CIO REPORTS
Monthly Outlook
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The Wealth Allocation Framework helps you put your goals and aspirations at the center of decisions about allocating your financial resources. Asset categories within the framework include:
Personal: Individual investors have a desire for safety and personal financial obligations they want to meet regardless of market conditions. To safeguard essential goals, investors can hold lower-risk assets—but they have to accept lower returns in exchange.
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To learn more, read the whitepaper, Investing in a Transforming World: The Wealth Allocation Framework
LIFE PRIORITIES
APRIL 2016
Chief Investment Office
John VeitVice President
John LieberkindVice President
Chris WolfeManaging Director
Where’s the Beef? Finding Value in Fixed IncomeIt is understandable that, in the near-decade that the Federal Reserve (Fed) did not raise interest
rates, savers were penalized and forced to search further out on the credit spectrum for higher
returns. The search paid off: For years, investors were rewarded with almost equity-like returns in High Yield (HY) credit — annualized returns of 12.6%, close to the annualized 14.8% return of the S&P 500 Index, from 2009 to 2015.
As the credit cycle is further along and market dynamics have shifted, however, investors need to think twice about their HY positions. The risk from deteriorating bond
market liquidity, particularly for lower-quality credit, is increasing; the price impact of liquidity
disruptions during periods of stress has become greater; recent episodes of market volatility
demonstrate that many fixed income investments are not behaving as expected and can lead to
increased volatility within portfolios; and default risk is growing in lower-rated portions of the
fixed income market.
Despite this, we believe that fixed income still plays an important role in a balanced portfolio and that relative value exists as investors ask where they can find value and yield in fixed income. On the back of higher-growth expectations, most strategists expected
the yield on the 10-year U.S. Treasury to be higher in 2016; however, at the end of the first
quarter of the year, it was 1.75%, down from 2.27% at the end of 2015. That is low relative to
history, but attractive relative to the yields on other Developed Market government bonds, which
are close to zero (e.g. Germany and Japan), though we recognize that it may be insufficient for
investors with greater income needs to meet their long-term goals.
Recent Publications
Weekly LetterWill Earnings Blossom
With Spring?Rollercoaster RideREITs Enter AdolescenceShopping for Yield and Growth
Monthly LetterForget Jack, Focus on
Charlie-in-the-Box
CIO OutlookThe Forces Shaping Our World
CIO REPORTS • The Monthly Letter 2
In our view, there is relative value in U.S. Investment Grade (IG) and municipal bonds, especially on a taxable equivalent yield basis. We think now is the right time for investors to consider reducing concentration in lower-quality fixed income, diversifying income sources within their portfolios, and getting “back to basics” using fixed income to help manage total portfolio risk.
Value in the fixed income market definedWe define value in a fixed income investment relative to
three factors:
• Inflation: The yield of a fixed income investment adjusted
for inflation.
• Its own history: The current spread relative to history,
except in the municipal market, where we use the Treasury-
to-municipal ratio.
• U.S. Treasuries: Since the U.S. Treasury bond is commonly
seen as a riskless asset that is liquid, we take the difference
in yields of the fixed income asset class relative to those of
U.S. Treasuries.
In our view, the combination of these three factors provides
a framework to help guide investors looking for value in the
fixed income market.
Where does value exist now?Most investors think there is no value in the fixed income
market but, in reality, there are pockets of it in various fixed
income sub-asset classes. It is true that investors looking for
real yield in U.S. Treasury bonds are not finding much. The
yield on the 10-Year Treasury (which we use as a proxy for
the market) is 1.75%1. After subtracting 1.70% for the U.S.
Personal Consumption Expenditure (PCE), the Fed’s preferred
measure of inflation, the real yield on the 10-Year Treasury
is 0.05% — almost zero. IG, however, is a different story. The
IG yield is 3.13%2. After subtracting 1.70% for the PCE, an
investor receives almost 1.50%, much more than what a
U.S. Treasury offers, though with slightly more risk. Investors looking for value in the fixed income market need to look beyond the index and to specific fixed income asset classes.
Taxable vs. Tax-ExemptWhen investors invest in fixed income, they have the option
of doing it in the taxable or tax-exempt portion of the
market. The majority of bonds are taxable, meaning that
investors must pay taxes on any receipts from them, reducing
investment returns. Some examples of taxable bonds are IG or
HY bonds. Smaller, less discussed, is the tax-exempt portion
of the fixed income market. It includes municipal bonds, which
are exempt from federal taxes on interest income. This tax-
exempt status can be valuable to investors who are in higher
tax brackets or are tax-sensitive. For example, the yield on
municipal bonds is 2.08%3 but, when converted to a taxable-
equivalent yield (based on the top marginal tax rate — 43.4%),
the yield an investor receives is 3.61% and, after adjusting for
inflation, the real yield is 1.91%, which looks very attractive
relative to U.S. Treasuries.
Municipals: Decent yield without indecent riskWe maintain a positive view on the municipal market along
with a relatively neutral duration. Strong year-to-date
performance has been driven by lower supply, healthy demand
and a Fed that appears willing to be patient in raising rates.
