BofA Merrill Lynch Global Cross‑Asset Strategy Outlook Post‑Trump Election

Global Cross Asset Strategy – Year Ahead The Trump inflection Investment Strategy 30 November 2016 Corrected Key takeaways • Market response to Trump is logical but moves have been frontloaded. We now see USD & rates only modestly higher next year. • We see higher growth and inflation, notably in Japan. We go long NKY, stay long EM AXJ & selective yield in equity/ credit. • Risk is an overshoot so we stay long USD/ short rates, adding a CNH put and short 10Y real rates. CNH a hedge vs trade risk. Investment strategy Global James Barty >> Investment Strategist MLI (UK) +44 20 7996 3291 [email protected] See Team Page for Full List of Contributors Trump extends some trends, starts others In the three weeks since Donald Trump’s election victory global markets have seen some dramatic moves. Som1e of those moves are extending trends that had already started – higher yields, higher USD, rotation from long to short duration. Others are new – JPY lower, NKY higher, EM lower. The key question is how much more they can go? Growth/inflation higher in 17/18 - modest fiscal boost Our economists think the fiscal impact of Trump will be modest at 0.5% on growth in H2 next year. Fiscal stimulus elsewhere also to be modest but it is taking the pressure off monetary policy. Growth was already improving so any fiscal stimulus helps. Our economists have both growth and inflation higher into 2017 and 2018. Inflection point in markets but much discounted already Market moves at turning points are often violent. The task of investors is to work out how much is already discounted. Our fixed income strategists have 10Y US yields at 2.65bp and bunds at 65bp at end 2017, also EUR/USD at 1.02 so moves look frontloaded to us. That suggests their implications for other markets should fade. Unauthorized redistribution of this report is prohibited. This report is intended for [email protected] Evolution not revolution – long NKY, short 10Y real rates If that is the case then we do not want to make wholesale changes to our strategy. We make two key changes today, adding long NKY (Japan strategist targets 20k) and short 10Y real rates trades. The former is part of our strategy to be pro-growth and we think it complements our long EM Asia trade being affected differently by USD strength. The hunt for yield is dead, long live the hunt for yield If yields only rise modestly next year then the hunt for yield will live on. We keep a yield basket in European equities, AT1s and spread in Euro/US credit. We go outright long European Healthcare by lifting our Food & Beverage short, which has dropped sharply. Overshoot in rates, USD and trade key risks – add CNH put The world would look very different if the US 10Y blew through 3% and the USD went on a tear, so we stay long USD and short rates. We add a CNH put vs USD as a hedge against an escalation of trade tensions under the new Trump administration. >> Employed by a non-US affiliate of MLPF&S and is not registered/qualified as a research analyst under the FINRA rules. Refer to "Other Important Disclosures" for information on certain BofA Merrill Lynch entities that take responsibility for this report in particular jurisdictions. This document is intended for BofA Merrill Lynch institutional investors only. It may not be distributed to BofA Merrill Lynch Financial Advisors, retail clients or retail prospects. BofA Merrill Lynch does and seeks to do business with issuers covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Refer to important disclosures on page 26 to 27. Analyst Certification on page 25. 11691609 Timestamp: 30 November 2016 12:00AM EST Current trade recommendations Table 1: Current cross asset trades Asset Trade idea Strategist Long European Quality Yield Screen (yield) James Barty Long SXDP Index Ronan Carr Equities Long Nikkei Shusuke Yamada Long European index dividend futures James Barty Long MSCI Asia ex-Japan Ajay Kapur Long RTY short SPX 2y variance swap Nitin Saksena 3000-2850 SX5E put spread Dec 16 expiry James Barty Equity vol Long NKY short SPX Dec 18 variance swap Benjamin Bowler Long SX5E short SPX Dec 18 variance spread Abhinandan Deb Eurostoxx 2y/3y put calendar Abhinandan Deb Short EUR/SEK Kamal Sharma Long USD/CNY call Claudio Piron FX Short GBP/USD Kamal Sharma Long USD/AUD Ian Gordon Long RUB/ZAR David Hauner 2s-5s-10s fly Shyam S.Rajan Fixed Income Short US 10y real rates Shyam S.Rajan Paying 5y GBP real rate swap Mark Capleton Buy 30y US IG Industrial spreads Hans Mikkelsen Credit Buy basket of Euro AT1s Barnaby Martin Long Xover short Main Ioannis Angelakis Source: BofA Merrill Lynch Global Research. For the full methodology and reference pricing please see Appendices. New trades in bold. Themes Long Cyclicality • Long Asia EM – recovering growth, earnings revisions and cheap valuation. • Long Nikkei – growth picking up, JPY soft, 20k target. Long Yield • Long European dividend yield stocks – 5% yield, big pick up over IG credit. • Long Dec 18 SX5E dividend future – implies 4% drop from 2016, we see 4% rise. • Long basket of AT1s – high yield, equity cushion to rise. • Long XOver short Main – investors’ reach for yield to push them towards Crossover. • Long basket of 30Y US industrial IG spreads – further spread compression. Hedge the Fed/Trump • 2-5-10 fly – 5Y part of the curve looks most vulnerable to Fed hiking. • Short 10Y real yields – inflation breakevens have adjusted real rates have not. • Long USD – long via USD/GBP and USD/AUD, we think policy divergence will drive USD stronger if the Fed tightens as our economists expect. • Long USD/CNH 7.6 6 month call – hedge against trade tensions Hedge the Rest • We are long SX5E, NKY and RTY vs SPX variance. Carry positive, convex in a sell-off. • Long Dec 17/18 SX5E put spread. Long 3000-2850 Dec 16 put spread. Alpha Trades • Long European Pharma. Sector discounting no pipeline, valuation back to cheapest since 2011. Solid yield too. • Paying 5y UK real rates at -254bp. Implied inflation/rates inconsistent. • Long RUB/ZAR (positive on oil, cautious on S African politics). • Short EUR/SEK, strong Swedish growth, limiting room for Riksbank easing. 2 Global Cross Asset Strategy – Year Ahead | 30 November 2016 The Trump inflection Changes today: Add NKY long, 10Y real rate short and CNH put, close forward Kospi vol and Food & Beverage short. We are not making mass changes today. While some of our trades have worked better than others post-election we are broadly happy with the balance. We still want exposure to growth and to own yield where we can but also want to protect ourselves from a further surge in the USD and rates. We diversify our equity long in EM and European yield with a long Nikkei position. It is not the best entry point but we suspect it has further to run on a one year horizon. A stronger USD is good for Japanese equities where it is not for EM, so they complement one another. We add a short US 10Y real rate trade too to protect against rising US yields, as breakevens have already moved significantly. We close our Kospi vol trade (changed view from strategists) and drop the short Food leg of our Pharma/Food trade, reflecting the sharp sell-off in the long duration sectors of late. Summary: Still be long growth and yield but hedge with USD and Rates Year aheads are notoriously tricky to write and almost always wrong. Anyone who wanted to correctly predict the outcomes and how markets would react to them in 2016 did not need so much as crystal ball as a time machine. As investors and strategists we have to make calculations as to the most likely outcomes, where is the best upside to play them and how best to hedge the risks around them. Donald Trump’s election is in our view an inflection point for global markets, starting new trends in some asset classes and extending trends in others. It does not completely change the world though, as the disinflationary and weak growth pressures that have plagued the world since the GFC are structural rather than cyclical. But the shift to fiscal and populism is likely to boost growth and inflation, so it does change the picture to a significant degree. If we are to call it an earthquake it is perhaps a five rather than a nine on the Richter scale. We have to adjust our way of thinking though. The rise in rates and higher USD that we had hedged against now look like they are going to go further. That is going to hurt longer duration assets. So we continue to run our long USD positions and add to our short rate positions (via 10Y real rates). There is risk around trade and geopolitics, which has to make us more nervous of our EM positions. So we diversify our risks by pairing our long EM position with a long Japan position and add a CNH put. But the world is not completely changing. Even in the new order we only forecast 10Y Treasuries at 2.65% and Bund yields at 65bp end 2017. So the hunt for yield will not disappear completely. We still want to own yield, but as we have said of late it cannot be yield for yield’s sake. Yield