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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
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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.
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information is neither reviewed nor approved by BofA ML Research. This information and any discussion should not be construed as a personalized and individual recommendation, which
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No investment program is risk-free, and a systematic investing plan does not ensure a profit or protect against a loss in declining markets. Any investment plan should be subject to periodic
review for changes in your individual circumstances, including changes in market conditions and your financial ability to continue purchases.
Asset allocation and diversification do not assure a profit or protect against a loss during declining markets.
Investments in MLPs in the energy sector will be subject to more risks than if the investment were broadly diversified over numerous sectors of the economy. A downturn in the energy
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The investments discussed have varying degrees of risk. Some of the risks involved with equities include the possibility that the value of the stocks may fluctuate in response
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Investments in high-yield bonds may be subject to greater market fluctuations and risk of loss of income and principal than securities in higher rated categories. Investments
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