Our positive municipal view is anchored on:
1. attractive yield in a low-rate world, particularly as taxes continue to increase while rates fall
2. attractive valuation as compared to Treasuries
3. ability to mitigate portfolio volatility and act as a ballast to equity risk
The BofA Merrill Lynch (BofAML) Global Research Municipal
Strategy team sees fundamentals such as supply/demand
dynamics and higher tax revenues remaining favorable for
municipals in 2016, and they should remain supportive as
Treasury rates remain low, in line with our view that rates
in general will remain lower for longer. While municipal yields may appear low on an absolute basis, munis still represent good value versus many taxable bond alternatives. Municipal-to-Treasury yield ratios, commonly used to value municipals, indicate fair value (see Exhibit 1).
(Keep in mind, Treasuries are U.S. government-guaranteed for the timely payment of principal and interest.)
1 Bloomberg. As of April 15, 2016. 2 BofA Merrill Lynch U.S. Corporate Index. As of April 15, 2016. 3 BofA Merrill Lynch U.S. Municipal Master Index. As of April 15, 2016.
CIO REPORTS • The Monthly Letter 3
Exhibit 1: Valuations relative to Treasuries remain attractive
0.02010 2013 2014 201520122011 2003 2016
4.0
5.0
6.0
7.0
0
200
160
120
100
20
3.0
2.0
1.0
Yiel
d (%
)
180
140
40
60
80
Tax-Equivalent Yield of BofAML U.S. Municipal Master IndexBofAML U.S. Treasury Index
Municipal/Treasury AAA Ratio (taxable)-RHS
Source: Bloomberg and Merrill Lynch Chief Investment Office. Data as of April 15, 2016. Please see Appendix for index definitions. Past performance is no guarantee of future results.
Supply/demand outlook favorableOne factor supporting municipals is the supply/demand
balance. In each of the past two years, over $300 billion in
issuance has been eagerly absorbed by the market. In fact,
municipal bond fund net inflows continue to be supportive of
the asset class (see Exhibit 2). Inflows continue to support
the asset class in 2016, and we see demand remaining strong
throughout the year as rates remain low.
Exhibit 2: Flows into municipal bond funds have been positive for most of 2H 2015 –2016 year-to-date
-$8Jan–10 Jan–14 Jan–15Jan–13Jan–11 Jan–12 Jan–16
-$2
$0
$2
$4
$100
$130
$125
$120
$105
-$4
-$6
$ Bi
llion
$110
$115
Weekly Municipal Flows
BofAML U.S. Muni Master Price Return Index Value (RHS)
Source: Bloomberg, Haver Analytics, Investment Company Institute and Merrill Lynch Chief Investment Office. Data as of April 6, 2016. Please see Appendix for index definitions. Past performance is no guarantee of future results.
The BofAML Global Research Municipal Strategy team expects
issuance of municipals to pick up slightly, reaching $440 billion
this year. The low-rate environment continues to encourage
state and local governments to refund or call existing debt
and refinance at lower rates. The low-rate environment also
remains favorable for new borrowing, as issuers have better
balance sheets than they have had in several years.
Municipal finances on the mendThe U.S. macroeconomic outlook continues to improve,
with more jobs, greater consumer spending, and growth at
low but sustainable rates. An improving economy has been
positive for state and local governments, as tax collections
have increased, allowing them to rebuild their balance sheets.
Tax revenue is the main source of payment for municipal
bond interest, and the improvement in government budget
balances improves the credit quality of their bonds. According
to the Rockefeller Institute of Government, major sources of
state and local government revenue continue to grow , but at
a slower rate compared to a year ago (see Exhibit 3). At the
local government level, property tax collections rose 3.4%
during the period.
Exhibit 3: A slow but steady path of fundamental improvement in fiscal revenues
-302000 2008 2012201020062002 2004 2014
-10
0
20
30
-20Year
-ove
r-Ye
ar P
erce
nt C
hang
e
10
Personal Income Tax Sales Tax Revenue Total State Tax
Sources: U.S. Census Bureau, Quarterly Summary of State & Local Government Tax Revenue, Rockefeller Institute of Government, Haver Analytics and Merrill Lynch Chief Investment Office. Data as of 3Q 2015. Data for the most recent quarter reflect adjustments by the Rockefeller Institute to include information released after initial publication.
Challenges facing municipalitiesWhile many short- and intermediate-term trends are favorable,
one long-term issue, state pensions, is not. The combination of
an older workforce retiring sooner and lower discount rates has
led to a rise in pension liabilities. The BofAML Global Research
Municipal Strategy team expects growth of unfunded liabilities,
CIO REPORTS • The Monthly Letter 4
a credit negative. Despite that, with revenues steadily increasing
at the state and local levels, we expect that governments, for the
most part, will be better positioned to fund their annual required
contributions, easing the pain of growing unfunded liabilities.
For now, we think there is time to address pension reforms
and, therefore, consider it a secondary issue when assessing
municipal securities.
Distressed situations in Puerto Rico and Detroit, as well as in
certain Michigan municipalities, highlight the headline risk that
has affected some investors’ perceptions of municipal bonds.
While they show that investing in municipal securities is not
without risks, it is important to keep in mind that the problems
relating to those localities developed over time and were well-
documented. We believe it is misleading to view certain municipal bond distressed situations as representative of the overall municipal bond market. Most state and local governments stand on solid footing, having made significant progress in pension reform and closing budget gaps.
