Improving Growth, Low Inflation and Favorable Markets

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1 CIO REPORTS The Monthly Letter Office of the CIO DECEMBER 2013 Improving Growth, Low Inflation and Favorable Markets Three Macro Drivers and 10 Portfolio Themes for 2014 In our final edition of The Monthly Letter for 2013, we outline our 10 portfolio themes for We believe three key macro drivers will shape asset returns and portfolio positioning. First, we expect to see a stronger global economy, led by the U.S., and an ongoing recovery in corporate spending. Second, despite higher growth, inflation should remain moderate, especially within the developed world, allowing central banks to keep policy rates at historic lows (see Exhibit 1). The third macro driver, however, presents a possible problem: As the Federal Reserve (Fed) begins to reduce its bond-buying commitments (tapering), policy mistakes, misperceptions or Exhibit 1: Better growth and low inflation to support equities outperforming bonds in F 2014F Global GDP GDP Average ( ) Global CPI CPI Average ( ) unexpected political developments could lead to greater market volatility. At the outset, we believe investors should first and foremost invest according to their goals and regularly measure progress toward them. U.S. equities have had an excellent run, with the S&P 500 rising more than 150% since the lows of As the global economy and asset markets begin to normalize in 2014, we recommend clients take into consideration our tactical preferences and rebalance their portfolios closer in line with their strategic asset allocations. Forecast Source: Haver Analytics, International Monetary Fund, BofAML Global Research and ML GWM Investment Management & Guidance. Ashvin B. Chhabra Chief Investment Officer, Merrill Lynch Wealth Management Head of Investment Management & Guidance In this edition of The Monthly Letter, The Office of the CIO looks ahead, presenting 10 portfolio themes that capture the investment opportunities and address the pitfalls we anticipate for These themes emerge from the three macro drivers we expect to shape the environment an improving global economy, continued moderate inflation and lower liquidity that could exacerbate market volatility. Our outlook is positive, but we acknowledge that the risk of an equity correction has increased. We recommend being more sensitive to valuations and more selective among asset classes and regions. Sincerely, Merrill Lynch Wealth Management makes available products and services offered by Merrill Lynch, Pierce, Fenner & Smith Incorporated (MLPF&S) and other subsidiaries of Bank of America Corporation. Investment products offered through MLPF&S: Are Not FDIC Insured Are Not Bank Guaranteed May Lose Value 2013 Bank of America Corporation. All rights reserved. Please see important disclosure information on the last page.

2 MACRO DRIVER 1: A stronger global economy Theme 1: Equities outperform bonds Theme 2: Invest in Team USA Tech, Energy, Autos and Manufacturing Theme 3: International equities prove resilient Theme 4: The equity rotation within the Great Rotation continues After years of a subpar recovery, our forecast calls for global economic growth to accelerate from 2.9% in 2013 to 3.5% in 2014 (see Exhibit 2). We expect this pickup to be led by the developed world, especially the U.S., which has the potential to surprise to the upside. With fiscal headwinds fading significantly in 2014, the resiliency of the private sector could be the driver of stronger gross domestic product (GDP) growth. Ongoing employment gains (resulting in higher aggregate wages) and a considerable decline in household debt levels should support consumer spending. Corporate spending also appears set to drive this pickup in economic activity (see Exhibit 3). Bank of America Merrill Lynch (BofAML) Global Research expects growth in consumer spending and nonresidential investment to increase from 1.9% to 2.6% and from 2.4% to 4.3% in 2013 to 2014, respectively. This sweet spot of a stronger economy, moderate inflation and historically low but gradually rising interest rates would maintain an environment where equities outperform bonds (Theme 1). Exhibit 2: Forecasts for 2014 GDP 2013 Forecast 2014 Forecast Global 2.9% 3.5% U.S. 1.7% 2.6% Eurozone -0.5% 0.8% Japan 1.8% 2.0% China 7.7% 7.6% Developed Markets 1.1% 2.0% Emerging Markets 4.6% 5.0% Market forecasts S&P 500 EPS $110 $118 S&P 500 Index Target 2,000* U.S. 10 Year Treasury Yield 2.90%* 3.75%* EUR-USD 1.33* 1.25* USD-JPY 103* 108* Source: BofAML Global Research, ML GWM Investment Management & Guidance. Data as of December * Forecasts at year-end. Exhibit 3: Corporate investment and household spending on durable goods forecast to rise in % 28% 26% 24% 22% 20% Fixed Investment + Durable Goods (% of GDP) Average Source: Bureau of Economic Analysis, ML GWM Investment Management & Guidance. Data as of September We also believe U.S. equity sectors linked to stronger household and corporate spending will outperform. We identify the Technology, Energy, Automobile and Manufacturing sectors what we term TEAM USA as the ones positioned to benefit the most (Theme 2). Specific to manufacturing, various large industrial conglomerates as well as transport companies should benefit. In addition, companies in the areas of industrial automation, industrial Internet and 3D printing have the potential to revolutionize manufacturing. Economic growth also appears likely to improve in Europe and to remain relatively strong in Japan. The Eurozone economy started to grow in the second quarter of 2013, and activity indicators point to an ongoing recovery. In addition, possible further action by the European Central Bank (ECB), after bolstering the economy with two rate cuts in 2013, should keep monetary conditions favorable for growth. In Japan, despite an expected rise in the consumption tax from 5% to 8% next April, we think the economic stimulus policies of Prime Minister Shinzo Abe and the likelihood of another monetary easing program by the Bank of Japan (BoJ) should support higher corporate spending, moderately higher wages and employment gains. We therefore recommend investors continue to focus on international developed market equities, starting with Europe and Japan (Theme 3). With valuations for these regions undemanding, and following several years of broad U.S. equity outperformance, we believe investors should refocus on opportunities there. A more globally synchronized acceleration of growth should continue to drive the equity rotation within the Great Rotation (Theme 4). Stronger growth favors select economically sensitive sectors, such as industrials, over relatively more expensive CIO REPORTS The Monthly Letter 2

