File 014432
BofA Merrill Lynch Global Cross Asset Strategy - Year Ahead Investment Report (File 014432)
BofA Merrill Lynch investment strategy report analyzing global market response to Trump's 2016 election victory, with recommended cross-asset trades and hedging strategies for 2017-2018.
Summary
This November 30, 2016 investment strategy report from BofA Merrill Lynch examines the market implications of Donald Trump's election victory. The analysis concludes that many market moves have been frontloaded and recommends positioning for modest growth and inflation increases, particularly in Japan. The strategy includes long positions in Nikkei (NKY), emerging market equities, and yield-bearing assets, while hedging against potential USD strength and rising rates through short 10-year real rate positions and Chinese yuan put options. The report presents a diversified portfolio of cross-asset trades across equities, fixed income, credit, and foreign exchange markets.
Global Cross Asset Strategy – Year AheadThe Trump inflectionInvestment Strategy30 November 2016 CorrectedKey takeaways• Market response to Trump is logical but moves have been frontloaded. We now seeUSD & rates only modestly higher next year.• We see higher growth and inflation, notably in Japan. We go long NKY, stay long EMAXJ & selective yield in equity/ credit.• Risk is an overshoot so we stay long USD/ short rates, adding a CNH put and short10Y real rates. CNH a hedge vs trade risk.Investment strategyGlobalJames Barty >>Investment StrategistMLI (UK)+44 20 7996 3291james.barty@baml.comSee Team Page for Full List of ContributorsTrump extends some trends, starts othersIn the three weeks since Donald Trump’s election victory global markets have seen somedramatic moves. Som1e of those moves are extending trends that had already started –higher yields, higher USD, rotation from long to short duration. Others are new – JPYlower, NKY higher, EM lower. The key question is how much more they can go?Growth/inflation higher in 17/18 - modest fiscal boostOur economists think the fiscal impact of Trump will be modest at 0.5% on growth inH2 next year. Fiscal stimulus elsewhere also to be modest but it is taking the pressureoff monetary policy. Growth was already improving so any fiscal stimulus helps. Oureconomists have both growth and inflation higher into 2017 and 2018.Inflection point in markets but much discounted alreadyMarket moves at turning points are often violent. The task of investors is to work outhow much is already discounted. Our fixed income strategists have 10Y US yields at2.65bp and bunds at 65bp at end 2017, also EUR/USD at 1.02 so moves lookfrontloaded to us. That suggests their implications for other markets should fade.Unauthorized redistribution of this report is prohibited. This report is intended for amanda.ens@baml.comEvolution not revolution – long NKY, short 10Y real ratesIf that is the case then we do not want to make wholesale changes to our strategy. Wemake two key changes today, adding long NKY (Japan strategist targets 20k) and short10Y real rates trades. The former is part of our strategy to be pro-growth and we thinkit complements our long EM Asia trade being affected differently by USD strength.The hunt for yield is dead, long live the hunt for yieldIf yields only rise modestly next year then the hunt for yield will live on. We keep a yieldbasket in European equities, AT1s and spread in Euro/US credit. We go outright longEuropean Healthcare by lifting our Food & Beverage short, which has dropped sharply.Overshoot in rates, USD and trade key risks – add CNH putThe world would look very different if the US 10Y blew through 3% and the USD wenton a tear, so we stay long USD and short rates. We add a CNH put vs USD as a hedgeagainst an escalation of trade tensions under the new Trump administration.>> Employed by a non-US affiliate of MLPF&S and is not registered/qualified as a research analyst underthe FINRA rules.Refer to "Other Important Disclosures" for information on certain BofA Merrill Lynch entities that takeresponsibility for this report in particular jurisdictions.This document is intended for BofA Merrill Lynch institutional investors only. It may not bedistributed to BofA Merrill Lynch Financial Advisors, retail clients or retail prospects.BofA Merrill Lynch does and seeks to do business with issuers covered in its research reports. As aresult, investors should be aware that the firm may have a conflict of interest that could affect theobjectivity of this report. Investors should consider this report as only a single factor in makingtheir investment decision.Refer to important disclosures on page 26 to 27. Analyst Certification on page 25. 