A recent report from BofA Merrill Lynch Global Research highlights latest investment trends and concerns.
To “risk-on” or to “risk-off”?
Despite a large number of unexpected shocks ranging from natural disasters to political unrest or sovereign debt woes,  BofA Merrill Lynch Global Research December 2010 recommendation to overweight equities and commodities and limit holdings of sovereign debt has held up so far. Looking forward, BofA Merrill Lynch Global Research is concerned about the withdrawal of global monetary policy stimulus and the potential for further oil supply losses in the MENA region. But the US economy is improving steadily and global imbalances such as China’s large current account surplus or the lack of competitiveness in the Eurozone periphery are starting to unwind, reducing the risks to growth. Most crucially, the world economy remains on a firm expansion path. BofA Merrill Lynch Global Research economists project global GDP growth of 4.2% this year and 4.9% in 2012. Thus they argue that investors should continue to keep their portfolios in a “risk-on” mode for now.
We remain overweight equities and commodities
The months ahead present a number of key challenges for investors. On the one hand, some additional upward pressure on commodities should not upset the economic recovery, as long as it is transitory. On the other, a persistent uplift in Brent crude oil prices above $130/bbl this year could create severe economic damage. Still, we believe that the economic recovery currently underway, coupled with relatively easy monetary policy, should continue to boost corporate profits and commodity prices. But the risks are different relative to those in December. BofA Merrill Lynch Global Research now increase our overweight in commodities, while at the same time reducing the overweight in global equities. In the absence of further shocks, we expect the recovery to broaden, and we maintain our underweight in fixed income and cash.
Headline inflation volatility is a key risk to our view
With so much spare capacity in many parts of the global economy, it is hard to argue against a low interest rate environment. But this spare capacity is not evenly distributed. Utilization rates in the commodity sector are close to cyclical highs, while other sectors remain depressed. In our view, this gap in utilization rates across economic sectors is a structural, not a cyclical problem. Thus, by focusing on core inflation and ignoring the structural issues, the Fed may be aggravating the sharp swings in commodity prices. In turn, the volatility of headline inflation is correlated with the volatility of economic growth, a major driver of price volatility across financial and physical assets.
We suggest renewed investor focus on tail-risk hedging
With swings in headline inflation and economic growth among potential risks, hedging remains prudent at the right price. Cash is an unattractive hedge as it underperforms as assets rally, doesn’t protect the rest of the portfolio in a downturn, and is earning negative real yields. BofA Merrill Lynch Global Research suggest reducing cash to fund selective tail-risk hedges. With equity hedge costs back down to pre credit-crisis levels, equity put options remain the cheapest place to hedge a “risk-off” event, and costs can be further reduced by avoiding crowded trades.