3 defensive sectors such as consumer staples and utilities. The consumer discretionary sector as a whole seems overextended, but we believe there are still opportunities within it, such as the auto and the media industry. We also favor U.S. multinational companies that benefit from rising global trade. According to BofAML Research, multinationals are under-owned and valuations are attractive. We also recommend moving up the size scale since large and mid caps should provide better returns than small caps as recent outperformance has propelled small cap valuations to near all-time highs. MACRO DRIVER 2: Yet moderate inflation keeps interest rates historically low Theme 5: Fixed income is challenged by greater interest rate volatility Theme 6: You get a bigger bang for your buck as the dollar strengthens Although our outlook is for a stronger economy in the coming year, we see inflation risks as relatively muted for now. A large portion of the increase in money supply has been trapped within the financial sector, which explains why the expansionary monetary policies of central banks have not yet generated higher global inflation. Financial assets have rallied, while capital has trickled rather than flowed to the real economy, leading to a weak recovery. This weakness has resulted in a large degree of economic slack what economists refer to as the output gap. During this phase, inflation typically stays low, as was the case in 2013 and will likely continue to be in 2014 (see Exhibit 4). Exhibit 4: In developed markets, inflation remains below central bank targets Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13 U.S. (%) Eurozone (%) Japan (%) 2% inflation target Source: Bloomberg, ML GWM Investment Management & Guidance. Data as of November Low inflation within the developed world allows central banks to keep short-term interest rates at their historically low levels. We see the Fed strengthening its forward guidance in an attempt to convince the market the policy rate is unlikely to rise in the coming years and expect that the Fed will eventually convince market participants to accept its interest rate stance. But this is unlikely to be smooth sailing. The taper tantrums in May and June of 2013 showed that markets are having a tough time identifying the Fed s direction, which is leading to episodes of higher volatility in fixed income markets. We would not be surprised to see similar volatility next year. A stronger global economy ought to lead to higher Treasury yields, but our base case is for this rise to be gradual. (BofAML Research forecasts 10-year Treasury yields to rise to 3.75% by end 2014.) We therefore contend that investors should not abandon fixed income, but rather manage for higher interest rate volatility in 2014 (Theme 5) as markets discount the gradual reversal of the long bull market in bonds (see Exhibit 5). We recommend investors manage the rise in bond yields by using absolute return strategies as well as bond laddering. In addition, we prefer taking credit risk over duration risk and favor allocations to high-yield corporate bonds, where yields are higher compared to other segments of the fixed income market (see Exhibit 6). For investors in the Exhibit 5: Higher bond yields led to higher fixed income volatility last May as taper talk rose Jan-13 Apr-13 Jul-13 Oct-13 U.S. 10-Year Treasury Yield (%) Merrill Lynch Move Index (Right) Source: Bloomberg, ML GWM Investment Management & Guidance. Data as of December Exhibit 6: High yield provides higher income within fixed income 7.5% 6.5% 5.5% 4.5% 3.5% 2.5% 1.5% 0.5% MBS Int'l: developed Treasuries Munis* IG corporates Preferreds $ Emerging mkts HY corporates Local currency EM Source: BofAML Global Research, ML GWM Investment Management & Guidance. Data as of December *Note: Muni return is taxable equivalent at 28% rate. CIO REPORTS The Monthly Letter 3

