The Trap of Positive Thinking
It's true, things eventually do get better. But not on their own.
Portfolio strategies must account for one of the biggest risks facing investors in the next few years: deflation. The debt excesses in developed markets drive our view on deflationary risks. Until the debt is repaid, restructured or repudiated, secular growth will remain low and strategies that produce income and explicitly manage risk are favored.
In the short term, there will always be rallies in markets fueled by newsflow: Look! Europe is improving! No, it's not! Oh, it is again! These are distractions from the real money that investors need to earn over the long term to meet their goals and stay ahead of taxes and inflation. At present, the consensus seems to be that the equity and commodity markets have hit bottom and now may be a very good time to invest for the long term. As evidence, many commentators point to the heavily depressed European stock valuations, the decline in emerging equity markets on the heels of dimming EM growth prospects, the fall in commodity prices stemming from the slowdown in global economic growth, and the fact that, paradoxically, bonds continue to shine (which must mean a bond bubble and a flood into equities is at hand). This is all part of a general pattern in investment groupthink. Many commentators look to a cycle of bad news, and, when it gets to a low point, assume it has to begin recovering soon and markets will respond in kind. While we believe there are some positive surprises due in the coming months, awaiting improving news ignores what we see as several fundamental truths about the current investing environment:
- The driver for economic and corporate financial performance for the past generation has been debt.
- Debt has so saturated the financial system that central banks have resorted to printing money to provide liquidity and, by extension, solvency to ailing financial institutions.
- Current plans to repay debt require either economic growth or austerity. But the first adds more debt and the second cuts growth.
- Unless and until debt burdens are reduced, restructured or repudiated (all of which generally hurt growth), a new secular growth story cannot take hold.
The third and fourth points are obviously circular. But that is the point: Absent higher growth, there is little individuals can do to pay down their debt more quickly and help us stop the broken record. So how governments choose to repay their portion of the nation's debt burden is of critical importance. In our view (and the view expressed by the Congressional Budget Office), the only way forward to lowering the debt burden and creating a more sustainable environment for growth includes a combination of higher taxes and lower government spending. The only problem is one of the two major political parties in Washington has come to view higher taxes as anathema, while the past performance of neither party engenders much confidence that its members will successfully negotiate reductions to their favorite pet projects. This is the backdrop against which otherwise strong corporate fundamentals must be viewed. In his recent reports, BofA Merrill Lynch Global Research economist Ethan Harris notes how uncertainty in Washington has infected the corporate sector. The low levels of hiring by corporations, the accumulation of cash on their balance sheets and the rise in dividends belie the fact that corporations are managing their financials to preserve their margins, not nurture growth. Thus, while corporate cash flows have blossomed, economic growth has withered. It's another circular conundrum. One potentially strong factor that could finally move the needle and sustain a recovery, the opening of corporate coffers, remains on hold until those who could do the moving see greater clarity from Washington.
Continue to "follow the corporate cash" until more coherent blueprints emerge for addressing the debt burdens in the U.S. and Europe.
With the consensus looking for the next immediate upturn based on the news, we think investors should stay the course and continue to "follow the corporate cash" until more coherent blueprints emerge for addressing the debt burdens of the U.S. and Europe. There have been no changes in our overall portfolio recommendations since last month. In our view, markets remain dependent on government sponsored income, credit and liquidity flowing through the financial system. After the strong first quarter rally, markets have come down, reflecting a growing concern that Europe's half-hearted measures to resolve the central question of how much integration its members are really willing to accept will fall short. We expect politicians to continue muddling through on both sides of the Atlantic for the foreseeable future. In light of the likely ongoing politically-driven volatility in markets, we reiterate our view that portfolio positioning in the second half of 2012 should remain cautious, awaiting the deployment of corporate cash or greater clarity from Washington on taxes, deficit reduction and job creation. In our view, the following strategies remain the focus for new money and portfolio repositioning opportunities:  a broad, globally diversified portfolio;  explicitly managing portfolio risk using derivatives or market linked notes;  adding foreign currency exposure as a way to hedge risks to the U.S. dollar  within hedge funds, redeploying toward managed futures and relative value and away from traditional long/short strategies; and  within equities focusing on specific sectors like technology, as well as on individual companies that are buying back their shares and paying dividends.
This report has been issued and prepared by Investment Management & Guidance and the Chief Investment Office of the Private Banking & Investment Group and is not a publication of BofA Merrill Lynch Global Research. This publication has been prepared for use with Merrill Lynch clients not residing in the UK and may not be redistributed, retransmitted or disclosed, in whole or in part, or in any form or manner, without the express written consent of Merrill Lynch. Any unauthorized use or disclosure is prohibited. The information herein was obtained from various sources that we deem reliable, but we do not guarantee its accuracy.
This report provides general information only. Neither the information nor any views expressed constitutes an offer or an invitation to make an offer, to buy or sell any securities or other investment or any options, futures or derivatives related to such securities or investments. It is not intended to provide personal investment advice and it does not take into account the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. Investors should seek financial advice regarding the appropriateness of investing in any securities, other investment or investment strategies discussed in this report and should understand that statements regarding future prospects may not be realized. Investors should note that income from securities or other investments, if any, may fluctuate and that price or value of such securities and investments may rise or fall. Accordingly, investors may receive back less than originally invested. Past performance is not necessarily a guide to future performance. Any information relating to the tax status of financial instruments discussed herein is not intended to provide tax advice or to be used by anyone to provide tax advice. Investors are urged to seek tax advice based on their particular circumstances from an independent tax professional.
Asset allocation and diversification do not assure a profit or protect against a loss during declining markets. Some or all alternative investment programs may not be suitable for certain investors. Many alternative investment products, specifically private equity and most hedge funds, require purchasers to be "qualified purchasers" within the meaning of the federal securities laws (generally, individuals who own at least $5 million in "investments" and institutional investors who own at least $25 million in "investments," as such term is defined in the federal securities laws). No assurance can be given that any alternative investment's investment objectives will be achieved. In addition to certain general risks, each product will be subject to its own specific risks, including strategy and market risk.
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. Foreign currency rates of exchange may adversely affect the value, price or income of any security or related investment mentioned in this report. In addition, investors in securities such as ADRs, whose values are influenced by the currency of the underlying security, effectively assume currency risk. Officers of Merrill Lynch or one or more of its affiliates may have a financial interest in securities of the issuer(s) or in related investments.