OUTLOOK FOR 2014 ANDBEYONDJanuary 2014

OUTLOOK FOR 2014 AND BEYONDPage 1

EXECUTIVE SUMMARY

Mercer thinks that 2013 marks the end of the period of soft global growthfollowing the global financial crisis. Global growth should pick up to trendor above in 2014 and stay there for a couple of years. This will eventuallyreturn most economies to full capacity, with government deficits also backunder control. The return to full capacity represents a return to normality,not a deviation from it. Inflation is likely to stay low with wage growth onlypicking up slowly.

While economic activity should start to look more normal, the samecannot be said of monetary policy. The key central banks are unlikely toraise interest rates, while the Bank of Japan and the European CentralBank may provide further stimulus. However, with the US Fed ending allnew bond purchases and unemployment falling below 7% in the UK,attention will switch to when interest rates will rise.

Equity markets have been anticipating better economic conditions overthe last few years, with price increases caused by rising multiples rather than rising earnings. While multiples still havethe potential to expand (especially outside the US) given the backdrop of still low interest rates, investors will need tosee earnings growth pick up in order to push markets higher. We think this will happen and expect profit margins toremain high, until wage growth eventually starts to eat into profits in a few years’ time. Bond markets have also startedto anticipate a return to normality with real and forward yields rising after the QE game plan was announced in May2013. We expect yields to rise further, although do not expect a bond market crash and do not think bond markets are ina bubble.

The performance of most emerging market economies will be in their own hands. Those economies that fail to improvetheir efficiency and competitiveness could be challenged by rising US bond yields over the next few years. Those thatrespond could be rewarded with stronger economies, currencies and stock markets. On balance, weak sentiment andvaluations have set the bar very low and we expect most countries to be able to outperform these weak expectationsover the medium term.

2013 marks the end of theperiod of soft global growthfollowing the global financialcrisis.

While global growth shouldpick up to trend Inflation islikely to stay low with wagegrowth only picking up slowly.

OUTLOOK FOR 2014 AND BEYONDPage 2

The key risk in 2014 is whether markets (bond and equity) will be able towithstand the Fed’s reduction in new bond purchases (tapering) and thepossibility of interest rate increases in 2015. Other risks include: will theeconomic momentum visible now be sustained as the year progresses;will profit growth pick up enough to meet heightened expectations; willChina reforms happen; and will emerging markets in general cope with ahigher yield environment. So in summary, we expect:

Stronger global economy, with companies increasing their spendingon labour and capitalInterest rates staying exceptionally low, but tone shifts away fromeasing. Inflation stays lowEquities perform well, although modestly rising bond yields puts the onus on earnings rather than multipleexpansion. Returns are much lower than seen in 2013Core bond yields rise modestly, although peripheral and non-government bonds do betterMost EM economies and markets outperform soft expectations with strong export growth boosting overall growth,profit margins and reducing external imbalancesKey risk relates to whether bond yields rise only modestly or whether the ‘end of cheap money’ causes morematerial bond market weakness, undermining all asset classes

This report will discuss the outlook for the global economy and key individual economies. It will then discuss the outlookfor equity markets in general and the key equity asset classes that Mercer recommends to clients (Developed MarketEquities (DME), Emerging Market Equities (EME), Low Vol Equities (LVE), Small Cap Equities (SCE)). The note will thenconsider the outlook for the key bond sectors, foreign exchange and commodities.

While the note focuses on what we consider to be the most likely outcome, there are risks to this outlook. The mostsignificant risk for both the global economy and global financial markets is the extent to which the Federal Reserve (andeventually other central banks as well) can withdraw from QE and other extra-ordinary monetary policies in an orderlyfashion. Other risks include whether China can rebalance and reform its economy, and whether the global economy willrun out of steam again. On a more optimistic note, it is possible that productivity in developed markets and reform inemerging markets could pick up. These risks are discussed towards the end of the note.

This paper is designed to be read in conjunctionwith our 2014 Strategic Research Themes andOpportunities paper, which highlights a numberof investment ideas for the current environment.

