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Preparing for a Volatile Year February 2014

Last years Ten Surprises had a cautious tone. 2012 had been a good year for the market, but I expected the United States economy to experience slow growth in 2013 and I was worried that corporate revenues would only increase modestly. As a result I thought profit margins ran the risk of peaking and earnings could be disappointing. As it turned out, the economy did only expand slowly throughout the year, profit margins were essentially flat and revenues were not robust. Share repurchases were strong, however, as companies used the considerable cash on their balance sheets to reduce the number of outstanding shares, and therefore increases in earnings per share were pretty much on target. Corporate net income for the year was less impressive. The Federal Reserve remained accommodative throughout the year, increasing its balance sheet by over $1 trillion through aggressive buying of Treasurys and mortgage-backed securities. A large part of this liquidity found its way into financial assets, keeping interest rates low and causing equity prices to rise. The Standard & Poors had a total return of 32.4% for the year. By the end of the year, the U.S. economy was doing better. The bright spots included vehicle sales, housing and energy production. Job creation remained slow, but the unemployment rate improved as frustrated people seeking employment dropped out of the work force. In Europe the recession was expected to end and limited growth was projected for 2014. The European Union remained intact and the euro looked like it would endure as the continents currency, but few structural reforms (like a banking union) had taken place. Shinzo Abes policies of fiscal and monetary expansion were working in Japan and the economy there was about to start growing again. China continued to expand at a 7.5% rate, but growth in other emerging markets slowed and their stock markets had another difficult year. Nonetheless investor attitudes, buoyed by the strong performance of the developed markets, were positive at year-end. In the United States some fundamental reasons for optimism were also developing. The Purchasing Managers Index for manufacturing was showing consistent strength and capital spending was expected to improve. Projections for U.S. economic growth for 2013 moved up to 2.5% from 2.0%. While the economy is not yet accelerating, this positive shift had an influence on the Ten Surprises of 2014. The definition of a surprise is a market-influencing event where I believe the probability of it happening during the year is better than 50%, but most money managers would only assign a one in three likelihood of it taking place. The Surprises are not always contrarian. Some are in the direction of the consensus but more extreme. In my first Surprise I thought the S&P 500 might suffer a correction of as much as 10% early in the year because investor attitudes were too optimistic and the market almost always experiences a setback when the various sentiment measures (particularly those based on transactions) are so positive. I thought that geopolitical problems in Iraq, Iran, the South China Sea, or Afghanistan would contribute to investor

nervousness. I believed the S&P 500 would be up 20% for the full year, however. A year when the index is up 25% or more is generally followed by another one of favorable performance (although not always in double digits), particularly when the fundamentals are improving. In the second Surprise I thought that the economic momentum that was building in the latter part of 2013 would continue and that the U.S. economy would show growth in excess of 3%. I also said that the unemployment rate would drop to 6% by year-end. I had no idea that it would decline .3% in December, but that was primarily because the participation rate dropped. I thought the unemployment rate would improve while the participation rate normalized to a somewhat higher level. I expected the Federal Reserve to continue to reduce its monthly bond-buying program without having a negative impact on either the economy or the stock market. Last spring, when thenFed Chairman Ben Bernanke suggested he might taper, both the bond and stock markets reacted sharply, but in December when the first wave of tapering was actually announced, stocks continued to rise. Thats because, by then, investors knew a reduction in bond-buying was coming but the economy itself was doing better. As long as that is the case, further reductions in the Feds accommodation should be absorbed by the financial markets without a dislocation. In the third Surprise I expected the dollar to strengthen. Currencies often reflect the differential growth rates of various economies and the United States will be growing much faster than Europe or Japan. But currencies are also affected by monetary policy and the Federal Reserve balance sheet has been increasing while that of the European Central Bank (ECB) has been decreasing as loans made to banks on the continent have been paid back. That partially explains why the euro has been relatively strong recently. Now the Fed is reducing its bond-buying and the ECB may become more accommodative to bolster growth there. I think we could see dollar/euro at $1.25 and yen/dollar at 120. In the fourth Surprise I expected further strength in the Japanese equity market as the economy shows that it is pulling out of its twenty-year deflationary recession. The Nikkei 225 goes to 18,000 in the first half of the year as the expansive fiscal and monetary stimulus programs continue to work favorably on the economy in Japan. Later in the year, however, as the so-called Third Arrow regulatory reforms are implemented, some negative forces begin to have an impact. The increase in the sales tax reduces consumer spending, Chinas slowdown affects exports, the aging population increases social costs and the decline in the working age population makes growth more difficult. The Japanese market drops sharply (20%) in the second half. China is the focus of the fifth Surprise. In the Third Plenum meeting in November Chinas leadership pledged reforms to deal with corruption and programs to reduce the importance of credit expansion in the growth of the economy. The objective is to increase consumer spending as a percentage of GDP and lessen investment in state-owned enterprises and infrastructure. Right now investment spending accounts for 45% of GDP and the consumer for 35%. The goal is to reverse these percentages, restoring the condition that existed in the 1990s. Various authoritative studies have shown that it will be difficult to accomplish this shift without reducing the growth of Chinese GDP from 7.5% to something nearer 6% for 2014. A slowdown of this magnitude would have both social and political implications and it will be important to watch whether the new leadership group has the political will to risk the public reaction to slower growth and less job creation. They say they want to do what is best for the country in the long run and rebalancing the economy toward the consumer passes that test. Lets see whether there is evidence that these objectives are being met this year. Emerging markets have been a disappointment to investors for several years. While their economies have continued to grow, their equity markets have performed poorly. In the sixth Surprise I recommended two countries I thought could provide positive returns. Mexico and South Korea both have manageable debt obligations and strong manufacturing bases. Mexico should benefit from improving economic conditions in the United States, but South Korea could be negatively affected by a slowdown in China. South Korea exports to countries all over the world and if Europe and the United States improve their growth rates, exports from that countrys world-class electronics and automobile companies should remain strong. In fact, because South Korea has a per capita income level of $11,000, some observers believe it should be considered a developed market. While I expect challenges to investing well in Brazil, Russia, India and China, I think there are opportunities in South Korea and Mexico.

