A number of highly complex trends are sweeping across the globe and creating a wave of new investment opportunities and unanticipated risks in the process, according to a Bank of America-Merrill Lynch (BAC) report released on Wednesday.
“The linkages across financial markets and economies can present both opportunities and risks to you as an investor … we are connecting all of our talent and capabilities to offer you insights and trends that can help you to be successful and stay one step ahead,” said Bank of America CEO Brian Moynihan, in an introduction to the bank’s analysis, “A Transforming World.”
To help advisors and clients doing business with both Merrill Lynch and U.S. Trust keep up with the present pace of change, the group laid out five strategic areas for investors to consider as part of their portfolio strategy.
“Dynamic forces are right now reshaping our financial lives. We’re at a rare inflection point,” says Mary Ann Bartels, chief investment officer of portfolio strategies at Merrill Lynch. “If we can understand the larger patterns in the global economy and see how those forces are coming together, we can put ourselves in the strongest position to take advantage of them.”
Demographic shifts, for instance, “are creating imbalances that are changing the nature of global growth,” according to Chris Hyzy, chief investment officer at U.S. Trust. “So are the movement of capital around the world and the related political pressures. In all these developments, we see a number of megatrends and investment themes emerging.”
Keep reading for the bank’s analysis and advice on five major investment trends related to the latest market shifts. 1. The movement to stocks from bonds
Early 2013’s market highs have underlined what has become obvious to many—that at least some investors are bolstering their stock portfolios. What’s less certain is who is participating in this return to equities and how long the surge will last.
A recent report from BofA Merrill Lynch Global Research expressed the idea that U.S. stocks are “in the early stages of a new secular bull market.”
The shift back to stocks has been described, variously, as a “great rotation” or a “rebalancing,” in which investors gradually move away from the conservative, bond-heavy allocations they’ve favored since the financial crisis and devote a higher percentage of their assets to equities.
Between late November 2012 and mid-May of this year, $45 billion flowed into long-only stock funds, marking one of the strongest signals in years that investors are again starting to believe in equities, according to BofA Merrill Lynch Global Research. Yet with the Dow and S&P notching all-time highs, it’s fair to ask whether the optimal moment for equities has already passed.
Perhaps not, according to a recent BofA Merrill Lynch Global Research report, which concluded that investors remain “structurally underweight” when it comes to the proportion of stocks in their portfolios.
And by traditional measures, stocks have remained relatively inexpensive.
“In our view, equities are still valued at a discount, even in the face of the big move this year,” explains Hyzy.
That’s because even as stock prices are rising, so are expectations for corporate earnings. It’s true that as a whole, the market this has seen a rise in the price/earnings ratio—the price that stocks are selling for, compared with their earnings per share—from 13 times projected 2013 earnings to 14.5 times.
However, that number isn’t yet high enough to make stocks costly. Hyzy maintains there is room for further market gains before stocks reach “fair value.”
2. Interest rates and inflation
Persistently low interest rates are one reason for the surge in equities.
Investors looking primarily for income have found themselves gravitating toward the higher risks and potential rewards of dividend-paying stocks and high-yield corporate bonds.
“If you keep interest rates low for long enough, it forces you into a higher risk profile, whether or not that’s aligned with your goals,” says Charles J. Wolfe, chief investment officer for Merrill Lynch’s private banking and investment group.
But low interest rates won’t last indefinitely. As prospects for the global economy brighten, inflation will almost certainly follow, and the U.S. Federal Reserve and other central banks around the world will inevitably force rates higher as a countermeasure.
Timing rate increases is a delicate business, Wolfe notes. There’s no guarantee that central bankers will get it right, increasing rates enough to forestall inflation without slowing growth significantly. A serious policy mistake could send interest rates higher and bond prices even lower.
There’s little doubt that inflation will increase to some degree. The Federal Reserve’s policy of quantitative easing has pumped so much cash into the system that a rise in prices is more or less inevitable.
Michael Hartnett, chief investment strategist at BofA Merrill Lynch Global Research, sees an inflection point approaching—and believes it “should prove very bullish for stocks.” But he doesn’t expect inflation to get out of hand, and that could be more good news for stocks.
“During the past 50 years, when inflation has remained between 1% and 4%, that has marked a sweet spot for equity returns compared with bonds,” Hartnett says.
Indeed, economists at BofA Merrill Lynch Global Research project inflation of just 2% for the next two years, with price increases held in check by continuing weakness in the labor market and continued “slack”—unused production capacity—in the economy.
“We’re a long way from inflation being detrimental to equity market performance,” agrees Savita Subramanian, head of U.S. equity and quantitative strategy.
As long as the inflation rate remains modest and corporate performance continues to improve, the role of bonds in most investors’ portfolios is unlikely to change very dramatically.