4 higher tax brackets, we continue to find value in municipal bonds, especially as an attractively priced alternative to Treasuries. With the trend much closer to deflation in the Eurozone and Japan, we expect monetary policy in these regions to become more, rather than less, accommodative. As the market begins to discount a more dovish ECB and BoJ relative to the Fed and as the U.S. grows faster than either the Eurozone or Japan, we believe Treasury yields in the U.S. will end 2014 relatively higher than the comparative government bond yields in the UK, Germany or Japan. With the U.S. having relatively higher interest rates, stronger manufacturing growth and a lower current account deficit (partly due to less dependence on foreign oil), we expect the U.S. dollar to appreciate in 2014 (Theme 6, see Exhibit 7). However, currencies are likely to remain volatile as central bank exit strategies are unlikely to be synchronized, and investors should benefit from hedging international equity exposures. Exhibit 7: U.S. dollar to appreciate in 2014 as Treasury yields rise U.S. Dollar Index (Left) Composite Interest Rate Spread* Source: BofAML Global Research, Bloomberg, ML GWM Investment Management & Guidance. Data as of December * Composite interest rate spread calculated as U.S. 5-year Treasury yield minus weighted 5-year government bond yields of Germany, Japan, UK, Canada, Sweden and Switzerland. Respective weights are same as those in the Dollar Index. MACRO DRIVER 3: Policy uncertainty + investor complacency + higher starting valuations = greater volatility Theme 7: Be selective in Emerging Markets Theme 8: An expanded investment toolkit offers downside protection and diversification Theme 9: Hedge funds and private equity beat commodities Theme 10: Tax awareness pays off The encouraging economic and inflation outlooks suggest another positive year of returns from global equities, while providing headwinds for fixed income. However, we believe portfolios should be prepared for the possibility that policy or political developments lead to volatility in the bond markets, which could spill over into equities. This caveat is particularly important with somewhat fuller valuations and such an overwhelmingly positive consensus regarding the year ahead. One risk is the potential for a policy mistake, especially by the Fed, which is widely expected to start tapering its bond-buying commitments soon. It could hike rates prematurely, particularly if U.S. economic growth surprises to the upside. In addition, investors may have trouble differentiating between forward guidance and actual tapering. They might expect a more immediate increase in the policy rate, leading to higher Treasury yields than we anticipate. These possibilities increase the chances of a leg-down in Emerging Market growth rates and risks for economies that experienced credit booms and have weak external accounts. Our guidance in Emerging Markets is to search out opportunities where cheaper valuations have already factored in downside risks (Theme 7). This approach supports select Emerging Market equities (see Exhibit 8) over fixed income as valuations for equities are relatively cheaper, and many emerging economies are likely to see currency depreciation, which is more detrimental to bond returns for U.S.-based investors. We emphasize that Emerging Markets are not a homogenous asset class and an active manager should be able to exploit the imbalances e.g., countries with better growth prospects versus those experiencing a slowdown, or favoring stocks in the inexpensive Exhibit 8: Regional Emerging Market country views Equity Market Country Views Positive Neutral Negative China India Indonesia Korea Philippines Malaysia Brazil Poland Thailand Mexico Turkey Colombia Russia Nigeria Qatar South Africa Source: BofAML Global Research, ML GWM Investment Management & Guidance. Note: Country views reflect that of BofAML Global Research regional equity strategists; Ajay Kapur (Asia-Pacific) and Felipe Hirai (LatAm); Michael Harris (CEEMEA). CIO REPORTS The Monthly Letter 4