Many investors are optimistic that the increased production of oil using hydraulic fracking processes will bring North America toward energy self-sufficiency by 2020. There are others who think that increased production from Iraq and Iran will change the supply/demand balance and we will see lower oil prices in 2014. I am skeptical, and in the seventh Surprise I said that the price of West Texas Intermediate crude would rise to $110 a barrel in 2014. Rail accidents resulting in oil spills in North Dakota have encouraged authorities to propose tougher safety standards for oil transportation. Environmental groups contend that there has been a higher incidence of earthquakes, heavy use of roads by large vehicles and significant problematic water consumption in the fracking process. As a result, production of oil from fracking may increase at a rate slower than many (including myself) originally thought. As for Iraq and Iran, we cannot yet be assured of stability in those countries and both require substantial foreign investment to realize their full energy production potential. At present, worldwide demand for oil (primarily from the developing world) is increasing faster than worldwide production, and that is why I expect an increase in oil prices this year. I believe the consensus is that the price of crude will drop, so this is clearly a contrarian call. Last year I thought variable weather patterns caused by global warming would produce a series of crop failures. I also believed the continued increase in the standard of living in the developing world would result in an improvement in diets, increasing the demand for grains for personal consumption and the feeding of poultry and livestock. These factors would result in higher prices for corn, wheat and soy beans. That did not happen, but the forces are still in place for higher agricultural prices in 2014 and I have corn going to $5.25 a bushel, wheat to $7.50 and soybeans to $16.00. This one is a carry-over from last year, which I do not do often, but I think is warranted, and it is another contrarian surprise. For years strategists have been anticipating a rise in U.S. intermediate and long-term Treasury yields, but they have remained persistently low and even gone a lower than many expected. The average yield on the 10-year Treasury over the last half-century is about 6%, so yields below 3% are very uncommon. During 2013 the yield on the 10-year note almost doubled from 1.7% to 3% and I believe we will see 4% by the end of this year. I don't, however, expect inflation to be the driver. Without a sharp rise in wages or house prices, I expect inflation to remain subdued. The reduced buying of Treasurys by the Federal Reserve will be a factor. In 2007, before the aggressive bond-buying program began, the Fed balance sheet was $1 trillion and Treasurys represented less than 10% of it. By 2013 the Fed balance sheet had swollen to $3.5 trillion and Treasurys represented 25%. The Fed was very active in the Treasury market and that is one reason why yields remained so low. Now, with the tapering process underway, that buying will diminish. In addition, the stronger economy and the better performance of risk assets will divert attention away from bonds. While most observers expect intermediate Treasury yields to rise somewhat, I think they can reach 4%, which is in the direction of the consensus but more extreme. Finally, in the tenth Surprise I expected the Affordable Care Act to have a turnaround. I recognized that the launch of the plan was disastrous because of technology failures. I believe those are fixable. More serious is the failure of young, healthy working people to sign up for the program. That must happen if universal health care is going to succeed. I believe incentives will be initiated if young people do not sign up on their own. If there were a turnaround, I think Obama's approval rating would continue to rise and the Democrats would be in a better position to compete in the November congressional elections. I have them actually gaining seats in the House of Representatives and maintaining control of the Senate. The Affordable Care Act is the signature achievement (or failure) of the Obama presidency. If it does prove successful, the political balance will shift. That is clearly a contrarian view at this time. Every year I always have a few surprises that do not make the Ten, but are worth thinking about. These are investment-related possibilities which I either do not believe are probable, having a better than 50% chance of happening, or do not think are as relevant as the Ten I have used. I wrote this first Also Ran before Governor Chris Christie got embroiled in the George Washington Bridge lane closing flap. I expected his popularity to fade partly because of his provincialism and his lack of any experience with international issues. I thought Ted Cruz would become a leading candidate. His association with the Tea Party could be an advantage in the primaries. He is generally thought to be highly intelligent, strategic, cunning and charismatic. With Christie damaged, the Republicans will want to choose a candidate who has the potential to win in 2016.

