C IO REPORTS
The Weekly Letter
Office of the CIO • FEBRUARY 10, 2015
unging for Yield: We expand the discussion of income assets to international markets, highlighting potential
L
opportunities in higher-quality European equities and Emerging Markets debt. However, with higher yield typically comes
greater volatility, and investors should consider the relevant risks. They should not abandon high-quality bonds in their
search for income, and remain within their tolerance for risk.
arkets In Review: Equities rallied last week, with the S&P 500 rising 3.1% on another strong week of earnings, and the
M
MSCI EAFE Index up 1.7%. The employment report for January showed an unexpectedly large pickup in both new jobs and wage
growth, leading to increased expectations that the Federal Reserve will begin to raise interest rates sooner. Treasury yields rose
sharply, with the 10-year yielding 1.96% from 1.64% the prior week. WTI crude oil rose by 7.2% to $51.70 per barrel on further
signs that U.S. producers were meaningfully scaling back production, while gold fell 3.9% to $1,234 per ounce.
ooking Ahead: January retail sales in the U.S. are expected to be dragged down by the decline in gasoline prices, and
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consumer sentiment is expected to moderate from the 15-year high in December. Euro-area gross domestic product (GDP) is
expected to increase, led by strong growth in Germany.
In our last Monthly Letter, “Low for Longer,” we highlighted
ways to diversify income strategies, some through equities.
With many international markets looking increasingly attractive,
we now expand the hunt for yield overseas (see Exhibit 1).
Central banks are driving down yields
In the past year, choppy global growth and declining inflation
have led central banks around the world to implement ultraaccommodative monetary policies, bringing interest rates to
zero or even below, and pushing bond yields down.
7%
U.S. High
Yield
6%
5%
4%
3%
Higher Yield
During the decade leading up to the financial crisis, 10-year
Treasuries yielded 5% on average, but now yield less than 2%.
In a yield-starved world, finding reliable sources of income is
proving increasingly challenging. In the past, high-quality bonds
have been the preferred place to look. However, in today’s
zero interest rate environment, clipping coupons from
fixed income securities is proving insufficient for most
investors. We have been forced to expand our horizons in
seeking yield, and we find that several areas within the global
markets offer opportunities – but with added risks.
Exhibit 1: Increasingly, investors looking for yield will need
to take more risks
Current Yield*
Lunging for Yield
2%
BONDS
MLPs
EQUITIES
European
Equities
U.S. IG Credit
Global REITs
S&P 500
U.S. Treasuries
1%
0%
0%
EM Sovereign Debt
(USD)
Intl Govt Bonds
More Risk
10%
20%
30%
40%
50%
60%
70%
80%
10yr Maximum Drawdown
Source: Bloomberg, MLWM Investment Management & Guidance, data as of February 5, 2015.
Proxies: Intl Govt Bonds – BofAML Global Sovereign ex U.S., U.S. Treasuries – BofAML Treasury
Master, U.S. IG Credit – BofAML U.S. Corporate, EM Sovereign Debt (USD) – BofAML USD EM
Sovereign, U.S. High Yield – BofAML U.S. High Yield, European Equities – MSCI Europe, Global
REITs – S&P Global REIT, MLPs – Alerian MLP
While most discussions of accommodative central banks have
centered on the Federal Reserve (Fed), European Central Bank
(ECB) and Bank of Japan (BoJ), more recently Canada, Australia
and Singapore have joined the ranks of countries where central
bankers are cutting rates. BofA Merrill Lynch (BofAML) Global
Research strategist Michael Hartnett recently wrote that over
half of all government bonds in the world currently yield
1% or less. As a result, finding fixed income yields at pre-crisis
levels without taking substantially more risk is nearly impossible.
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May Lose Value
Equities offer yield but with higher volatility
In recent years, the hunt for yield has pushed income-seeking
investors into previously uncharted territories (see Exhibit 2). This
“portfolio effect” of assets moving into riskier investments in
search of yield will likely only accelerate given the growing amount
of bonds with zero or negative yields. Within U.S. equity markets,
the sectors that traditionally have provided higher dividend yields
are Utilities, Telecom, Tobacco and Real Estate Investment Trusts
(REITs). They have benefited from this trend over the past year, far
outpacing the broader market. Investors have flocked to these
sectors, ignoring the fact that many of the stocks may be
overvalued. However, given the lack of alternatives, they may
continue to be supported by further inflows.
