2014 OUTLooK

Investment Directions
DECEMBER 9, 2013

MARKET OUTLooK
`` The Economy: Slowly Moving in the Right Direction We expect modestly faster growth in 2014 in the United States and globally. A combination of less scal drag and stronger consumer balance sheets should allow the U.S. economy to edge past the post-recession 2% level to around 2.5%. Global growth should accelerate to around 3.5%. `` Interest Rates: Low for Longer Growth picking up should lead to slightly higher interest rates, mostly through higher real rates, or the interest rate after ination. As the Federal Reserve (Fed) tapers its bond-buying programpossibly beginning over the next few monthswe believe the 10-year Treasury yield will modestly climb around 0.5% next year. The Fed is likely to keep short-term interest rates anchored at zero, keeping long-term rates from sharply increasing, or melting up. `` The Not-So-Good News A few things temper our outlook. Wage growth is likely to remain subdued, a result of long-term factors, namely demographics, technology and global labor competition. That means household spending is likely to remain soft. And political dysfunction continues to represent a risk for the economy and the markets, as budget and debt ceiling debates will persist through 2014. `` Bottom Line: We Favor Stocks, Especially International Ones, and Remain Cautious Toward Bonds Equities are no longer cheap, but they may offer a better alternative to cash or bonds for many investors. That said, the United States is looking fully valued. While stocks can move higher, gains will need to come from earnings growth, rather than further multiple expansion. Outside of the United States, stocks look more reasonably priced, especially in emerging markets. Within xed income, put simply, there are few bargains.

Russ Koesterich, CFA Managing Director Chief Investment Strategist

WHATS NEW
Downgrade of Brazil to Neutral from Overweight  Preparing portfolios for 2014  What low for longer means for investors Pg. 4

So whAT do I do wiTh mY monEY? TM

OVERWEIGHT
Equities Emerging Markets U.S. Mega Caps Fixed Income Credit Sectors

q UNDERWEIGHT
Bonds Developed Markets U.S. Small Caps Treasuries

ADDITIONALLY, FOCUS ON

Potential downside protection through

minimum volatility funds and high quality global dividend stocks. but consider trimming exposure to gold, which is likely to come under pressure from rising rates, a benign ination outlook, and poor supply and demand dynamics.

Maintaining a strategic allocation to commodities

UniTEd STATEs
`` U.S. stocks are looking pricey compared to international markets. After very strong performance this year in the United States, can the rally continue? Our take: The Feds accommodative monetary policy will continue to provide a tailwind for U.S. equities. To the extent that interest rates stay low for long and wage growth remains subdued, good margins should continue to lend support to U.S. valuations (see the chart to the right). However, further gains will need to come alongside earnings growth, a challenge in a still-sluggish economy. Moreover, Washington dysfunction continues to represent a risk for the U.S. economy and markets, particularly if budget and debt ceiling debates persist through 2014. As the U.S. economy increasingly appears to be moving at two speeds, with manufacturing leading consumption growth, we prefer manufacturingfocused sectors levered to improving global growth. Overall, we think that the risk and reward on U.S. equities is looking balanced.

U.S. compAniEs opERATing mARgins REmAin sTRong

15

U.S. S&P 500 CORPORATE OPERATING MARGINS (%)

12

6 1993 1998 2003 2008 2013

U.S. operating margins remain strong, helped by low interest rates and slow wage growth.
Source: Bloomberg as of 11/29/13.

