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BofA Merrill Lynch Global Research Calls for U.S.-Led Red, White and Bull Market in Year Ahead

Higher U.S. Dollar, Interest Rates and Rate Volatility Create Upside Risk

BofA Merrill Lynch Global Research today released its outlook for the markets in 2014, calling for strong U.S.-led economic growth, higher yields and solid U.S. stock gains that are lower than in 2013 but higher than consensus. Meanwhile, a rising U.S. dollar and rising rates, as well as rising rate volatility, will have consequences for markets around the world as credit cycles diverge.

At the annual BofA Merrill Lynch Year Ahead outlook news conference held today in New York, analysts summarized the macro story of the year as inherent upside risk in a vigorous bull market for the U.S. dollar and a low, but rising interest rate environment.

“In 2013, we saw the 30-year bull market in bonds wind down and stocks soar, with a stronger recovery since 2009 than in the last five market cycles,” said Candace Browning, head of BofA Merrill Lynch Global Research. “As we move into 2014, we expect this trend to moderate but continue forward even with Federal Reserve tapering mid-year.”

Bearish on rates and commodities, long on volatility and bullish on real estate and equities, the BofA Merrill Lynch team expects a shift to lower liquidity/higher growth in 2014 and overall positive asset returns. Rejecting the outright bear market case for equities, analysts remain optimistic about stock market gains in the near term as high-quality, U.S. based companies with global exposure unleash value. However, they advise to move to middle ground, shedding the extremes of high yield or high growth stocks as long-term trends in the great global rotation continue to play out.

The BofA Merrill Lynch Global Research team made the following 10 macro calls for the year ahead:

  • The Standard and Poor’s 500 Index is expected to rise to 2000 and the MSCI All-Country World Index to reach 444 by year-end. Gains in the year ahead imply a price return of approximately 11 percent, with modest earnings growth of 7 percent, driven by higher sales and additional buybacks.
  • U.S. and global economic GDP growth is expected to accelerate in 2014, to 2.6 percent and 3.5 percent, respectively. The U.S. economy is expected to expand in the second half of the year at a 3 percent rate, driven by the end of fiscal austerity and pent-up demand for capital goods. Slow growth of 0.8 percent is expected in Europe as credit and fiscal policy remains tight. China’s GDP growth will marginally decline from 7.7 percent in 2013 to 7.6 percent in 2014, but remains highest among the leading emerging market economies, while Japan is in transition, with another year of 2 percent growth.
  • Modest rebound for emerging markets. Following flat lined growth since 2007, the emerging markets should prove resilient in 2014, with modest growth recovery and rising productivity. Emerging market GDP is expected to rise 4.9 percent in 2014 with modest returns of 2.9 percent, 0.7 percent and 0.3 percent for local debt, emerging market foreign exchange and external sovereign debt.
  • U.S. rates to head higher, with 10-year Treasury yields expected to reach 3.75 percent. A rise in the Treasury yields by 85 basis points will have consequences for markets around the world, likely resulting in an increased interest rate differential in favor of the U.S. dollar, especially against the euro, which is expected to decline to 1.25 by year end. In addition, rising rate volatility may surprise. Interest rate volatility is expected going into 2014, with a target of 100 for the Merrill Option Volatility Expectations (MOVE) Index. Market complacency over the timing and impact of Federal Reserve tapering could leave some investors unprepared for rising volatility in rates. Long vol positions in U.S. rates and dollar and long swap spread positions are favored as insurance against higher interest rate volatility.
  • Challenging year for fixed income. Tightening spreads and rising rates could make total returns challenging for fixed income investors. Corporates are favored over government bonds. High-yield bonds are expected to produce positive returns, though about half the gains seen in 2013. U.S. high-yield bonds may offer the best potential, with a total return of 4 percent to 5 percent. Among investment-grade bonds, Europe should lead the way with a return of up to 2 percent, followed by the U.S. at 1.5 percent, while Asia and emerging markets may suffer negative returns.
  • Global inflation rate to remain stable at close to 3 percent. After surging in 2011, inflation has fallen in almost every country, with the exception of those facing foreign exchange fueled price increases, namely Japan, Brazil, India and Turkey. Inflation in emerging markets is expected to increase from 4.7 percent in 2013 to 5.3 percent in 2014.
  • The U.S. housing recovery continues. The ongoing strengthening of the U.S. economy is expected to boost real estate values by another 5 percent in 2014.
  • Oversupply to contain commodities pricing. Global commodities prices will be contained in 2014 by oversupply in key sectors, especially global oil and grain, a strong U.S. dollar and modest global economic growth. The Merrill Lynch Commodity Index (MLCX) is expected to decline by 1.6 percent, less than the steep 5 percent decline in 2013. Gold values are expected to drop to $1,250 an ounce in the first quarter, before rebounding to normal levels later in the year. Other metals not in surplus, including zinc, platinum and industrial metals could outperform.
  • “Three Bs” corroborate evidence of great rotation. Higher bond yields, a higher “buck” and higher bank stocks (a leading barometer of domestic demand) in 2014 will corroborate evidence of a great rotational shift in the markets: outperformance of real estate over commodities, stocks over bonds, developed markets over emerging markets, small cap over large cap, high yield over investment grade and cyclical over defensives. The shift will continue in 2014, with Fed tapering causing little, if any, pause in the process.
  • Institutional reverse rotation. While the attractiveness of equities lures retail investors away from bonds, institutional investors, including insurers, sovereign wealth funds, central banks and even U.S. pension funds, are expected to take part in a “reverse rotation” – selling stocks and buying bonds.