Exhibit 2: Global equity yields are now higher than those
for government bonds
Global Equities - Dividend Yield
Global Govt Bonds - Yield to Worst
8%
7%
6%
5%
4%
3%
2%
1%
0%
1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015
Source: Bloomberg, MLWM Investment Management & Guidance. Data as of February 6, 2015.
Global Equities – MSCI ACWI, Global Government Bonds – BofAML Global Government.
More recently, Master Limited Partnerships (MLPs) have provided
another income alternative. Many have attractive yields and
can offer added tax advantages, while providing investors with
exposure to the boom in U.S. energy. However, MLPs have been
hit by the decline in oil prices over the past six months. BofAML
Global Research believes overall production growth should
continue in 2015 even with oil prices at current levels, and many
MLPs have secured revenues by locking in projects over the next
two years. Investors should be selective, and evaluate investments
on a case-by-case basis as a long-term downturn in commodity
prices can create the risk of distribution cuts in this space.
Looking across the ocean
As the field of attractive income opportunities in the U.S.
has narrowed, we think investors should shift their gaze
overseas. In Europe, equity dividend yields are much higher on
average than in the U.S., and valuation measures (like price to
book value) are generally lower.
The region’s economic outlook hinges on whether the actions
of the ECB can overcome significant political and demographic
challenges. As growth remains feeble, it is important to select
CIO REPORTS • The Weekly Letter
high-quality, larger cap companies that have stronger balance
sheets and global exposure. Our strategists at BofAML
Global Research believe the speed of portfolio rebalancing
into higher-quality European equities with yield will
pick up given the dearth of fixed income opportunities
there. They highlight REITs, Consumer Staples, Insurance
and Pharmaceuticals as having the most companies with
these attractive traits. However, the negative pressure that
accommodative monetary policy has on exchange rates means
hedging foreign currency risk is critical.
Within Emerging Markets, we feel there are opportunities
for yield in EM debt. While geopolitics and deteriorating
conditions in China are risks to the view, there are areas of
the asset class that seem compelling based on widening rate
differentials versus Treasuries and additional liquidity from
accommodative central banks. However, EM debt is a volatile asset
class, and investors should be cautious when adding it to portfolios.
EM currencies add another layer of risk, and we therefore favor U.S.
dollar-denominated bonds. Given the variability of fundamentals
between countries and even sectors within those countries, we
prefer active over passive strategies in this space.
Expanding the investor toolkit
For some investors, additional approaches can
supplement income, such as covered call writing and
other option overlay strategies that can also reduce
the volatility of equity portfolios. While the increased
market turbulence we have experienced in the past several
months is generally unfavorable for investors, higher volatility
increases option premiums, generating more income from
such strategies. However, these approaches can limit upside
potential and may not be suitable for everyone.
Portfolio Strategy: The bottom line is that in a lowinflation, low-yield environment, which may be with us
for a while, yield-seeking investors may have to consider
alternatives to traditional fixed income portfolios that may
involve more risk. The desire for higher yields should be
balanced with the potential for loss of capital.
We believe that investors should not abandon fixed
income in their search for yield, and that they should
remain within their risk tolerance. Risk-averse investors
with a focus on capital preservation may need to stay
with lower-yielding investments such as Treasuries and
high-grade corporate bonds.
2
Markets in Review
Equities
Trailing Economic Releases
n
A strong employment report for January showed that nonfarm payrolls
increased by 257,000, above expectations of 228,000. Additionally, there
was a net positive revision of 147,000 to prior months. Because of a pickup
in the labor force participation rate however, the U.S. unemployment rate
rose to 5.7% while expectations were for no change from 5.6%.
n
Average hourly earnings for January rose a greater-than-expected 0.5%
from December, reversing the decline from that month. This put the annual
growth rate at 2.2% after positive revisions to prior months. While this is
a positive sign for tightening of slack in the labor market, wage growth
remains relatively low, not strong enough to significantly change the
narrative of declining inflation in the U.S.