InTERnATionAL DEvELopEd MARKETs

`` Outside of the United States, stocks look more reasonably priced. We would highlight two areas in particular: Japan and the eurozone, with an important caveat. While we advocate benchmark weights for both regions, the reality is that many, if not most, U.S. investors are typically underweight non-U.S. stocks. In short, for those underweight international equities, wed suggest paring back some U.S. holdings and considering nonU.S. stocks. `` The eurozone: Out of crisis, but challenges ahead. Thanks to the European Central Bank (ECB)s support and signicant current account improvement in peripheral countries, the region is out of crisis mode. But make no mistake: There are still signicant challenges ahead. Weak credit growth continues to be a drag on the economy, and rising non-performing loans weigh on sentiment toward the banking sector (the upcoming asset quality reviews and single supervisory mechanism may help provide a resolution to that). The ECB may need to ease further through a negative deposit rate or some form of quantitative easing if deationary risks persist (see the chart to the right). However, large internal imbalances, with interest rates and the exchange rate low for Germany but high for peripheral countries, are likely to complicate policy setting. Still, eurozone equity valuations remain attractive relative to U.S. stocks and provide investors with cyclical exposure; as such, we maintain our benchmark allocation. `` We maintain a neutral view on Japan, though we continue to see near-term opportunities in Japanese equities on a currency-hedged basis. Japanese stocks still trade at a signicant discount to U.S. stocks. As the Bank of Japan continues its aggressive easing to ght

DEfLATion is A Rising RisK To mAjoR EURoZonE coUnTRiEs

CONSUMER PRICE INDEX YOY (%)
2.5

2.0

1.5

1.0

0.5 12/2012

2/2013

4/2013

6/2013

8/2013

10/2013

Germany CPI yoy%

France CPI yoy%

Italy CPI yoy%

Prices have being falling in most European economies during the second half of 2013.
Source: Bloomberg as of 11/29/13.

deation, a cheaper yen should provide a further tailwind to corporate earnings next year. While there have been some tentative signs of rising prices thanks to higher import costs, a sustained reation needs to come from stronger domestic demand on the back of positive income growth. The main risk to Japans growth is the planned 2014 consumption tax hike, whose ultimate impact will largely depend on the policy reaction from the central bank as well as the effect of economic measures announced this month. For Japan to represent a more attractive long-term investment, the government will need to deliver on bold reforms to boost the countrys long-term growth potential via expanding the labor force and increased private investment.
[2]

EmERging MARKETs
`` We continue to like emerging market (EM) stocks. While concerns over EM corporate governance, rising local debt and deteriorating external balances remain, EM equities still represent good long-term value relative to U.S. stocks. Looking ahead, sentiment toward EM will likely be driven by market expectations on the timing and speed of Fed tapering. Countries dependent on foreign funding, such as India and Indonesia, are likely to struggle disproportionately. Meanwhile, prot margin erosion could be an increasing concern in countries such as South Africa and Brazil where local rates are rising fast (see the chart to the right) and cost pressures are acute due to rising wages and import prices. `` Chinese stocks still look cheap considering growth and protability prospects. The reforms agreed to at the policy-setting meeting in November are far-reaching, aiming to strengthen the market-based economy with nancial liberalization and land reforms and potentially changing the role of the government. Going forward, we believe policy implementation will be the key. Yet, in the near term, growth could slow as support from housing and infrastructure investments fades, while the overheated housing market and ballooning shadow banking system debt require policymakers to keep credit conditions tight. `` We are downgrading Brazil to neutral, while maintaining underweights to Mexico and South Africa. While Brazilian stocks remain attractively valued, ongoing local monetary

RATEs ARE Rising in BRAZiL, IndiA & IndonEsiA

10

CENTRAL BANK BENCHMARK POLICY RATE (%)

9 8 7 6 5 4 12/2012

2/2013

4/2013

6/2013

8/2013

10/2013

Brazil Selic Target Rate

India Repo Rate

Indonesia Reference Interest Rate

Local rates are rising in many emerging markets, as the countries try to stem capital outows.
Source: Bloomberg annual data as of 11/29/13.

tightening and a deteriorating scal position pose risks to the economy and the stock market. Also, despite economic stagnation and rising social unrest, the likelihood that President Rousseff will be re-elected remains high, and continued state intervention will weigh on company prots. Meanwhile, we remain cautious on South Africa due to extended valuations, large external imbalances and under-pressure prot margins. And while Mexican fundamentals are improving, local stocks look relatively expensive.