in equity markets has been safest in the shortest duration buckets, such as Banks and Cyclicals since the summer. We changed our yield basket last month is this direction so we keep it. We stay long AT1’s and in credit we keep our spread trades both in Europe and the US. AND we remind investors of something we said at the start of 2016, be prepared to trade the ranges in markets. If there was one lesson of the last year it was that. When assets get very loved and overbought, sell them, when it is the opposite you have to buy them. Think of buying EM and commodities in February. Think of selling defensive equities and bonds and buying banks post-Brexit. None of us will get that right all of the time, but the Warren Buffet maxim “be greedy when others are fearful and fearful when others are greedy” is particularly useful in current markets. Finally, as cross asset investors think about what can go wrong with your positions and find asymmetric hedges for them if you can. That should be the edge you have at looking across the range of asset classes compared to single asset class investors. We would like to thank our BofAML colleagues who have supported our product this year by providing many such ideas and trust they will continue to do so through 2017. Global Cross Asset Strategy – Year Ahead | 30 November 2016 3 X Asset Strategy: Long growth, short bonds, long USD but the hunt for yield lives on Clearly markets are different and will continue to be so under President elect Trump BUT not everything will change. The disinflationary forces triggered by the GFC have not gone away but the decision to focus on fiscal stimulus, not just in the US but also Japan and to a lesser extent the UK, is a welcome shift taking some of the burden away from monetary policy. It means rates should be higher for any given amount of growth. But higher does not mean a return to pre GFC levels of rates, which we need to bear in mind when setting our strategy. Indeed, our strategists 10Y forecasts are US 2.65%, Euro 0.65% and Japan 0% for end 2017. Similarly on trade, for all the rhetoric of the President-elect again we do not think he wants to trigger trade wars that would damage US growth. That means we should not necessarily drop our pro-EM bias. So we think of it as an evolution rather than a revolution in the way our strategy is structured. We wanted to be exposed to growth, we tweak that by adding a NKY long to replace our US energy long. We continue to have yield in the portfolio where we can find it, which is through a mixture of equities and credit (AT1’s, European yield basket, Xover v Main and US long date industrial spreads). Even more than before we want to be protected against a stronger USD and higher rates, hence the addition of the 10Y real yield trade, and trade tensions which we have tried to cover through our CNH put. Nov 8 th accelerates some trends, starts other Before the US election we said that the tectonic plates were starting to shift, with bond yields having troughed and starting to head higher. We thought there were signs too that global growth might be shifting up a gear. So we wanted to have defensive positions in bond markets, be long the USD and be long growth where we could. The election of Donald Trump has arguably turned this gradual shifting of plates into a full blown earthquake for global financial markets. The key questions for investors as we look ahead to 2017 are how big an earthquake and how much the moves that have happened since November 8 th are likely to be extended into next year vs how much we have frontloaded them already in 2016. Chart 1: USD/JPY has surged post-Trump Chart 2: As have bond yields 125 2.5 120 115 JPY/USD 2.3 2.1 10y UST yield 110 1.9 105 1.7 100 1.5 95 1.3 Oct-15 Nov-15 Dec-15 Jan-16 Feb-16 Mar-16 Apr-16 May-16 Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 Oct-15 Nov-15 Dec-15 Jan-16 Feb-16 Mar-16 Apr-16 May-16 Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 Source: Bloomberg Source: Bloomberg 4 Global Cross Asset Strategy – Year Ahead | 30 November 2016 Chart 3: EM debt and equity have been hit Chart 4: While Banks versus Staples has gone ballistic 950 900 850 800 750 700 650 Oct-15 Nov-15 Dec-15 MSCI EM Wisdom Tree EM Local Debt Fund (RHS) Jan-16 Feb-16 Mar-16 Apr-16 May-16 Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 40 39 38 37 36 35 34 33 32 0.43 0.41 0.39 0.37 0.35 0.33 0.31 0.29 0.27 0.25 Oct-15 Nov-15 Dec-15 Jan-16 S&P 500 Banks relative to Food & Bev Feb-16 Mar-16 Apr-16 May-16 Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 Source: Bloomberg Source: Bloomberg The moves since Nov 8 th have certainly been violent in certain asset classes. USD/JPY stands out, but the sell-off in US treasuries has been very marked, the hit to EM fixed income equally big, while in equity markets the outperformance of the Russell, the surge in the US banks and the sell-off in long duration equities has been remarkable. Some of these moves, such as stronger USD, higher yields, banks vs staples were extensions of moves that had already begun. Others, such as Russell vs S&P, JPY, Nikkei, were the start of new moves where 8 Nov marked a key turning point. The moves that had already started are now getting quite stretched with US 10Y yields up 5 standard deviations from the July low, with US Banks up by a similar amount vs Staples. The USD/JPY move though is more like a 2 SD move, with the NKY similar (if we exclude the 7% drop on US election day). Peak liquidity, deflation, inequality and globalisation – watch for Peak Trump So what does a Trump presidency mean for the world? Michael Hartnett, our Chief Investment Strategist sums it up nicely with four of his seven peaks. Peak liquidity – the era of excess liquidity is over; Peak inequality – with fiscal stimulus to address inequality; Peak globalisation- free movement of trade, labour and capital ending, FX wars starting; and Peak deflation – the secular low point in bond yields now behind us. We would add a peak to that which investors need to bear in mind – Peak Trump. What we mean by that is at what point do the policy changes of the Trump presidency get fully discounted in markets. We have moved pretty quickly to do that but we suspect there is more to go, even if the quick returns have probably already been made. If we think about these peak questions, the two that stand out to use as obvious and not really open to challenge are Peak liquidity and Peak deflation. The Fed left its peak liquidity position behind ages ago, the BOJ has moved to yield rather than liquidity targeting, the BOE may extend its current programme of QE one more time but then is probably done and even the ECB is talking about tapering, even if they are unlikely to do it in December. The Peak deflation theme follows on from this with the secular low in bond yields surely behind us if the central banks are stepping away from flooding the world with ever more liquidity. Peak liquidity/deflation means higher yields – inflation expectations adjusting The question then is how much yields will likely rise from here. Much of course depends on how quickly inflation picks up. Markets have already moved to price in a significant pick-up in expected inflation as the two charts below show. To our mind breakeven inflation rates had been too low for too long, which is one reason we wanted to be defensive in bond markets. It would seem to us that inflation expectations are now up with events. US headline CPI at 2.5% is consistent with the Fed modestly overshooting Global Cross Asset Strategy – Year Ahead | 30 November 2016 5 its 2% core PCE target. Our economists think that the Fed may well aim a little high in the short term on inflation to ensure they have sufficient room to ease in the event of a downturn. However, it is unlikely that the Fed would tolerate a sustained overshoot of their inflation objective. That is particularly the case if the Fed under President Trump is made more hawkish as our economists think it probably will be (see Liquid Insight: Trump’s stamp on the FOMC). Chart 5: US 5Y5Y forward inflation back towards 2.5% 3.3 3.1 2.9 2.7 2.5 2.3 2.1 1.9 US 5y5y fwd inflation swap 1.7 Chart 6: Euro 5Y5Y forward inflation up to 1.6% 2.8 2.6 2.4 2.2 2 1.8 1.6 EUR 5y5y fwd inflation swap 1.4 1.2 Source: Bloomberg Source: Bloomberg Equally, our economists in Europe are sceptical on the ECB’s ability to get inflation to rise significantly from current levels. Optically there is scope for European breakevens to head higher if the ECB were to be successful but investors are likely to want to see some evidence of rising inflation first before they price that in. We will return to this below. For now we agree with our fixed income strategists that the rise in inflation expectations is probably sufficient and that any rise in yields from here has to be one of higher real yields. They think such a rise as a tightening of monetary conditions which may be self-limiting in the short term, particularly as the fiscal boost in the US is likely to be back loaded in terms of 2017. If