Investment Grade: One of the last pockets of yieldThe highly volatile start to the year in financial markets,
given concerns over oil, China and global growth, has spurred
investors to sell risk assets and seek shelter in safe-haven
assets and cash. In this environment, bonds have proven
resilient: Year-to-date, through April 18, bonds (as measured
by the Barclays U.S. Aggregate Bond Index) have total returns
of 3.4%, while U.S. Investment Grade corporate bonds are up
4.8% Within a diversified bond portfolio, U.S. Investment Grade
corporate bonds and high-quality municipal bonds remain our
preferred exposures.
We are bullish on U.S. IG for three key reasons:
1. Big foreign inflows, as investors reach for yield in the U.S. corporate bond market — the only game in town (see Exhibit 4)
2. Improving fundamentals as M&A and share buyback volumes taper, and upside surprises to earnings
3. Still fairly attractive valuations — acknowledging that most of the spread tightening is already behind us
Exhibit 4: U.S. Investment Grade (IG) yield income as % of global IG yield income vs. foreign investor flow
-60
Dec–
09
Jun–
10
Dec–
10
Jun–
11
Dec–
11
Jun–
12
Dec–
12
Jun–
13
Dec–
13
Jun–
14
Dec–
14
Jun–
15
Dec–
15
30
0
120
180
-30
150
90
60
55%
50%
70%
80%
45%
75%
65%
60%
U.S. IG Yield as % of Global IG Yield (RHS)Foreign Investor Buying of U.S. IG ($bn, LHS)
Source: BofAML Credit Research and Merrill Lynch Chief Investment Office. Data as of 4Q 2015. Past performance is no guarantee of future results.
We live in a yield-hungry world The demand for U.S. IG credit has been fueled in part by the
meaningful amount of negative-yielding debt globally. Thirteen
European countries have negative-yielding sovereign debt, and
the Bank of Japan introduced negative interest rates recently
(see the February 4 Investment Insights, Whatever It Takes).
In the eurozone, the negative rate experiment is already more
than a year old. Roughly 2.5 trillion euros of sovereign debt
and 60 billion euros of corporate debt carry negative rates,
according to BofAML Global Research.
Lower for longerThe zero interest-rate policy (ZIRP) that the Fed held from
December 2008 to December 2015 created a significant
hunger for yield, and U.S. IG and HY bonds benefited
tremendously from it. By the same token, it has been widely
believed that the beneficiaries of ZIRP would suffer as the Fed
started to tighten monetary policy. However, U.S. Treasury
bond yields are still stubbornly low, with the 10-year yielding
just 1.89% as of April 22 and, as mentioned earlier, there
is a significant amount of negative-yielding debt globally.
Furthermore, BofAML Global Research now expects the Fed to
hike rates only twice (rather than three or four times) in 2016.
CIO REPORTS • The Monthly Letter 5
Attractive valuations We believe that investors’ appetite for income and relatively
higher-quality income assets will remain in place. IG spreads
are trading at the 70th percentile, indicating that spreads are
wide relative to history (see Exhibit 5).
Exhibit 5: Investment grade spreads are trading at recession-like levels
01997 2007 2009 2011 201320051999 2001 2003 2015
400
500
600
700
300
200
100
Spre
ads
(bp)
IG-70th Percentile
Recession Periods Investment Grade Spreads
Source: Bloomberg and Merrill Lynch Chief Investment Office. Data as of March 31, 2016. Investment Grade index = BofA Merrill Lynch U.S. Corporate Index. Please see Appendix for index definition. Past performance is no guarantee of future results.
IG credit metrics and fundamentals remain stable despite the
higher volatility in the credit markets. Over the last year, the
difference between the yields on U.S. Treasuries and U.S. IG
widened by 30 basis points (bps), from 133bps to 163bps.
BofAML Global Research forecasts a 2016 U.S. IG spread of
150bps, implying a potential for 13bps of spread tightening
from current levels. Thus, valuations still look fairly attractive.
Chasing High Yield…tread lightlyAs investors have stretched for yield, one area of the bond
market that has gotten much attention is High Yield. A quick
glance shows why, as the yield on the BofA Merrill Lynch
U.S. High Yield Master Index was 8.4% at the end of the first
quarter of the year. While the yield in HY looks attractive,
HY bonds come with additional risks, as well as a higher
correlation with the equity market. We do not believe that all
HY is bad; however, investors need to know what they own
and, for most investors, the allocation to HY should be low.
The elephant in the High Yield market: EnergyWhat’s given us pause in the HY market recently? The HY
market contains a greater sensitivity to Energy companies,
as approximately 13% of the BofA Merrill Lynch U.S. High
Yield Master Index consists of Energy companies. The decline
in oil prices over the past 18 months has put pressure on
Energy company profits. The large Energy exposure in the HY index is one reason we believe investors should use an active manager when investing in HY. In addition to
the fact that HY is historically more volatile than other fixed
income asset classes, there is even greater volatility in the
Energy sector from the underlying volatility in oil prices.
The pressure of lower oil prices on the Energy sector has
resulted in default rates much higher than in the broad HY
universe, as well as in deteriorating revenues (see Exhibit 6).
