The following is excerpted from a report by the Chief Investment Officer Team for Merrill Lynch Wealth Management. The team is headed by Lisa Shallet, CIO of Merrill Lynch Global Wealth Management and head of investment management & guidance.
Sometimes we all need a little perspective. Disappointing employment data in the
U.S. and anti-austerity electoral outcomes in Greece and France have investors once again questioning their risk positioning. Given the volatility of the past several years, this is natural. We agree that the current complex environment demands vigilance as there are few clear signals for a self-sustaining growth recovery. However, we believe that the right strategy today is not to embrace the “risk-on”/“risk-off” behavior of recent years, nor to stay on the sidelines in the perceived safety of cash. Rather, anchored to a very constructive relative view on equities for the intermediate term, we are recommending that investors with an eye to the future begin focusing opportunistically on stock selection geared to battle what we call the “Triple Threat.”
What is the “triple threat?” Well, for the past several decades—and especially the last 10 years—capital markets, especially in the U.S., have been characterized by huge positive tailwinds from historically low and secularly falling interest rates, low to moderate inflation and historically low taxes. These are factors that have disproportionately benefited fixed income investments. Recent experience of solid returns, eerily low volatility, unprecedented government intervention and huge positive inflows have spoiled bond investors—making them largely immune to the gathering storm clouds. Like “the boy who cried wolf,” cautions about coming bond market volatility have routinely been swamped by low growth, deflation fears, and central bank intervention so as to fall on deaf ears. Similarly, benefits to the U.S. Treasury market driven by problems outside the country—like safe haven flows fleeing the Eurozone debt crisis—have diluted the market pricing of America’s increasingly fragile fiscal reality. While we have no crystal ball on timing how the “triple threat” will unfold, we believe that the U.S. dealing with the “fiscal cliff” at least in part by 2013, the Eurozone moving toward a growth balanced crisis workout plan that will allow some inflation, and the recovery of China will combine to unleash its forces. Ultimately, the withdrawal of Federal Reserve (Fed) stimulus will play a critical role.
Under this scenario, stock returns meaningfully trump bond returns, ushering in what Bank of America Merrill Lynch (BofA ML) global equity strategist, Michael Hartnett has called the “Great Rotation.” Battling the “triple threat” will require investors to build portfolios leveraged to companies with pricing power (brands and proprietary technology), commodities, and real assets (real estate, real estate investment trusts and gold). Under this scenario, cash is toxic as it rapidly loses its purchasing power, especially in the beginning as negative real returns expand as long as the Fed is “behind the curve” in pricing the shift in sentiment. We don’t think we are there yet, but we want to start preparing by building our shopping lists of longer duration assets (primarily stocks) with attractive valuations.
However, in the current short-term environment, we want to “cherry pick the dips,” rather than “buying them” or “selling them.” This is important and a subtle shift from the purely macro-driven risk-on/risk-off positioning executed by many market participants in response to systemic and macro forces that have dominated the post-crisis markets. Although we believe that we are far from out of the woods with regards to “the role of macro” in shaping the backdrop—we do think that the transition back to a market that discriminates on company fundamentals has begun. This is a glacial sentiment shift that reflects the age of the 12-year bear market in equities, the extraordinarily high levels of cash on the sidelines and reasonable valuations for the best global companies. In essence, we think the expiration date of “kicking the can down the road” is approaching and we want a disciplined strategy for navigating the transition. Specifically, as Hartnett noted in this month’s Research Investment Committee Report, The 3-2-1% Rules, as long as the U.S. is experiencing gross domestic product (GDP) growth in the 2% range (such as the 2.2% estimated for the first quarter) and policy stimulus in the form of another quantitative easing (“QE3”) is possible, fear still reigns and thus bond yields remain low.
Consequently, in the interim and through year-end 2012, we are positioning for a narrowing equity rally that grinds upward. As BofA ML U.S. equity strategist Savita Submaranian noted this week, the S&P 500 target is roughly 1,450 by year end. The implication is that for a core subset of equities, we think that risk/return is asymmetric and that short-term upside is just meaningfully higher than downside—especially compared to other investments. We believe this scenario will reward those companies that possess the rare and still reasonably valued attributes of growth, quality and income. These companies, with pristine balance sheets, high cash balances and sustainably high profit margins are exploiting their brands, proprietary technology and global footprints. They will likely reward investors with above-average dividend growth and constructive shareholder friendly cash-flow deployment. We are finding the best opportunities in U.S. large cap multi-nationals and among Emerging Market local best-of-breed companies.
For our strategic asset allocations, we are neutral global equities, as we want to remain strongly underweight in the Eurozone. In global fixed income, we have remained overweight to our strategic asset allocation, as we see a near-term opportunity to potentially exploit three key dimensions of the environment: 1) continued aggressive central bank liquidity accommodation, 2) historically strong corporate balance sheets, and thus low default probabilities; and 3) low issuance volumes. In U.S.
Treasuries and other “safe haven” sovereigns that we believe are overvalued, we have preferred global investment-grade corporates, high yields, high-quality essential revenue municipals and Emerging Market debt. As we have noted, we expect credit and spread-oriented securities to meaningfully outperform history this cycle. Emblematic of the transformation of the fixed-income asset class this cycle is the fact that in 2009 more than 50% of the sovereign bond issuance was AAA rated. Today that volume is 10% and likely to fall even more. Conversely, within the S&P 500 alone, there are 36 issues with credit default swap (CDS) spreads below the U.S. Treasury. That said, we recognize that the “triple threat” awaits and on the margin we prefer not only credit risk to duration and rate risk, but increasingly we prefer to gain our income exposure through equities.
One way investors can gain active exposure to this pending “great rotation” between stocks and bonds is by considering a global flexible asset allocation fund in their portfolio. We would source this allocation from our fixed income sleeves today. Among alternatives, we continue to prefer gold, oil and timber among commodities; and non-directional approaches among hedged strategies—relative value, market neutral, arbitrage and global macro. Current private equity vintages should also continue to benefit, exploiting the low costs of financing and reasonable asset valuations.