11691609Timestamp: 30 November 2016 12:00AM ESTCurrent trade recommendationsTable 1: Current cross asset tradesAsset Trade idea StrategistLong European Quality Yield Screen (yield)James BartyLong SXDP IndexRonan CarrEquitiesLong NikkeiShusuke YamadaLong European index dividend futuresJames BartyLong MSCI Asia ex-JapanAjay KapurLong RTY short SPX 2y variance swapNitin Saksena3000-2850 SX5E put spread Dec 16 expiry James BartyEquity volLong NKY short SPX Dec 18 variance swapBenjamin BowlerLong SX5E short SPX Dec 18 variance spreadAbhinandan DebEurostoxx 2y/3y put calendarAbhinandan DebShort EUR/SEKKamal SharmaLong USD/CNY callClaudio PironFXShort GBP/USDKamal SharmaLong USD/AUDIan GordonLong RUB/ZARDavid Hauner2s-5s-10s flyShyam S.RajanFixed IncomeShort US 10y real ratesShyam S.RajanPaying 5y GBP real rate swapMark CapletonBuy 30y US IG Industrial spreadsHans MikkelsenCreditBuy basket of Euro AT1sBarnaby MartinLong Xover short MainIoannis AngelakisSource: BofA Merrill Lynch Global Research. For the full methodology and reference pricing please see Appendices. New trades in bold.ThemesLong Cyclicality• Long Asia EM – recovering growth, earnings revisions and cheap valuation.• Long Nikkei – growth picking up, JPY soft, 20k target.Long Yield• Long European dividend yield stocks – 5% yield, big pick up over IG credit.• Long Dec 18 SX5E dividend future – implies 4% drop from 2016, we see 4% rise.• Long basket of AT1s – high yield, equity cushion to rise.• Long XOver short Main – investors’ reach for yield to push them towards Crossover.• Long basket of 30Y US industrial IG spreads – further spread compression.Hedge the Fed/Trump• 2-5-10 fly – 5Y part of the curve looks most vulnerable to Fed hiking.• Short 10Y real yields – inflation breakevens have adjusted real rates have not.• Long USD – long via USD/GBP and USD/AUD, we think policy divergence will driveUSD stronger if the Fed tightens as our economists expect.• Long USD/CNH 7.6 6 month call – hedge against trade tensionsHedge the Rest• We are long SX5E, NKY and RTY vs SPX variance. Carry positive, convex in a sell-off.• Long Dec 17/18 SX5E put spread. Long 3000-2850 Dec 16 put spread.Alpha Trades• Long European Pharma. Sector discounting no pipeline, valuation back to cheapestsince 2011. Solid yield too.• Paying 5y UK real rates at -254bp. Implied inflation/rates inconsistent.• Long RUB/ZAR (positive on oil, cautious on S African politics).• Short EUR/SEK, strong Swedish growth, limiting room for Riksbank easing.2 Global Cross Asset Strategy – Year Ahead | 30 November 2016The Trump inflectionChanges today: Add NKY long, 10Y real rate short and CNH put, close forwardKospi vol and Food & Beverage short. We are not making mass changes today. Whilesome of our trades have worked better than others post-election we are broadly happywith the balance. We still want exposure to growth and to own yield where we can butalso want to protect ourselves from a further surge in the USD and rates.We diversify our equity long in EM and European yield with a long Nikkei position.It is not the best entry point but we suspect it has further to run on a one year horizon.A stronger USD is good for Japanese equities where it is not for EM, so theycomplement one another. We add a short US 10Y real rate trade too to protectagainst rising US yields, as breakevens have already moved significantly. We close ourKospi vol trade (changed view from strategists) and drop the short Food leg of ourPharma/Food trade, reflecting the sharp sell-off in the long duration sectors of late.Summary: Still be long growth and yield but hedge with USD and RatesYear aheads are notoriously tricky to write and almost always wrong. Anyone whowanted to correctly predict the outcomes and how markets would react to them in 2016did not need so much as crystal ball as a time machine. As investors and strategists wehave to make calculations as to the most likely outcomes, where is the best upside toplay them and how best to hedge the risks around them.Donald Trump’s election is in our view an inflection point for global markets,starting new trends in some asset classes and extending trends in others. It doesnot completely change the world though, as the disinflationary and weak growthpressures that have plagued the world since the GFC are structural rather than cyclical.But the shift to fiscal and populism is likely to boost growth and inflation, so it doeschange the picture to a significant degree. If we are to call it an earthquake it is perhapsa five rather than a nine on the Richter scale.We have to adjust our way of thinking though. The rise in rates and higher USD thatwe had hedged against now look like they are going to go further. That is going