rates move too quickly and the USD follows before the fiscal stimulus kicks in they could actually dampen growth. Indeed, our US economists have shaved their near term growth forecasts already to reflect the current moves. They do not expect the fiscal stimulus to start to boost growth before the 3 rd quarter. Fiscal + hawkish Trump Fed means we stay short 5Y US via 2-5-10 butterfly Our fixed income team estimated how much fair values of the different parts of the curve would have to move were the market to move into line with the dot plot. Updating those estimates for the move since their publication we find 2Y rates can move another 11bp, 5Y 39bp and 10Y 33bp. They argue that given we are past the inflection point for rates, with fiscal policy being eased and now with a more hawkish Fed under Trump likely, the dot plot should form the floor not the ceiling for rate expectations. All of this translates into a view that 10Y yields can push to 2.65% by the second half of 2017. Given their views on the curve we continue to run the 2-5-10 butterfly. It has moved from around -10bp to +10bp since the election, and our fixed income strategists have moved their target to +20bp. 6 Global Cross Asset Strategy – Year Ahead | 30 November 2016 Chart 7: 5Y yields to continue to underperform 0.5 0.4 0.3 0.2 0.1 0 -0.1 2s-5s-10s US fly -0.2 Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16 Source: Bloomberg Chart 8: Real rates likely to feel the pressure going forward 3.5 3 2.5 2 10y US TIP yield 1.5 1 0.5 0 -0.5 -1 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Source: Bloomberg Peak globalization/inequality means higher real rates – short 10Y US real rates Our fixed income team make the point that globalization has been a driving force behind lower real rates as it has been good for EM growth and reserves. Those reserves then found their way back into the US holding real rates lower. They argue that as the global savings glut unwinds real rates have room to re-price. Peak inequality also means an unwind of globalization as politicians seek to protect workers from the depressing effect on wages coming from overseas. Donald Trump has already said he intends to charge China with being a currency manipulator. Whether he does or not and what action he takes to accompany it remains to be seen, but artificially low currencies generating high current account surpluses are unlikely to go down well with the new administration. That lends weight to the fixed income team’s arguments. Peak inequality may also mean less migration across the world – think Trump’s arguments on illegal immigration from Mexico and Theresa May’s desire to limit migration into the UK post Brexit. Less migration likely means more upward pressure on wages, which is the inflation expectations side of the argument. But Michael Hartnett also thinks it means more action on fiscal policy. The UK government have implemented a £24bn infrastructure fund in the Autumn statement. Donald Trump wants to trigger up to $1tn of infrastructure spending in the US in addition to the tax cuts. The fiscal boost should push real rates higher (at least in the short term). Some Fed members have acknowledged this suggesting that equilibrium interest rate might be moved higher by fiscal stimulus. The rates team also rightly says while they want to be bearish rates given the speed of the move so far it is also right not to be foolish. Given how much inflation expectations have moved they think there is better risk reward in real rates. They argue the 10Y real rate is the most vulnerable to further moves higher in rates. Although they have already risen from around zero in the summer to ~50bp now they think 10Y real rates can reach 1%. So we add that trade to our 2-5-10s position. Implications for other asset classes: Stronger USD, weaker EM? The forces impacting on markets from the Trump victory have not been confined to rates markets, although it is probably fair to say that most (although certainly not all) of the impact stems from the move in rates. Higher US rates have meant a stronger USD, an outperformance of short duration over long duration equities, a hit to EM debt and all forms of carry trades. Global Cross Asset Strategy – Year Ahead | 30 November 2016 7 Chart 9: USD breaks to new highs 105 DXY Curncy 100 95 90 85 80 75 Chart 10: As Treasury yields open big gaps with Europe and Japan 2.7 2.5 2.3 2.1 1.9 1.7 1.5 US 10y yield 10y Bund yield (RHS) 10y JGB yield (RHS) 1 0.8 0.6 0.4 0.2 0 -0.2 Source: Bloomberg 1.3 -0.4 Oct-14 Feb-15 Jun-15 Oct-15 Feb-16 Jun-16 Oct-16 Source: Bloomberg The USD is a case in point, with the higher US rates creating a significant gap to equivalent Euro and JPY rates. With the ECB likely to extend QE by the full current amount (despite the debate over timing) and the BOJ committed to capping JGB yields at zero, a surge higher in the USD was the logical outcome. Given that the biggest gap in intentions was relative to Japan it is perhaps not surprising that the JPY has been the biggest victim, with the JPY falling some 10% against the USD since the election. The DXY has broken out of the top end of the trading range it has been in since early 2014. The stronger USD is not just reliant on higher yields, but also other factors such as the likely repatriation of money into the US under a new proposal for US corporates to return funds at a concessionary tax rate, generally referred to as HIA2. We had positioned long USD as well as short rates, not so much as an explicit play on a Trump victory but more against a more hawkish Fed in 2017. We were also of the view though that a Trump win would likely be positive for the USD and higher yields. Going back to our fixed income strategists’ point that the dot plot should now perhaps be the base case for the markets that does imply higher yields which should continue to be dollar supportive. Like their bond yield forecasts though our strategists call for a modest further appreciation of the USD rather than a huge surge. They have the USD peaking at 1.02 vs the EUR, 120 against the JPY and 1.43 vs the CAD. So the big violent move has likely happened even if we still see the USD strengthening further next year. Certainly our FX strategists are not calling for a surge in the USD similar to the one that happened in 2014/15. The reaction of the US economy to “Trumponomics” is key These two things are important for other asset classes. If we really thought 10Y Treasuries were heading to 3%, the Fed likely to tighten above the dot plot and the USD to surge another 10% in quick order, the impact on other asset classes would likely be more severe. That would undoubtedly exacerbate the trends we have seen out of EM and long duration equities. We also suspect it would make it much harder for commodities to perform. We see holding USD and short rates positions as necessary to hedge against such an outcome with limited downside risk if it does not happen. 8 Global Cross Asset Strategy – Year Ahead | 30 November 2016 Chart 11: Dollar strength leads to immediate trade drag (inverse relationship) 1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5 Contribution of net exports to real GDP (lhs, pp) Real trade weighted USD, QoQ (rhs, % yoy) -2.0 Q2-2013 Q1-2014 Q4-2014 Q3-2015 Q2-2016 Source: Federal Reserve Board, Bureau of Economic Analysis 6% 4% 2% 0% -2% -4% Chart 12: Expected path of fed hiking cycle (bp) 200 180 160 140 120 100 80 60 40 20 0 Current market pricing Median dot, Sep-16 SEP BofAML forecast 0 4 8 12 16 20 24 # of meetings into tightening cycle Source: BofA Merrill Lynch Global Research, Federal Reserve, Bloomberg Nevertheless it is not our central scenario in part because there is a risk that much of a Trump surge could be bad for growth. As we noted above the fiscal stimulus is likely to be back loaded as far as 2017 is concerned. In the meantime the FX and Rates teams predict an 8-10% appreciation of the USD from pre-election levels and 10Y rates about 80bp higher. Our economists note that a 10% appreciation of the USD is estimated to slice around 0.5% off of US GDP growth over two years. Higher mortgage rates from higher bond yields would also likely dampen growth. As a result, they have actually lowered their forecast for US growth in the first half of next year to around 1.5% before seeing it rebound to around 2.3% in H2 and then 2.5% in 2018 as the fiscal stimulus feeds through. Various Fed members, notably Bill Dudley of the NY Fed, have said this year that a stronger USD would have an impact on monetary policy. So to some extent we see USD strength as self-limiting as it would start to lower the profile of likely Fed tightening. Our economists are also cautious as to the extent of the impact of the Trump fiscal plans. Assuming that there is a compromise between the Trump administration and Congress our economists think the likely scale of tax cuts is $2-3tn over 10 years, with $200-300bn of this in 2017. Given the low estimated multiplier from any proposed tax cuts and a Congress likely to limit the amount of an increase