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.
Although recent earnings announcements have provided a balancing perspective for markets based on the resilience of corporate fundamentals—especially as expectations have been reduced—investors need to keep in perspective that results are being delivered against the backdrop of slowing global growth.
Specifically, when all is said and done, it currently looks like first-quarter profits will grow 3% year-over-year and will be down 1% sequentially from the fourth quarter, after 13% year-on-year growth in the fourth quarter. Sales growth in the first quarter was up 4%, and year-on-year it was down 3% sequentially. The reality is that among the high frequency data, the picture is increasingly mixed. China GDP at 8.1% missed expectations of 8.3% and showed sequential slowing from the fourth quarter of 1.8% versus 2%. While we don’t expect a hard landing in China and agree with BofA ML China analyst Ting Lu that the first quarter of 2012 is probably the nadir for growth—with fixed asset investment (FAI) still running at 21% growth and March retail sales still growing above a 15% annual pace—there is little doubt that global trade growth has slowed. Eurozone industrial production is contracting at an annual pace of 1.7%, despite ebullient sentiment surveys from Germany—where European Central Bank (ECB) policy has been a punch bowl. Inflation is moderating almost everywhere in the world. India joined in on making central bank policy actions, as we had been hoping, by cutting rates by a more-than-expected 50 basis points (bps) to 8% from 8.5%. In the U.S., the mixed message is even messier—Michigan consumer confidence ticked down and new housing starts fell versus last month and versus expectations. Retail sales were broadly a blowout, as sales were up 0.8% versus the consensus of up 0.3%. Building permits were also up. Industrial production held steady in the month. Our conclusion: We continue to be in a low growth, low inflation and low rate environment.
This is the “sweet spot” for corporate credit and that is where the bulk of our strategic asset allocation overweights are located. Against this backdrop, we see specific opportunities to have a balanced exposure to risk assets. We have been positioning for a continuing equity rally that would grind higher and narrow, becoming more selective over time. Within equities, where we are neutral to our strategic allocation, our preferences remain for the U.S. large cap dividend growers and those companies that should meet and beat expectations because of global leading brands, technology and pricing power, which offsets pressures on peak margins. These companies continue to be found in technology, healthcare and industrials.
We want to be active stock pickers in a narrowing market that grinds upward. In addition, valuation in Emerging Market equities is compelling, with forward price/earnings ratios of 10.8 times versus 13.5 times in the S&P 500, and earnings growth of 14-15% versus 8-9% for the S&P 500. Emerging Market stocks are seeing their long-run beta and volatility decline just as the quality of their balance sheets improve. Other international exposure should favor Canada, Japan and Australia while continuing to underweight Europe.
In global fixed income, where we have an overweight recommendation versus strategic allocations, recent Treasury (and other sovereign markets, i.e., German bunds) market rallies have once again exposed the relative bargains available in municipals, investment grade and Emerging Market debt.
Our favored position currently remains to add to high-yield bonds where spreads to Treasuries widened back to 625 bps versus the target of 550-580 bps. Our thesis for the corporate credit asset class continues to be that corporate debt of all stripes will massively outperform historic spreads this cycle as balance sheet quality is at historic strength, cash on hand is ample and default rates will undershoot. The majority of players have advantageously refinanced at very low costs of capital with reasonable duration. As noted above, we want to continue to caution investors about Treasuries. Volatility trends in the past month, where we have seen 4% moves in either direction from 2.4% to 1.99% round-trip in the 10-year yields, are extreme and annualized would suggest risk levels at 1.6 times equities. While we are not forecasting or extrapolating that—we are suggesting that we are getting into the ninth inning with the Federal Reserve Board’s (Fed) direct support. Among alternatives, we want to be overweight with a preference for private equity, which should benefit from attractive valuations and low debt financing costs, gold which remains a great hedge to risk based assets and central bank money printing.
Within hedged strategies, we prefer absolute return mandates. In this category we like market neutral, relative value, distressed debt, merger arbitrage and global macro approaches.