tohurt longer duration assets. So we continue to run our long USD positions and add toour short rate positions (via 10Y real rates). There is risk around trade and geopolitics,which has to make us more nervous of our EM positions. So we diversify our risks bypairing our long EM position with a long Japan position and add a CNH put.But the world is not completely changing. Even in the new order we only forecast 10YTreasuries at 2.65% and Bund yields at 65bp end 2017. So the hunt for yield will notdisappear completely. We still want to own yield, but as we have said of late it cannotbe yield for yield’s sake. Yield in equity markets has been safest in the shortest durationbuckets, such as Banks and Cyclicals since the summer. We changed our yield basket lastmonth is this direction so we keep it. We stay long AT1’s and in credit we keep ourspread trades both in Europe and the US.AND we remind investors of something we said at the start of 2016, be preparedto trade the ranges in markets. If there was one lesson of the last year it was that.When assets get very loved and overbought, sell them, when it is the opposite you haveto buy them. Think of buying EM and commodities in February. Think of sellingdefensive equities and bonds and buying banks post-Brexit. None of us will get thatright all of the time, but the Warren Buffet maxim “be greedy when others are fearfuland fearful when others are greedy” is particularly useful in current markets.Finally, as cross asset investors think about what can go wrong with your positionsand find asymmetric hedges for them if you can. That should be the edge you have atlooking across the range of asset classes compared to single asset class investors.We would like to thank our BofAML colleagues who have supported our product thisyear by providing many such ideas and trust they will continue to do so through 2017.Global Cross Asset Strategy – Year Ahead | 30 November 2016 3X Asset Strategy: Long growth, short bonds, long USD butthe hunt for yield lives onClearly markets are different and will continue to be so under President elect TrumpBUT not everything will change. The disinflationary forces triggered by the GFC havenot gone away but the decision to focus on fiscal stimulus, not just in the US but alsoJapan and to a lesser extent the UK, is a welcome shift taking some of the burden awayfrom monetary policy. It means rates should be higher for any given amount of growth.But higher does not mean a return to pre GFC levels of rates, which we need to bear inmind when setting our strategy. Indeed, our strategists 10Y forecasts are US 2.65%,Euro 0.65% and Japan 0% for end 2017.Similarly on trade, for all the rhetoric of the President-elect again we do not think hewants to trigger trade wars that would damage US growth. That means we should notnecessarily drop our pro-EM bias.So we think of it as an evolution rather than a revolution in the way our strategy isstructured. We wanted to be exposed to growth, we tweak that by adding a NKY long toreplace our US energy long. We continue to have yield in the portfolio where we can findit, which is through a mixture of equities and credit (AT1’s, European yield basket, Xoverv Main and US long date industrial spreads).Even more than before we want to be protected against a stronger USD and higherrates, hence the addition of the 10Y real yield trade, and trade tensions which we havetried to cover through our CNH put.Nov 8 th accelerates some trends, starts otherBefore the US election we said that the tectonic plates were starting to shift, with bondyields having troughed and starting to head higher. We thought there were signs toothat global growth might be shifting up a gear. So we wanted to have defensivepositions in bond markets, be long the USD and be long growth where we could. Theelection of Donald Trump has arguably turned this gradual shifting of plates into a fullblown earthquake for global financial markets.The key questions for investors as we look ahead to 2017 are how big an earthquakeand how much the moves that have happened since November 8 th are likely to beextended into next year vs how much we have frontloaded them already in 2016.Chart 1: USD/JPY has surged post-TrumpChart 2: As have bond yields1252.5120115JPY/USD2.32.110y UST yield1101.91051.71001.5951.3Oct-15Nov-15Dec-15Jan-16Feb-16Mar-16Apr-16May-16Jun-16Jul-16Aug-16Sep-16Oct-16Oct-15Nov-15Dec-15Jan-16Feb-16Mar-16Apr-16May-16Jun-16Jul-16Aug-16Sep-16Oct-16Source: BloombergSource: Bloomberg4 Global Cross Asset Strategy – Year Ahead | 30 November 2016Chart 3: EM debt and equity have been hitChart 4: While Banks versus Staples has gone ballistic950900850800750700650Oct-15Nov-15Dec-15MSCI EMWisdom Tree EM