The key risk in 2014 is whethermarkets will be able towithstand the Fed’s reductionin new bond purchases and thepossibility of interest rateincreases in 2015.

OUTLOOK FOR 2014 AND BEYONDPage 3

GLOBAL ECONOMIC OUTLOOKWe think that the outlook for the global economy has improved materially over the last few quarters and that the globaleconomy should start to grow at a trend or above trend rate over the next few years. In the short term, Chart 1 shows thepurchasing manager indices, which track activity closely, have risen significantly, while Chart 2 shows real consumerspending in the US has also risen sharply over the last few months.

Chart 1: Global economy strengthening Chart 2: US consumption picking up

Source: JP Morgan Source: Deutsche Bank

Normally, after a recession or economic downturn the economy returns to full capacity fairly quickly as unemployedresources are put back to work with the help of low interest rates. This time, however, economic growth has remainedbelow trend with unemployment remaining painfully high.

This has been because the global economy has been held back by 4 significant headwinds which have hitsimultaneously and have offset the tailwind of very loose monetary policy. The first headwind is that fiscal policy hasbeen tightened in almost all developed world economies. Normally tighter fiscal policy can be offset by looser monetarypolicy, leading to little impact on overall growth. This time, however, with policy rates and bond yields already very lowthere has been little scope for monetary policy to loosen significantly. QE has helped, but it is not as powerful as biginterest rate cuts.

Second, individuals and businesses have been tightening their belts, paying back debt and reducing leverage, inresponse to high unemployment and the uncertain outlook. Third, banks have also been tightening their belts in anattempt to repair their balance sheets and increase capital levels for regulatory reasons. This has led to weak creditgrowth.

Finally, the very existence of the euro has been called into question with many expecting the Eurozone to break up. Thiscould have caused a new banking crisis, leading the global economy back into recession with governments running lowon monetary and fiscal policy defences.

However, significant progress has been made in resolving these problems. First, budget deficit positions haveimproved suggesting less fiscal tightening ahead. In the US and Germany, debt to GDP ratios have already peaked,while significant progress has been made across much of Europe. While deficit positions are in better shape and arelikely to fall further, total government debt levels are likely to remain very high for many years, which will be an area ofvulnerability for some time, especially in the Eurozone and Japan.

Chart 3 shows the US household debt as a % of GDP has fallen back to 2002 levels, while Chart 4 shows household netwealth is at its highest ever. Finally, debt service costs relative to income are at their lowest in over 30 years.

OUTLOOK FOR 2014 AND BEYONDPage 4

Chart 3: Household leverage falling Chart 4: Household wealth all-time high

Source: Deutsche Bank Source: Deutsche Bank

Banks have increased their capital levels significantly over the last few years (Chart 5). While some European banks havemore to do, higher capital levels should at last allow banks to start lending more freely. Chart 6 shows peripheralEuropean economies have substantially improved their competitiveness, with their economies now running currentaccount surpluses rather than deficits. While this does not mean that these will necessarily grow strongly, it does meanthat it is now highly unlikely that any of them will leave the Eurozone.

Chart 5: Banks much stronger Chart 6: Peripherals competitive

Source: Deutsche Bank Source: Credit Suisse

In summary, while the headwinds haven’t disappeared they appear to have diminished significantly in terms of theirferocity. While the headwinds will continue for a while yet we expect them to be more than offset by the boost from lowinterest rates and pent up demand in a number of sectors such as US housing and capital expenditure globally.

US ECONOMYWe think that the US economy will strengthen in 2014, growing at an above trend rate helped by stronger consumption,investment and less fiscal tightening. Income growth is likely to pick up modestly helped by ongoing job growth and amodest rise in wage growth. Consumption will also be supported by the recent strength in both stock and home prices.Growth should also be supported by less fiscal tightening. In 2013, fiscal policy tightened by 1.8%, while it is likely totighten by only 0.5% in 2014 and should be largely unchanged in 2015 and beyond.