in government spending, they look for a modest 0.5% boost to growth. Upside risk to growth and rates if Trump does more on fiscal, less on trade If Congress passes more of the Trump stimulus plan, particularly on the infrastructure side, and there are no significant changes to trade or immigration policies then our US economists think growth could potentially hit 3% in 2017 and 3.5% in 2018. That would likely be accompanied by a faster pace of Fed hikes than they currently assume (which is two hikes between now and end 2017 followed by 3 in 2018). Trade policy and its impact vital The other key factor of the new administration is going to be the direction on trade. President elect Trump has already said he will pull out of the TPP, TTIP looks likely to get the same treatment, while NAFTA is set to be renegotiated. Meantime Trump said he will label China a currency manipulator. This is the other side of the Peak Globalisation/Peak Inequality coin and none of it looks good for global trade. Combined with the stronger USD and higher rates, it is easy to understand the knee jerk reaction of investors to sell EM asset, particularly given the gains of earlier this year. Global Cross Asset Strategy – Year Ahead | 30 November 2016 9 Chart 13: China could be named a currency manipulator 7 6.9 6.8 CNY/USD 6.7 6.6 6.5 6.4 6.3 6.2 6.1 6 Source: Bloomberg Chart 14: But world trade has slowed – would Trump make it worse? 15 10 5 0 -5 -10 World Trade growth (%) -15 Jan-72 Jan-75 Jan-78 Jan-81 Jan-84 Jan-87 Jan-90 Jan-93 Jan-96 Jan-99 Jan-02 Jan-05 Jan-08 Jan-11 Jan-14 Source: WTO, BofA Merrill Lynch Global Research The question for investors is whether Trump the candidate or Trump the deal making businessman will eventually be the driver behind trade policy. It is not impossible to imagine the President-elect gaining some concessions from his hard line stance and then claiming victory. After all, since one of his aims is to get the US economy growing at 4% a year, a prosperous global economy to export into is probably preferable to one that is taking a hit from an aggressive US trade policy. That is the inclination of our EM strategists and economists, so they are expecting the reality to be softer than the rhetoric. At this stage we have to acknowledge that it is little more than an educated guess. It makes us less certain of our long EM equity position than we were. Nevertheless, we had already switched it out of an MSCI position into an Asia ex Japan in part because of US election risks and our strategists are particularly upbeat about Asian markets. They think they are cheap, they are positive on China and they think growth and hence earnings will surprise on the upside. What about the rest of the world? Growth has been improving Growth indicators have been improving around the world of late. Data since the US election would seem to support that with the PMIs in the Euro Area improving again and their equivalent in the US sustaining the gains seen last month. Our EM indicators remain robust and our China ACT indicator continues to indicate steady growth there too. Our economists forecast 3.5% global GDP growth with EM growth around 4.7%. Our Euro Area growth numbers have been nudged back up towards 1 ½% with Brexit not proving to be as much of a drag as feared. We still expect the UK economy to see something of a slowdown in 2017 as the lagged effect of the fall in the pound hits consumer incomes. Perhaps our most optimistic view of the world, relative to consensus, comes from Japan where with fiscal policy turning more supportive (we put the package at 1.5% of GDP) we see growth at 1.4% in 2017. 10 Global Cross Asset Strategy – Year Ahead | 30 November 2016 Chart 15: Eurozone PMI’s point to solid growth 60.0 58.0 56.0 54.0 52.0 50.0 48.0 46.0 44.0 42.0 EA Services PMI EA Manufacturing PMI 40.0 Aug-09 Aug-10 Aug-11 Aug-12 Aug-13 Aug-14 Aug-15 Aug-16 Source: Markit Chart 16: Japanese growth expected to accelerate in 2017 3.0 2.0 Forecasts 1.0 0.0 -1.0 -2.0 2011 2012 2013 2014 2015 2016 2017 Private demand Public demand Net exports Real GDP growth %YoY Source: BofA Merrill Lynch Global Research forecasts, CAO It is a decent global growth picture and it is not impossible to imagine it being still better should the US surprise on the upside and the impact on trade from a Trump presidency prove to be modest. It certainly fits with the Peak Deflation theme since this stronger growth is expected to be accompanied by a pick-up in inflation. We have core PCE in the US reaching 1.9% next year in our core scenario. Our headline inflation numbers are higher because of the expected increase in the oil price from our commodity strategists. Indeed with oil expected to reach $60pb (OPEC permitting) headline CPI inflation in the US could push 3%. In the Euro Area we see headline inflation rising to 1.2%, albeit with core inflation only nudging modestly higher. UK inflation is expected to move markedly higher care of the lower pound, again with headline inflation pushing towards 3%. In Japan driven by our more optimistic view of the economy we project core CPI at 1%. Chart 17: BofAML sees GDP accelerating into 2018… Global GDP growth % DM GDP growth % EM GDP growth % 4.7 5.1 3.2 4.1 3.1 4.1 3.5 3.8 2.1 1.5 1.7 1.9 Chart 18: …with inflation picking up too Global CPI inflation % DM CPI inflation % EM CPI inflation % 4.2 3.6 3.6 3.8 2.5 2.4 2.8 3 1.7 1.8 0.7 0.3 2015 2016F 2017F 2018F Source: BofA Merrill Lynch Global Research 2015 2016F 2017F 2018F Source: BofA Merrill Lynch Global Research Politics – does populism strike again, this time in Europe? Few would have predicted both Brexit and a Trump win in 2016. Both had something to do with the Peak Inequality and Peak Globalisation themes. Politicians on both sides of the Atlantic tapped into a deep disquiet, particularly amongst white male blue collar voters that they were not benefitting from this new globalised world. If opinion polls are to be believed (something which we have all learnt to question) then Italy may well end the year with another vote against the governing party - although that one is perhaps a little more complicated to dissect. We recently added a put spread on the eurostoxx to hedge against such a bad outcome here, which would be the case if it is perceived to be Global Cross Asset Strategy – Year Ahead | 30 November 2016 11 supportive of the 5 star movement or threatened the recapitalisation of the Italian banks (see Strategy Insights: Italy risks elevated). In 2017 the focus turns to core Europe, especially France and Germany. Because of the winner takes all system in France we find investors are more concerned with the situation there. Marine Le Pen and the Front National look likely to make it to the second round of voting (again according to polls) and until the vote comes in we suspect investors will be cautious about European markets. A Le Pen victory could likely bring the future of the EU and the Euro into question as she has talked about France withdrawing from both. That in turn has arguably the potential to be even more of an earthquake for the world’s financial markets. Our central case is that centre right President is elected in France (with Francois Fillon now the official Republican candidate) and Merkel is returned at the head of a coalition government in Germany. Chart 19: German polls show a consistent lead for Merkel’s CDU party 40 35 30 25 20 15 10 5 0 100 90 80 70 60 50 40 30 20 10 CDU SPD AfD 0 Chart 20: Fillon well ahead of Le Pen in polls showing a potential run-off 12-14 April 15-17 April 13-16 May 10-12 June 14-17 June 9-11 Sept Francois Fillon (%) Marine Le Pen (%) 25-Nov 27-Nov Source: Allensbach (15-Sept, 13-Oct), Emnid (7-Sept, 14-Sept, 21-Sept, 28-Sept, 5-Oct, 12-Oct, 19- Oct, 26-Oct, 2-Nov, 9-Nov, 19-Nov), Forsa (2-Sept, 9-Sept, 16-Sept, 23-Sept, 30-Sept, 7-Oct, 14-Oct, 21-Oct, 28-Oct, 4-Nov), Forschungsgruppe Wahlen (22-Sept, 13-Oct, 27-Oct, 10-Nov), GMS (14-Sept, 12-Oct, 12-Nov), Infratest dimap (21-Sept, 5-Oct, 19-Oct, 2-Nov), INSA (5-Sept, 12-Sept, 19-Sept, 26- Sept, 3-Oct, 10-Oct, 17-Oct, 24-Oct, 2-Nov, 7-Nov, 14-Nov, 22-Nov), Ipsos (10-Oct) Source: Ifop (12-14 Apr, 14-17 Jun), BVA (15-17 Apr, 13-16 Mar, 10-12 Jun, 9-11 Sept), Odoxa (25 Nov), Harris Interactive (27 Nov). Note: all 2016. Were this to be the case then we think there may well be room for a significant relief rally in European assets. Until then we think it likely investors will demand a higher risk premium. Brexit was the big political topic for Europe going into 2016. Going forward we see it as an ongoing issue but mostly for the UK. The political uncertainty is likely to be extended, even after Article 50 is triggered as any significant negotiations probably need to await the outcome of the French and German elections. We expect the UK economy to struggle as the lagged effect of the fall in the currency hurts consumers and while there may be contrarian trades available in the GBP during 2017, our strategists think it goes lower first on the triggering of Article 50. 