Local Debt Fund(RHS)Jan-16Feb-16Mar-16Apr-16May-16Jun-16Jul-16Aug-16Sep-16Oct-164039383736353433320.430.410.390.370.350.330.310.290.270.25Oct-15Nov-15Dec-15Jan-16S&P 500 Banks relative to Food & BevFeb-16Mar-16Apr-16May-16Jun-16Jul-16Aug-16Sep-16Oct-16Source: BloombergSource: BloombergThe moves since Nov 8 th have certainly been violent in certain asset classes. USD/JPYstands out, but the sell-off in US treasuries has been very marked, the hit to EM fixedincome equally big, while in equity markets the outperformance of the Russell, the surgein the US banks and the sell-off in long duration equities has been remarkable.Some of these moves, such as stronger USD, higher yields, banks vs staples wereextensions of moves that had already begun. Others, such as Russell vs S&P, JPY, Nikkei,were the start of new moves where 8 Nov marked a key turning point.The moves that had already started are now getting quite stretched with US 10Y yieldsup 5 standard deviations from the July low, with US Banks up by a similar amount vsStaples. The USD/JPY move though is more like a 2 SD move, with the NKY similar (ifwe exclude the 7% drop on US election day).Peak liquidity, deflation, inequality and globalisation – watch for Peak TrumpSo what does a Trump presidency mean for the world? Michael Hartnett, our ChiefInvestment Strategist sums it up nicely with four of his seven peaks. Peak liquidity –the era of excess liquidity is over; Peak inequality – with fiscal stimulus to addressinequality; Peak globalisation- free movement of trade, labour and capital ending, FXwars starting; and Peak deflation – the secular low point in bond yields now behind us.We would add a peak to that which investors need to bear in mind – Peak Trump. Whatwe mean by that is at what point do the policy changes of the Trump presidency getfully discounted in markets. We have moved pretty quickly to do that but we suspectthere is more to go, even if the quick returns have probably already been made.If we think about these peak questions, the two that stand out to use as obvious and notreally open to challenge are Peak liquidity and Peak deflation. The Fed left its peakliquidity position behind ages ago, the BOJ has moved to yield rather than liquiditytargeting, the BOE may extend its current programme of QE one more time but then isprobably done and even the ECB is talking about tapering, even if they are unlikely to doit in December. The Peak deflation theme follows on from this with the secular low inbond yields surely behind us if the central banks are stepping away from flooding theworld with ever more liquidity.Peak liquidity/deflation means higher yields – inflation expectations adjustingThe question then is how much yields will likely rise from here. Much of course dependson how quickly inflation picks up. Markets have already moved to price in a significantpick-up in expected inflation as the two charts below show. To our mind breakeveninflation rates had been too low for too long, which is one reason we wanted to bedefensive in bond markets. It would seem to us that inflation expectations are now upwith events. US headline CPI at 2.5% is consistent with the Fed modestly overshootingGlobal Cross Asset Strategy – Year Ahead | 30 November 2016 5its 2% core PCE target. Our economists think that the Fed may well aim a little high inthe short term on inflation to ensure they have sufficient room to ease in the event of adownturn. However, it is unlikely that the Fed would tolerate a sustained overshoot oftheir inflation objective. That is particularly the case if the Fed under President Trump ismade more hawkish as our economists think it probably will be (see Liquid Insight:Trump’s stamp on the FOMC).Chart 5: US 5Y5Y forward inflation back towards 2.5%3.33.12.92.72.52.32.11.9US 5y5y fwd inflation swap1.7Chart 6: Euro 5Y5Y forward inflation up to 1.6%2.82.62.42.221.81.6EUR 5y5y fwd inflation swap1.41.2Source: BloombergSource: BloombergEqually, our economists in Europe are sceptical on the ECB’s ability to get inflation torise significantly from current levels. Optically there is scope for European breakevensto head higher if the ECB were to be successful but investors are likely to want to seesome evidence of rising inflation first before they price that in. We will return to thisbelow. For now we agree with our fixed income strategists that the rise in inflationexpectations is probably sufficient and that any rise in yields from here has to be one ofhigher real yields.They think such a rise as a tightening of monetary conditions which may be self-limitingin the short term, particularly as the fiscal boost in the US is likely to be back loaded interms of 2017. If rates move too quickly and