We expect capital expenditure to strengthen. Business surveys of capex plans have picked up while the banks arelending more freely to businesses. Chart 7 shows the percentage of small businesses reporting that credit was harder toget has fallen to pre-crisis levels, while Chart 8 shows average age of businesses’ assets have increased, following anumber of years of weak capital expenditure. The US economy is also likely to continue to be boosted by the housingmarket with both activity and prices rising.

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Chart 7: US credit easier to get Chart 8: Fixed Assets getting old

Source: Deutsche Bank Source: Deutsche Bank

Inflation is likely to remain subdued and below target, although we do not expect it to fall further. Wages, which accountfor roughly two-thirds of all corporate costs are likely to remain subdued and should keep inflation below target,especially if commodity prices are stable as we expect. Wage growth could start to rise modestly as the year developssetting the scene for inflation to return to 2% in 2015 or 2016.

The Federal Reserve (Fed) is likely to continue scaling back its new bond purchases and then end them completely in thesecond half of 2014 as the unemployment rate falls below 6.5%. The Fed is likely to reduce its new bond purchases in ameasured fashion although it will be watching the bond market closely to ensure that economic activity remains strongand is not choked by rising bond yields. As the year develops speculation could mount over the timing of the firstinterest rate rise with some commentators likely to argue for an interest rate increase in early 2015. We think the Fed islikely to err on the side of caution and not raise interest rates until the second half of 2015 or 2016.

EUROZONE ECONOMYThe Eurozone is likely to continue to grow, although not at a pace that will put a significant dent in the record highunemployment rate. The recovery in the global economy and less fiscal tightening should provide some support,although lingering strains in some peripheral economies and on-going weakness in France will hold back the recovery.It is possible that as the year develops a more material recovery could ensue if confidence in the banking sectorimproves with the asset quality tests later in the year. Charts 9 and 10 show that the peripheral economies haveregained competitiveness, suggesting their economies should grow and that the risk of a new crisis is low. Nonetheless,it will be many, many years before the region returns to full employment, especially in the periphery (with the possibleexception of Ireland).

Chart 9: Peripherals now competitive Chart 10: Unit labour costs have adjusted

Source: Goldman Sachs AM Source: Goldman Sachs AM

OUTLOOK FOR 2014 AND BEYONDPage 6

Inflation is likely to remain well below the level that the European Central Bank (ECB) sees as consistent with its inflationmandate (close to, but below 2%). With unemployment at a record high, it is clear that monetary policy in the Eurozonehas been too tight for many years. The ECB has hinted that it is concerned by the very low inflation rate, which it expectsto persist, suggesting it could come up with more radical policy to boost the economies, such as supporting creditdirectly to the peripheral economies. However, with global growth picking up and the difficulties associated with tryingto reach a consensus within the ECB, the ECB is likely to err on the side of caution.

UK ECONOMYWe expect the UK economy to continue to grow strongly at an above trend rate in 2014, although growth on anannualized basis could fall to around 3% from the current 4% pace. We expect growth to be slightly stronger than theBank of England is projecting (Chart 11) which itself is stronger than most forecasts. Consumption growth is likely toremain strong boosted by employment growth and positive wealth effects from rising stock and house prices. Capitalexpenditure should pick up supported by high profit margins, high cash levels and the low return on those cashholdings. Strong business confidence suggests that companies are ready to invest after a number of years of weakness.Employment growth should remain strong, with the unemployment rate falling below 7% in 2014.

UK inflation fell to 2% in December, in line with its 2% target for the first time in four years. We expect UK inflation to fallfurther in 2014, averaging about or just below 2% for the year as a whole, in line with the Bank of England’s projection(Chart 12). Falling global food prices and the recent rise in sterling should contribute to lower inflation as will still lowwage growth, even if some increase in wage growth is seen later in the year. We expect the Bank of England to keep itsstock of asset purchases unchanged and not raise interest rates in 2014.

Chart 11: Growth should be strong Chart 12: Inflation back to target-Bank of England growth forecast - Bank of England Inflation forecast

Source: Bank of England Source: Bank of England

CHINAWe expect the Chinese economy to grow by a trend-like 7%-7.5% in 2014 and 2015. 2014 is an important year for Chinaas it attempts to transition from a credit led growth model to a more balanced one. While credit growth has slowed overthe last few years, it remains too strong and will need to slow further. Credit will also need to flow to the private sectorwhere productivity growth is strong and away from state owned enterprises where productivity is weak.

