Valuation vs. Yield Clash of the Titans

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1 CIO REPORTS The Monthly Letter Valuation vs. Yield Clash of the Titans Anemic global growth and low inflation set in motion a quest for yield among investors. Bonds have traditionally been the vehicle of choice for income-oriented investors, but after a 35-year bull market their yields have been dropping and their prices, which move inversely to their yields, are now at record high levels. The easing policies that central banks around the world have pursued since the financial crisis have accelerated this trend. Seven years into the U.S. economic recovery, the Federal Reserve (the Fed) has managed to increase its short-term target rate only once, by a meager 0.25%, and the markets imply a very slow and muted path to further increases in the next few years. The easing policies, especially the extraordinarily unconventional ones of central banks in Europe and Japan that include negative interest rates intended to stimulate growth and fight the threat of deflation, have left a sizable portion of the bond universe with negative yields, to the tune of several trillions of dollars globally. Political and policy uncertainty, and the associated flight to safety, also play a role: The Brexit vote caused U.K. yields to drop by about half. This phenomenon is not restricted to government bonds; corporations have started to take advantage of it to issue bonds at very low yields in some cases zero and below. This is equivalent to investors paying for the privilege of lending to the issuer, whether a government or a corporation. SEPTEMBER 2016 GWIM Chief Investment Office John Veit Vice President Emmanuel D. Hatzakis Director Recent Publications Weekly Letter Anxiety amid Monetary Policy Uncertainty Oil The Swing Factor Managing rising bond risks Markets in Review & Looking Ahead Monthly Letter Updates on asset allocation and currencies CIO Outlook The Forces Shaping Our World Thus, by pushing bond yields down towards zero, or in some cases below it, and driving an historic search for financial assets offering yield and stable growth, the central banks quantitative easing (QE) in the face of low inflation has triggered a massive valuation-led rise in prices for the majority of financial assets. The Wealth Allocation Framework LIFE PRIORITIES The Wealth Allocation Framework helps you put your goals and aspirations at the center of decisions about allocating your financial resources. Asset categories within the framework include: Personal: Individual investors have a desire for safety and personal financial obligations they want to meet regardless of market conditions. To safeguard essential goals, investors can hold lower-risk assets but they have to accept lower returns in exchange. Market: When we invest, we strive to capture market growth most efficiently. Today, access to a broadening array of asset classes and types makes diversifying beyond stocks and bonds easier than ever before. Aspirational: Investors seek significant wealth mobility. To pursue goals that require higher-than-market returns, investors often need to take higher and concentrated risks. To learn more, read the whitepaper, Investing in a Transforming World: The Wealth Allocation Framework 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 ( BofA Corp. ). Investment products: Are Not FDIC Insured Are Not Bank Guaranteed May Lose Value Please see important disclosure information on the last page.

2 BofA Merrill Lynch (BofAML) Global Research has observed that, in this environment, there has been a role reversal between bonds and stocks 1. Bonds have assumed the role of price appreciation. With 56% of the S&P 500 having a higher yield than 10-year Treasuries, equities have become a source of income. Not all equity sectors have benefitted from the global search for yield. Coupled with poor growth, the quest for income has enhanced the attraction of defensive, low-volatility, stable growth companies, such as those in Consumer Staples. As expected, the bond-investing crowd has flocked to the kind of stocks known as bond proxies, which provide the risk-return characteristics they seek for their portfolios. By directing a sizable portion of flows to these areas, investors have caused them to outperform and their valuations to swell relative to those of other sectors they have avoided, such as cyclicals. We believe the steep rise in valuations in the last few years has reduced the magnitude of expected future returns. The S&P 500 has enjoyed an almost 40% increase in its priceearnings multiple (P/E) since 2011, and other markets have seen even greater expansion. With bonds and equities at lofty valuations, we believe that the investable universe of securities that offer an attractive risk-return tradeoff and potential for diversification has significantly narrowed, leaving asset allocators with fewer choices that would enable them to build portfolios without increasing their overall risk. This higher level of overall risk and a view that the upside and downside risks are equal has led to our risk-neutral portfolio positioning. More importantly, however, the wide valuation dispersions that have emerged as a result of the muted growth and low inflation, coupled with the distortions caused by easing policies of central banks, have made