GLobAL SEcToRs
`` We remain overweight the global energy and information technology (IT) sectors, and underweight the utilities sector. Energy companies are trading at attractive valuations, and despite the recent decline in oil prices, analysts are expecting a signicant improvement in the sectors protability over the next year. We expect the Fed to begin tapering in the coming months and real rates to slowly back up; the low debt level of the IT sector renders it less sensitive to rising interest rates, while utilities companies as bond proxies are likely to face pressure. `` We remain underweight consumer staples and consumer discretionary companies. Both sectors have extended valuations. Slow U.S. income growth is likely to continue due to competition from emerging markets and slow U.S. labor productivity growth. With a backup in rates, we dont expect the housing market to be as strong of a tailwind to the economy in 2014 as it was in the rst half of 2013. A weaker housing recovery and government spending cuts are likely to put consumer condence and personal consumption under pressure (see the chart to the right).

STRong HoUsing REcovERY in 2013 mighT noT REpEAT in 2014

250

THE S&P/CASE-SHILLER HOME PRICE INDEX

200

150

100 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Given that housing prices have already experienced a strong recovery in 2013 and mortgage rates might increase next year if the Fed tapers, housing price gains are unlikely to be as strong in 2014 as they were this year.Source: Bloomberg as of 11/29/13.

Any prolonged scal debate in 2014 is likely to exacerbate economic policy uncertainty, further restraining improvement in business and consumer condence and spending.
[3]

FiXEd IncomE
`` With the Fed and other central banks on a buying spree in recent years, driving bond yields lower and propping up prices, there are few bargains to be found. This is particularly true for longer-duration Treasury and government-related bonds. Indeed, risks in this segment of the bond market are higher in light of the Feds plan to pull back on its extraordinary bond-buying program. To that point, we expect the Fed to announce tapering in these programs in the coming months. However, the leaders of the Feds policy committee have been working hard to assure investors that the Fed funds rate will remain low for longer, so we expect the Fed to act gingerly in order to temper market reaction. `` On the taxable side, we continue to prefer high yield bonds and bank loans over Treasuries. Being nimble and diversied globally remains key as the potential for central bank actions in Europe creates potential opportunities there, and selectivity in emerging markets along with cheaper valuations could make these areas good diversiers to U.S. xed income portfolios. `` Amid the rising tax bite from Washington, investors should consider tax-exempt municipal bonds for their relative value to taxable alternatives. While Detroit and Puerto Rico make

mUnis LooK good bEfoRE And AfTER TAX

5 4 3 2 1 0 U.S. Treasuries Corporate Bonds Municipal Bonds Municipal Bonds Municipal Bonds 1.28 2.48 2.68 Actual Yield Tax-Equivalent Yield 4.73 YIELD TO WORST (%) 4.12

(35% tax rate) (43.4% tax rate*)

* 43.4% tax rate assumes the highest marginal tax rate (39.6%), plus 3.8% tax in Affordable Care Act. Source: Barclays Live. Data as of 6/26/13. U.S. Treasuries represented by the Barclays Treasury Index; Municipal Bonds by the Barclays Municipal Index; Corporate Bonds by the Barclays Corporate Index. Past performance is no guarantee of future results. Index performance is shown for illustrative purposes only. It is not possible to invest directly in an index.

for rousing headlines, they are not representative of the broader municipal market. Overall, munis remain a highquality, relatively low-volatility option for investors focused on tax-advantaged income and capital preservation (see the chart above).