The new leadership team outlined an impressive list of reforms last in November and has already started to implementthem. However, much more remains to be done over the next few quarters and years and some powerful vestedinterests are opposed to the plans. On balance, we are optimistic that China will make sufficient progress to ensurestrong growth over the next few years. Nonetheless, China remains one of the key risks for 2014.

OUTLOOK FOR 2014 AND BEYONDPage 7

JAPANThe Japanese economy is likely to slow sharply in 2014 as a result of the rise in consumption tax to 8% in April. However,on an underlying basis we think the Japanese economy should remain strong, with monetary policy possibly looseningfurther. Looking further ahead, a sustained expansion and a permanent exit from deflation requires wage growth andcapital investment to pick up. Recent data, especially on the capital expenditure side, has been encouraging. However,it is far too early claim victory and the government will need to step with the reform pace to stop the recovery frompetering out. Inflation, which rose in 2013 on the back of the weakness in the yen, is likely to rise further this year on theback of the increase in the consumption tax. However, excluding these two shocks, inflation is likely to remain very low,albeit in positive territory.

MARKET OUTLOOKEQUITIESWe expect global equities to rise in 2014, albeit at a slower pace than seen in 2013. Global equities should be boosted bya recovery in corporate profit growth. We expect global earnings growth, which has been very weak over the last fewyears, to pick up on the back of the global economic recovery. Corporate profit margins, which are very wide in the USand some other markets, are expected to remain wide for some time with wage growth only picking up slowly.

The valuation tailwind is likely to be less supportive in 2014 due to recent market strength, although valuations are stillsupportive outside the US and relative to cash and bonds (Chart 13). However, in the US, some valuation measureshave moved at least into more neutral territory, especially those that assume that profit margins will return tohistorically normal levels over the next few years (Chart 14)

Chart 13: US equities cheap vs bonds Chart 14: US equities not cheap on CAPE

Source: Goldman Sachs AM Source: Goldman Sachs AM

Sentiment is likely to have a neutral impact on global equities although could be supportive for emerging marketequities. In developed markets, momentum is very positive while equities’ ability to withstand the Fed’s surprise QEtapering in December suggests further tapering may not be as disruptive as previously feared. However, recent equitymarket strength suggests that at least part of the improved outlook is already priced in, while most investors andstrategists are bullish, suggesting good news is likely to have less impact on markets than has been the case over thelast few years.

EQUITY SECTORSThe strategic benchmark for Mercer’s global growth portfolios is made up of 4 sectors; developed markets (DM),emerging markets (EM), small cap (SC) and low volatility (LVE) equities. Within those 4 sectors, our prefered sectors areEM and DM, followed by SC and finally LVE.

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OUTLOOK FOR 2014 AND BEYONDPage 8

We think that EM will keep track with developed equities in 2014, having underperformed substantially in 2013 on theback of rising US bond yields and sluggish growth. This year, we expect EM to be supported by stronger economic andcorporate profit growth on the back of a recovery in exports. DM domestic demand growth should boost EM exports(Chart 15), while that stronger growth should also boost EM profit margins which have fallen sharply over the last fewyears (Chart 16). In addition valuations and confidence in EM are very low, suggesting that even a modest improvementin EM earnings could cause EM equities to perform well. While rising US bond yields will remain headwind, we thinkthey will cause less damage this year. Finally, we think China will make sufficient reforms to boost confidence that stronggrowth in China will continue over the medium term.

Chart 15: DM recovery to boost EM exports Chart 16: EM growth should boost EM margins

Source: JP Morgan Source: MSCI, J.P.Morgan

We expect SC equities to marginally underperform DM equities. While profit growth at smaller companies is strong, thisappears more than already priced into SC equities where valuations are high level relative to DM equities. We expectLVE to underperform. LVE have performed well over the last few years as investors have preferred safer companies,which typically have less volatility than riskier equities. With the global economy normalizing, we think that thevaluation premium built into LVE will diminish.

