The Weekly Letter - Merrill Lynch

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Aug 8, 2017 - financials credit default swap index, a measure of bank credit risk, recently fell to a new low of under 50 basis points (bps). The improvement in ...
CHIEF INVESTMENT OFFICE

The Weekly Letter AUGUST 8, 2017 Authors

Europe and Japan rally: Should European and Japanese stocks retain their lead over those of the U.S. for the remainder of 2017, this would be their first full year of outperformance (in dollars) since 2012. The underperformance of recent years has, however, left their valuations well below their long-term averages relative to those in the U.S. This year’s turnaround should, therefore, have room to continue given the underlying improvement underway in both economies. Markets in Review: Equities moved higher last week, with the S&P 500 adding 0.2% and international equities, as measured by the MSCI EAFE Index, gaining 0.9%. Bond prices moved higher, with the 10-year Treasury yield falling 3 basis points to 2.26% from 2.29% on Friday of the prior week. Commodities as measured by the Bloomberg Commodity Index fell 1.4%, with WTI crude having shed 0.3% to $49.58 per barrel. Gold lost 0.9% to end at $1,258.88 per ounce. Looking Ahead: In the U.S. this week, investors will digest various measures of inflation along with preliminary indicators of industrial activity. Overseas, they will be watching to see if industrial production in the U.K. will bolster the economy after recent declines.

Europe and Japan rally We have been favoring international developed markets, and their equities have been outperforming the United States this year. Should they retain their lead for the remainder of 2017, this would be their first full year of outperformance over U.S. equities in dollars since 2012. For the year so far, equities in developed markets in the European Economic and Monetary Union (EMU)1 have outpaced those of the U.S. by close to 10 percentage points while Japanese equities have performed broadly in line. If the dollar remains stable, as we expect, future returns to the U.S.based investor will be driven more by the macro environment and fundamentals in those markets, which remain favorable. The last period of outperformance for international developed markets in 2012 came on the back of strength in local returns after a dovish shift in the policy outlook for both the European Central Bank (ECB) and the Bank of Japan (BoJ). Both the ECB and the BoJ have since delivered on their pledges of monetary support. But macro conditions have nonetheless remained relatively weak in both economies. Annual real growth in the Eurozone has averaged just 1.2% between 2013 and 2016, with core consumer price index (CPI) inflation remaining below 1% for most of the period. And in Japan, growth has been just above 1% over the same time period, while inflation has also fallen well 1

Chief Investment Office

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short of the 2% central bank target. Corporate earnings growth in both markets has been weak, contracting by more than in the U.S. during 2015 and 2016. The macroeconomic and market underperformance of recent years has, however, left European and Japanese equity valuations well below their long-term averages relative to those in the U.S. Across price-to-earnings and price-to-book ratios, multiples for European stocks stand at 0.74x U.S. levels compared with a 10year average of 0.81x, while Japanese equities are currently at 0.57x versus a 10-year average of 0.72x (see Exhibit 1). The 2017 turnaround in relative market performance should, therefore, have room to continue given the underlying improvement underway in both economies.

Eurozone expansion looks steady In the Eurozone, the cyclical manufacturing PMI index rose for 10 consecutive months to a series high of 57.4 in June, alongside an annualized growth rate of over 2% for the past two quarters. And despite the relative weakness of the euro exchange rate over recent years, domestic demand has remained the largest contributor to gross domestic product (GDP) growth. At the same time, the Eurozone banking sector is recovering gradually. Aggregate non-performing loan rates remain relatively high at 5.4%, but continue to trend downward from their 2013

Developed market countries in the EMU include: Austria, Belgium, Finland, France, Germany, Ireland, Italy, the Netherlands, Portugal and Spain. 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 (BofA Corp.). Investment products: Are Not FDIC Insured

Are Not Bank Guaranteed

May Lose Value

Exhibit 1: European and Japanese stocks have been historically inexpensive relative to the U.S., and even more so currently 1.2

Europe

0.9

0.8

10-year average

0.7

0.6 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Relative price-to-earnings / relative price-to-book average