5 state owned enterprise (SOE) sectors. We expect frontier markets to be an attractive long-term beneficiary of favorable secular demographic and economic trends. Another potential risk for 2014 is an adverse political event in the U.S. We expect fiscal negotiations early in the year to pass relatively smoothly. However, events this past October showed how far politicians were willing to push the markets. Additionally, as we enter the final quarter of 2014, November mid-term elections could produce an unexpected result, with an ensuing market reaction. Our colleagues at BofAML Technical Research note that markets typically experience a correction during the second year of a presidential cycle or the mid-term election years. We believe the markets may be particularly vulnerable to disappointing headlines political or economic given that indicators of financial stress and market volatility remain muted (see Exhibit 9) and the consensus for 2014 seems quite bullish. The Institutional Investor s survey of newsletter writers shows that the percentage of bearish respondents is at an all-time low. Investors can protect against adverse events in accordance with their investment goals by expanding their investment toolkit (Theme 8). One approach is to include holdings with downside protection through option strategies, where applicable, or by using market-linked investments. Another one is adopting a core-satellite approach to portfolios where the core represents the base case and the satellite includes protective assets. Similarly, holding assets that are less directly impacted by the market risk premium can be an important strategy for diversifying returns. The approaches here include private equity and certain hedge fund strategies such as relative value and global macro (Theme 9). Exhibit 9: Financial stress and equity volatility remains low VIX Index BofAML Global Financial Stress Index (Right) Source: Bloomberg, ML GWM Investment Management & Guidance. Data as of December Valuations should provide less of a tailwind in In the last few years, risk assets (such as equities and credit) have performed well. While clearly central bank policies have played their role, these assets benefited from incredibly attractive valuations in early In our view, the rally brought valuations to more reasonable territory (see Exhibit 10). Considering that a significant portion of long-term returns are attributable to starting valuations, we think returns are likely to be more moderate in the coming years. Combined with the prospect of higher individual tax rates, this moderation should make investing with an after-tax approach increasingly important (Theme 10, see Exhibit 11). Effective ways to achieve higher after-tax returns include focusing on taxadvantaged asset classes (such as municipal bonds), tax-efficient investment vehicles (such as separately managed accounts) and proactive tax planning strategies (such as tax-loss harvesting). Exhibit 10: One metric of U.S. equity valuation suggests forward earnings expectations may be reasonable S&P 500 Index 12 Month Forward Price/Earnings Ratio Average Source: Factset, ML GWM Investment Management & Guidance. Data as of November Average Annual Return Exhibit 11: Tax drag on investment returns ( ) 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% 9.8% 7.0% 5.4% 3.0% Stocks After-tax Bonds After-tax stocks Bonds 75% of the stocks return is assumed to be taxed at long-term capital gains rate of 23.8% and 25% of the return taxed at the short-term income rate of 43.4%. Bonds are assumed to be taxed at the short-term income rate of 43.4%. Tax rate includes the new 3.8% health care tax. Stocks are represented by the S&P 500 Index. Bonds are represented by the 10-year Treasury bond. Source: Bloomberg, Robert Shiller, ML GWM Investment Management & Guidance. CIO REPORTS The Monthly Letter 5

6 Trends beyond 2014: The Longevity Revolution Market volatility and sell-offs provide good opportunities to build positions in long-term secular investment themes such as evolving demographics. As life expectancy has increased around the globe and birth rates have fallen, there has been a rise in the average age of the world s population, especially in developed countries. By 2030, the median age in the wealthy countries that belong to the Organisation for Economic Cooperation and Development (OECD) countries is expected to rise from 38 in 2010 to nearly 43. The healthcare sector is expected to benefit from this trend, especially makers of orthopedics and medical devices such as defibrillators and pacemakers. Other beneficiaries include companies in the travel industry, such as hotel and cruise operators, and financial services firms, like asset managers, that cater to retirement needs. For more on other long-term secular themes, please visit our A Transforming World website. Summary Our themes for 2014 reflect expectations of a stronger economy with modest inflation, being conscious of risk as we go ahead. We expect equities and credit to outperform again, but we acknowledge that the risk of an equity correction has increased. In an environment of lower liquidity, with political risks emanating from Washington D.C. s budget battles and mid-term elections, investors should be sensitive to valuations and more selective among asset classes and regions. Investors should take the opportunity to rebalance their portfolios, bringing them more in line with their strategic asset allocations. CIO REPORTS The Monthly Letter 6