GLOBAL BONDSWe think that the 30 year global bond bull market ended in 2013 (Chart 17 and 18). While it will take many years forbond yields to return to more normal levels (of 4%-5%), we expect the process of transitioning back to normal thatbegan last year will continue. This implies a further back-up in bond yields, although with inflation and interest rateslikely to remain very low this year, further bond market weakness is likely to be less severe with bond yields rising onlyslightly more than is already priced into bond markets.

Charts 17 and 18: US and UK bond yields close to all-time lows

Source: Credit Suisse Source: Credit Suisse

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OUTLOOK FOR 2014 AND BEYONDPage 9

DM BOND MARKETSWe expect DM bond markets to perform poorly in 2014 and beyond, struggling to generate a positive return as yieldsrise by slightly more than is currently priced into markets. The Fed is likely to continue scaling back its new bondpurchases and ending them in the second half of 2014, although the ECB and in particular the Bank of Japan (BoJ) maygive their economies one further boost after the consumption tax increase. However, as the year develops the marketsmay start thinking about when interest rates in the US and the UK might start to go up as their unemployment rates fallbelow 6.5% and 7% respectively. We expect the UK and the US to start raising interest rates gently in the second half of2015 or 2016 and the ECB and then the BoJ a few years later.

We expect peripheral European bond market spreads to narrow further as economic growth and debt and deficitsimprove across the peripheral economies. While unemployment is likely to remain painfully high for a number of years,we think 2014 will mark another year of positive progress from a bond market point of view.

INVESTMENT GRADE (IG) AND HIGH YIELD BONDS (HY)Although spreads (the difference in yield between government bonds and IG and HY bonds) are already narrow, we seefew reasons for those spreads to widen substantially and expect IG and HY to outperform government bonds. However,on an absolute basis IG and HY returns are likely to be low (although positive). While rising US bond yields could lead torising pressure on spreads, we expect them to remain largely unchanged as companies remain highly profitable anddefaults very low. There could be more dispersion between different corporate issuers as some use the currentlyfavourable market conditions as an opportunity to increase their leverage. The bonds of those that lever are likely tounderperform.

EMERGING MARKET DEBT (EMD)We think that EMD will perform well in 2014, outperforming government and corporate bonds (IG and HY). After a yearof substantial underperformance, valuations both in terms of yields and currency value have become more favorable.Although Fed tapering and the prospect of an eventual rise in interest rates will put pressure on some EM bondsthrough the year, we think that most EM bonds will be able withstand that pressure.

The fragile 5 (India, Indonesia, South Africa, Brazil, Turkey) will remain in focus because of their current account deficitswhich make them reliant on overseas capital flows. We expect these markets to be more resilient than they were lastyear, supported by a recovery in their exports on the back of the recovery in the global economy.

FXWe expect the US dollar to strengthen against most currencies this year, supported by strong economic growth, afurther reduction of new bond purchases and the possibility of the Fed raising interest rates in 2015. The US dollar willalso benefit from the further development of its oil and gas reserves, which will keep US energy costs well below those inother countries and reduce its oil imports further. The euro is expected to weaken as its economic recovery lags that ofthe US and elsewhere. The ECB is unlikely to raise interest rates for many years. We expect sterling to be relatively firm,supported by strong growth, while the weak Australian economy could weaken the Australian dollar further. TheJapanese yen could weaken further as the Bank of Japan takes further steps to boost the economy after the rise inconsumption tax in April.

We expect emerging market currencies to be mixed. On the one hand, rising US bond yields could put further pressureon the currencies of those economies with current account deficits. On the other hand, strong export growth because ofthe recovery in the developed world should boost overall activity and reduce current account deficits.