Relative price-to-earnings / relative price-to-book average

1.0

Japan

1.1 1.0 0.9 0.8

10-year average

0.7 0.6 0.5 0.4 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Europe is Stoxx 600, Japan is Topix. Source: Bloomberg. Data as of July 26, 2017. Past performance is no guarantee of future results.

peak of 7.9%. And Eurozone-wide loan growth is also improving. The year-on-year growth rate reached 2.6% in June, its highest level since 2011. Recent state support for three financial institutions in Italy (where non-performing loans are still several times higher than the Eurozone average) has also helped to improve market sentiment toward the sector. The five-year iTraxx financials credit default swap index, a measure of bank credit risk, recently fell to a new low of under 50 basis points (bps).

Sectors color the outlook

The improvement in the outlook for Eurozone cohesion over the three months since the first round of the French presidential election has also continued to lower government borrowing costs across the region. Last month’s agreement by the International Monetary Fund to participate in a new loan package for the Greek government further eases the pressure on peripheral debt markets, with Greece returning to the public bond market for the first time in three years. And the ECB asset purchases are likely to continue at their current pace into 2018, which should also keep borrowing costs contained.

In Japan, the major overweights versus the U.S. are in Consumer Discretionary and Industrials. Consumer Discretionary in particular is likely to benefit from a weaker yen exchange rate and structural demand from the growing and underpenetrated consumer class in emerging Asia.

Similarly, in Japan, real economic activity is improving, while the central bank stays supportive. Real GDP growth has now been in positive territory for five consecutive quarters (its longest streak since the global financial crisis), while the jobs-to-applicants ratio—a key local measure of labor market strength—moved above its high of the late-1980s boom in April of this year. At the same time, pension funds continue to reallocate from bonds to equities, with the central bank also offering direct support for stocks through its purchases of exchange-traded funds. According to official central bank forecasts, real growth in both Japan and the Eurozone will accelerate this year from 1.0% to 1.8%, and from 1.8% to 1.9%, respectively. And crucially for both local equity markets, the recovery in earnings growth is now outpacing that of the U.S. (Exhibit 2). Japan’s three-month earnings revision ratio is currently the highest among major global equity markets at 1.24, which signals that analysts upgrade about five stocks for each four they downgrade, on average. CIO REPORTS • The Weekly Letter

For both Europe and Japan, the largest relative underweight is in the Information Technology sector. Within its technology holdings, the Eurozone benefits from a high (close to 90%) concentration in the fast-growing segments of semiconductors, software and services. But as our favored long-term growth sector, the low weighting in technology overall is likely to be a relative headwind for both markets. Exhibit 2: Europe and Japan are outpacing the U.S. in earnings growth

Year-on-year growth (%)

In Japan the trend is upward too

Looking forward, the sector exposures compared with U.S. equities influence the relative return outlook. For the Eurozone, the largest sector overweight relative to the U.S. market is in Financials. Here, the recent steepening of the Eurozone yield curve should boost bank profitability, while the gradual improvement in loan growth and falling rate of non-performing loans offer further support for the sector.

30 25 20 15 10 5 0 -5 -10 -15 -20 -25 -30

Trailing 12-months EPS U.S.

15Q1

15Q2

15Q3

Europe

15Q4

16Q1

16Q2

Japan

16Q3

16Q4

17Q1

17Q2

U.S. is S&P 500, Europe is Stoxx 600, Japan is Topix. Source: Bloomberg. Data as of July 26, 2017. Past performance is no guarantee of future results.

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Nicholas Giorgi Vice President

Markets in Review Trailing Economic Releases

Equities

„„The

U.S. Census Bureau reported factory orders growth of 3% monthover-month (MoM) for June, in line with BofA Merrill Lynch (BofAML) Global Research’s projection. The measure tracks new orders for manufactured goods and indicates future business activity. The increase follows a pullback of 0.3% in the prior month.

„„The

unemployment rate ticked down to 4.3% in July from 4.4% in June while wages moved up 0.3%, according to the Department of Labor. The result was in line with BofAML Global Research expectations. In a tight labor market, wage growth has not strengthened as expected.