Revenue declines for the Energy sector are much more severe
when compared to the broad HY market. This concerns us, as
declining revenues raise concerns about Energy companies’
ability to service their debt (see Exhibit 7). While we have not
seen contagion in the HY market from the Energy sector, we
are cautious and continue to monitor credit fundamentals for
signs of decline. We also believe that the pessimism relating
to oil prices and their impact on the Energy sector of HY is
priced into the market. The decline in lower-rated HY Energy
bond prices (Energy companies that are more likely to default)
is significant, implying that the market has already taken the
risk of lower oil prices and is reflected in the lower price.
Exhibit 6: Defaults remain concentrated in the HY Energy sector
01998 2006 2008 2010 2012 20142000 2002 2004 2016
12
14
16
10
8
4
6
2LTM
Issu
er D
efau
lt Ra
te (%
)
BofAML U.S. HY Default Rate Energy
Source: BofAML Credit Strategy and Merrill Lynch Chief Investment Office. Data as of March 31, 2016. High Yield index = BofA Merrill Lynch U.S. High Yield Master Index. Please see Appendix for index definition. Past performance is no guarantee of future results.
CIO REPORTS • The Monthly Letter 6
Exhibit 7: Revenues in the HY space remain stable excluding the Energy sector
0
1998 2008 2010 20122006200 2002 2004 2014
20
40
60
80
-20
Reve
nue,
YoY
% C
hang
e
-40
-60
Energy BofAML U.S. High Yield Master Index
Source: BofAML Credit Strategy and Merrill Lynch Chief Investment Office. Data as of 4Q 2015. Please see Appendix for index definition. Past performance is no guarantee of future results.
Macro headwinds tightenFor the first time since 2008, the Fed’s Commercial &
Industrial lending survey showed a net higher number of
regional banks tightening their lending standards versus
loosening them. This is the second quarter in a row where
we have seen tightening of lending standards. This is a
concerning trend for High Yield because it indicates that we
are in the later stages of the credit cycle and access to credit
is declining. Historically, the tightening of lending standards is a leading indicator of increasing HY default rates 12 –18 months ahead (see Exhibit 8). So, while we have seen two
consecutive quarters of tightening, we are still in the early
stages of the default cycle. The relationship between lending standards and defaults is one we are watching closely as a signpost that High Yield is set for another leg down.
Exhibit 8: Tightening lending standards indicate that we are moving into the final stages of the credit cycle, reducing credit availability to issuers
-401990 1992 1994 1996 1998 2000 2002 2004 2005 2008 2010 2012 2014
40
60
80
100
0
16
14
12
10
8
6
4
2
20
0
-20
LTM Issuer Default Rate
Net
Per
cent
of B
anks
Tig
hten
ing
Stan
dard
s
U.S. HY LTM Issuer Default Rate (RHS)Net Percent of Banks Tightening Standards
Source: BofAML Credit Strategy and Merrill Lynch Chief Investment Office. Quarterly data as of 4Q 2015. High Yield index = BofA Merrill Lynch U.S. High Yield Master Index. Please see Appendix for index definition. Past performance is no guarantee of future results.
Portfolio Strategy: See Page 7.
CIO REPORTS • The Monthly Letter 7
Portfolio Strategy: It is easy to see why investors, in
a yield-starved environment, have stretched for income
into riskier parts of the bond market. In this hunt for yield,
investors have taken unintended risks in their portfolios.
Recent bouts of episodic volatility have demonstrated that
many of these investments aren’t behaving as expected and
can lead to increased volatility within portfolios. Despite this, fixed income continues to have an important role managing total risk in balanced portfolios, and investors can find relative yield by asking “Where’s the beef?” Using the relative value framework, investors can find yield as well as diversifying sources of income within their portfolio.
We advocate a core/satellite approach for fixed income
portfolio construction (see Exhibit 9). The core of the portfolio
is intended to provide broad exposure to a diverse set of high-
quality fixed income asset classes. The core of the portfolio
is higher-quality fixed income, expected to provide capital
preservation and dampen total portfolio volatility. Municipals
and U.S. Investment Grade can provide effective diversification
from equities. During the last five equity market drawdowns,
when total returns fell by more than 10%, total returns from
high-quality municipal bonds (as measured by the BofAML
U.S. Municipal Master Index) were, in fact, positive (see
Exhibit 10). Meanwhile, U.S. Investment Grade total returns
were positive in four of the five equity market drawdowns.
Exhibit 9: A core/satellite approach to fixed income
Municipals
Satellite• TIPS* • Senior
Loans**
CoreU.S. Treasuries
and High-QualityMunicipals
CoreInvestment
GradeCorporates
* Treasury Inflation-Protected Securities.**May be subject to significant credit, valuation and liquidity risk.
Source: Merrill Lynch Chief Investment Office. For illustrative purposes only. U.S. Treasury inflation-indexed securities are subject to interest rate risk. If interest rates rise, the market value of your Treasury investment will decline. While you may be able to liquidate your investment in the secondary market, you may receive less than the face value of your investment.