OUTLOOK FOR 2014 AND BEYONDPage 10

RISKSAs discussed earlier, our central view is that the global economy will strengthen to a modestly above trend pace, bondyields will rise modestly and that equities will perform well, with EM outperforming. However, there are a number ofrisks to this central view. There are a large number of potential risks, but the four issues we consider are: 1) sharp rise inUS bond yields 2) China runs into problems as it tries to rebalance its economy 3) global growth recovery peters out 4)productivity and reforms accelerate

1. Sharp rise in bond yields: We expect US bond yields to rise modestly this year, with 10 year yields averaging lessthan 4% in the second half of the year. However, bond yields could rise by more for a number of different reasons.First, they could rise more significantly if the US grows more strongly than expected, leading to an acceleratedtapering process and the possibility of earlier interest rate increases. Second, they could rise if investors reducetheir bond holdings in anticipation of a prolonged period of weakness. Third, they could increase further if there aresigns that inflation could start to rise, perhaps in an environment of weak productivity growth and a further declinein the size of the labor market.

2. Chinese growth slows sharply: We expect Chinese growth to be about 7%-7.5% in 2014. However, it is possiblethat Chinese growth could slow sharply as China attempts to bring credit growth under control. This slowdown incredit and the overall economy could lead to rising defaults, which the authorities could struggle to deal with in anorderly fashion.

3. Global growth rolls over: We expect global growth to rise to a trend or above trend pace and stay there for a fewyears. However, after strengthening in early 2014, it is possible that growth could weaken again as lingering fearsover debt levels worldwide and any further shocks that could hit dampen sentiment. While a recession seems veryunlikely a further period of prolonged weakness could ensue.

4. Goldilocks: productivity in DM, reform in EM: Productivity in most of the developed world has been very weaksince the financial crisis. Many have speculated that this is structural in nature, reflecting high debt levels, greaterregulation and worsening demographics. It is possible, however, that much of the weakness is cyclical and theworld could enjoy a few years of strong productivity growth, boosting the overall economy and corporate profits.

Most emerging economies have slowed sharply over the last few years as reforms have stalled and economies havestruggled to transition away from export led growth. It is possible that the weakness seen in some EMs in the middleof 2013 could trigger a policy response in some key economies. China has announced an ambitious reform programwhile there will be elections in all of the fragile 5 economies in 2014.

The following table shows what impact the risks identified above would have of DME, EME, EM FX and governmentbonds.

*= if higher bond yields were caused by the prospect of higher inflation then the impact all of the asset classes would be worse

DevelopedMarket Equities

EmergingMarket Equities

EmergingMarket FX

GovernmentBonds

Higher Bond Yields *

China Slows =

Growth Rolls Over =

Productivity & Reform

OUTLOOK FOR 2014 AND BEYONDPage 11

SUMMARY AND CONCLUSIONS

Mercer thinks that the period of weak global growth following the financial crisis is over. While the headwinds that haveheld back the recovery have not been eliminated, enough progress has been made to allow very low interest rates,rising asset prices and pent-up demand in a number of places to generate trend or above trend growth.

However, while stronger growth is unambiguously good news for corporate profits, government deficits andunemployment, it is not necessarily good news for all asset classes. The stronger growth is likely to lead to higher bondyields although some of this is already priced into markets. For equities, which have front run the better economic news,the eventual end of QE and rising bond yields will pose a new challenge over the next year and beyond. We think thatequities will overcome this new hurdle and that the emergence of a sustained economic recovery will propel equitieshigher over the next few years, albeit at a slower pace than seen in the last few years.

©2014 Mercer LLC

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The findings, ratings and/or opinions expressed herein are the intellectual property of Mercer and are subject tochange without notice. They are not intended to convey any guarantees as to the future performance of theinvestment products, asset classes or capital markets discussed. Past performance does not guarantee futureresults. Mercer's ratings do not constitute individualized investment advice.

This does not contain investment advice relating to your particular circumstances. No investment decision shouldbe made based on this information without first obtaining appropriate professional advice and considering yourcircumstances.

Information contained herein has been obtained from a range of third party sources. While the information isbelieved to be reliable, Mercer has not sought to verify it independently. As such, Mercer makes no representationsor warranties as to the accuracy of the information presented and takes no responsibility or liability (including forindirect, consequential, or incidental damages) for any error, omission or inaccuracy in the data supplied by anythird party.

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©2014 Mercer LLC

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