Equities, corporate debt seen bullish

our last edition of The Thundering Word for 2012, we briefly discuss four things that could surprise consensus in 2013.

2012 was a good year for contrarian trades. Investors entered the year defensively positioned and fearful of a euro break-up, a China hard-landing, conflict in the Middle East and the US fiscal cliff. Few expected the best performing bond markets to be in Greece, Portugal and Ireland; Financials to be the best performing equity and the IG bond sector and Tech to be the worst; or for volatility to be in a bear market.

Going into the New Year, the BofAML house view is for the global economy to pick up steam in the second half of the year, following a resolution to the Fiscal Cliff and after Spain asks for formal help from the ECB. Global central banks will keep rates low and continue to provide high liquidity to the market. As we begin to observe evidence that policy is successfully stimulating growth, we expect to see the initial stages of the Great Rotation from bonds into equities. We enter 2013 bullish on equities and corporate credit, bearish on government bonds and cash, and neutral commodities.

Higher Rates (did the Fed just tighten?)

Higher interest rates in 2013 would be a genuine surprise. Bond funds have seen dramatic inflows this year, with EM debt fund flows accounting for a remarkable 25% of AUM. The ability of fixed income funds to attract so much money is indicative of investor expectations for rates to remain very low

We find the change in the Fed’s “exit strategy” from its zero interest rate policy from late-2015 to an economic threshold of unemployment below 6.5% (and manageable inflation) to be very interesting. In our view, this brings into question the expectation that high liquidity is here to stay, and is perhaps a reason why gold prices have struggled this year. Also, since the Fed meeting last week, bond fund inflows have reversed. In just four days we’ve seen $2.5bn of outflows, which is on course to be the first weekly outflow in 30 weeks, and the largest outflow in 70 weeks.

What’s more, the math for bonds isn’t great. For 10-year US Treasuries to match the long-run return of equities (roughly 10% per annum), the yield would need to fall from 1.8% to 0.8%. And for US IG credit to deliver 10% total returns in 2013, spreads would need to tighten from 155bp to an alltime low of 79bp, and riskless rates would also need to fall to record lows.

Currently, no one is positioned for higher rates. But if we get a disorderly Great Rotation whereby yields rise rapidly in response to stronger than expected economic growth (as was the case in 1994, see “The surprises of 2013”), then many leveraged areas of the fixed income market (such as EM) are at risk. One thing to watch for next year is the relationship between yields and the dollar. A disorderly rotation would likely coincide with higher rates and a weaker dollar (as was the case in the US in 1994 and Europe over the past two years).

Lower growth, driven by the US consumer

Another surprise would be much weaker than expected growth, particularly if it’s caused by a weaker US consumer. As we saw in the latest global Fund Manager Survey, global growth expectations rose to the highest level in 22 months, and regional and sector positioning is skewed towards segments of the market that should benefit from stronger consumer spending. But if that doesn’t come to pass, portfolios will likely have to be re-allocated.

Our house view is for US consumer spending to rise gradually from 1.3% at the beginning of next year to 2% by the end of 2013, and we remain steadfast bulls on real estate (our housing specialists forecast a 5% rise in home prices in 2012 and a 36% cumulative gain over the next 10 years). But we acknowledge that a lot of asset allocation is predicated on the hope that US real estate and consumer spending will be strong next year. A big risk is if we fail to see a clear resolution to the fiscal cliff, and that the can gets kicked down the road, causing fiscal uncertainty to linger. Consumption would likely weaken amid expectations for higher taxes, spending cuts and an increased cost of living (note that NY subway fares were recently raised for the second time since 2009). Note that sentiment at small businesses (a big