DJIA NASDAQ S&P 500 S&P 400 Mid Cap Russell 2000 MSCI World MSCI EAFE MSCI Emerging Mkts

Reserve Bank of India cut its policy interest rate by 25 bps, to 6.00% from 6.25%, after taking into consideration concerns over lower inflation and weaker growth.

Yield (%) ML US Broad Market ML 10-Year US Treasury ML US Muni Master ML US IG Corp Master ML US HY Corp Master

S&P 500 Sector Returns (as of last Friday’s market close) S&P 500 Sector Total Returns (as of last Friday's close)

0.8% 0.4% -0.1% -0.1% -0.4% -0.6% -0.6% -0.8% -1.0% -1%

0%

1%

2.45 2.26 2.24 3.13 5.51

Total Return in USD (%) WTD MTD YTD 0.2 0.6 3.0 0.2 0.6 2.9 0.3 1.0 4.4 0.2 0.9 4.9 0.0 1.2 6.2

Commodities & Currencies 1.9% 1.5%

-2%

Total Return in USD (%) WTD MTD YTD 1.2 3.6 13.3 -0.3 3.5 18.7 0.2 2.4 11.9 -0.6 0.4 6.4 -1.2 -0.1 4.8 0.4 2.8 13.7 0.9 3.5 17.8 0.4 6.1 25.7

Fixed Income

„„The

Financials Utilities Industrials Information Technology Telecom Real Estate Consumer Discretionary Healthcare Consumer Staples Materials Energy

Level 22,092.8 6,351.6 2,476.8 1,751.5 1,412.3 1,967.8 1,947.6 1,067.3

2%

Bloomberg Commodity WTI Crude $/Barrel1 Gold Spot $/Ounce1

Level 169.2 49.6 1,258.8

Level EUR/USD USD/JPY

Current 1.18 110.69

Total Return in USD (%) WTD MTD YTD -1.4 0.9 -4.4 -0.3 7.7 -7.7 -0.9 1.4 9.2 Prior Prior 2016 Week End Month End Year End 1.18 1.18 1.05 110.68 110.26 116.96

Source: Bloomberg.1 Spot price returns. All data as of last Friday’s close. Past performance is no guarantee of future results.

Looking Ahead Upcoming Economic Releases „„On

Wednesday, the Bureau of Labor Statistics will release preliminary second-quarter nonfarm labor productivity figures. BofAML Global Research projects an increase of only 0.2%, up minimally from a flat reading for the first quarter.

„„On

Friday, the Bureau of Labor Statistics will report the Consumer Price Index (CPI) and Core CPI, which excludes food and energy, for July. BofAML Global Research forecasts a month-over-month increase of 0.2% in both metrics. With inflation waning over the past few months, the Federal Reserve’s path towards further tightening has become more uncertain.

„„On

Thursday, the U.K. Office for National Statistics will report the country’s Industrial Production for June. BofAML Global Research estimates an increase of 0.1% MoM, up from a 0.1% decline for May.

BofA Merrill Lynch Global Research Key Year-End Forecasts S&P 500 Outlook Target

2017 E 2,450

EPS

$129.00

Real Gross Domestic Product

2017 E

Global

3.5%

U.S.

2.1%

Euro Area

1.9%

Emerging Markets

4.6%

U.S. Interest Rates 

2017 E

Fed Funds (eop)

1.38%

10-Year T-Note (eop)

2.85%

Commodities

2017 E

Gold ($/oz-period average)

$1,276

WTI Crude Oil ($/bbl-eop)

$47.00

All data as of last Friday’s close. CIO REPORTS • The Weekly Letter

3

CHIEF INVESTMENT OFFICE Christopher Hyzy

Chief Investment Officer Bank of America Global Wealth & Investment Management

Mary Ann Bartels

Karin Kimbrough

Niladri Mukherjee

Head of Merrill Lynch Wealth Management Portfolio Strategy

Head of Investment Strategy Merrill Lynch Wealth Management

Director of Portfolio Strategy, Private Banking & Investment Group (PBIG) and International

Nicholas Giorgi

Emmanuel D. Hatzakis

Marci McGregor

Rodrigo C. Serrano

John Veit

Vice President

Director

Director

Vice President

Director

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