n
DJIA
Nasdaq
S&P 500
S&P 400 Mid Cap
Russell 2000
MSCI World
MSCI EAFE
MSCI Emerging Mkts
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 -3.6%
-5.0%
Total Return in USD (%)
WTD
MTD
YTD
3.9
3.9
0.2
2.4
2.4
0.3
3.1
3.1
0.0
2.9
2.9
1.8
3.5
3.5
0.1
2.6
2.6
0.7
1.7
1.7
2.2
1.8
1.8
2.4
Yield (%)
2.05
1.96
2.14
3.07
6.29
Total Return in USD (%)
WTD
MTD
YTD
-1.1
-1.1
1.1
-2.2
-2.2
2.3
-0.7
-0.7
1.1
-1.2
-1.2
1.5
1.0
1.0
1.7
Fixed Income
Looking abroad, German Industrial Production for December was down
0.7% YoY, despite an upward revision to November’s decline. Factory
orders rose a greater than expected 3.4% after falling 0.4% in November.
While manufacturing and construction have remained weak in Germany,
this is being slightly offset by stronger retail sales and a pickup in the
services sector.
Level
17,824.3
4,744.4
2,055.5
1,476.9
1,205.5
1,720.6
1,812.1
978.6
ML U.S. Broad Market
U.S. 10-Year Treasury
ML Muni Master
ML U.S. Corp Master
ML High Yield
Commodities & Currencies
4.2%
2.2%
5.6%
4.9%
0.8%
3.0%
2.6%
4.7%
6.9%
0.0%
5.0%
Prior Week
10.0%
Bloomberg Commodity
Gold Spot 1
WTI Crude $/Barrel 1
Level
206.7
1,233.9
51.7
Level
EUR/USD
USD/JPY
Current
1.13
119.1
Total Return in USD (%)
WTD
MTD
YTD
1.8
1.8
-1.6
-3.9
-3.9
4.1
7.2
7.2
-3.0
Prior
Prior
2014
Week End Month End Year End
1.13
1.13
1.21
117.5
117.5
119.8
Source: Bloomberg. 1Spot Price Returns. All data as of last Friday’s close.
Past performance is no guarantee of future results.
Looking Ahead
January retail sales in the U.S. are expected to be dragged down by the decline in gasoline prices, and
consumer sentiment is expected to moderate from the 15-year high in December. Euro-area gross
domestic product (GDP) is expected to increase, led by strong growth in Germany.
S&P Outlook
2015 E
S&P 500 Target
EPS
2,200
$119.50
On Thursday, retail sales in January are expected to be down 0.6% due to a drop in spending at gasoline
Real Gross Domestic Product
2015 E
stations. Core control sales, which exclude spending on gasoline and autos, are expected to be up 0.4%,
reversing an equal decline in December. This would be consistent with the large increase in job growth in
the retail trade sector for January.
Global
3.5%
U.S.
3.3%
Euro Area
Emerging Markets
1.4%
4.2%
Upcoming Economic Releases
n
n
n
BofA Merrill Lynch Global Research
Key Year-End Forecasts
On Friday, the University of Michigan Consumer Sentiment Index is expected to moderate slightly to 97,
from 98.1 in January – a 15-year high. After a steep decline in gasoline prices over the past six months, they
rose slightly in January, which should weigh on the index. However, the labor market continues to see solid
improvement, as shown by last week’s employment report.
U.S. Interest Rates Looking abroad, on Friday euro-area fourth-quarter GDP is expected to be up 0.3% from the prior quarter,
Commodities
a 0.8% annual increase. Growth in Germany is expected to push the reading for the overall region higher,
while Italy should weigh on the number. While the Eurozone economy is expected to improve in 2015,
growth remains weak and expectations are high for the recent expansion of the European Central Bank’s
Quantitative Easing program to stimulate growth and inflation.
CIO REPORTS • The Weekly Letter
Fed Funds
10-Year T-Note
Gold
WTI Crude Oil
2015 E
0.50-0.75%
2.35%
2015 E
1,238
$57
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
Emmanuel D.
“Manos” Hatzakis
Niladri “Neel”
Mukherjee
Adon
Vanwoerden
John
Veit
Vice President
Director
Managing Director
Asst. Vice President
Vice President
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