HoT Topic: Low foR LongER

Heading into 2014, a criticalperhaps the criticalquestion facing investors: What is the outlook for monetary policy, and what will be its impact? Our take: Though we believe the Fed could begin tapering over the next few months, monetary policy is likely to remain accommodative for an extended period of time. The Fed has signicant latitude in how it adjusts monetary policy and will maintain easy money policy by other means, including forward guidance on the path of short-term rates and potentially cutting the interest rate paid to banks on their excess reserves. These moves will essentially anchor shortterm interest rates at zero for some time to come. In a slow growth world, the Fed does not wish to be too aggressive. And clearly the Fed wants to avoid a repeat of last summer and having the market misinterpret tapering as a prelude to an imminent interest rate hike. Continued accommodative policy should help support equities, especially as it means stocks will still look more attractive than cash or bonds, even at current valuations. In addition, given the sluggish nature of the recovery and the structural headwinds suppressing wage growth, ination, now

U.S. InfLATion is bELow TREnd And wiLL LiKELY REmAin modEsT in ThE nEAR fUTURE
CONSUMER PRICE INDEX YOY (%)
6 5 4 3 2 1 0 -1 -2 -3 2005 2006 2007 2008 2009 2010 2011 2012 2013

Realized Ination

Average Ination (11/2003-11/2013)

U.S. ination is currently below its 10-year average and will likely remain modest in the coming year.
Source: Bloomberg as of 11/29/13.

at a four-year low in the United States, is likely to stay low at least through 2014 (see the chart above). Meanwhile, other developed regions, notably Europe and Japan, will continue to irt with outright deation. Thats one reason the ECB is likely to also maintain, if not increase, its own monetary accommodation in 2014.

[4]

DRiLLing Down: EQUiTY And FiXEd IncomE OUTLooKs

Global Region deVeLoped MarKeTs North America United States Canada Europe Eurozone Switzerland United Kingdom Asia Pacic Japan Australia emerging MarKeTs Asia Pacic China India South Korea Latin America Brazil Mexico Emerging EMEA Russia South Africa Global Sector & Style CycLicaL SecTors Consumer Discretionary Energy Financials Industrials Information Technology Materials DefensiVe SecTors Consumer Staples Healthcare Telecommunications Utilities sTyLes U.S. Small/Mid Caps U.S. Mega/Large Caps Fixed Income Sector Emerging Markets U.S. High Yield Credit U.S. Investment Grade Credit U.S. Mortgage-Backed Securities U.S. Municipals Non-U.S. Developed Markets U.S. TIPS U.S. Treasuries +
Supply & Demand Valuations Growth Protability Risk/ Sentiment underweight Our View neutral overweight Related iShares ETF Tickers

+ + + + + + + +

EUSA EWC IEV EWL EWU EWJ EWA

+ +

+ + +

+ +

+ +

Our View neutral overweight

MCHI INDA EWY EWZ EWW ERUS EZA

+
Valuations

Growth

Protability

Risk/ Sentiment

underweight

Related iShares ETF Tickers

+ + + +

+ + +

RXI IXC IXG EXI IXN MXI KXI IXJ IXP JXI IWM OEF
Related iShares ETF Tickers

+ +

+ +

Our View neutral

Valuations Economics Risk/ Sentiment underweight overweight

EMB HYG LQD MBB, GNMA MUB ISHG, IGOV STIP, TIP SHV, SHY, IEI, IEF, TLH, TLT
ETF Tickers

+ + +

Opportunity Holding Cost Safe Haven Ination Hedge Demand Demand

Our View neutral

underweight

overweight

Gold*

GLossARY

current underweight outlook

unattractive + attractive neutral current overweight outlook current neutral outlook Neutral: Consider benchmark allocation

Underweight: Potentially decrease allocation

Overweight: Potentially increase allocation

* See the appendix for an explanation of the methodology for our gold views and other outlooks. Please note that the views expressed above in the factor table are for timeframes of at least three months. This material represents an assessment of the market environment at a specic time and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research, investment advice or a recommendation regarding the iShares Funds or any security in particular. This information is strictly for illustrative and educational purposes and is subject to change. This information does not represent the actual current, past or future holdings or portfolio of any BlackRock client. [5]

In FocUs: InvEsTmEnT ThEmEs And SoLUTions To ConsidER foR 2014 REThinK YoUR Bonds