equities vulnerable to rotations. The premium paid by investors for bond-proxy sectors may persist for as long as rates remain low, but could be susceptible to declines on early indications that the situation may be reversing. We ve seen an example of this behavior during the jump in yields since late August, when low-volatility stocks underperformed. This should remind investors to avoid being complacent about the risks in these stocks, despite their reassuring label. As we noted in our Mid-Year CIO Outlook, For What It s Worth: Something s Happening Here, this situation is a continuation of the flatter world we ve been describing for some time, with increasing volatility and greater uncertainty. It means a persistence, that is, of modest growth with low yields and steady valuations, an environment in which stable and predictable growth outperform, and income contributes meaningfully to portfolios total return. We see equities not as exorbitantly cheap but relatively cheap, especially when compared to bonds. In this world of financial repression the search for yield may simply drive equities higher for longer, enabling investors to find opportunities in economically sensitive sectors with dividend growth while staying clear of bond proxies in the form of highyield equities that are overvalued. Making sense of higher valuations Falling bond yields and interest rates have had a significant catalytic effect in raising valuations of equities and fixed income securities. Both asset classes are on the higher side of their historical valuation ranges. Even where corporate earnings have stagnated or declined the Euro area, for example equity markets have risen steeply from their troughs. Should investors be concerned? Perhaps, but the depressed level of government bond yields set the bar lower for the required returns for the rest of the fixed income universe and for equities. Lower required returns mean higher present valuations. The current very low levels of government bond yields have reset to a lower level the risk-free interest rate used to discount these cash flows to the present, and the result is justification of higher present values for both bonds and stocks, which arguably support their elevated valuations, especially in regions where some bond yields are negative. While the present value of a bond is unambiguous since its cash flows are established contractually, this cannot be said for stocks. A risk-free rate around zero may lead one to believe that the equity valuation framework, developed during a time of higher interest rates, has become meaningless. According to this thinking, stocks may actually be cheap since the new low-rate environment could support even higher valuations, even with the price-to-earnings ratio (P/E) up about 40% for the S&P 500, and even more for other regions equities, since early in the decade. As a result, some investors believe that absolute equity valuation levels are not meaningful as a metric to watch 1 BofA ML Global Research The RIC Report: Finding yield, August 9. CIO REPORTS The Monthly Letter 2

3 because, with the risk-free interest rate around zero, shouldn t equities deserve valuations even higher than at present perhaps P/Es of 30 or above? While we believe that this view has its merits, the fact remains that yields alone can impact equity valuations only to a certain extent. The viewpoint seems valid until we consider that additional factors determine stock prices. Ultimately, equity valuations must incorporate realistic longterm nominal growth assumptions and reflect expectations about earnings growth. This is the principal reason why comparisons of equity and bond valuations ought to be made in the proper context. While both bonds and stocks are expensive compared to their own history, and this may imply lower future returns, a differentiation starts to emerge if we compare their valuations relative to each other. The equity risk premium (ERP) is an established measure of equity valuations. The ERP reflects how much return above the risk-free rate investors require to buy the more risky and volatile equity asset class. It reflects all the factors that matter for equity valuations, and it has been increasing for the last several years on a world-wide basis. A higher ERP implies lower prices and by this metric stocks may look inexpensive both relative to their own history, but also when compared to bonds. In fact, it indicates that equities look extremely attractively valued (see Exhibit 1). A large part of the explanation for why equities appear cheap versus bonds is the extent to which bond yields have declined. The great dilemma Investors are at a critical juncture: Current bond yields indicate that valuations of financial assets could keep rising, continuing the trend of the last several years. On the other hand, the ultralow risk-free rates prevailing at present can persist in the future only if we assume lower expected long-term growth. As noted, we do believe returns are likely to be lower going forward as the risk-free component of investors required return on equities has fallen, consistent with the decline in government bond yields (see Exhibit 2). A lower required return for equities consistent with the decline in government bond yields would be slightly below historical growth rates, close to a long-term required return