12 Global Cross Asset Strategy – Year Ahead | 30 November 2016 X Asset Trade Ideas Rates – short 5Y US nominal and 10Y real rates, short 5Y UK real rates As discussed above on the rates side we keep our 2-5-10’s butterfly but add a 10Y short real rates trade, to reflect the view of our fixed strategists that if yields are to go higher then real rates will need to move. So we will not repeat the analysis here. Chart 21: Markets do not expect the BOE to react… 4 3 2 1 0 -1 -2 -3 5y UK nominal 5y UK real 5y UK inflation -4 Chart 22: …to a sustained overshoot of its inflation target 3.7 UK 5y5y inflation swap fwd 3.6 3.5 3.4 3.3 3.2 3.1 3 2.9 2.8 Oct-15 Nov-15 Dec-15 Jan-16 Feb-16 Mar-16 Apr-16 May-16 Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 Nov-16 Oct-15 Nov-15 Dec-15 Jan-16 Feb-16 Mar-16 Apr-16 May-16 Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 Nov-16 Source: Bloomberg Source: Bloomberg The other fixed income trade we continue to like is short 5Y UK real rates. The market continues to discount the Bank of England consistently overshooting its inflation target without a response on monetary policy. Yet Governor Carney and other members of the BOE’s MPC have said that while they are willing to look through a short term inflation shock they would not tolerate a sustained overshoot. The market therefore is pricing something which suggests that the BOE will sacrifice its credibility on the inflation side to (presumably) support growth. We would rather take the side of the Bank in this situation. It is worth bearing in mind too that those on the right of the Conservative party who have been critical of Governor Carney and the BOE have tended to want higher not lower short rates. When the PM and Chancellor have to replace the Governor at the end of 2018 it is unlikely that they are going to choose someone more dovish. FX – long USD, short GBP, AUD, CNH We have been long USD since August believing the risk reward to be skewed in favour of a stronger currency because we saw more room for the Fed to tighten than other central banks. Given the fiscal stimulus expected from the new administration the risks on that tightening profile have been skewed to the upside. We think the FX and Fixed Income strategists are right to think of the dot plot as a floor now for markets. With yields still needing to move higher to get there that should put further upward pressure on the USD. The scope for gains though depends on the currency. The Euro is already just 3.5% from the target for next year whereas both the GBP and the JPY have about 7- 8% to fall to our FX team’s targets. The team also continue to like short AUD positions as they think this also captures risk off in the event of concerns over China. Whilst the short GBP has only worked modestly since the US election, we continue to think Brexit uncertainties will weigh on the currency into 2017 and our FX strategists target 1.15 in the aftermath of the article 50 decision. Global Cross Asset Strategy – Year Ahead | 30 November 2016 13 Chart 23: AUD fell post US elections… Chart 24: …GBP has held up so far but article 50 looms in Q1 0.8 1.55 0.78 0.76 0.74 AUD/USD 1.5 1.45 1.4 1.35 0.72 1.3 0.7 0.68 Oct-15 Nov-15 Dec-15 Jan-16 Feb-16 Mar-16 Apr-16 May-16 Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 Nov-16 1.25 1.2 1.15 Oct-15 Nov-15 Dec-15 Jan-16 GBP/USD Feb-16 Mar-16 Apr-16 May-… Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 Nov-16 Source: Bloomberg Source: Bloomberg Today we add a CNH put (expressed as a USD/CNH call at 7.6 strike) partly because it fits with our positive USD call but also because it is a potential hedge against the trade rhetoric of the new administration descending into something more meaningful. Given the stated intent to declare the Chinese as currency manipulators and the concern that our currency strategists already have about the amount of reserves the Chinese hold, it is not impossible to imagine a much weaker CNY/CNH should the Chinese authorities allow a free float. We see this as a sensible hedge against our long EM equity position. Chart 25: CNH continues to weaken, risk of more on trade tensions? Chart 26: RUB/ZAR choppy on oil and SA politics 6.9 6.8 CNH/USD 0.25 0.24 6.7 6.6 6.5 6.4 0.23 0.22 0.21 6.3 6.2 0.2 0.19 RUB/ZAR Oct-15 Nov-15 Dec-15 Jan-16 Feb-16 Mar-16 Apr-16 May-16 Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 Oct-15 Nov-15 Dec-15 Jan-16 Feb-16 Mar-16 Apr-16 May-16 Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 Nov-16 Source: Bloomberg Source: Bloomberg We have two other standalone currency trades, short EUR/SEK and long RUB/ZAR. The former has dropped as the EUR has weakened against the USD. We continue to think that the Swedish economy is more robust than the Eurozone and that the Riksbank will sooner or later have to adjust monetary policy accordingly. We see a lot more room for this pair to move in 2017, particularly if there are political concerns ahead of the French presidential elections as these will likely weigh on the EUR. RUB/ZAR has been quite erratic since we re-established the trade, reflecting both volatility in the oil price and developments in South African politics. The latest no confidence vote against President Zuma underlines how tricky South African politics are at the moment. Concerns will remain on the economic progress of the country until the political situation becomes clearer. In the meantime we expect a higher risk premium to be associated with the currency. 14 Global Cross Asset Strategy – Year Ahead | 30 November 2016 Equities: Add long Nikkei to EM Asia Global equity markets have gone in very different directions post the US election. EM have fared worst, Europe little changed, S&P at new all-time highs, the Russell and Nikkei on a tear higher. This is not how we were positioned so we need to ask the question of whether and what we need to change. Table 2: MSCI EM Asia at a 2PE point discount to other equity markets MSCI EM Asia 12m fwd PE MSCI Japan 12m fwd PE MSCI Europe 12m fwd PE MSCI US 12m fwd PE Latest 11.9 14.1 14.3 17.0 Min 7.6 9.7 7.4 10.4 Max 18.5 44.5 23.9 25.2 Av 11.5 18.2 14.0 15.9 SD 1.8 6.8 3.4 3.2 Z-score 0.2 -0.6 0.1 0.3 %ile 68% 31% 60% 73% Source: BofA Merrill Lynch Global Research, MSCI, IBES Chart 27: Japan relatively cheap at 14.1x fwd earnings 50 45 40 35 30 25 20 15 10 5 0 MSCI Japan 12m fwd PE 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 If we stand back from the noise and just look at the valuations, the US is the most expensive, MSCI Asia ex the cheapest in absolute terms. Our strategists see decent earnings growth likely to come through in EM Asia, and while there is upside to US earnings estimates from potential corporate tax cuts at least part of it is priced in. Savita Subrahamian has a target for the US of 2300 in her year ahead Euphoria or fiscal fizzle?, an upside of a less than 5%. Our European strategists have an upside of around 6%. So that leaves EM Asia and Japan (given our 20k target) as the stand outs according to our equity strategists. Indeed, the PE of Japan is towards the bottom end of the range since 2000. Sticking with EM Asia One of our concerns on EM was a more hawkish Fed and therefore a stronger USD. So we regarded our positions in those asset classes as something of a hedge to our EM positions. As we explained above we are keeping that stance as on our central scenario there is more to go and on a risk scenario where bond markets overshoot the USD is likely to follow. In the equity world, if our fixed income and FX forecasts are right, then we do not see them as being an impediment to our EM Asia position working again. Our EM strategists remain upbeat and Ajay Kapur actually upgraded his call to buy from a tactical pause post the election (A Call to Action: Time to BUY Asia/EMs). They think the right focus is one on growth rather than the USD and we continue to be upbeat on the prospects for EM growth, particularly in Asia. Ajay in particular makes the point that Chinese nominal GDP growth has been accelerating and that tends to be very good for Asian equity markets. Nigel Tupper’s global wave has continued to improve and he argues that remains consistent with strong performance from Asia ex Japan equities. Source: BofA Merrill Lynch Global Research, MSCI, IBES Global Cross Asset Strategy – Year Ahead | 30 November 2016 15 Chart 28: The world economy is improving – broad-based recovery – good for Asia/EMs Chart 29: EM cyclicals outperform as China’s NOMINAL GDP recovers. More to go. 100 Based on 29 1200 180 MSCI EM cyclicals/EM defensives price index, LS China Bloomberg Monthly GDP Estimate YoY +… 24 80 1100 160 Cyclicals = energy, materials, consumer 19 60 1000 140 14 900 120 9 40 Percentage of Countries with… MSCI EM, RS 20 1/11 1/12 1/13 1/14 1/15 1/16 800 700 100 80 1/05 1/06 1/07 1/08 1/09 1/10 1/11 1/12 1/13 1/14 1/15 1/16 1/17 4 -1 Source: BofA Merrill Lynch Global Research, Haver, Bloomberg Source: BofA Merrill Lynch Global Research, Bloomberg. Assumed GDP estimate for October-16 to be similar to that for September-16. The question then is