7 10 PORTFOLIO THEMES FOR Equities again outshine bonds Accommodative monetary policy, lower fiscal drag, strong corporate fundamentals and low interest rates should enable equities to outperform bonds once again. 6 Bigger bang for your buck as the dollar strengthens Stronger growth and a less dovish Fed (relative to other developed market central banks) should support a stronger U.S. dollar. The unsynchronized withdrawal of central bank liquidity likely will cause greater foreign exchange market (FX) volatility. Investors should benefit from hedging foreign currency exposure. 2 Invest in Team USA Tech, Energy, Autos and Manufacturing In the U.S., drivers of the next leg of growth should include secular factors such as energy independence and the resurgence of domestic manufacturing as well as cyclical ones such as the business investment cycle and pent-up household demand. 7 Be selective in Emerging Markets We favor EM equities over EM bonds on more supportive valuations. Lower central bank liquidity could hurt countries with the greatest dependence on external creditors. Weaker currency would present headwinds for EM bond returns. 3 International equities prove resilient Despite strong performance recently, these markets should continue to benefit from recovering economies and earnings growth along with further central bank easing. 4 The equity rotation within the Great Rotation continues Within equities, there should be more of the rotation that began in April 2013, which supports select cyclicals over defensives. In the U.S. we also favor large cap over small cap and multinationals. 5 Fixed income is challenged by greater interest rate volatility Driven by tapering from the Fed, bond volatility is likely to increase, favoring asset classes that can absorb higher rates, specifically high yield and municipals. 8 An expanded investment toolkit offers downside protection and diversification As sentiment and consensus forecasts are bullish, investors should prudently protect against adverse events: option strategies, market-linked investments, nontraditional mutual funds. 9 Hedge funds and private equity beat commodities a. Equity Long/Short is poised to benefit in an environment of reduced correlation. Relative value and Global macro enhance diversification and are less correlated with traditional asset classes. b. While the bank lending environment will be restrained, private lending may fill that gap. Investors should be sufficiently compensated for lack of liquidity. 10 Tax awareness pays off A combination of moderate returns and higher tax rates increases the value of tax-aware investing. CIO REPORTS The Monthly Letter 7

8 When considering 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 Cash OFFICE OF THE CIO VIEW Negative Neutral Positive COMMENTS Further upside expected in 2014, based on improving economic and earnings growth and undemanding valuations. However, return expectations for 2014 should be lower than Fair valuation and improved economic growth to support globally exposed cyclical sectors; preference for energy, tech and industrials. Small cap valuations, both absolute and relative to large cap, are extended. Select opportunities for active managers remain. Positive on Europe as growth improves and profit margins expand from depressed levels; Japan to benefit from continued reflationary Abenomics. Structural headwinds remain as global liquidity eases; go beyond index and BRIC exposure to include frontier markets. Bonds continue to provide diversification, income and stability within total portfolios. However with higher prospective fixed income yields and volatility, our preference is to remain flexible. Prefer to be short duration as longer maturity yields rise on better global growth. Current valuations are stretched especially on longer maturities. Valuations relative to Treasuries remain attractive and tax-exempt status is not likely to be threatened in the near term; advise a nationally diversified approach. Current valuation doesn t leave much room for spread tightening and leaves investment grade more susceptible to rising rates. High yield still offers a relatively attractive profile given a low corporate default outlook. One of our preferred segments within fixed income. Higher rates and the start of Fed tapering are likely to increase spread volatility. Continued improvement in housing to present select opportunities in non-agency MBS. Select opportunities in European credit, including financials, however recent strong performance has moved valuations to fair. Core European (UK & Germany) yields have rich valuations; peripheral Eurozone yields are attractive but greater event risk remains; prefer active management. Vulnerable to Fed tapering and lower global liquidity; preference for countries with current account surpluses. Local EM debt likely to remain volatile due to FX component; prefer active management. Select alternative investments help broaden the investment toolkit to diversify traditional stock and bond portfolios. Prices likely kept under pressure in 2014 as EM demand more muted and global supply still abundant. The balance of risk is to the downside for gold and oil prices. Equity Long/Short is poised to benefit in an environment of reduced correlation. Relative value and Global macro enhance diversification and are less correlated with traditional asset classes. Prefer direct real estate investments. Within REITs volatility is likely to increase as rates rise, opportunities remain in industrial and office sectors. The combination of an improving economy and banks still reluctant to lend provides attractive opportunities that compensates for reduced liquidity. Monetary policy by developed market central banks reduces the attractiveness of cash, especially on an after-inflation basis. * Alternative Investments are available only to pre-qualified clients. CIO REPORTS The Monthly Letter 8

9 OFFICE OF THE CIO Ashvin B. Chhabra Chief Investment Officer, Merrill Lynch Wealth Management Head of Investment Management & Guidance Mary Ann Bartels CIO, Portfolio Solutions, U.S. Wealth Management Christopher J. Wolfe CIO, Portfolio Solutions, PBIG & Institutional Rachel Bertsch Vice President Hany Boutros Vice President Ahmed Shan Hasnat Vice President Niladri Neel Mukherjee Director John Veit Vice President GWM Investment Management & Guidance (IMG) provides industry-leading investment solutions, portfolio construction advice and wealth management guidance. This material was prepared by the Investment Management & Guidance Group (IMG) and is not a publication of BofA Merrill Lynch Global Research. The views expressed are those of IMG only and are subject to change. This information should not be construed as investment advice. 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