rate for equities of 4.0% to 4.5% (see Exhibit 3). Exhibit 2: The decline in the risk-free rate is consistent with the decline in U.S. government bond yields Real Normalized Risk-Free Rate 10-Year U.S. Treasury Yield 10% 9% 8% 7% 6% 5% 4% 3% 2% 1% 0% Source: BofAML Global Research, Bloomberg and GWIM Chief Investment Office. Data as of August 31, Past performance is no guarantee of future results. Exhibit 1: The equity risk premium is still elevated but should decline 1, Average (ex-tech Bubble) = 358bp Equity Optimism Financial Crisis Euro Crisis, Fiscal Cliff/Election 2016 Forecast Equity Fear Tech Bubble Note: Calculated as spread between normalized EPS yield and normalized real risk-free rate. Normalized EPS yield based on log-linear regression of S&P 500 operating EPS; normalized risk-free rate is difference between: 1) avgerage of 30-year Treasury yield and 5-year rolling average of 10-year Treasury yield, and 2) 10-year TIPS spread and 5-year rolling average CPI inflation rate. Source: BofA Merrill Lynch U.S. Equity and Quantitative Strategy Team. Data as of September 13, Past performance is no guarantee of future results. Percent (%) Exhibit 3: U.S. equity yields are being driven by falling bond yields U.S. 10-Year Treasury Yield S&P 500 Earnings Yield (Right) 1.00 Jan 14 Jul 14 Jan 15 Jul 15 Jan 16 Jul 16 Source: Bloomberg and GWIM Chief Investment Office. Data as of September 15, Past performance is no guarantee of future results Percent (%) CIO REPORTS The Monthly Letter 3

4 This long-term growth rate is typically what analysts expect for companies profits or earnings, and provides a guide to the annual returns that investors should expect. Putting it at 4.5% translates into a price-to-earnings valuation for the S&P 500 of approximately 20x-25x. That s close to its current P/E of 19x and the Shiller P/E ratio of 27x (see Exhibit 4). In our view, the decline in the risk-free rate and therefore investors required return signals a higher level of equilibrium valuations going forward. Even though higher valuations are likely to be around for a while, higher valuations pose an additional risk of episodic volatility induced by negative surprises. Exhibit 4: Valuation shows markets are at the high end of the range, but not exuberant Shiller Cyclically Adjusted P/E Ratio (CAPE) S&P 500 P/E Ratio Last 12 Months S&P 500 P/E Ratio Next 12 Months Source: FactSet, Robert Shiller and GWIM CIO Investment Office. Data as of September We believe higher average asset valuations are likely to be around for a while, given the prospects for global growth. This is a continuation of the theme we have seen playing out over the past year. Equities are unlikely to be driven higher by valuation alone but are likely to benefit from some modest profit growth and an attractive yield. In this environment, we believe equities are likely to grind higher (driven by some modest profit growth and cash returns to shareholders) in a relatively flat range while outperforming bonds. In our view, investors are likely to continue to buy equities because the alternatives are unattractive. Where to look in a flat and wide market? In the short term, we thus believe there are some good reasons why, despite being at the high end of fair value, equities could push higher. If interest rates stay low and investors become more confident about the ability and willingness of governments to stimulate growth via fiscal policy, then fears of deflation and stagnation risks may fade to some degree. But, over the medium term, investors must be more selective as not all regions, equity styles and sectors will react the same way (see Exhibit 5). Exhibit 5: Policy measures have pushed most equity markets higher but not above average Cyclically Adjusted P/E Ratio U.S. Eurozone Emerging Market Global U.S. Average: Source: Absolute Stategy Research and GWIM Chief Investment Office. Data as of September 16, Again, we caution investors against blindly seeking out the stocks with the highest dividend yields or, worse, equating a high dividend yield with safety. Just as with high-yield bonds, some higher equity yields could be viewed as a function of unsustainable dividends. Given that typical high-yielding stocks offer slower growth and higher payout ratios, they are more likely to live up to their nickname of bond proxies and, like bonds, be vulnerable to the negative impact of rising interest rates. They are also more expensive than high-dividend-growth equities; typically they trade at a 17% premium. CIO REPORTS The Monthly Letter 4

5 Portfolio considerations: With low bond yields, the search for income has intensified. Going forward, yield-seeking investors may consider getting the income they require from equities, understanding that stocks are more volatile than bonds, not only in market prices but also in the income they provide, as firms have the discretion to reduce or eliminate dividends (see Exhibit 6). High-quality stocks offer dividends that are well-covered by the company s earnings and, in many cases, are expected to rise. BofAML Global Research considers dividend yields between 2.5% and 4.5% to be the sweet spot for income investors 2 ; this range corresponds to yields that are 25% to 125% higher than the yield of the S&P 500 index. Exhibit 6: Declining bond yields have pushed investors to take on more risk Current Yield* 