whether the strong USD or trade tensions from the new Trump administration can outweigh the more positive macro backdrop. We are inclined to back the view of our strategists and think that it will, so we are sticking with our long EM Asia position. We are doing so with hedges via a long USD and a CNH put. Long Nikkei: target 20,000 We had previously paired our long EM position with a long US oil equity position, but with our US strategists downgrading the sector ahead of OPEC we removed it earlier this week. We were therefore looking for another pro-growth trade to run alongside our EM position. Long Japanese equities seemed the logical place to look. While we acknowledge we have missed the lows and that today’s entry point may not be ideal, we suspect investors are not particularly long Japan yet since it was still showing as modestly underweight in the last Fund Manager Survey. Chart 30: Net % AA say they are overweight Japanese equities 60 Asset Allocation: JP Equities 140 40 130 120 20 110 0 100 -20 90 -40 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 80 FMS Net% say OW JP Equities, lhs JP Performance vs World, rhs Source: Thomson Reuters Datastream Source: BofA Merrill Lynch Global Fund Manager Survey Our Japanese equity and FX strategist Shusuke Yamada has been arguing for a while that we would see both a weaker JPY and a rebound in Japanese equities. While arguably the JPY had turned beforehand, the Trump victory turbo charged the move. As the chart shows below Japanese equities do well historically during a period of bear steepening of the US yield curve. Our economists are also more upbeat on Japan thinking the weaker USD, the new policy stance of the BOJ and the fiscal stimulus will push growth and inflation higher next year. 16 Global Cross Asset Strategy – Year Ahead | 30 November 2016 The combination of these factors suggest Japanese equities have further to run. We also see the position as being complementary to our EM position since whereas a stronger USD is a drag on EM performance, it is beneficial for the NKY position. Chart 31: Japan equities have outperformed during US bear-steepening led by cyclicals, banks and insurance 12 10 8 6 4 2 0 -2 -4 -6 -8 -10 -12 Japan Sector = cyclical outperform on UST bear-steepening USDJPY DXY MSCI JP MSCI JP / ex JP Discretionary Financials Materials IT Industrials Energy Telecom Staples Utilities Health care Bear steep Bear flat Bull steep Bull flat Source: BofA Merrill Lynch Global Research, Bloomberg. Curve movements based on 2yr move and 2s10s move (Bloomberg US Treasury yield index), so includes twist movements, but even if we exclude these implications do not materially change. Bear steepening (2yr + 16bps, 2s10s +33bps) = 11 quarters, bear flattening (2yr +26bps, 2s10s -20bps) = 10 quarters, bull steepening (2yr -48bps, 2s10s +28bps) = 10 quarters, bull flattening (2yr - 27bps, 2s10s -30bps) = 12 quarters Long Europe equities via yield stocks & index dividends We continue to run two yield related trades in European equities. First, we remain long a broad selection of high yielding European equities. The dividend yield on offer in European equities is one of the asset class’s key attractions. Europe offers a higher dividend yield than the other regions, with a 1.1% yield pick-up versus the DM average and 0.9% against EM equities. Those also look attractive relative to history: Europe’s yield spread to DM ranks at the 87 th percentile of the 20-year range. Europe’s DY also looks attractive relative to sovereign and corporate bonds despite the recent sell off in fixed income markets: the yield pick-up relative to investment grade corporates is still 289bp. Given the concerns over European politics we prefer yield based strategies in Europe to those looking for capital appreciation at least in the short term. Chart 32: Equity DYs remain attractive relative to credit & sov bond yields 5 4 3 2 1 0 -1 -2 Stoxx 600 DY less 10yr Bund yield -3 Stoxx 600 DY less Euro IG credit yield 2004 2006 2008 2010 2012 2014 2016 Source: BofA Merrill Lynch Global Research, Bloomberg, Datastream Chart 33: Europe offers a yield premium vs global equities too 2.0 1.5 1.0 0.5 0.0 -0.5 MSCI Europe less -1.0 EM DY spread -1.5 MSCI Europe less DM DY spread -2.0 12/80 12/84 12/88 12/92 12/96 12/00 12/04 12/08 12/12 Source: BofA Merrill Lynch Global Research, MSCI, Datastream European Yield Screen The rising rates backdrop has left yield not quite as scarce as it has been, but we continue to think investors should own yield where they can get it at decent value, such as in European equities. Last month we recommended investors rotate out of lower risk Global Cross Asset Strategy – Year Ahead | 30 November 2016 17 defensive dividend stocks to take advantage of the improving cyclical backdrop and rising bond yields. That meant our November screen included a high proportion of Financials. This somewhat remains the case but we note the addition of several industrial companies in our latest screen. As a reminder, to qualify the stock must be SXXP listed stocks with at least €2bn market cap, 4% DY, 1.2x DPS cover, 0% DPS 2YR CAGR and qualifying stocks must be on a Buy rating from our fundamental analysts. The yield on the basket is 5% with an average DPS CAGR of 7% and 1.8x covered. Table 3: European Yield Screen – December 2016 Sedol BofAML ticker Company name Sector Divi Yield (>4%) DPS 2Y CAGR Div'd Cover 426330 DNBHF DNB ASA Banks 4.2 23.9 2.0 B545MG XERSF SWISS RE AG Insurance 5.4 5.2 2.1 457481 MDIBF MEDIOBANCA SPA Banks 4.9 8.0 2.4 B1LB9P SZCRF SCOR SE Insurance 5.3 4.3 1.9 BZ5739 ING ING GROEP N.V. Banks 5.3 4.6 1.7 538003 NRDEF NORDEA BANK AB Banks 6.6 2.1 1.3 BDVZYZ ROYMF ROYAL MAIL PLC Industrial Goods & Services 5.0 4.2 1.8 458882 DNSKF DANSKE BANK A/S Banks 4.4 5.5 2.0 596651 SCGLF SOCIETE GENERALE Banks 5.6 0.6 2.0 021623 AIVAF AVIVA Insurance 5.1 9.9 1.8 B23K0M CTAGF CAPITA PLC Industrial Goods & Services 5.7 2.5 2.1 522603 SAXPF SAMPO PLC Insurance 5.4 4.6 1.2 481334 SVKEF SKAND ENSKILDA BKN Banks 5.8 3.7 1.4 B17BBQ IVTJF INVESTEC Financial Services 4.4 10.0 1.9 528983 EBKOF ERSTE GROUP BK AG Banks 3.6 12.5 3.1 766716 ATASF ATLANTIA SPA Industrial Goods & Services 4.9 11.2 1.3 B83VD9 MNGPF MAN GROUP PLC Financial Services 5.8 15.1 1.2 B5ZQ9D EVKIF EVONIK INDUSTRIES Chemicals 4.4 2.9 1.7 B01FLG GFSZF G4S Industrial Goods & Services 3.9 5.6 1.6 BGLP8L IMIAF IMI Industrial Goods & Services 4.0 4.0 1.5 Source: BofA Merrill Lynch Global Research, Factset. The European Quality Yield Screen identified as a screen above is intended to be an indicative metric only and may not be used for reference purposes or as a measure of performance for any financial instrument or contract, or otherwise relied upon by third parties for any other purpose, without the prior written consent of BofA Merrill Lynch Global Research. This screen was not created to act as a benchmark. Long SX5E 2018 Index dividend futures With our second dividend related trade, we remain long SX5E 2018 index dividend futures (DEDZ8), a trade where we continue to see value even with the future price trading close to the high for the year. The 2018 contract implies a 4% decline in dividends paid from the 2016 level. In the absence of a recession, we think that is too pessimistic – 2013 was the last year to see a material 2-year decline in dividends (in the wake of the sovereign crisis and recession). The 2018 contract also still trades at a discount to the level implied by our stock analysts’ DPS forecasts. Our derivative strategists using BofAML forecasts for 2018 estimate 8% upside from current prices. Although the upside is now more limited the risk around this trade is also much lower now. The pull to par effect will become the dominant driver over the coming months and the full year results should provide clarity on where the 2018 contract will settle. 