In the second Also Ran I thought bitcoins would fall out of favor. They do not have golds history as a store of value and their principal utility is for transactions where anonymity is important. I may be too much of a Luddite to appreciate the significance of bitcoins, but I believe that a year from now they will still exist but no longer be a hot topic of conversation within the financial community. We have been talking about recognizing Cuba as a sovereign nation since the 1960s, but the Cuban exile community who had their assets seized has been strongly against it. I used a form of this third Also Ran as one of the Ten Surprises in the 1980s but that turned out to be premature. It may still be too early, but its going to happen no later than after both Castros pass away. We would establish trade and diplomatic relations and provide loans to Cuba in the form of bonds, which would quickly become known as Castro convertibles. Hillary Clinton decides not to be the Democratic presidential candidate in 2016 is the fourth and final Also Ran. Up until now the speculation on whether she will or will not run has been based on the condition of her health. I specifically said that she will rule that out as a factor if she decides not to run. I also think her role as Secretary of State in the Benghazi terrorist attack resulting in the death of our Libyan ambassador will have faded from memory by then. The key reason for her decision will be the frustration of dealing with the legislative branch and the difficulty any president would have getting a constructive agenda passed into law. While the thought of becoming the first woman to be President of the United States will be tempting, the prospect of accomplishing little during four exhausting years may discourage her. Bill Clinton may, however, have a different opinion. So, there they are, The Ten Surprises and the four Also Rans. Now lets see how the year turns out. Be prepared for a rough ride but a generally positive investment outcome with the major countries of Asia being an exception. * * * * *

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____________________________________________ The views expressed in this commentary are the personal views of Byron Wien of Blackstone Advisory Partners L.P. (together with its affiliates, Blackstone) and do not necessarily reflect the views of Blackstone itself. The views expressed reflect the current views of Mr. Wien as of the date hereof and neither Mr. Wien nor Blackstone undertakes to advise you of any changes in the views expressed herein. This commentary does not constitute an offer to sell any securities or the solicitation of an offer to purchase any securities. Such offer may only be made by means of an Offering Memorandum, which would contain, among other things, a description of the applicable risks. Blackstone and others associated with it may have positions in and effect transactions in securities of companies mentioned or indirectly referenced in this commentary and may also perform or seek to perform investment banking services for those companies. Blackstone and/or its employees have or may have a long or short position or holding in the securities, options on securities, or other related investments of those companies. Investment concepts mentioned in this commentary may be unsuitable for investors depending on their specific investment objectives and financial position. Where a referenced investment is denominated in a currency other than the investors currency, changes in rates of exchange may have an adverse effect on the value, price of or income derived from the investment. Tax considerations, margin requirements, commissions and other transaction costs may significantly affect the economic consequences of any transaction concepts referenced in this commentary and should be reviewed carefully with ones investment and tax advisors. Certain assumptions may have been made in this commentary as a basis for any indicated returns. No representation is made that any indicated returns will be achieved. Differing facts from the assumptions may have a material impact on any indicated returns. Past performance is not necessarily indicative of future performance. The price or value of investments to which this commentary relates, directly or indirectly, may rise or fall. This commentary does not constitute an offer to sell any security or the solicitation of an offer to purchase any security. To recipients in the United Kingdom: this commentary has been issued by Blackstone Advisory Partners L.P. and approved by The Blackstone Group International Partners LLP, which is authorized and regulated by the Financial Services Authority. The Blackstone Group International Partners LLP and/or its affiliates may be providing or may have provided significant advice or investment services, including investment banking services, for any company mentioned or indirectly referenced in this commentary. The investment concepts referenced in this commentary may be unsuitable for investors depending on their specific investment objectives and financial position. This commentary is disseminated in Japan by The Blackstone Group Japan KK and in Hong Kong by The Blackstone Group (HK) Limited.