7% 6% 5% 4% 3% 2% 1% Higher Yield EM Sovereign Debt (USD) U.S. Investment Grade Credit U.S. Treasuries Intl Govt Bonds U.S. High Yield MLPs Global REITs European Equities S&P 500 More Risk 0 0% 10% 20% 30% 40% 50% 60% 70% 80% 10-Year Maximum Drawdown Source: Bloomberg and GWIM Chief Investment Office. Data as of June 30, *Current dividend yield measured from trailing 12-month dividends. Past performance is no guarantee of future results. Many of these stocks can be found in what are traditionally considered defensive sectors, such as Consumer Staples, Utilities and Telecommunications (see Exhibit 7). Because of these characteristics, however, some defensive stocks have been bid up in price by income-seeking investors. Beyond that space, banks offer decent yields, tend to be still relatively inexpensive and would benefit in an environment of rising interest rates. Real Estate Investment Trusts (REITs) offer high dividend yields that can grow, and their prices could also benefit now that Real Estate is a Level 1 sector in the Global Industry Classification Standard and portfolio managers are buying to reduce their chronic underweight of the category. Exhibit 7: Utilities, Telecoms and Staples are attractive for yield-seeking investors, but REITS, Energy and Financials are also good targets S&P 500 Sector Yield* % of companies yielding above 10-year UST Telecommunications Services 5.29% 80% Real Estate 4.09% 96% Utilities 3.26% 100% Energy 2.15% 51% Consumer Staples 2.13% 69% S&P 500 Index 2.12% 56% Financials 2.11% 73% Materials 2.02% 52% Consumer Discretionary 1.90% 45% Industrials 1.76% 54% 10-Year U.S. Treasury 1.63% N/A Information Technology 1.63% 42% Health Care 0.87% 26% Source: Bloomberg, GWIM Chief Investment Office. Data as of September 22, * Yield shown for each sector is calculated as the arithemtic average over all the companies in the sector. Other potentially good sources of equity income include select integrated oil companies, Master Limited Partnerships and some established Technology and Healthcare companies. Pharmaceutical companies, for example, have attractive dividend yields. For fixed income investors, corporate credit may be a good place to look for income in both the investment grade and high-yield areas, and high-quality municipal bonds could be appropriate for investors in high tax brackets. As always, income-seeking investors must balance their need for yield with the risk they are taking on, especially when investing in equities and corporate credit. 2 BofA ML Global Research The RIC Report: Finding Yield, August 9. CIO REPORTS The Monthly Letter 5

6 CIO Insights A Conversation with Jon Gray* Insights and the best thinking from distinguished investors around the world. Jonathan D. Gray is Global Head of Real Estate and a member of the board of directors of Blackstone. He also sits on the firm s Management Committee. Since joining Blackstone in 1992, Mr. Gray has helped build the largest real estate platform in the world with $101 billion in investor capital under management. Blackstone s portfolio includes hotel, office, retail, industrial and residential properties in the U.S., Europe, Asia and Latin America. Mr. Gray currently serves as Chairman of the Board of Hilton Worldwide and is a board member of Brixmor Properties. He is also Chairman of the Board of Harlem Village Academies and a board member of Trinity School. Mr. Gray and his wife, Mindy, established the Basser Center for BRCA at the University of Pennsylvania School of Medicine focused on the prevention and treatment of certain genetically caused cancers. Mr. Gray received a BS in Economics from the Wharton School, as well as a BA in English from the College of Arts and Sciences at the University of Pennsylvania, where he graduated magna cum laude and was elected to Phi Beta Kappa. GWIM CIO: What is your outlook for the global economy and some of the key risks you see going forward? Jon Gray Global Head of Real Estate, Blackstone Jon Gray: We think more of the same subpar but steady growth is a reasonable base case for the global economy over the near term. Headwinds persist in developed markets from significant leverage and aging demographics. The slowdown in the Chinese investment cycle continues to impact emerging markets as well. That said, strength from technological innovation, the fall of energy prices, continuing recovery of housing markets most notably in the U.S. and highly accommodative central bank policies are all supportive of growth. In terms of potential risks, I would identify one for each major region around the globe. For the U.S., the presence of wage inflation could emerge to spook bond investors and overall asset values. In Europe, unforeseen political developments, like what we witnessed with Brexit but more severe, could create a crisis of confidence for the European Union. Finally, in China, the slowdown of the economy combined with escalated debt levels could lead to larger challenges than anticipated. We don t believe these are likely outcomes, but as investors we have to be constantly looking out for potential storm clouds on the horizon. Central banks have adopted creative policies such as negative deposit rates. How do you view such strategies and their ability to bring growth and inflation? Also, what is your view on rates going forward? I am not an economist, so