C IO REPORTS The Weekly Letter Office of the CIO • NOVEMBER 11, 2014 J apan Opens the Spigot: We look at how the Bank of Japan surprised the market recently by accelerating the pace of its bond purchases in order to stimulate economic growth. In addition, the Government Pension Investment Fund (GPIF) announced its intention to double its previous equity allocation. These actions have made us incrementally more positive on Japanese equities for the near to medium term. arkets In Review: U.S. stocks rose, with the S&P 500 gaining 0.8% for the week ending Friday to close at a record high for M the second consecutive week. International equities were mixed, with Japanese stocks rallying on last Friday’s announcement from the Bank of Japan, while European markets fell despite dovish comments from European Central Bank President Mario Draghi. Bond yields fell, with the 10-year Treasury at 2.30% versus 2.34% the prior week. WTI crude oil declined for the sixth consecutive week, dropping 2.3%, while gold ended the week up 0.4% after rallying Friday on a weak employment report. ooking Ahead: Retail sales likely will show a rebound for October, while consumer sentiment should rise to the highest L level since 2007. Euro-area gross domestic product is expected to tick up, and inflation there to remain unchanged from preliminary estimates. Japan Opens the Spigot The Bank of Japan (BoJ) surprised the market recently by accelerating the pace of its bond purchases in order to stimulate economic growth. In addition, the Government Pension Investment Fund (GPIF) announced its intention to double its previous equity allocation. These actions have made us incrementally more positive on Japanese equities for the near to medium term. Exhibit 1: Japanese equities have rallied as the Bank of Japan has expanded its balance sheet Nikkei 225 Index (Left) 20000 Bank of Japan Balance Sheet as % of GDP (Right) 60% 17500 50% 15000 40% 12500 30% 10000 20% 7500 5000 2009 2010 2011 2012 2013 2014 10% How we got here Source: Bloomberg, MLWM Investment Management & Guidance. Data as of October 31, 2014 Japan reappeared on the radar screens of many investors when an election campaign in 2012 brought hope that a new leader might rally the country to end two decades of economic stagnation. Prime Minister Shinzo Abe has delivered a muchneeded jolt through several initiatives designed to spur inflation, weaken the yen and expand the economy. Japan has seen some modest successes from these steps, the expansion of the central bank’s balance sheet being the primary one, and the domestic equity market has responded very well (see Exhibit 1). declined significantly. Manufacturing activity has fallen as well, and industrial production contracted for two consecutive months. The sluggishness of the economy since the tax increase drove the BoJ to take aggressive action to fuel growth. In April, the government enacted an increase in the national sales tax from 5% to 8% as part of its longer-term plan to raise inflation and fund stimulus measures. Anticipation of the tax increase pulled forward consumer spending early in the year, after which it The Kuroda put Similar to the tactics used by the U.S. Federal Reserve, the BoJ, led by Haruhiko Kuroda, is buying domestic government bonds. One goal is lowering interest rates to motivate individuals to invest their savings in riskier assets. The hope is that this increased investment would spur economic activity, lifting Japan out of its dormancy. By expanding its balance sheet, the BoJ is also putting downward pressure on the yen, which has declined from around 80 per U.S. dollar two years ago to roughly 115 per 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 © 2014 Bank of America Corporation. All rights reserved. May Lose Value dollar today. A weaker currency makes Japanese exports, which account for 15% of the country’s gross domestic product (GDP), more competitive globally. Achieving lower interest rates and a weaker currency have been the easy parts for Japan thus far; what’s proving more difficult is creating inflation and a sustainable expansion of the economy. Rather than wait for confirmation of progress, the BoJ has doubled down and expanded stimulus measures. This could go on for longer The BoJ aims to raise inflation while pushing interest rates down further. This should create a negative real return on cash and other short-term assets, reducing their appeal and prompting households