A Major Pivot at Work

Transcription

1 GWIM INVESTMENT STRATEGY COMMITTEE Viewpoint Chief Investment Office NOVEMBER 2016 A Major Pivot at Work This month s Investment Strategy Committee meeting focused on the investment implications of the summer pivot in global cyclical momentum. The key takeaways are as follows: By a number of metrics global cyclical momentum pivoted in early summer and has been slowly rising since then. For example, the Markit global manufacturing purchasing managers index (PMI) has risen for four straight months. In the U.S., the mid-cycle slowdown appears to be fading as real growth in gross domestic product (GDP) accelerated in the third quarter and manufacturing survey data bottomed in August and have been picking up. Global bond yields have also pivoted and we have likely seen the cycle low. In the U.S., the 10-year Treasury yield is up around 50 basis points from the July low. The Fed will likely raise rates in December, the Bank of Japan is firmly on hold (pegging long rates near zero) and the European Central Bank is also holding steady for now but could be shifting to a more flexible version of quantitative easing at some point in Yield curves are shifting up. In the U.S., short rates are moving higher on Fed rate hike expectations and long rates are being pushed higher by positive global economic developments. There has been a clear pivot away from deflation concerns to reflationary traction as domestic inflation expectations have picked up and commodity prices have stabilized. Nominal economic data are firming, which helps global earnings growth. A pivot to cyclical investments: The backdrop of rising cyclical momentum and rising inflation expectations has benefitted cyclical value investments over defensive and yield-driven strategies. Emerging market equities have outperformed U.S. equities as the U.S. business cycle is the most advanced. Shorter-duration bonds have been favored to long-duration bonds on the view that we have seen the cycle low in rates. Similarly, as inflation picks up, Treasury Inflation Protected Securities (TIPS) offer more protection for fixed income investors in this environment than Treasuries. The rates environment has been positive for bank stocks, which have outperformed more defensive sectors like health care and consumer staples. The dollar has also pivoted and is up over 4% since May (using the Bloomberg Dollar Index). 1 We think these trends will continue as we head into early 2017 and are positioning portfolios accordingly. We recently upgraded emerging markets to overweight and within fixed income we maintain a short duration strategy and would be adding to TIPS versus Treasuries and more credit-sensitive overall. Portfolio strategy and asset allocation We continue to expect global equities to outperform fixed income: Equities should remain on a longer-term uptrend as U.S. and global expansions gradually continue. While valuations are full on an absolute basis, relative valuations versus fixed income in general remain attractive. We would continue our get paid to wait strategy (accumulation of cash flows across assets), increase lesscorrelated investments and commit to an increased level of tax efficiency and rebalancing. Information technology remains our favored sector for long-term growth. U.S. equities remain at a neutral weight: We remain neutral equities overall as negative interest rate policies (NIRPs) on the part of central banks become less effective and political risks are an overhang. U.S. equity market valuations are full at about 20 times earnings on a trailing 1 From May 31, 2016 to November 1, Merrill Lynch Wealth Management makes available products and services offered by Merrill Lynch, Pierce, Fenner & Smith Incorporated (MLPF&S), a registered broker-dealer and Member SIPC, and other subsidiaries of Bank of America Corporation. Investment products: Are Not FDIC Insured Are Not Bank Guaranteed May Lose Value 2016 Bank of America Corporation. All rights reserved.