Exhibit 10: Historically, U.S. municipal and Investment Grade total returns have risen as U.S. equities have fallen
-55Jun–90 to
Oct–90Jul–98 toAug–98
Sep–00 toSep–02
May–11 toSep–11
Nov–07 toFeb–09
5
15
25
0-5
-15
-25
-35
-45
Perc
ent C
hang
e
S&P 500 Index Drawdown BofAML Municipal Master Index Total ReturnBofAML U.S. Corporate Index
Source: Bloomberg, MPI and Merrill Lynch Chief Investment Office. Drawdown is defined as the maximum peak-to-trough percentage decline in value experienced during the given period. Please see Appendix for index definition. Past performance is no guarantee of future results.
The satellite portion of the fixed income portfolio is intended
to augment portfolio income. The satellite piece of the
portfolio, while designed to generate income, may take
on additional duration or credit risk. That additional risk is
why the satellite allocation as a percentage of the total
fixed income portfolio is small. For the satellite portion of
the portfolio, investors may look to senior loans, TIPS or
High Yield.
Ultimately, an investor’s goal, risk tolerance and time
horizon drive the asset allocation decision. Longer-term
investors should look past short-term volatility and focus
on the fundamentals that drive longer-term returns.
The fundamentals for IG bonds and municipals remain
intact for long-term investors.
Investors looking for capital preservation should consider
keeping their investments primarily in high-quality fixed
income to mitigate drawdown risk. Investors who need
a portion of their portfolio for disbursements or other
spending needs in the near term should consider keeping
that portion of their portfolio in cash or cash-like products
to ensure liquidity.
CIO InsightsInsights and the best thinking from distinguished investors around the world.
CIO REPORTS • The Monthly Letter 8
A Conversation with Dennis Stattman*
Dennis Stattman, CFA, Managing Director and portfolio manager, is head of the Global Allocation team within BlackRock’s Multi-Asset Strategies Group. He serves as a member of BlackRock’s Global Operating and Leadership Committees.
Mr. Stattman’s service with the firm dates back to 1989, including his years with Merrill Lynch Investment Managers (MLIM), which merged with BlackRock in 2006. Mr. Stattman joined Merrill Lynch Investment Managers as a portfolio manager of the Merrill Lynch Global Allocation Fund at the Fund’s inception in 1989. From 1989 through 1996, he was also a portfolio manager of the Merrill Lynch Special Value Fund. Prior to joining MLIM, Mr. Stattman served as the director of research for Meridian Management Company, and as pension investment officer for the World Bank, supervising the management of U.S. equities in the Bank’s Retirement Plan.
Mr. Stattman earned a BS degree in commerce from the University of Virginia in 1973 and an MBA degree, with honors, from the University of Chicago in 1980. Mr. Stattman is a CFA Charterholder
CIO Office: What’s your outlook for the global economy, and what are some of the key risks you see going forward?
Dennis Stattman: We expect slow but positive growth in the global economy, but acknowledge that the risks are skewed to the downside. First, secular trends, including lower productivity growth and demographic changes (e.g., aging populations), suggest that long-term growth is likely to be lower than the post-WWII average. Second, international developments represent an ongoing risk for the global economy. Chief among them is China, which is challenged to transition from an economy driven by investments and exports to one that is consumption-led, while at the same time coping with a large buildup in debt and slowing growth. In addition, political challenges are evident in several developing markets, particularly in Europe and Latin America.
The market’s expectations for the Fed to continue to raise rates this year have dropped precipitously. How should investors look to position across asset classes in this lower-for-longer environment and yield-hungry world?
In a world characterized by slow growth and relatively tame inflation, investors expect nominal rates to remain low. This, in turn, suggests that the “stretch for yield” will continue, with investors willing to pay a premium for income-producing assets.
The dilemma is that after seven years of zero-interest-rate policy, and with interest rates falling into negative territory in an increasing number of geographies and maturities, most income-producing assets are expensive. To address this challenge, we believe income-seeking investors should consider casting a wide net and including selective, price-sensitive exposure to investment grade and high yield corporate bonds and international dividend stocks, as well as more niche asset classes, such as preferred stocks.
Investment returns may be anemic going forward. Coupling that with the trend of longevity, which means people’s money has to last longer, do we need to start getting used to taking more risks?
Each person is clearly unique, but it does seem fairly obvious that many investors are facing more difficult choices in planning for retirement today.
If you are nearing retirement, and particularly if you had built up a significant portfolio, the good news is that bull markets in stocks and bonds have lifted many asset prices above what many could have imagined or expected after the financial crisis. On the other hand, low interest rates, increasing longevity and a decline in private defined-benefit pension plans all require you to adapt your retirement strategy.
There is no single solution to this conundrum. Certainly focusing on those assets likely to produce higher real returns, such as equities, has the potential to facilitate growth in a retirement portfolio. This can be particularly advantageous for younger investors who have the time horizon to withstand the incremental risk. Overall, however, investors should be wary about increasing risk in their portfolios after a prolonged period of rising asset prices. Our favored approach is using a global multi-asset strategy in an effort to balance risk and reward.
Beyond refining your investment approach, behavioral changes may play a key role in securing retirement goals. These include a higher savings rate during working years and, most powerfully, delaying retirement for a few more years.
Dennis Stattman
CFA, Managing Director and portfolio manager
CIO InsightsInsights and the best thinking from distinguished investors around the world.
CIO REPORTS • The Monthly Letter 9
A Conversation with Dennis Stattman* (cont’d)
We’ve seen a reversal in U.S. equities this year with value outperforming growth. What do you see as the driver behind this, and do you expect this trend to persist? Also, are there any segments or sectors of the U.S. markets that you like?
