The RIC Report Investment Strategy | Global 08 January 2013 2013: back to the future Research Investment Committee MLPF&S The Cliff Compromise Kate Moore Equities rallied sharply in the first days of the New Year, following the last minute Global Equity Strategist MLPF&S congressional compromise on the Fiscal Cliff. While the deal was far from perfect, it averted not only a disaster for the US economy, but also a potentially painful hit Michael Hartnett to risk asset markets. Economist Ethan Harris points out that the compromise was Chief Investment Strategist a significant and very important first step to resolving the US fiscal picture. And MLPF&S critically for investors, consumers, and business leaders, it provided a measure of Swathi Putcha clarity. Though policy uncertainty will linger in early 2013, our base case for a Global Equity Strategist gradual pickup in economic growth throughout the year remains intact. MLPF&S The winners of 2012 See Team Page for Full List of Contributors Asset markets were fueled once again by policy and liquidity in 2012. Global central banks cut interest rates 75 times over the last year, while the balance sheets of the major CBs continued to inflate. Global equities returned a solid 17%, outpacing both bonds (5%) and commodities (-0.3%). EM equities outperformed DM equities, while EM and high yield bonds led fixed income. But in our view, the three most memorable stories of 2012 were the positive surprises in US housing, bank stocks, and Europe. Asset allocation & three reasons to own equities now After fixating on policy in the US and Europe over the last year, the RIC recommends investors focus back on the future of asset returns. Our regional equity strategists forecast returns ranging from 10-20% globally, while US IG and HY credit are expected to offer returns of just 1.6% and 7.0%. Global government bond yields are forecast to rise modestly as the global economy slowly recovers. Click the image above to watch the video. Despite potential for near-term volatility and policy noise, we continue to think investors should look for opportunities to add to risk assets during periods of weakness. We highlight three reasons to own equities now: Table of contents Financial markets recap 2 The push from bonds (interest rate risk): The historically low level of bond 2013: back to the future 3 yields offers a bleak outlook for fixed income returns, and significant interest rate Asset markets: base case, ideas, risks 10 risk for bond holders. If the 30-year Treasury yield, which is currently 3.1%, were Global equity market convictions: ideas & risks 11 to rise above 3.32%, the return over the next 12 months would be negative. Asset allocation 12 Major market sector recommendations 17 The pull from equities (attractive yield): Global equity dividend yields and Global stock lists, forecasts 19 payout ratios have been on the rise in recent years, and the removal of uncertainty regarding tax policy strengthens the case for owning dividend stocks. Next issue We identified 43 stocks with div yields higher than their corporate bond yields. 12 February 2013 Investors are far from being “all-in”: Recent fund flow data shows early signs of investor rotation from bonds to equities, but the stubborn preference for ETFs over long-only funds indicates cautious, rather than confident bullishness. Moreover, a long-run look at positioning shows that investors have shunned equities in favor of bond funds (which saw record inflows in 2012). c58da9b710df662c BofA Merrill Lynch does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Refer to important disclosures on page 26 to 28. Analyst Certification on Page 25. Link to Definitions on page 25. 