it is difficult to comment on the full consequences of these policies. As an investor, however, the concept of negative interest rates seems odd and ultimately unsustainable as it rewards borrowing and punishes savings. Low rates are also resulting in a global hunt for yield that distorts capital allocation. I do understand policy makers desire to try to restore growth I m just concerned about the unintended impact. It is difficult to know how and when this experiment will end. I believe investors should expect some mean reversion in the future with higher rates even if it is likely to take some time, particularly in Europe and Japan. Guessing when this happens is not easy and I ve been wrong on this for some time, but interest rates will not stay at 0% forever, and we have to be prepared for that eventuality. I do understand policy makers desire to try to restore growth I m just concerned about the unintended impact. Let s shift to real estate and the housing market. On August 16th the Commerce Department report showed housing starts unexpectedly climbed in July to the second-highest pace of the economic expansion, indicating the housing industry remains an area of strength for the economy. What is your outlook on the housing industry? We have a very positive outlook on the U.S. housing market. As background, our real estate business is one of the largest owners of residential properties in the U.S. with approximately 50,000 rental apartments and 50,000 single-family homes for rent. Our confidence is supported by the basic law of supply and demand: Last year 1.1 million dwellings were built in the U.S., which was about 1/3 lower than the historic average and 1/3 below what is required to keep up with population growth. We believe this shortfall will continue to be positive for rents and housing prices. Ultimately, as pricing rises further, new construction should pick up to meet this unmet demand. We are looking for more ways to get exposure to this multi-year recovery in housing. CIO REPORTS The Monthly Letter 6

7 CIO Insights A Conversation with Jon Gray* (cont d) Insights and the best thinking from distinguished investors around the world. What are some of the secular trends you have seen in real estate and housing? For example, do Millennials prefer to rent rather than buy and baby boomers prefer downsizing and moving to urban centers? Also, are there specific geographic regions which are faring better than others given such changes? There is a significant urbanization trend underway in the U.S. Lower crime rates, improved quality of life, the benefit of mobile devices and the sharing economy are drawing young, educated professionals back to urban environments. You can see it in disparate places like Brooklyn, Downtown Dallas and the Arts District in Los Angeles. Companies have reacted to these geographic shifts. For example, G.E. is moving its headquarters from suburban Connecticut to Boston, while McDonalds is going from Oakbrook, IL to Chicago. They are moving to where the talent is located. There is also a powerful megatrend around cities that are home to innovation, many of which are on the West Coast. The dynamism these days in places like Northern California, Seattle, Austin, and Lower Manhattan is extraordinary. As new technology continues to revolutionize nearly every corner of the economy, cities at the forefront of innovation are seeing enormous increases in job growth and tenant demand. In the residential area specifically, the scar tissue from the housing crisis, less credit availability, more urban living and declining marriage rates, all lead to a shift towards renting versus owning. We have seen that reflected in homeownership levels which have declined from 67% to 63% over the last few years. The American dream of homeownership is alive and well but it may just be at a lower level going forward. At Merrill Lynch we have investors with varying risk tolerances, from conservative all the way to aggressive. Given this, how do you recommend our investors approach getting exposure to the real estate space? Also, do you view real estate as an income, growth or diversifying asset in the total portfolio? Or some combination of these? We believe an allocation to real estate in a diversified portfolio can improve a portfolio s overall return while reducing volatility. Real estate provides both current income like bonds or utilities, but also appreciation more like traditional stocks from rising rents and values. Given the favorable supply/demand picture in both commercial and residential real estate in the U.S. today with new supply well below historic levels, we think it continues to make sense to have exposure to this sector. The major risk in real estate investing is generally from reckless use of leverage that forces a sale at the wrong moment. Commercial real estate investment vehicles are available to accommodate a range of risk tolerances and investment objectives. Overall, we believe investors tend to under allocate to real estate, gaining access to it, if at all, primarily through listed equity REITs. There are other options. For example, investors interested in current yield may want to consider public mortgage REITs, private REITs or core real estate funds that offer income-oriented solutions. And for investors looking for higher returns, private