Value has benefited this year from two key factors: 1) the fact that it is relatively cheap and 2) a more recent comfort with the global economic outlook. Value typically performs best when expectations for economic growth are rising. To the extent recent economic data have alleviated recession fears, value has been a natural beneficiary. However, one reason growth was able to outperform for many years, even as the stocks became somewhat expensive, was because profitability at growth companies held up better than profitability at many value firms. For value to continue to outperform, we would need to see improvements in corporate profitability, notably improved return-on-equity, at value firms.
After a seven-year bull market and with the corporate profit share of gross domestic product (GDP) near a cyclical high, we are selective in our exposure to the U.S. stock market and have only small overweights in our largest sector exposures — namely, health care and energy. In health care, we see good value relative to other stable growth sectors of the market. Within energy, we believe depressed prices may offer a good entry point for long-term investors.
What about international equities? It was expected that easy monetary policy and low to negative interest rates would serve as a boon to European and Japanese equities, but we’ve witnessed mixed reactions in these markets. Where do you see value in these regions, and how do you expect monetary policy and the continued slowdown in Emerging Markets to impact these markets?
We continue to see value in international markets, particularly Japan. That said, monetary policy is not providing the tailwind that we’ve witnessed in recent years past. Part of the challenge is that after seven years of extraordinary efforts by central bankers to bolster economies and markets, monetary policy is proving less effective at lifting asset prices. This reflects several developments: Asset markets are generally more expensive, economic growth has not accelerated as expected and some of the tools currently being deployed, notably negative deposit rates, exert a cost on the financial sector.
Inflation has been below expectations of investors and central bankers. Where do you see inflation headed in the U.S. and globally, and how are you positioning your allocations accordingly? How would you advise clients tackle portfolio duration in the current rate environment?
The outlook for inflation is very dependent on geography. Despite strong global disinflationary forces, inflation in the U.S. appears stable, and by many measures is even rising. Core inflation, which excludes volatile food and energy prices, has been firming. This is particularly true in the service sector, where we see evidence of rising costs for housing and medical care.
We do not expect inflation to become a major problem, but given relatively low expectations for future inflation, it is certainly possible that inflation could surprise to the upside. One way to address this scenario is with U.S. Treasury Inflation Protected Securities (TIPS). While inflation expectations have risen, they are still low by historical standards. This suggests that TIPS offer value relative to traditional Treasury notes and bonds.
Given the TINA (“There is no alternative”) environment across asset classes, have you been looking at any non-traditional asset classes such as commodities? Also, what is your view on the U.S. dollar?
Within the parameters of our investment mandate as relates to non-traditional asset classes, we have enjoyed success in private placements and distressed debt, although these investments have never represented a large portion of the portfolio. Today, we believe oil- and gas-related securities represent an area of opportunity for long-term value investors. Also, since forgone interest income is a key opportunity cost for owners of gold, the yellow metal has grown more attractive in today’s environment of negative interest rates, which are evident in more than 25% of the sovereign bond universe.
We have been overweight the dollar for several years, based on the strong performance of the U.S. economy relative to the rest of the developed world and the improvement in America’s trade balance and current account due to greater domestic oil production. More recently, we have taken some profits on our dollar overweight given both the appreciation of the dollar and the more muted outlook for Federal Reserve interest rate hikes.
What has been the biggest shift in your thinking about investing over your career?
Over the course of my 36-year career, I would like to believe my thinking has become more sophisticated, broader and more objective, and that I see the investment world from a greater variety of perspectives. Certainly I now spend more time on global macro topics and non-U.S. investing given the exponential growth of economies and opportunities around the world. As the opportunity set has grown, so too have the data and analytical resources available to support our portfolio decision making. Tools matter to thinking, and today at BlackRock, our information tools are dramatically more powerful than even a few years ago. This added capability influences what we think about, as well as how we think. We see all of this as a clear benefit to our shareholders, which always have and always will remain central to our thinking as we seek to invest for optimal risk-adjusted returns.
CIO InsightsInsights and the best thinking from distinguished investors around the world.
CIO REPORTS • The Monthly Letter 10
* The views and opinions expressed are those of the speaker as of April 28, 2016, are subject to change without notice at any time, and may differ from views expressed by Bank of America Corporation, Merrill Lynch, Pierce, Fenner & Smith Incorporated, or any affiliates. This conversation is presented for informational purposes only and should not be used or construed as a recommendation of any service, security or sector. Before acting on the information provided, you should consider suitability for your circumstances and, if necessary, seek professional advice.
A Conversation with Dennis Stattman* (cont’d)
DISCLOSURE:You should consider the investment objectives, risks, charges and expenses of the BlackRock Global Allocation Fund carefully
before investing. The Fund’s prospectus and, if available, the summary prospectus contain this and other information about the
Fund and are available, along with information about other BlackRock funds, by calling 800-882-0052 or from your financial
professional. The prospectus and, if available, the summary prospectus should be read carefully before investing.
International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the
possibility of substantial volatility due to adverse political, economic or other developments. These risks are magnified for investments in
emerging or smaller capital markets.
Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values.
Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Non-investment-grade
debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than
higher-rated securities.
This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or
solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are those of the portfolio manager
profiled as of April 2016, and may change as subsequent conditions vary. Individual portfolio managers for BlackRock may have opinions
and/or make investment decisions that may, in certain respects, not be consistent with the information contained in this report. The
information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by BlackRock to be
reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There
is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the
reader. Investment involves risks. The fund is actively managed, and its holdings and portfolio characteristics are subject to change.
CIO REPORTS • The Monthly Letter 11CIO REPORTS • The Monthly Letter 11
When assessing your portfolio in light of our current guidance, consider the tactical positioning around asset allocation in reference to your own individual risk tolerance, time horizon, objectives and liquidity needs. Certain investments may not be appropriate, given your specific circumstances and investment plan. Certain security types, like hedged strategies and private equity investments, are subject to eligibility and suitability criteria. Your financial advisor can help you customize your portfolio in light of your specific circumstances.
ASSET CLASSCHIEF INVESTMENT
OFFICE VIEW COMMENTSNegative Neutral Positive
Global EquitiesFurther upside expected based on improving economic and earnings growth and valuations, which remain close to fair value. However, return expectations should be lower than in recent history.
U.S. Large Cap Full valuations and headwinds of stronger dollar, lower energy prices and weak economic activity may lead to higher volatility. Higher quality is preferred in a rising volatility environment.
U.S. Mid & Small CapValuation multiples remain extended, although the valuation gap with large caps has narrowed. Investors with a higher risk tolerance may consider select opportunities within higher-quality small caps.
International Developed
Extension of European Central Bank quantitative easing till March 2017 and evidence of green-shoots in European economy should drive European equities higher. Japan should continue to benefit from reflationary “Abenomics.”
Emerging MarketsStronger dollar, weaker growth in China and downward pressure on commodity prices will challenge Emerging Markets (EM).
Global Fixed IncomeBonds continue to provide diversification, income and stability within total portfolios. Interest rates remaining lower for longer limit total return opportunities in bonds.
U.S. Treasuries Current valuations are stretched, especially on longer maturities. Consider TIPS as a high-quality alternative.
U.S. MunicipalsValuations relative to U.S. Treasuries remain attractive, and tax-exempt status is not likely to be threatened in the near term; advise a nationally diversified approach.
U.S. Investment GradeRisk of rates rising subsiding. Stable to improving fundamentals expected to attract high-quality foreign investors as yield differentials are supported by divergent monetary policy.
U.S. High YieldWe remain cautious, as defaults expected to increase; spreads to remain range-bound until further economic growth.
U.S. CollateralizedHigher rates and Federal Reserve tapering are likely to increase spread volatility. A shortage of new issues should counter the effects of tapering.
Non-U.S. CorporatesSelect opportunities in European credit, including financials; however, any yield pickup likely to be hampered by a stronger dollar.
Non-U.S. Sovereigns Yields are unattractive after the current run-up in performance; prefer active management.
Emerging Market DebtVulnerable to less accommodative Fed policy and lower global liquidity; prefer U.S. dollar-denominated EM debt. Local EM debt likely to remain volatile due to foreign exchange component; prefer active management.
Alternatives*Select Alternative investments help broaden the investment toolkit to diversify traditional stock and bond portfolios.
Commodities Medium-/long-term potential upside on stabilizing oil prices; near-term opportunities in energy equities /credits.
Hedged StrategiesEquity Event-Driven & Distressed gain from recent event selloff and increasing default potential. Global Macro a timely diversifier, given higher expected volatility across equity, fixed income and foreign exchange markets.
Real EstateStrong fundamentals driving increased investment; cap rates continue to compress; favor global opportunistic.
Private Equity Strong fund raising and high valuations; special situations, energy, and private credit favored.
U.S. DollarStronger domestic growth and a less dovish Federal Reserve policy (relative to the monetary policies of other Developed Market central banks) support a stronger dollar going forward.
CashMonetary policy by Developed Market central banks reduces the attractiveness of cash, especially on an after-inflation basis.
* Many products that pursue Alternative Investment strategies, specifically Private Equity and Hedge Funds, are available only to pre-qualified clients.
CIO REPORTS • The Monthly Letter 12
Appendix
Index Definitions
The S&P 500 Index is a market-capitalization weighted index that measures the market value of 500 large U.S. companies having common stock listed on the New York Stock Exchange or NASDAQ. The S&P 500 index components and weightings are determined by S&P Dow Jones Indices.
The Barclays U.S. Aggregate Bond Index is a broad-based flagship benchmark that measures the Investment Grade, U.S. dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS and CMBS (agency and non-agency).
The BofA Merrill Lynch U.S. High Yield Master Index tracks the performance of below Investment Grade U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market. “Yankee” bonds (debt of foreign issuers issued in the U.S. domestic market) are included in the index provided the issuer is domiciled in a country having an Investment Grade foreign currency long-term debt rating (based on a composite of Moody’s and S&P).
The BofA Merrill Lynch U.S. Municipal Masters Index tracks the performance of the Investment Grade U.S. tax-exempt bond market.