2 12-month basis for the S&P 500 index. The U.S. equity market is now at the upper end of the range for valuation and index target levels. Within equities, we maintain a slight overweight to U.S. large-cap stocks for their high quality, stronger free cash flows and dividend growth. We also recently upgraded emerging market equities to overweight, funding the overweight by reducing exposure to international developed market equities. We are overweight emerging market equities: While emerging market equities continue to face a range of challenges, including low commodity prices, gradual normalization of Federal Reserve interest rate policy and the structural downshift in China s growth rate, we believe they will benefit from the recent pickup in global cyclical momentum and valuations are attractive. We still view markets such as India that are less trade- and commoditydependent, and have more domestic support from monetary policy and internal reform as the best-positioned. On a structural basis, we continue to expect strength in demand from the emerging market consumer, as incomes and spending power increase over the longer term. We recently shifted to an underweight position in international developed market equities versus our strategic allocation to fund the overweight position in emerging market equities, and would approach currency hedging on a case-by-case basis: The global economic backdrop should provide sufficient tailwinds to support modest growth in Europe, although there are offsetting factors in some elevated headline risks major elections in 2017, a potential delayed Brexit impact, valuations and bank stress. We would approach hedging Japanese and European equities on a case-by-case basis, given our more neutral view on the dollar. We remain underweight fixed income, but we still find opportunities selectively in credit: Bonds provide portfolio diversification, income and stability, but low rates skew downside risk. Neutral duration in conservative strategies is warranted, balancing expected higher short-term rates in the U.S. with overwhelming demand for fixed income globally. Strategies with benchmark durations over five years should be cautious and slightly underweight duration. We continue to prefer credit over Treasuries, with an emphasis on investment-grade corporate bonds as well as municipal securities. However, in the current higher-volatility market, some allocation to Treasuries for liquidity and relative safety is advised. An allocation to TIPS should be considered where appropriate. We would caution against an over-allocation to long-duration assets given an unfavorable risk-reward tradeoff. Given the upward bias of the U.S. dollar, we are generally avoiding non-dollar sovereign bonds. Within fixed income, we advocate a neutral weight to corporate high-yield (HY). An allocation to leveraged loans is advised within HY due to the floating-rate coupon, secured status, and minimal give up to unsecured status in the capital structure. Allocations to HY should be with an active manager that overweights the higher end of the quality spectrum. Valuations and fundamental risks, including the acceleration in default rates, lead us to be cautious on allocations to indexbased solutions in high-yield. For all sectors, we recommend an active management approach to improve potential returns in a rising and volatile rate environment. A barbell strategy of owning bonds with both longer and shorter maturities should perform better than a laddered or bulleted strategy in a flattening yield curve environment. We are neutral commodities: Commodity prices are likely range-bound in the near-term, weighed down by global economic policy uncertainty but held up by stable global cyclical momentum. We think oil prices will finish the year in the $45-$55 dollar range and move slightly higher next year. We are neutral hedge funds: We currently emphasize hedge fund strategies that have low to moderate levels of market exposure, and those managers that can generate a large portion of their return from asset selection and/or market timing. We are neutral private equity: We see potential opportunities in special situations/opportunistic and private credit strategies. We remain neutral in real estate as an asset class: We prefer opportunistic and value sectors. The dollar: Our base case is that the dollar will likely remain generally stable with some upside potential if, for example, wage growth in the U.S. picks up faster than expected, euro breakup sentiment gains traction or relative emerging market cyclical momentum stalls, further narrowing the growth differential with the U.S. GWIM Investment Strategy Committee Viewpoint 2

3 A Transforming World investment themes (Earth, people, innovation, markets, government): We favor themes such as robotics, cloud computing, big data, cybersecurity, agriculture, water scarcity, financial technology, emerging market internet users, alternative energy and defense. Macro strategy The global expansion has become more synchronized in 2016 as emerging markets begin to pick up after a five-year slowdown. Combined with a U.S. reacceleration, which is evident in corporate profits growth turning positive, global growth is improving going into year-end. More policy makers are talking about the need for better monetary and fiscal coordination, a trend that should strengthen in the year ahead and help reinforce the emerging global economic momentum. In the U.S., a solid jobs market, unemployment headed toward 4% and strong real wage gains should keep the U.S. consumer moving forward. With inflation moving gradually higher, we expect the Fed to raise rates in December. Housing is an important tailwind for the U.S., and residential investment should rebound following two weak quarters in a row. Longer-term themes and trends Water Agricultural Commodities ClimateChange Global Obesity Global Healthcare Robotics and Global Information Technology Rise of the Emerging Market Middle-Class Consumer Womenomics Global Commercial Real Estate Global Defense and Cyber Security GWIM Investment Strategy Committee Viewpoint 3