equity-oriented real estate, sometimes called opportunistic real estate, might be appropriate. We live in an increasingly uncertain world. Disruptive technology, rising debt levels, market volatility, lower interest rates and increasing geopolitical risks seem to be the norm. At the same time, we expect returns from traditional investments like stocks and bonds to be lower. All that being said, what is Blackstone s advice to clients on portfolio construction as it relates to pursuing one s goals? We agree that investors increasingly are structuring their portfolios with an eye on their longer-term goals whether it s their children s education, retirement, a financial legacy or other priorities. But uncertainty in the global economy coupled with record low interest rates is making those goals seem ever harder to reach. Institutional investors like pensions and university endowments gradually have incorporated significant allocations to alternative investments in order to pursue their objectives. Alternative strategies such as private equity, venture capital, private credit and real estate have at times allowed them to achieve solid results by trading liquidity for higher-returning strategies. Manager selection in this arena is obviously critical. If done correctly, it is our view that qualified individual investors may begin to see the benefit of incorporating more alternative strategies in their portfolios going forward. Our confidence is supported by the basic law of supply and demand: Last year 1.1 million dwellings were built in the U.S., which was about 1 3 lower than the historic average and 1 3 below what is required to keep up with population growth. * The views and opinions expressed are those of the speaker as of September 14, 2016, are subject to change without notice at any time, and may differ from views expressed by Bank of America Corporation, Merrill Lynch, Pierce, Fenner & Smith Incorporated, or any affiliates. This conversation is presented for informational purposes only and should not be used or construed as a recommendation of any service, security or sector. Before acting on the information provided, you should consider suitability for your circumstances and, if necessary, seek professional advice. Neither The Blackstone Group L.P. nor any of its affiliates nor Jon Gray takes any responsibility for the other views and opinions expressed in this publication. CIO REPORTS The Monthly Letter 7

8 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 Future returns are likely to be lower than history. Risks are balanced between rising political uncertainty and monetary policy exhaustion versus reasonable valuation compared to bonds and weak investor sentiment. 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. Weak organic earnings growth and heightened risk related to central bank policies in Europe and Japan (NIRP) offset improving economic environment. Valuations are cheap and stability in commodity prices and Chinese economic activity have led to better investor sentiment. However risks remain from a potentially stronger U.S. dollar and heightened volatility. Bonds continue to provide diversification, income and stability within total portfolios. Interest rates remaining lower for longer limit total return opportunities in bonds. 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. * Boxed section, updated since last month. ** Many products that pursue Alternative Investment strategies, specifically Private Equity and Hedge Funds, are available only to pre-qualified clients. As we continue to converge our guidance across US Trust and Merrill Lynch, we will no longer provide tactical over-weights or under-weights for Alternatives overall, or for Hedged Strategies, Real Estate, and Private Equity. However, we will continue to highlight areas of opportunity within each of these asset classes through the Navigator, our quarterly outlook for alternative investments. CIO REPORTS The Monthly Letter 8

9 Appendix Index Definitions Alerian MLP Index is a composite of the 50 most prominent energy master limited partnerships and is calculated by Standard & Poor s using a float-adjusted, market capitalizationweighted methodology. The total return index is calculated on an end-of-day basis and is disseminated daily through its ticker symbol, AMZX, on the New York Stock Exchange. The cyclically adjusted price-to-earnings ratio, commonly known as CAPE, Shiller P/E, or P/E 10 ratio, is a valuation measure usually applied to the US S&P 500 equity market. It is defined as price divided by the average of ten years of earnings (moving average), adjusted for inflation. FTSE EPRA /NAREIT Global Index is a free float, market capitalization-weighted real estate index designed to represent publicly traded equity REITs and listed property companies globally. The MSCI ACWI Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. As of July 2009, the MSCI Emerging Markets Index consisted of the following 25 emerging market country indexes: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey. ML U.S. Corporate Master Index tracks the performance of U.S. dollar-denominated Investment Grade corporate public debt issued in the U.S. domestic bond market. Qualifying bonds must have at least one year remaining term to maturity, a fixed coupon schedule and a minimum amount outstanding of $150 