The BofA Merrill Lynch U.S. Corporate Index tracks the performance of U.S. dollar-denominated Investment Grade corporate debt publicly issued in the U.S. domestic market. Qualifying securities must have an Investment Grade rating (based on an average of Moody’s, S&P and Fitch), at least 18 months to final maturity at the time of issuance, at least one year remaining term to final maturity as of the rebalancing date, a fixed coupon schedule and a minimum amount outstanding of $250 million.
The BofA Merrill Lynch U.S. Treasury Index tracks the performance of U.S. dollar-denominated sovereign debt publicly issued by the U.S. government in its domestic market. Qualifying securities must have at least one year remaining term to final maturity, a fixed coupon schedule and a minimum amount outstanding of $1 billion.
Christopher J. Wolfe Head of the Merrill Lynch Chief Investment Office
Mary Ann BartelsHead of Merrill Lynch Wealth
Management Portfolio Strategy
Karin KimbroughHead of Macro and Economic Policy Merrill Lynch Wealth Management
Niladri MukherjeeManaging Director
Chief Investment Office
Maxwell Gold
Vice President
Emmanuel D. “Manos” Hatzakis
Director
Jon LieberkindVice President
John Veit
Vice President
Christopher HyzyChief Investment Officer
Bank of America Global Wealth and Investment Management
CHIEF INVESTMENT OFFICE
This material was prepared by the Merrill Lynch Chief Investment Office and is not a publication of BofA Merrill Lynch Global Research. The views expressed are those of the Merrill Lynch Chief Investment Officeonly and are subject to change. This information should not be construed as investment advice. It is presented for information purposes only and is not intended to be either a specific offer by any Merrill Lynch entity to sell or provide, or a specific invitation for a consumer to apply for, any particular retail financial product or service that may be available.
This information and any discussion should not be construed as a personalized and individual client recommendation, which should be based on each client’s investment objectives, risk tolerance, and financial situation and needs. This information and any discussion also is not intended as a specific offer by Merrill Lynch, its affiliates, or any related entity to sell or provide, or a specific invitation for a consumer to apply for, any particular retail financial product or service. Investments and opinions are subject to change due to market conditions and the opinions and guidance may not be profitable or realized. Any information presented in connection with BofA Merrill Lynch Global Research is general in nature and is not intended to provide personal investment advice. The information does not take into account the specific investment objectives, financial situation and particular needs of any specific person who may receive it. Investors should understand that statements regarding future prospects may not be realized.
Asset allocation and diversification do not assure a profit or protect against a loss during declining markets.
Alternative investments, such as hedge funds and private equity funds, are speculative and involve a high degree of risk. There generally are no readily available secondary markets, none are expected to develop and there may be restrictions on transferring fund investments. Alternative investments may engage in leverage that can increase risk of loss, performance may be volatile and funds may have high fees and expenses that reduce returns. Alternative investments are not suitable for all investors. Investors may lose all or a portion of the capital invested.
The investments discussed have varying degrees of risk. Some of the risks involved with equities include the possibility that the value of the stocks may fluctuate in response to events specific to the companies or markets, as well as economic, political or social events in the U.S. or abroad. Bonds are subject to interest rate, inflation and credit risks. Investments in high-yield bonds may be subject to greater market fluctuations and risk of loss of income and principal than securities in higher rated categories. Income from investing in municipal bonds is generally exempt from federal and state taxes for residents of the issuing state. While the interest income is tax exempt, any capital gains distributed are taxable to the investor. Income for some investors may be subject to the federal alternative minimum tax (AMT). Investments in foreign securities involve special risks, including foreign currency risk and the possibility of substantial volatility due to adverse political, economic or other developments. These risks are magnified for investments made in emerging markets. Investments in a certain industry or sector may pose additional risk due to lack of diversification and sector concentration. Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates, and risk related to renting properties, such as rental defaults. There are special risks associated with an investment in commodities, including market price fluctuations, regulatory changes, interest rate changes, credit risk, economic changes and the impact of adverse political or financial factors.
No investment program is risk-free, and a systematic investing plan does not ensure a profit or protect against a loss in declining markets. Any investment plan should be subject to periodic review for changes in your individual circumstances, including changes in market conditions and your financial ability to continue purchases.
Reference to indices, or other measures of relative market performance over a specified period of time (each, an “index”) are provided for illustrative purposes only, do not represent a benchmark or proxy for the return or volatility of any particular product, portfolio, security holding, or AI. Investors cannot invest directly in indices. Indices are unmanaged. The figures for the index reflect the reinvestment of dividends but do not reflect the deduction of any fees or expenses which would reduce returns. Merrill Lynch does not guarantee the accuracy of the index returns and does not recommend any investment or other decision based on the results presented.
The Private Banking and Investment Group is a division of MLPF&S that offers a broad array of personalized wealth management products and services. Both brokerage and investment advisory services (including financial planning) are offered by the Group’s Private Wealth Advisors through MLPF&S, a registered broker-dealer and registered investment adviser. The nature and degree of advice and assistance provided, the fees charged, and client rights and Merrill Lynch’s obligations will differ among these services.
The banking, credit and trust services sold by the Group’s Private Wealth Advisors are offered by licensed banks and trust companies, including Bank of America, N.A., Member FDIC, and other affiliated banks.
MLPF&S is a registered broker-dealer, registered investment adviser, member SIPC and wholly owned subsidiary of BofA Corp.
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