Past week

1 Greece Govt Bonds 2 Italy Equities 3 Portugal Equities 4 Spain Equities 5 Poland Equities 6 Italy Govt Bonds 7 Portugal Govt Bonds 8 Spain Govt Bonds 9 S. Africa Equities 10 Ireland Govt Bonds 11 Germany Equities 12 Japan Equities 13 S. Africa Govt Bonds 14 Russia Equities 15 Mexico Equities 16 France Equities 17 Korea Equities 18 Singapore Equities 19 Poland Govt Bonds 20 France Govt Bonds 21 China Equities 22 Global Equity Index 23 Switzerland Govt Bonds 24 US Equities 25 Germany Govt Bonds 26 Switzerland Equities 27 UK Equities 28 Turkey Equities 29 Canada Equities 30 Brazil Equities 31 Indonesia Equities 32 Indonesia Govt Bonds 33 Turkey Govt Bonds 34 Australia Equities 35 Mexico Govt Bonds 36 Ireland Equities 37 China Govt Bonds 38 US HY Corp Bonds 39 China IG Corp Bonds 40 UK Govt Bonds 41 Singapore Govt Bonds 42 Taiwan Equities 43 Hong Kong Equities 44 Korea Govt Bonds 45 Russia Govt Bonds 46 Hong Kong Govt Bonds 47 Canada Govt Bonds 48 Global Govt Bond Index 49 Brazil Govt Bonds 50 US IG Corp Bonds 51 Australia Govt Bonds 52 US Govt Bonds 53 India Govt Bonds 54 India Equities 55 Japan IG Corp Bonds 56 Japan Govt Bonds 57 Greece Equities 58 Israel Equities 6.8% 5.0% 4.8% 4.7% 3.9% 3.7% 3.6% 2.6% 2.6% 2.4% 2.3% 2.2% 2.1% 1.9% 1.8% 1.7% 1.6% 1.6% 1.6% 1.4% 1.4% 1.4% 1.4% 1.3% 1.3% 1.3% 1.1% 0.8% 0.8% 0.7% 0.7% 0.6% 0.6% 0.5% 0.4% 0.4% 0.3% 0.3% 0.2% 0.2% 0.1% 0.0% 0.0% -0.1% -0.2% -0.2% -0.4% -0.4% -0.6% -0.7% -0.8% -0.8% -0.9% -1.1% -2.0% -2.3% -2.5% -6.1% source of US job creation) recently collapsed. Yen debasement: Y113/$ in 2013? Japanese equities have been very strong in recent weeks. The NKY rose from 8,660 in mid-November to over 10,000. This has gone hand in hand with expectations for reflationary policy and a weaker yen. FX Strategist David Woo warns that there is some short-term risk, as a lot of positioning has been based on a weaker yen. But Japan continues to be one of our favored contrarian trades. Following the recent LDP victory, we expect to see fiscal stimulus and a new BoJ governor with a 2% inflation target.

Japan is the ultimate anti-deflation trade. Reasons to buy Japan: a weaker yen is good for stocks; the FMS allocation to stocks in the region recently fell to a 3.5 year low; stocks in the region are 50% cheaper than other DM; Japan is just 7% of the global equity marketdown from 44% in 1988.

Another area of the market that is very unloved according to the FMS is resources. Even though EM equities appear to be overbought according to our fund flows, EM resources are another potential contrarian trade for 2013, particularly given the increase in Chinese growth expectations. Note that historically, when more than 50% of EM fund managers have reported underweight positions in to Materials, it has marked a turning point for the sector’s relative performance to MSCI EM.

Volatility resurfaces, or the era of Macro is over

One of the biggest surprises this year was the bear market in volatility. Massive liquidity programs from global central banks trumped tail risks. Derivatives strategist Ben Bowler points out that both global equity volatility and cross-asset risk (measured by the Global Financial Stress Index) fell to the lowest levels since 2007. A rise in volatility next year would not be a surprise, particularly in the FX market. With policy rates around the world close to zero, the new automatic stabilizer is FX. Downward revisions to growth expectations will put pressure on currencies. And central banks that don’t match the Fed’s easing face the prospect of stronger currencies (think of the BoJ’s current bind) and weaker economies.

But perhaps the biggest surprise in 2013 and beyond is that the era of tail risks is coming to an end. Note that the pair-wise correlations of all S&P 500 stock combinations has fallen to 30%, down from a high of 70% in 2011. This indicates that we are close to being in a differentiated/stock picker’s market. Appendix: Bond Math In 2013 we expect to see the onset of the ‘Great Rotation’ out of bonds, into stocks. There are two prerequisites for the rotation to begin: investors need a reason to sell their bond holdings and a reason to buy equity. The gradual economic recovery plus high central bank liquidity is supportive for equity markets and should pull investors into stocks. But investors probably need clear evidence that bonds have run out of yield to push them out of credit markets. Over the last 30 years, US IG credit investors have enjoyed equitylike returns with average annual returns of ca. 10%. Since the inception of our US IG index (C0A0) in 1972 and our EU IG index (ER00) in 1995, average annual returns are 8.6% and 5.4% respectively. With yields now at 280bp for US IG and 200bp for EU IG it is becoming mathematically unrealistic for investors to expect the type of returns they’ve become used to.

What it would take to see 10% US IG returns in 2013

Basis points Current US IG spread (OAS) Current US IG duration Current 7y riskless rate All time low OAS spread PV chg from spread tightening

to lows All time low in 7y riskless rate PV chg from riskless rally to

the lows 1yr coupon income Total theoretical return at record low OAS spreads and riskless rates

For US IG credit to deliver total returns of 10% once again in 2013 spreads would need to tighten to all time lows, and riskless rates would also need to fall to record lows. Table 1 breaks the numbers down given current levels of credit spread (from Option Adjusted Spread, OAS) and riskless rate (from US government bonds). While it may be theoretically possible to see 10% total returns in US IG next year, the scenario that it would require - tighter spreads and lower riskless rates - is highly unlikely in practice. When we saw credit spreads at record tight levels (OAS of 79bp in March 2005), the 7y riskless rate was at 4.1%. By contrast, when 7y riskless rates reached their lows (93bp in July 2012) US IG credit spreads were at 199bp. The problem for credit investors is that a further rally in credit spreads requires a better outlook, which likely means higher riskless rates. Conversely, conditions that see 7y riskless rates back at their lows probably are not compatible with tighter credit spreads; even for US IG firms.

