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5 Huge Market Shifts, and How Investors Should Respond: Merrill

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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. Traders on the NYSE. (Photo: AP)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.

Wolfe suggests thinking about high-yield debt and emerging-market bonds while staying cautious about U.S. Treasuries. High-quality stocks with solid dividends, too, remain a cornerstone of many people’s investment strategies.

Meanwhile, Wolfe says, the possibility of renewed inflation could be countered by a greater allocation to real assets—physical things with value, such as real estate, precious metals and commodities—when suitable. Real assets, which also include farmland, timberland and commercial real estate, could provide a hedge against inflation because their values tend to rise in step with consumer prices.

Investors can gain exposure to real assets indirectly, through shares of agricultural companies, ETFs that track commodities indexes, and real estate investment trusts (REITs). Also worth considering is an actively managed portfolio of commodities futures. These alternatives are easier to buy and sell than the real assets underlying them, and they require smaller investments than buying actual land or real estate.

Still, for wealthier investors, direct investment brings many potential benefits. Farmland can provide annual income, usually through lease payments from farm operators, while timberland offers another potentially efficient engine for appreciation. In the current real estate market, prices remain very affordable in many parts of the U.S., and financing costs for commercial real estate have stayed relatively low. 3. The impact of higher taxes

The new tax legislation, which became effective Jan. 1, raised the top rate for short-term capital gains and nonqualified dividends to 43.4% (including a new 3.8% Medicare surcharge).

That’s almost twice as high as the top rate of 23.8% on long-term capital gains and qualified dividends. For that reason, tax-planning strategies have become more important than ever for many investors.

This can mean taking a few simple steps. Buying municipal bonds in after-tax accounts, for example, has long been a means of achieving tax efficiency.

Investors can also hold on to investments for more than one year so that they qualify for the much-lower rate applied to long-term capital gains.

When an investment must be sold, the tax liability attributable to both long-and short-term capital gains can be limited or eliminated. That can offset the gains with any losses you may have recognized during the same tax year, or from previous years.

“Diversifying globally means making careful choices,” says Bartels.

On new investments, taxpayers may be able to maximize after-tax returns in two important ways. The first is by seeing to it that a portion of the portfolio is devoted to investments such as municipal bonds and certain structured investments, which are tax-efficient by nature.

The second is to keep taxes in mind in choosing the location of assets, whether they’re in tax-free accounts such as Roth IRAs, tax-deferred accounts such as traditional IRAs, or traditional investment accounts.

In applying both of these criteria to their investments, investors may want, in some cases, to include assets held in trusts. 4. Social impact investing

There has been an upsurge of interest recently in what’s called values-based investing, or VBI. In this approach, investors pursue strategies meant to help people, societies and the environment while also offering competitive returns.

According to a November study by US SIF Foundation, a nonprofit that measures sustainable and responsible investing, VBI accounts for $3.74 trillion of the dollars under professional management in the U.S.—a 38% jump from the organization’s 2007 study. More than half of investors under age 44 cite their values as a highly important factor in their investment selection, according to a recent Bank of America Merrill Lynch survey.

The list of investment vehicles that can give you access to VBI strategies is growing. These investments include the socially responsible mutual funds that have long dominated the segment, along with VBI-oriented ETFs, closed-end funds, private equity funds and venture capital funds.

For wealthier investors, separately managed accounts can offer the opportunity to create a VBI portfolio customized to their specific interests and taking into account their overall holdings.

5. The increasingly global nature of investing

During the financial crisis and its aftermath, U.S. investments were buoyed by the global view of America as a relative safe haven—especially as the European debt crisis unfolded—and by the aggressive actions of the U.S. Federal Reserve.

As a result, U.S. equities outperformed even many fast-growing emerging markets.

But as shifts in global markets accelerate, it makes sense to consider a more global point of view, adding geographical diversity to portfolios at a favorably priced moment.

According to Wolfe, as well as the Investment Management and Guidance group at Merrill Lynch, countries that presently combine relatively low price/earnings ratios and healthy rates of economic growth include Japan and frontier markets—countries that have yet to become emerging markets, such as Vietnam, Indonesia and Thailand.

In looking at international investments, it might make sense to pay attention to global equity indexes that include a variety of stocks and countries.

But, as Bartels notes, “diversifying globally means making careful choices”—for example, in Europe. While much of the continent remains troubled, there has been solid revenue growth from certain large multinational companies that export largely to the U.S. and Asia. At the same time, many of these companies have inexpensive share prices because they’ve been painted by the broad, negative brush of Europe’s recession and debt problems.

While ETFs that track national or regional stock indexes can be a useful way to take advantage of global growth, actively managed funds and separately managed accounts are also able to help investors navigate markets that may not be as familiar to them—particularly frontier markets.

Read How to Invest Like Yale’s David Swensen on AdvisorOne.