18 Global Cross Asset Strategy – Year Ahead | 30 November 2016 Chart 34: SX5E dividends: 2-yr implied growth in 2018 still looks cautious 10% 5% 0% -5% -10% 2 year growth implied / realised % -15% 2011 2012 2013 2014 2015 2016 2017 2018 2019 Source: BofA Merrill Lynch Global Research, Bloomberg Chart 35: BofAML’s SX5E Dec18 div forecast implies 8% upside ESTX50 Div (index points) 150 140 130 120 110 100 90 80 70 89.0 89.3 83.4 71.4 83.3 99.0 ESTX50 realised dividends Dividend futures Consensus BofAML 121.9 146.5 158.6 Source: BofA Merrill Lynch Global Research, Bloomberg 123.1 117.1 115.2 112.8 124.3 115.6 109.8 114.1 114.9 118.5 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 124.8 117.3div pts paid in 2016 YTD European equities: switch to outright long Healthcare We switch our European sector pair trade preferring Healthcare over Food & Beverage into an outright long in Healthcare. Both sectors have suffered versus the market from the rotation out of defensives and bond proxies. That has reduced the valuation of the Food & Beverage sector to less extreme levels. Meanwhile Healthcare looks very attractively valued and we see compelling risk reward in the sector on an outright basis at current levels. The fundamental bull case for Health rests on the strong pipeline of new products for the big cap pharma universe. Our sector analysts forecast EU Pharma to deliver a 2018- 21E EPS CAGR of 11%, up from mid-single digit levels in recent years. Historically that would justify a PE re-rating and a multiple for the pharma sub-sector nearer 17-18x than the current 13x 2018 PE. Chart 36: Extreme overvaluation in Food & Bev has moderated 1.80 1.70 1.60 1.50 1.40 1.30 1.20 1.10 1.00 0.90 Food & Bev 12m fwd PE relative 0.80 2001 2003 2005 2007 2009 2011 2013 2015 Source: BofA Merrill Lynch Global Research, Datastream, IBES, Bloomberg Chart 37: Healthcare PE – back near market multiple and patent cliff lows 1.70 1.60 1.50 1.40 1.30 1.20 1.10 1.00 0.90 HealthCare 12m fwd PE relative 0.80 1999 2001 2003 2005 2007 2009 2011 2013 2015 Source: BofA Merrill Lynch Global Research, Datastream, IBES, Bloomberg We believe the Republican clean sweep in the US elections represents a positive catalyst as it significantly decreases the potential for legislative initiatives to aggressively control drug pricing in the US. The catalyst for the sector to re-rate will come progressively from newsflow around new products. The next 12 months should see progress on this front with several of the European large caps expected to announce key data on important drugs in 2017. Global Cross Asset Strategy – Year Ahead | 30 November 2016 19 Healthcare’s forward PE is now down to just a 7% premium relative to the market and nearing the valuation lows recorded in 2010-12 when the patent cliff was at its worst and pipelines were very weak. Today pipelines are twice the size they were in 2011 and innovation is the key to growth in the sector - pricing power remains strong in drug categories with differentiated products. Credit: Long Spreads in Europe and US Europe: Long Xover short Main Rate cuts are off the table it seems, as central banks are starting to recognise the side effects of NIRP. This reinforces our view that a continuation of CSPP, entails that the reach for yield will extend to those assets that have not seen it yet; long Crossover vs iTraxx Main. The beta outperformance has already started in the cash market. We look at synthetics and we see that Crossover has not mirrored that performance. Even though XO has outperformed recently, it still has further to go to close the gap vs cash market’s performance. Ioannis Angelakis thinks that rising political risks in the following twelve months are more likely to weigh on iTraxx Main performance than Crossover, as Main has higher concentration vs XO on names domiciled in countries with elections. Buy 30y US IG Industrial spreads US high-grade is the market our colleagues in Credit Strategy are most bullish into 2017. Hans Mikkelsen thinks IG corporate spread maturity curves super-flatten as global credit investors do the twist - i.e. sell shorter maturities and buy the long end. Foreign inflows are now concentrated in the back-end, as credit spreads have rallied while the cost of currency hedging increased. That means that only the back end of the steep US corporate spread curve offers enough spread to overcome the high cost of currency hedging. The flip side is that the front end of the US credit spread curve is very unattractive and we expect domestic and foreign investors to accelerate their selling of shorter maturity US corporate bonds. Overall, Hans expects the 30yr corporate bond part of the market to generate 8%-9% total returns next year. Chart 38: High grade spread forecast 250 HG Spread (bps) Forecast 200 150 135 120 115 100 Chart 39: High grade returns forecast Excess Return (%) Total Return (%) 6.0 5.2 4.0 3.8 3.5 2.0 0.0 -2.0 -1.6 -0.6 4.0 Source: BofA Merrill Lynch Global Research Source: BofA Merrill Lynch Global Research Long AT1s basket Contingent capital continues to offer a compelling premium to European HY and lower volatility than bank equity. The asset class also received a boost last week when the European Commission submitted a proposal for AT1 coupons to be prioritized over common dividends and bonuses if the bank breaches its combined buffer. This placates one of the main concerns investors have, i.e. that banks could decide to skip a coupon payment but maintain their dividend. The confirmation of the role of AT1s in Pillar 2 capital is another example of regulators providing clarity on how contingent capital fits within the overall capital structure. The main short term risk for the trade is the fate of the Italian banks recap, so we will be watching closely to see how that develops. 20 Global Cross Asset Strategy – Year Ahead | 30 November 2016 Chart 40: European AT1s offer a compelling yield for total return investors 8 Stoxx Banks 12m fwd DY (%) Coco Index yield (%) 7 6 5 4 3 Source: BofA Merrill Lynch Global Research, Bloomberg, Datastream, IBES Volatility: Sticking with Relative trades While 2016 started off with a bang volatility wise it has ended with a whimper. Neither Brexit nor the US presidential election proved to be anything more than a blip. Realised vol in the S&P 500 over the last 100 days is just 9.5%. That compares to 13.6% for the Eurostoxx 15.1% for the Russell and 21.8% for the NKY. Chart 41: Neither the Trump election… 45 40 35 30 25 20 VIX Index Chart 42: …nor Brexit led to a sustained period of higher volatility 45 40 35 30 25 20 15 10 15 10 V2X Index Source: Bloomberg Source: Bloomberg That is why we prefer relative variance trades. They tend to carry flat to positive but have convexity to the downside. We are happy to continue to run these trades into 2017 and then use shorter term instruments to hedge specific events. We did this around Brexit and have recently bought a 3000-2850 Eurostoxx put spread to hedge our European exposure around the Italian referendum. While a No vote is expected we are not sure what the aftermath will look like and there is considerable uncertainty over the bank recapitalization of the banks afterwards. We also have a calendar put spread in eurostoxx which tends to pay off best around the 2500-2600 levels so that remains something that we will look to keep for now given downside risks in Europe over the first half of next year. One trade we are taking off today is our Kospi forward vol position. We had held that as a hedge against a China hard landing. Our derivative strategists no longer like it and we have no opted for a currency hedge for our China risk, as discussed above. Global Cross Asset Strategy – Year Ahead | 30 November 2016 21 Risks to trades Equity trades • The risks to long divi basket & Pharma trades are a steepening of rates curves and better than expected growth outside of Europe causing investors to rotate out of bond proxies. Plus our analysts’ expectations of improved earnings from the healthcare pipeline not coming through. • The risks to trade dividend future trade is lower than expected profits for major European sectors, e.g. Banks, Oils, causing a correction in dividend expectations. • The risk to EM Asia ex-Japan is from a stronger USD and faster than expected US rates hiking cycle. Trade tensions with the new US administration an additional risk now. • Risk to long Nikkei trade is a reversal of JPY weakness or a change in policy by the BOJ. Fixed income trades • The risks to the US rates trades are a dovish Fed responding to a tightening of monetary conditions before the fiscal boost kicks in. Disappointment on the fiscal stimulus also a risk. The risk to the UK inflation trade is that the BoE doesn’t respond to expected rising inflation by raising rates faster. • The risks to the Industrial spreads trade is a deterioration of US industrial growth and step away from credit purchasing by ECB/ BoE. • The risks the AT1 trade are the ECB pulling out of the credit markets causing a correction in the riskier portion of the market and bank profitability deteriorating raising concerns about default. • The risks to our XOVER trade are Eurozone growth disappointing and a risk-off event in markets causing a flight to quality amongst credit investors. Volatility trades • Our equity vol trades are hedges, the risks are that they expire worthless due to the lack of a financial event in China and persistent low vol spread in equity markets supported by higher growth. FX trades • The main risk to our FX trades is of a more dovish than expected Fed, a more hawkish than expected BOE, improved politics in South Africa/weaker oil price and a more dovish Riksbank. 