to convert them to equities. The average household in Japan holds 53% of its financial assets in cash compared to 15% for U.S. households, according to BofA Merrill Lynch (BofAML) Global Research (see Exhibit 2). A 20% shift into equities implies $3 trillion in purchases, which is equivalent to 90% of Japan’s current equity market capitalization. Household Financial Assets % Bonds Insurance and Pension Reserves 53% 5% 9% In a coordinated move, the Government Pension Investment Fund (GPIF) announced new allocations of its holdings, doubling its allotment to equities from 24% to 50%. Although these changes will likely be made over several years, the size of the shift in the GPIF’s balance sheet will have a significant impact on the Japanese equity market, with the hope that in anticipation of these changes investors will follow suit. Portfolio Strategy: Japan has been in focus for almost two years now due to ongoing political and economic reforms. Japanese equities responded positively when Abe was elected prime minister and announced his reforms, rising 90% over the last two years. The aggressive measures the BoJ announced on October 31st should boost corporate earnings for the heavily export-driven economy. MSCI Japan Relative to MSCI US - Price to Book 0.90 Investment Trusts Other 1% Japan: $15T The government is leading by example Exhibit 3: Japanese equities have underperformed the U.S. this year, and are trading at relatively attractive multiples Exhibit 2: Japanese households hold a majority of their assets in cash, a boon to equities if they reallocate Currency and Deposits Shares and other Equities again next year. Share buybacks from January to July were up 52% from a year earlier. 0.80 0.70 27% 5% 0.60 Avg: 0.64 0.50 15% 5% 12% US: $67T 0% 34% 32% 3% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Source: BofAML Global Research, MLWM Investment Management & Guidance. Data as of June 30, 2014. Like its citizens, Japanese companies are savers, with 50% of them maintaining a positive net cash position. The same negative real yield that may push individuals to shift their assets could drive companies to look for alternatives to cash. They could pay dividends, buy back shares, make capital expenditures or pursue acquisitions. They are already starting to use their $2.4 trillion of cash for share buybacks and dividends, according to BofAML Global Research. After rising 8% last year, dividends in Japan are expected to grow by a further 7% this year and 0.40 Current: 0.50 0.30 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 Source: Bloomberg, MLWM Investment Management & Guidance. Data as of October 31, 2014. Although Japanese equities have already priced in some of the unexpected news, with the TOPIX Index rising 7% in two days, Japanese equities have trailed those of the U.S. so far this year. The TOPIX Index is still roughly 25% below its highs of 2007, and is trading at relatively attractive valuations versus the U.S. (see Exhibit 3). We see further upside in Japanese equities, but suggest hedging yen exposure. Election Recap — The success of the Republicans in the November 4th elections exceeded expectations, with the party picking up seven seats in the U.S. Senate, winning control of the chamber. They added 13 seats in the House of Representatives, creating the largest Republican majority there since 1945. Arguably the biggest surprise was at the gubernatorial level, with nearly every close race going to the GOP. The Republicans won Senate seats in several states that went to President Obama in 2012, including Iowa, Colorado, and North Carolina, and gubernatorial seats in the traditionally Democratic states of Illinois, Maryland and Massachusetts. CIO REPORTS • The Weekly Letter 2 Markets in Review Trailing Economic Releases n Equities Republican success in the U.S. midterm elections exceeded expectations across the board. The party picked up at least seven Senate seats to win the majority in that chamber, and 13 additional seats in the House of Representatives for the largest Republican majority there since 1945. However, we may see continued gridlock in Congress, with the debt ceiling deadline in March providing a key test. n DJIA Nasdaq S&P 500 S&P 400 Mid Cap Russell 2000 MSCI World MSCI EAFE MSCI Emerging Mkts The European Central Bank (ECB) left interest rates unchanged as expected at its November meeting. President Mario Draghi re-emphasized the goal of increasing the