Traditional core bonds that were once considered safe investments may not be so safe anymore. In fact, with interest rates rising in 2013, these bonds did something theyve rarely done in 30 years lost money. Its time to think about a better approach to bond investing. Consider: Allocate to adaptable strategies Strategic Income Opportunities Fund (BASIX) Seek returns beyond traditional U.S. bonds Global Long/Short Credit Fund (BGCAX) Keep durations short, but know what you own iShares Floating Rate Bond ETF (FLOT) iShares Short Maturity Bond ETF (NEAR) Low Duration Bond Fund (BFRAX) Floating Rate Income Fund (BLDAX)

GEnERATE IncomE, BUT DonT OvERREAch

With interest rates near record lows, once-reliable sources of income have dried up. Now, more than ever, nding new ways to generate income is paramount. However, overreaching for yield without knowing what you own can be risky. Consider: Take a exible approach to income Multi-Asset Income Fund (BAICX) iShares Morningstar Multi-Asset Income ETF (IYLD) Overweight credit for yield High Yield Bond Fund (BHYAX) iShares iBoxx $ High Yield Corporate Bond ETF (HYG) Adapt to higher taxes National Municipal Fund (MDNLX) & Muni SMAs iShares National AMT-Free Muni Bond ETF (MUB)

SEEK GRowTh, MAnAgE VoLATiLiTY

People are living longer than ever before, but their savings are earning less. That means the chance of outliving your money has never been more real. With low interest rates, investments like cash and government bonds may not produce the results you need to meet your nancial goals. A new approach and a broader investment strategy is needed to seek out growth while managing volatility. Consider: Diversify into unconstrained and alternative strategies Global Allocation Fund (MDLOX) Global Long/Short Equity Fund (BDMAX) Allocate to higher growth opportunities Basic Value Fund (MDBAX) International Opportunities Fund (BREAX) Manage volatility with conservative equities Equity Dividend Fund (MDDVX & SMA) Global Dividend Fund (BABDX & SMA) iShares High Dividend ETF (HDV) iShares International Select Dividend ETF (IDV) iShares Minimum Volatility ETF Series (EEMV, EFAV, USMV, ACWV)

[6]

APPENDIX The analysis behind our equity views:

Our country and sector views are based on an analysis of the extent to which macroeconomic factors have been priced in at the country and sector level. We are overweight (underweight) countries and sectors where market valuations are low (high) relative to the underlying fundamentals, with the expectation that the economic factors will be fully incorporated into prices in the future. To determine our country views, we look at these macroeconomic factors: Valuations: If a country has a low price-to-book ratio (P/B) relative to both its own trading history and to other emerging or developed countries, we assign it a +; if high, a -. Growth prospects: We assign a + to countries that are growing faster (as measured by leading indicators and earnings growth prospects) than their past trends and a - to countries growing slower. Corporate sector protability: A country with a relatively protable corporate sector (as measured by ROA) is assigned a + and we give a - to countries growing more slowly. Risk / sentiment: A country that is perceived as relatively safe (according to historical volatilities and credit default swap (CDS) spreads) is assigned a +; a risky country is assigned a -. The factors are not equally important in driving returns at a given point in time. As a result, when it comes to formulating our nal views, the various factor readings are not additive. For example, a + value factor may overshadow negative readings in other factors, leading us to still like the country. We use a similar methodology for coming up with our sector and style views, focusing on valuations (P/B and P/E), protability (ROA) and risk / sentiment (historical volatilities and sector spreads). In addition, we consider the global growth outlook for cyclical and defensive sectors. In addition, our view on gold is similarly based on the macroeconomic factors that historically impact gold returns. These include the opportunity cost of holding gold (real interest rates); supply and demand; ination (gold as a real asset tends to act as an ination hedge); and safe haven demand (during periods of high nancial stress, demand for gold tends to increase).