22 Global Cross Asset Strategy – Year Ahead | 30 November 2016 Appendix 1: Methodology This publication is aimed at multi-asset institutional investors who tend to have a longer term time horizon for their investments. As such, we will be looking to come up with ideas that will have a minimum six month horizon and ideally longer than a year. The individual trade ideas will be sourced from our strategists across BofA Merrill Lynch Global Research. This publication is not meant to be an agglomeration of all the trade ideas published by BofAML Global Research strategists, but instead represents those that fit with our longer term themes (as opposed to shorter term tactical trades). In addition, there may be several different trade ideas published by BofAML Global Research strategists across different asset classes that seek to leverage off of the same theme. In most cases we will seek merely to take the trades that have the best risk adjusted return. By risk adjusted we mean the risk undertaken in a trade vs the likely return on that trade. In considering that we will look at the underlying volatility in the individual asset class. This will be combined with our own view of what the likely downside is in an adverse scenario vs the payoff in the expected scenario and our own assessment of the likelihoods of such scenarios. Once selected it is assumed that the trade would likely be retained for a minimum of six months (as per the selection rationale). Should any analyst change their view on the trade and cease to recommend it, then it will be immediately removed from our list 1 . Equally should our target be met for a trade and the relevant strategist feels it has run its course then it will also be removed (see footnote). Otherwise we will review our trades on a monthly basis in this publication. If we feel a new trade idea has a better risk adjusted return than an existing one in the same asset class then we would replace it. The objective of the trades is that they would be suitable for a typical objective of the multi-asset fund managers, which is typically framed in terms of a Libor+ benchmark (this can be anything from Libor +300bp to Libor +700bp). That return is also coupled with a target volatility, for example half MSCI ACWI volatility. The volatility target will, of course, be a function of the expected return, but there is a general focus on producing lower volatility returns. Our set of trades should not be regarded as a portfolio but a collection of ideas to implement in a multi-asset portfolio. Appendix 2 – Recommended COCO bonds Table 4: COCO basket ISIN Bond Issuing entity Price Mid YtM XS1055037177 ACAFP 6.5% EUR Perp-21 CREDIT AGRICOLE SA 100.5 5.4 XS1002801758 BACR 8% EUR Perp-20 BARCLAYS PLC 100.9 7.1 XS1033661866 BBVASM 7% EUR Perp-19 BANCO BILBAO VIZCAYA ARG 91.1 7.1 XS1073143932 NYKRE 4% EUR 2036-21 NYKREDIT REALKREDIT AS 102.4 2.7 XS0972523947 CS 5.75% EUR 2025-20 CREDIT SUISSE 107.6 3.6 DE000DB7XHP3 DB 6% EUR Perp-22 DEUTSCHE BANK AG 78.3 6.7 XS1043545059 LLOYDS 6.375% EUR Perp-20 LLOYDS BANKING GROUP PLC 97.5 5.7 XS1171914515 RABOBK 5.5% EUR Perp-20 COOPERATIEVE RABOBANK UA 98.5 5.5 XS0867620725 SOCGEN 6.75% EUR Perp-21 SOCIETE GENERALE 98.8 5.9 XS1107890847 UCGIM 6.75% EUR Perp-21 UNICREDIT SPA 84.5 7.7 Source: BofA Merrill Lynch Global Research *As of 28/11/2016 close 1 Under these circumstances, we will publish a note immediately. Global Cross Asset Strategy – Year Ahead | 30 November 2016 23 Appendix 3 – Indicative pricing/ levels Table 5: Latest indicative pricing/ levels for cross asset trades Asset Trade idea Indicative price / level Long European Quality Yield Screen (yield) 5% Long SXDP Index 681.6 Equities Long Nikkei 18307 Long European index dividend futures 113.4 Long MSCI Asia ex-Japan 525.7 Long RTY short SPX 2y variance swap 3.7** 3000-2850 SX5E put spread Dec 16 expiry 1.20% Equity vol Long NKY short SPX Dec 18 variance swap 6vols Long SX5E short SPX Dec 18 variance spread 6vols Eurostoxx 2y/3y put calendar 1.99 Short EUR/SEK 9.762 Long USD/CNH call 0.56%USD FX Short GBP/USD 1.250 Long USD/AUD 1.342 Long RUB/ZAR 0.213 2s-5s-10s fly (bp) 11 Fixed Income Short US 10y real rates (bp) 50 Paying 5y GBP real rate swap (bp) -254 Buy 30y US IG Industrial spreads (bp) 187 Credit Buy basket of Euro AT1s 5.80% Long Xover short Main (ratio) 4.22x Source: BofA Merrill Lynch Global Research, Bloomberg. Note: *all levels and prices as of 29/11/2016 at ~3pm or most recent local market close. **This is a theoretical level which may differ from actual tradable prices. ***This level is obtained by bootstrapping At-the-money forward volatility levels, does not represent a tradable instrument. The tradable strike of an FVA will likely differ considerably. Appendix 4 – Closed trades Table 6: Closed trades Asset Trade idea Strategist Open date Closed date Long Nikkei Kenji Abe 22/01/2016 01/04/2016 Long MSCI EM 1x 1x call ratio Ajay Kapur 01/03/2016 18/04/2016 Equities Long MSCI EM 1x 1x call ratio Long US Energy Ajay Kapur Savita Subramanian 01/03/2016 07/09/0216 18/04/2016 28/11/2016 Long MSCI EM Ajay Kapur 19/04/2016 30/09/2016 Long SXDP Index vs Short SX3P Index Ronan Carr 22/01/2016 28/11/2016 Long June V2X call spread collar Abhinandan Deb 01/04/2016 18/04/2016 Long Kospi fwd vol 6M/18M William Chan 22/01/2016 28/11/2016 Equity vol Short June V2X put Abhinandan Deb 01/04/2016 Expired Long (30-35) V2X Jul call spreads Abhinandan Deb 18/06/2016 Expired Long 2050-1950 S&P 500 Jul put spread Abhinandan Deb 18/06/2016 Expired Long NOK/USD Kamal Sharma 01/03/2016 04/05/2016 Long RUB/ZAR David Hauner 22/01/2016 17/05/2016 FX Short EUR/SEK Long JPY/KRW Kamal Sharma Adarsh Sinha 22/01/2016 22/01/2016 08/07/2016 31/03/2016 Long USD/CAD Ian Gordon 28/07/2016 07/07/2016 Short EUR/JPY Athanasios Vamvakidis 21/01/2016 30/09/2016 Short EUR/USD Athanasios Vamvakidis 08/07/2016 04/11/2016 Short EUR 5Y5Y inflation breakevens Ralf Preusser 22/01/2016 23/01/2016 Buy 30y real rates (bp) Ralf Preusser 22/01/2016 24/05/2016 Receive EUR pay US 5y5y fwd (bp) Ralf Preusser 22/01/2016 27/05/2016 Fixed Sell 6m 2s-5s-10s OTM receiver fly Shyam R. Rajan 07/09/2016 08/09/2016 Income US +15y IG credit (total return) Hans Mikkelsen 22/01/2016 04/05/2016 US +15y IG credit (Govt OAS) Hans Mikkelsen 04/05/2016 28/07/2016 Paying 2y3y GBP real rate swap Mark Capleton 02/09/2016 12/10/2016 3y 2s-10s US flattener Shyam R. Rajan 27/05/2016 10/10/2016 Source: BofA Merrill Lynch Global Research. Trades closed in this report (or recently) in bold. 24 Global Cross Asset Strategy – Year Ahead | 30 November 2016 Options Risk Statement Potential Risk at Expiry & Options Limited Duration Risk Unlike owning or shorting a stock, employing any listed options strategy is by definition governed by a finite duration. The most severe risks associated with general options trading are total loss of capital invested and delivery/assignment risk... all of which can occur in a short period. Investor suitability The use of standardized options and other related derivatives instruments are considered unsuitable for many investors. Investors considering such strategies are encouraged to become familiar with the "Characteristics and Risks of Standardized Options" (an OCC authored white paper on options risks). U.S. investors should consult with a FINRA Registered Options Principal. For detailed information regarding the risks involved with investing in listed options: http://www.theocc.com/about/publications/character-risks.jsp Analyst Certification We, James Barty, Abhinandan Deb, Barnaby Martin, Benjamin Bowler, Claudio Piron, David Hauner, CFA, Hans Mikkelsen, Ian Gordon, Ioannis Angelakis, Kamal Sharma, Mark Capleton, Ritesh Samadhiya, CFA, Shusuke Yamada, CFA and Shyam S.Rajan, hereby certify that the views each of us has expressed in this research report accurately reflect each of our respective personal views about the subject securities and issuers. 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Global Cross Asset Strategy – Year Ahead | 30 November 2016 27 Research Analysts James Barty >> Investment Strategist MLI (UK) +44 20 7996 3291 [email protected] Ronan Carr, CFA >> European Equity Strategist MLI (UK) +44 20 7996 3292 [email protected] Tommy Ricketts >> European Equity Strategist MLI (UK) +44 20 7996 3294 [email protected] Barnaby Martin Credit Strategist MLI (UK) +44 20 7995 0458 [email protected] Ioannis Angelakis Credit Derivatives Strategist MLI (UK) +44 20 7996 0059 [email protected] Hans Mikkelsen Credit Strategist MLPF&S +1 646 855 6468 [email protected] Abhinandan Deb >> Equity-Linked Analyst MLI (UK) +44 20 7995 7148 [email protected] Nitin Saksena Equity-Linked Analyst MLPF&S +1 646 855 5480 [email protected] Benjamin Bowler Equity-Linked Analyst MLPF&S +1 415 676 3595 [email protected] Ian Gordon FX Strategist MLPF&S +1 646 855 8749 [email protected] Kamal Sharma FX Strategist MLI (UK) +44 20 7996 4855 [email protected] Claudio Piron Emerging Asia FI/FX Strategist Merrill Lynch (Singapore) +65 6591 0401 [email protected] David Hauner, CFA EEMEA Cross Asset Strategist MLI (UK) +44 20 7996 1241 [email protected] Shyam S.Rajan Rates Strategist MLPF&S +1 646 855 9808 [email protected] Mark Capleton Rates Strategist MLI (UK) +44 20 7995 6118 [email protected] Ajay Singh Kapur, CFA >> Equity Strategist Merrill Lynch (Hong Kong) +852 3508 7753 [email protected] Shusuke Yamada, CFA >> FX/Equity Strategist Merrill Lynch (Japan) +81 3 6225 8515 [email protected] >> Employed by a non-US affiliate of MLPF&S and is not registered/qualified as a research analyst under the FINRA rules. 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