million. Bonds must be rated Investment Grade based on a composite of Moody s and S&P. ML Global Emerging Markets Sovereign Index tracks the performance of U.S. dollar-denominated debt of sovereign issuers domiciled in countries with a BB or lower foreign currency long-term sovereign debt rating. ML Global Sovereign Broad Market Index tracks the performance of local currency-denominated debt of Investment Grade-rated sovereign issuers. ML High Yield Master Index (H0A0) tracks the performance of below investment grade US dollar-denominated corporate bonds publicly issued in the US domestic market. Yankee bonds (debt of foreign issuers issued in the US domestic market) are included in the Index provided the issuer is domiciled in a country having an investment grade foreign currency long-term debt rating (based on a composite of Moody s and S&P). S&P 500 Index is widely regarded as the best single gauge of the US equities market, this world-renowned index includes a representative sample of 500 leading companies in leading industries of the US economy. Although the S&P 500 focuses on the large-cap segment of the market, with approximately 75% coverage of US equities, it is also an ideal proxy for the total market. An investor cannot invest directly in an index. The STOXX Europe 600 Index is derived from the STOXX Europe Total Market Index (TMI) and is a subset of the STOXX Global 1800 Index. With a fixed number of 600 components, the STOXX Europe 600 Index represents large, mid and small capitalization companies across 18 countries of the European region. Ten-Year Treasury relates the yield on a security to its time to maturity and is based on the closing market bid yields on actively traded Treasury securities in the over-the-counter market. CIO REPORTS The Monthly Letter 9

10 CHIEF INVESTMENT OFFICE Christopher Hyzy Chief Investment Officer Bank of America Global Wealth and Investment Management Mary Ann Bartels Head of Merrill Lynch Wealth Management Portfolio Strategy Karin Kimbrough Head of Macro and Economic Policy Merrill Lynch Wealth Management Niladri Mukherjee Managing Director Chief Investment Office Emmanuel D. Hatzakis Director Rodrigo C. Serrano Vice President John Veit Vice President This material was prepared by the Global Wealth & Investment Management (GWIM) Chief Investment Office and is not a publication of BofA Merrill Lynch Global Research. The views expressed are those of the GWIM Chief Investment Office only and are subject to change. This information should not be construed as investment advice. It is presented for information purposes only and is not intended to be either a specific offer by any Merrill Lynch entity to sell or provide, or a specific invitation for a consumer to apply for, any particular retail financial product or service that may be available. This information and any discussion should not be construed as a personalized and individual client recommendation, which should be based on each client s investment objectives, risk tolerance, and financial situation and needs. This information and any discussion also is not intended as a specific offer by Merrill Lynch, its affiliates, or any related entity to sell or provide, or a specific invitation for a consumer to apply for, any particular retail financial product or service. Investments and opinions are subject to change due to market conditions and the opinions and guidance may not be profitable or realized. Any information presented in connection with BofA Merrill Lynch Global Research is general in nature and is not intended to provide personal investment advice. The information does not take into account the specific investment objectives, financial situation and particular needs of any specific person who may receive it. Investors should understand that statements regarding future prospects may not be realized. Asset allocation and diversification do not assure a profit or protect against a loss during declining markets. Alternative investments, such as hedge funds and private equity funds, are speculative and involve a high degree of risk. There generally are no readily available secondary markets, none are expected to develop and there may be restrictions on transferring fund investments. Alternative investments may engage in leverage that can increase risk of loss, performance may be volatile and funds may have high fees and expenses that reduce returns. 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No investment program is risk-free, and a systematic investing plan does not ensure a profit or protect against a loss in declining markets. Any investment plan should be subject to periodic review for changes in your individual circumstances, including changes in market conditions and your financial ability to continue purchases. Reference to indices, or other measures of relative market performance over a specified period of time (each, an index ) are provided for illustrative purposes only, do not represent a benchmark or proxy for the return or volatility of any particular product, portfolio, security holding, or AI. Investors cannot invest directly in indices. Indices are unmanaged. The figures for the index reflect the reinvestment of dividends but do not reflect the deduction of any fees or expenses which would reduce returns. 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