11234229 The RIC Report 08 January 2013 2012 Review Financial markets recap 2012 was an eventful year for global Table 1: Total return (%) markets, as both macro and policy As of 31 December 2012 surprises continued to dominate the Asset class 2011 1 mo 3 mo 2012 spotlight. Most asset markets, however, Equity Indices (%, US dollar terms) finished the year with double digit S&P 500 2.1 0.9 -0.4 16.0 returns, despite worries of a European NASDAQ Comp -0.8 0.6 -2.5 17.7 FTSE 100 -2.7 1.9 4.0 15.2 sovereign debt crisis, a China hard TOPIX -11.9 5.6 5.7 8.1 landing and the US Fiscal Cliff. Hang Seng -17.3 2.9 9.0 27.7 DJ Euro Stoxx 50 -16.7 4.0 10.4 20.2 Emerging Markets displayed an MSCI EAFE -11.7 3.2 6.6 17.9 MSCI Emerging Markets -18.2 4.9 5.6 18.6 outstanding performance in 2012, mostly attributable to reaccelerated Size & Style (%, US dollar terms) growth in the back half of the year. EM Russell 2000 -4.2 3.6 1.9 16.3 equities (+18.6%) outperformed S&P 500 Citigroup Growth 4.7 -0.1 -2.0 14.6 S&P 500 Citigroup Value -0.5 2.2 1.6 17.7 Developed Markets, while EM sovereigns S&P 600 Citigroup Growth 3.6 3.1 1.3 14.6 and corporate bonds provided healthy S&P 600 Citigroup Value -1.4 3.5 3.2 18.2 gains as well. S&P 500 Sectors (%, US dollar terms) Consumer Discretionary 6.1 0.5 2.1 23.9 Within US markets, the S&P (+16.0%) Consumer Staples 14.0 -2.2 -1.7 10.8 displayed its best performance in three Energy 4.7 0.6 -2.7 4.6 years. Value outperformed Growth in Financials -17.1 4.7 5.9 28.8 Health Care 12.7 -0.2 0.1 17.9 both size segments, with small-cap Industrials -0.6 2.6 3.7 15.3 Value (+18.2%) providing the strongest Information Technology 2.4 0.0 -5.7 14.8 returns. Materials -9.8 3.2 2.7 15.0 Telecom Services 6.3 -0.9 -6.0 18.3 Utilities 19.9 0.1 -2.9 1.3 Domestic-oriented areas led 2012’s US sector performance, with the biggest BofA Merrill Lynch Global Research Bond Indices (%, US dollar terms) gains coming from Financials (+28.8%) 10-Year Treasury 17.1 -1.1 -0.2 4.2 and Discretionary (+23.9%). The clear 2-Year Treasury 1.5 0.0 0.1 0.3 TIPS 14.1 -0.6 0.8 7.3 laggards were Utilities (+1.3%) and Municipals* 11.2 -1.6 0.5 7.3 Energy (+4.6%). US Corporate Bonds 7.5 0.0 1.2 10.4 US High Yield Bonds 4.4 1.6 3.2 15.6 Within fixed income markets, lower Emerging Market Corporate Bonds 3.8 1.1 3.1 15.8 Emerging Market Sovereign Bonds 5.8 1.1 3.5 17.6 quality bonds outperformed significantly Preferreds 4.1 -0.1 0.7 13.6 as investors continued to reach for yield. 2012’s best performing sectors Foreign Exchange** (%, in local currencies) were Emerging Markets, high yield, and US Dollar 0.5 0.9 2.6 1.5 British Pound 1.6 0.2 -0.9 2.9 preferred securities. Euro -3.2 1.3 3.5 0.9 Yen 5.9 -4.8 -10.4 -11.0 In FX markets, the most notable move Commodities** (%, US dollar terms) came from the yen (-11.0%), owing to CRB Index -8.3 -1.3 -4.6 -3.4 the election results in Japan. The euro Gold 10.1 -2.3 -5.5 7.1 appreciated 0.9% despite the ongoing WTI Crude Oil 8.2 3.3 -0.4 -7.1 Brent Crude Oil 13.8 -0.2 -0.4 3.8 economic woes in Europe. Alternative Investments† (%, US dollar terms) Brent crude oil returned 3.8% for the Hedge Fund - CS Tremont¹ -2.5 -0.2 1.7 5.4 year, as geopolitical risks and monetary Hedge Fund - HFRI Fund of Funds¹ -5.6 -0.4 1.3 3.1 pressures affected commodities as a Private Equity - Cambridge Assoc.² 10.8 NA -0.1 5.3 Private Real Estate - NCREIF TR³ 14.3 NA 2.3 7.8 whole. Gold returned 7.1% for the year, Notes: *Not tax adjusted. **BoE calculated effective FX indices. ¹Data as of 11/30/12; CS AUM-weighted, HFRI equal-weighted ²Quarterly data as of down 3.0% from its 2011 performance. 6/30/2012 ³Quarterly data as of 9/30/12†AI data not comparable to other asset classes because of reporting delays, lack of standardized reporting, and survivorship and self selection biases. Crude oil prices are spot in USD. Source: S&P, MSCI, Bloomberg, FactSet, BofAML Bond Indices (US Treasury Current 10yr, Current 2yr, Inflation-Linked; Muni Master, US Corp Master, US HY Master II Index; EM Corporate Plus Index; EM External Debt Sovereign Index; US Preferred Stock, Fixed Rate). 2 The RIC Report 08 January 2013 2013: back to the future Happy New Year from the RIC. After fixating on policy in the US and Europe over Kate Moore the last year, the RIC recommends investors focus back on the future of asset Global Equity Strategist returns. In this month’s report, we look back at a few of the biggest winners of MLPF&S 2012 – housing, Financials, and Europe, reiterate our asset allocation advice for the year ahead, and highlight three reasons why investors should own equities now: the push from bonds (interest rate risk), the pull from equities (attractive Michael Hartnett yield), and long-term positioning (still not stretched for the asset class).