4 When assessing your portfolio in light of our current guidance, consider the tactical positioning around asset allocation in reference to your own individual risk tolerance, time horizon, objectives and liquidity needs. Certain investments may not be appropriate, given your specific circumstances and investment plan. Certain security types, like hedged strategies and private equity investments, are subject to eligibility and suitability criteria. Your financial advisor can help you customize your portfolio in light of your specific circumstances. ASSET CLASS Global Equities U.S. Large Cap U.S. Mid & Small Cap International Developed Emerging Markets Global Fixed Income U.S. Treasuries U.S. Municipals U.S. Investment Grade U.S. High Yield U.S. Collateralized Non-U.S. Corporates Non-U.S. Sovereigns Emerging Market Debt Alternatives Commodities Hedged Strategies Real Estate Private Equity U.S. Dollar Cash CHIEF INVESTMENT OFFICE VIEW Negative Neutral Positive COMMENTS We are neutral equities. The latter mid-cycle stage of an expansion suggests a more balanced risk/ reward spectrum for equities. We prefer U.S. large caps for their high quality and dividend growth opportunities. Higher quality preferred given fuller valuations, political uncertainty, improving but subdued economic growth and earnings picture. Valuation multiples for small caps remain slightly extended; select opportunities within higher-quality can be considered. Downside risk to growth and inflation from bank stress and political uncertainty. Major elections in 2017 and negative interest rate policy offset highly accommodative monetary stance and improving global economy. Valuations are attractive for long term investors. Beneficiaries of the pickup in global cyclical momentum. Favor reform oriented countries and consumer spending. We remain underweight fixed income, as it is less attractive compared to asset classes such as equities. Bonds continue to provide diversification, income and stability within total portfolios. Current valuations are stretched, especially on longer maturities. Consider Treasury Inflation- Protected Securities as a high-quality alternative. Valuations relative to U.S. Treasuries remain attractive, and tax-exempt status is not likely to be threatened in the near term; advise a nationally diversified approach. Risk of rates rising subsiding. Stable to improving fundamentals expected to attract high-quality foreign investors as yield differentials are supported by divergent monetary policy. We remain cautious, as defaults expected to increase; spreads to remain range-bound until further economic growth. Higher rates and Federal Reserve tapering are likely to increase spread volatility. A shortage of new issues should counter the effects of tapering. Select opportunities in European credit, including financials; however, any yield pickup likely to be hampered by a stronger dollar. Yields are unattractive after the current run-up in performance; prefer active management. Vulnerable to less accommodative Federal Reserve policy and lower global liquidity; prefer U.S. dollardenominated Emerging Market debt. Local Emerging Market debt likely to remain volatile due to foreign exchange component; prefer active management. Select Alternative Investments help broaden the investment toolkit to diversify traditional stock and bond portfolios. Medium-/long-term potential upside on stabilizing oil prices; near-term opportunities in energy equities /credits. We currently emphasize hedge fund strategies that have low to moderate levels of market exposure and those managers that can generate a large portion of their return from asset selection and/or market timing. We prefer opportunistic and value sectors. We see potential opportunities in special situations/opportunistic and private credit strategies. Stronger domestic growth and a less dovish Federal Reserve policy (relative to the monetary policies of other Developed Market central banks) support a stronger dollar going forward. We have a small cash position awaiting deployment when opportunities arise. * Many products that pursue Alternative Investment strategies, specifically Private Equity and Hedge Funds, are available only to pre-qualified clients. GWIM Investment Strategy Committee Viewpoint 4

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