J.P. Morgan

J . P . M O R G A N A S S E T M A N A G E M E N T 5 Indeed, GDP-to-equity market capitalization ratios diverge greatly across the world. For example, Chinese and U.S. ratios contrast starkly: • Chinese economic activity is capitalized in the equity market at a ratio of $2.2 trillion to $9.2 trillion, or 0.24 • U.S. economic activity is capitalized at the ratio of $18.9 trillion to $16.8 trillion, or 1.12 (See "Exhibit 3: There is a mismatch between global economic activity and market capitalization," page 11.) Even though public market capitalization provides a portal for public investors to gain country exposure, China provides a clear example (as illustrated in Exhibits 3 and 4) that public market investing is not always the best way to approach extracting GDP, profits or sectoral growth. A closer look at the composition of country and regional indices is needed. Country indices are often highly skewed representations of actual nation-wide economic activity, from both an industry and capitalization perspective. China is again an excellent example. The Chinese equity market indices are weighted toward State Operated Enterprise (SOE), heavy industry, telecommunications and financial companies. In 1978, SOEs represented almost 78% of China's entire industrial output. By 2004, they were estimated to be only about 30%. 2 A greater index weight to SOEs may have been acceptable during years of high global and Chinese GDP growth. But recently and going forward, an index-based investment profile based on state-controlled heavy industry and financials may be problematic, at best. That is because: • Chinese and global growth for the next 10 years are expected to be lower than they were, on average, for the past 10 years • The most recent Chinese plenum established market forces as the preferred driver for future growth • China is pushing to build the domestic consumer part of its economy • Liberalization of the financial markets is a key goal of the Chinese government's future policy Regional economic growth is a necessary, albeit insufficient, condition when creating a portfolio's equities allocation. 2 OECD Working Group on Privatization and Corporate Governance of State Owned Assets, January 26, 2009. For example, it would be naïve to create a portfolio of countries with the fastest growing economies. There have been dramatic differences in growth rates between regional economies and their equity markets, which have persisted for long periods. From 1993 through 2013, for example, the Chinese economy grew more than 600%, while equity markets remained flat. In the 1990s, Korea experienced a similar disconnect. Even as the Korean economy more than doubled, equity markets failed to generate positive returns. (See "Exhibit 4: Economic growth is often uncorrelated with investor returns," page 12.) Brazil also shows how country GDP and quality of capitalization are not always the best indicators of the public markets' ability to deliver returns commensurate with a country's real growth. Despite Brazil's relatively large and growing economy, the Brazilian equity market is highly concentrated and industry focused. As of January 31, 2014, five stocks constituted 32% of the total equity market capitalization. Those five are focused on three industries. The top two, Vale and Petroleo Brasileiro, comprise 8.2% and 7.8% of the Brazil São Paulo BOVESPA Stock Index, respectively. With commodity prices expected to remain muted for some time, a Brazilian index investor may not realize returns consistent with underlying Brazilian GDP growth, or even participate in the more dynamic parts of the country's growth. In essence, single-country or even single-region public market investing often distills down to commodity, concentrated industry or state-dominated risks. (See "Exhibits 5, 6 and 7, which, together, illustrate the vagaries of both single-country/region and concentrated-industry investing, pages 12 and 13.) Essential building blocks We also turn to our forward-looking expectations for risk and return—which are essential to building an equity allocation. The most effective strategic allocation considers the current equilibrium, as indicated by GDP and market capitalization shares, then projects forward. It takes into account many "what if" considerations: relative growth, politics, demographics, economic themes such as deleveraging and the end of the commodity "supercycle," valuation metrics, earnings per share growth rates, dividend growth, productivity, corporate governance and more to determine base-case weightings.

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