Contributors
Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock, and Chief Global Investment Strategist for iShares. He is a founding member of the BlackRock Investment Institute, delivering BlackRocks insights on global investment issues. Nelli Oster, PhD, is an Investment Strategist in the MultiAsset Strategies Group of the BlackRock business, where her responsibilities include developing the tactical country, sector and asset allocation models. Heidi Richardson is a Global Investment Strategist for BlackRock, where her responsibilities include relating the Investment Strategy Teams research and investment views to key institutional and nancial advisor clients. Matt Tucker, CFA, is the Head of North American Fixed Income iShares Strategy within BlackRocks Fixed Income Portfolio Management team. Stephen Laipply is Product Strategist for BlackRocks ModelBased Fixed Income Portfolio Management Group.
How do you use this market commentary and do you nd it useful? Please share your feedback and any questions or concerns you have at questions@iShares.com. You also can nd the latest market commentary from the Investment Strategy Group at BlackRockblog.com, BlackRock.com and iShares.com.

Risk Appetite Dial

re Risk Mo

Less Ri sk

last month

The analysis behind our xed income views:

In general, when formulating our xed income views, we put more weight on the Valuations bucket than on either the Economics or Risk / sentiment buckets. Valuations: We focus on discounted risk-adjusted cash ows relative to market prices. When a sector exhibits market prices well above what our model sees as fair, we assign the sector a -; we assign a + when the opposite is true. Economics: In general, when the overall economic environment (as measured by basic economic and/or aggregate balance-sheet fundamentals) is particularly favorable for a given xed income sector, we assign a +; we assign a - when the opposite is true. Risk / sentiment: When a sector has exhibited strong positive returns/risk appetite (as measured by trailing returns) over the previous several months, we score it a +; we assign a - when the opposite is true.

RisK AppETiTE indEX:

Investors risk appetite has remained in risk-seeking territory since the last Investment Directions update. In signs of a growth recovery, global economic activities (proxied by global PMI) climbed to 53.2 from 52.1 last month, above the 50 mark that indicates expansion and the highest reading since May 2011. Despite renewed concerns about a looming Fed taper, global stocks extended their rally on optimism that a stronger U.S. economy is likely to withstand reduced monetary accommodation. Meanwhile, credit spreads between low-quality and high-quality U.S. corporate debt narrowed for the fth consecutive month.

[7]

Carefully consider the iShares Funds and BlackRock Mutual Funds investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Funds prospectuses and, if available, summary prospectuses, which may be obtained by visiting www.iShares.com or blackrock. com. Read the prospectus carefully before investing. Investing involves risk, including possible loss of principal.
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No guarantee as to the capital value of investments nor future returns is made by BlackRock or any company in the BlackRock group. Recipients of this document must not distribute copies of the document to third parties. This information is indicative, subject to change, and has been prepared for informational or educational purposes only. No warranty of accuracy or reliability is given and no responsibility arising in any way for errors or omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock. No representation or guarantee whatsoever, express or implied, is made to any person regarding this information. This information is general in nature and has been prepared without taking into account any individuals objectives, nancial situation, or needs. You should seek independent professional legal, nancial, taxation, and/or other professional advice before making an investment decision regarding the iShares funds. An iShares fund is not sponsored, endorsed, issued, sold or promoted by the provider of the index which a particular iShares fund seeks to track. No index provider makes any representation regarding the advisability of investing in the iShares funds. The iShares Funds are not sponsored, endorsed, issued, sold or promoted by MSCI Inc., Markit Indices Limited or Morningstar, Inc.nor do these companies make any representation regarding the advisability of investing in the Funds. BlackRock is not afliated with the companies listed above. 2013 BlackRock, Inc. All Rights reserved. BLACKROCK and iSHARES, are registered trademarks of BlackRock, Inc. in the United States and elsewhere. All other marks are the property of their respective owners. iS-11238-1213 5215-06RD-12/13 Not FDIC Insured No Bank Guarantee May Lose Value

iS-11238-1213

Lit. No. MKT-ID-1213