fixed income sectors simultaneously increase.

* Data as of May 31, 2013. Source of data: Bloomberg.

Conclusion

Although the bull market in developed country government bonds is largely behind us, we believe fixed income still provides

plenty of alpha opportunities for investors. An absolute return fixed income strategy managed against a cash-based benchmark

is one option for investors seeking reduced interest rate exposure and higher returns than cash. Among the array of absolute

return strategies available, we believe a diversified, blended approach that utilizes both top-down and bottom-up investment

strategies while constraining duration within a modest, specified band relative to a cash-based benchmark is the best strategy

to generate a consistent alpha stream with limited structural interest rate exposure.


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Notice

© Copyright 2013, Prudential Investment Management, Inc. Unless otherwise indicated, Prudential holds the copyright to the content of the article. Prudential Investment Management is the primary asset management business of Prudential Financial, Inc. Prudential Fixed Income is Prudential Investment Management’s largest public fixed income asset management unit, and operates through Prudential Investment Management, Inc. (PIM), a registered investment adviser. Prudential, the Prudential logo and the Rock symbol are service marks of Prudential Financial, Inc. and its related entities, registered in many jurisdictions worldwide.

These materials represent the views, opinions and recommendations of the author(s) regarding the economic conditions, asset classes, securities, issuers or financial instruments referenced herein. Distribution of this information to any person other than the person to whom it was originally delivered and to such person’s advisers is unauthorized, and any reproduction of these materials, in whole or in part, or the divulgence of any of the contents hereof, without prior consent of Prudential Fixed Income is prohibited. Certain information contained herein has been obtained from sources that Prudential Fixed Income believes to be reliable as of the date presented; however, Prudential Fixed Income cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. The information contained herein is current as of the date of issuance (or such earlier date as referenced herein) and is subject to change without notice. Prudential Fixed Income has no obligation to update any or all of such information; nor do we make any express or implied warranties or representations as to the completeness or accuracy or accept responsibility for errors. These materials are not intended as an offer or solicitation with respect to the purchase or sale of any security or other financial

instrument or any investment management services and should not be used as the basis for any investment decision. No investment strategy

or risk management technique can guarantee returns or eliminate risk in any market environment. Past performance is not a guarantee or a

reliable indicator of future results. No liability whatsoever is accepted for any loss (whether direct, indirect, or consequential) that may arise from any use of the information contained in or derived from this report. Prudential Fixed Income and its affiliates may make investment decisions that are inconsistent with the recommendations or views expressed herein, including for proprietary accounts of Prudential Fixed Income or its affiliates.


Conflicts of Interest: Prudential Fixed Income and its affiliates may have investment advisory or other business relationships with the issuers of securities referenced herein. Prudential Fixed Income and its affiliates, officers, directors and employees may from time to time have long or short positions in and buy or sell securities or financial instruments referenced herein. Prudential Fixed Income affiliates may develop and publish research that is independent of, and different than, the recommendations contained herein. Prudential Fixed Income personnel other than the author(s), such as sales, marketing and trading personnel, may provide oral or written market commentary or ideas to Prudential Fixed Income’s clients or prospects or

proprietary investment ideas that differ from the views expressed herein. Additional information regarding actual and potential conflicts of interest is available in Part 2A of PIM’s Form ADV.

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edward f. keon, jr. managing director and portfolio manager...

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