Our base case sees US IG credit returns being just 1.6% next year, as slowly rising riskless rates dominate any further credit spread tightening. As the lack of performance in credit markets gradually manifests itself through 2013, investors who are used to equity like returns will be forced to look elsewhere. The gradual exit from OW credit positions into HY and Equity longs is central to our base case of the Great Rotation gathering pace in 2013. The risk is that economic data surprise to the upside and bond markets begin to discount future rate hikes. If this were to happen expect a more violent sell off in credit markets which may, in turn destabilize other asset markets in the short-term. However, with central banks in a highly accommodative mode, our base case is for gradual rotation from bonds to stocks as investors realize that the returns they’re used to have dried up.

Asset allocation and positioning

In 2013, we believe investors should be overweight equities and corporate bonds, underweight government bonds and cash, and neutral on commodities. Within equities, we are overweight European stocks over the first half of 2013 as the capitulation into the shunned assets of recent years is completed. European mining stocks and German auto stocks are the best way to play this trade, in our view. But over the second half of the year, we would rotate back toward the high quality growth stocks within the US market. Emerging Markets are likely once again to be marked by differentiation, as dollar strength and range-bound commodities prevent a clear bull market. EM consumer plays should outperform. Meanwhile Japan is our favored contrarian long, which we would play through NKY call options and Japanese banks. Incremental rotation from defensives to cyclicals, Growth to Value, and large to small is likely next year.

In credit markets, high yield bonds should be preferred, as tight spreads on defensive IG credits feel the impact of higher riskless rates. In particular, we are buyers of European senior Financials and US banks and insurer bonds to play the Great Rotation trade in credit. We are underweight government bonds, but would not write off the asset class entirely. Easy policy and the US fiscal cliff should cause a flatter curve, to the benefit of US 7s30s flatteners, at least in the early part of the year. Meanwhile, bunds should outperform in Europe, particularly versus UK Gilts. Lastly, to hedge against a resurrection of volatility, we recommend buying 3m AUDUSD options, longer dated EURUSD options and options on Asian equity indices. Rules & Tools Below we highlight our proprietary market and sentiment indicators. Our EM flow trading rule just gave a “sell” signal last Thursday, which suggests Emerging Markets will likely underperform Developed Markets over the next 4-5 weeks. Otherwise, most of our trading indicators (including the FMS cash indicator) are currently neutral.

Appendix: asset allocation approach

Our Dynamic Asset Allocation Framework incorporates short and long term views to recommend core positioning plus actionable trades across 17 asset classes. Core view Our Core View represents our base case view of the Global economy along with fundamentals of all the asset classes and the investment time horizon is targeted to be three to six months from the date of publication. The views are in simple terminology of Bullish = Positive on the asset, Bearish = Negative on the asset and Neutral as no strong recommendations on the asset. We incorporate our base case view of the Global economic outlook and the fundamentals of each asset. To optimize our core Asset Allocation we use a Black-Litterman approach. Trading signal Our trading signal is a “trading view” with a 3-6 week time horizon from the date of publication. Trading signals are based on a balanced score card incorporating sentiment, directional model, fund flows, valuation and technical analysis.

Statistical market model: A simple mean reversion model which looks for how stretched markets have become in the short run; the model measures the likelihood of a positive or negative return in an asset class over the short term based on recent price action and long run return expectations

Valuation: A short-run assessment of whether an asset class is cheap, rich or fairly valued vs either history or our house price targets. Equity valuations are based on a balanced scorecard. Government bond valuations measure current 10y yields vs house targets. Credit valuations are based on a zscore of the current level of OAS vs the business cycle adjusted average OAS spread; commodity valuations are based on an estimate of our valuations for raw commodities vs the current level of the forward curve

Technicals: chart signals for each asset class looking for key supports, resistances and chart formations as well as evidence that an asset is overbought or oversold; uses simple trendline, moving average and RSI

Flows: where available this is based on EPFR fund flows data; we rank asset classes by flows momentum and look for evidence of a reversal in sentiment being reflected in flows; flows are measured as a z-score of current flows vs 10y average

Positioning: an aggregation of our FMS positioning, taking net over and underweights for each of the assets we track, and CFTC positioning data; both FMS and CFTC data are z-scored vs 10y average; the aggregate score gives a rank of overowned/underowned/neutral

The output from the balanced scorecard together with the fundamental views of the Investment Strategy Team and other strategists is the basis of the short-term signal. This is presented as a five-point scale from “strong trading sell” to “strong trading buy.” The short-term signal can and will disagree with the core view at times - we may hold a core bullish view on an asset, but short-term signals could certainly indicate a “trading sell” after a sharp rally. In such an instance the recommended actions will reflect the core and short-term views - eg, hedging an asset where we are fundamentally bullish but see it as having run up too far too fast. 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 NASD Registered Options Principal. For detailed information regarding the risks involved with investing in listed options:

http://www.theocc.com/about/publications/character-risks.jsp