balance sheet to the highs of 2012, and presented a detailed road map for further action if economic data continues to disappoint, implicitly reinforcing the possibility of sovereign bond purchases. n Level 17,573.9 4,632.5 2,031.9 1,430.1 1,173.3 1,707.0 1,798.7 987.7 WTD 1.2 0.1 0.8 0.8 0.0 0.0 -1.0 -2.8 Total Return (%) MTD YTD 1.2 8.1 0.1 12.0 0.8 11.8 0.8 7.8 0.0 1.9 0.0 4.6 -1.0 -3.8 -2.8 0.7 Yield (%) 2.17 2.30 2.59 3.10 6.04 WTD 0.1 0.2 -0.3 0.0 -0.1 Total Return (%) MTD YTD 0.1 5.5 0.2 9.0 -0.3 8.7 0.0 7.0 -0.1 4.6 Fixed Income The U.S. employment report slightly disappointed expectations, but was still solid, with the gain in nonfarm payrolls coming in at 214,000 versus forecasts of 235,000. The unemployment rate ticked down to 5.8%, as revisions for the prior two months added 31,000 jobs. Despite the significant improvement in employment, wage growth has remained sluggish, increasing only 0.1% month-over-month (MoM) despite expectations of a 0.2% rise. ML U.S. Broad Market U.S. 10-Year Treasury ML Muni Master ML U.S. Corp Master ML High Yield S&P 500 Sector Returns (as of last Friday’s market close) Consumer Discretionary Consumer Staples Energy Financials Healthcare Industrials Information Technology Materials Telecom Utilities Commodities & Currencies -0.1% 2.1% 1.6% Bloomberg Commodity Gold Spot 1 WTI Crude $/Barrel 1 Level 237.0 1,178.0 78.7 1.7% Level EUR/USD USD/JPY Current 1.25 114.6 0.4% 1.3% -0.4% -5.0% 0.8% 0.5% 0.2% 0.0% Prior Week 5.0% Total Return (%) WTD MTD YTD -0.1 -0.1 -6.4 0.4 0.4 -2.3 -2.3 -2.3 -20.1 Prior Prior 2013 Week End Month End Year End 1.25 1.25 1.38 112.3 112.3 105.3 Source: Bloomberg. 1Spot Price Returns. All data as of last Friday’s close. Past performance is no guarantee of future results. Looking Ahead Retail sales likely will show a rebound for October, while consumer sentiment should rise to the highest level since 2007. Euro-area gross domestic product (GDP) is expected to tick up, and inflation there to remain unchanged from preliminary estimates. BofA Merrill Lynch Global Research Key Year-End Forecasts S&P Outlook Upcoming Economic Releases S&P 500 Target EPS Friday is a busy day, with several key economic reports being released: Real Gross Domestic Product n n 2,000 $118 2014 E U.S. retail sales are expected to rise 0.2% MoM for October, after falling 0.3% MoM in September. Global 3.1% Although gasoline prices have tumbled, on a seasonally-adjusted basis the decline is not as large. Core retail sales, which exclude autos, gasoline, building materials and food, likely also rose 0.2% MoM. Any further weakness carrying over from September may indicate downside risk to fourthquarter GDP estimates. U.S. 2.2% Euro Area Emerging Markets 0.7% 4.3% The University of Michigan Consumer Sentiment Index is expected to rise to 88 in the Fed Funds 10-Year T-Note preliminary report for November, up from 86.9 in October. This would mark the fourth consecutive monthly increase, as a gradually improving labor market and lower gas prices should boost consumer confidence. n 2014 E Euro-area third-quarter GDP is expected to tick up 0.1% quarter-over-quarter, from the unchanged reading in the second quarter. Consumer Price Index inflation for October is expected to be 0.4% year-over-year, unchanged from preliminary estimates. Bad news will be good news, given last week’s ECB statement that further policy easing is conditional on data. CIO REPORTS • The Weekly Letter U.S. Interest Rates Commodities Gold WTI Crude Oil 2014 E 0-0.25% 2.75% 2014 E 1,308 $95 All data as of last Friday’s close. 3 Office of the CIO Ashvin B. Chhabra Chief Investment Officer, Merrill Lynch Wealth Management Head of Investment Management & Guidance Mary Ann Bartels Christopher J. Wolfe CIO, Portfolio Solutions, U.S. Wealth Management CIO, Portfolio Solutions, PBIG & Institutional Hany Boutros Sarah Bull Niladri “Neel” Mukherjee Adon Vanwoerden John Veit Vice President Vice President Director Asst. Vice President Vice President Contributing Author Tony Golden GWM Investment Management & Guidance (IMG) provides investment solutions, portfolio construction advice and wealth management guidance. The opinions expressed are those of IMG only and are subject to change. While some of the information included draws upon research published by BofA Merrill Lynch Global Research, this information is neither reviewed nor approved by BofA ML Research. 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