the USD follows before the fiscal stimuluskicks in they could actually dampen growth. Indeed, our US economists have shavedtheir near term growth forecasts already to reflect the current moves. They do notexpect the fiscal stimulus to start to boost growth before the 3 rd quarter.Fiscal + hawkish Trump Fed means we stay short 5Y US via 2-5-10 butterflyOur fixed income team estimated how much fair values of the different parts of thecurve would have to move were the market to move into line with the dot plot. Updatingthose estimates for the move since their publication we find 2Y rates can move another11bp, 5Y 39bp and 10Y 33bp. They argue that given we are past the inflection point forrates, with fiscal policy being eased and now with a more hawkish Fed under Trumplikely, the dot plot should form the floor not the ceiling for rate expectations. All of thistranslates into a view that 10Y yields can push to 2.65% by the second half of 2017.Given their views on the curve we continue to run the 2-5-10 butterfly. It has movedfrom around -10bp to +10bp since the election, and our fixed income strategists havemoved their target to +20bp.6 Global Cross Asset Strategy – Year Ahead | 30 November 2016Chart 7: 5Y yields to continue to underperform0.50.40.30.20.10-0.12s-5s-10s US fly-0.2Jan-14 Jul-14 Jan-15 Jul-15 Jan-16 Jul-16Source: BloombergChart 8: Real rates likely to feel the pressure going forward3.532.5210y US TIP yield1.510.50-0.5-12007 2008 2009 2010 2011 2012 2013 2014 2015 2016Source: BloombergPeak globalization/inequality means higher real rates – short 10Y US real ratesOur fixed income team make the point that globalization has been a driving force behindlower real rates as it has been good for EM growth and reserves. Those reserves thenfound their way back into the US holding real rates lower. They argue that as the globalsavings glut unwinds real rates have room to re-price. Peak inequality also means anunwind of globalization as politicians seek to protect workers from the depressingeffect on wages coming from overseas. Donald Trump has already said he intends tocharge China with being a currency manipulator. Whether he does or not and whataction he takes to accompany it remains to be seen, but artificially low currenciesgenerating high current account surpluses are unlikely to go down well with the newadministration. That lends weight to the fixed income team’s arguments.Peak inequality may also mean less migration across the world – think Trump’sarguments on illegal immigration from Mexico and Theresa May’s desire to limitmigration into the UK post Brexit. Less migration likely means more upward pressure onwages, which is the inflation expectations side of the argument. But Michael Hartnettalso thinks it means more action on fiscal policy. The UK government have implementeda £24bn infrastructure fund in the Autumn statement. Donald Trump wants to trigger upto $1tn of infrastructure spending in the US in addition to the tax cuts.The fiscal boost should push real rates higher (at least in the short term). Some Fedmembers have acknowledged this suggesting that equilibrium interest rate might bemoved higher by fiscal stimulus. The rates team also rightly says while they want to bebearish rates given the speed of the move so far it is also right not to be foolish. Givenhow much inflation expectations have moved they think there is better risk reward inreal rates. They argue the 10Y real rate is the most vulnerable to further moves higher inrates. Although they have already risen from around zero in the summer to ~50bp nowthey think 10Y real rates can reach 1%. So we add that trade to our 2-5-10s position.Implications for other asset classes: Stronger USD, weaker EM?The forces impacting on markets from the Trump victory have not been confined torates markets, although it is probably fair to say that most (although certainly not all) ofthe impact stems from the move in rates. Higher US rates have meant a stronger USD,an outperformance of short duration over long duration equities, a hit to EM debt and allforms of carry trades.Global Cross Asset Strategy – Year Ahead | 30 November 2016 7Chart 9: USD breaks to new highs105DXY Curncy1009590858075Chart 10: As Treasury yields open big gaps with Europe and Japan2.72.52.32.11.91.71.5US 10y yield10y Bund yield (RHS)10y JGB yield (RHS)10.80.60.40.20-0.2Source: Bloomberg1.3-0.4Oct-14 Feb-15 Jun-15 Oct-15 Feb-16 Jun-16 Oct-16Source: BloombergThe USD is a case in point, with the higher US rates creating a significant gap toequivalent Euro and JPY rates. With the ECB likely to extend QE by the full currentamount (despite the debate over timing) and the BOJ committed to capping JGB yieldsat zero, a surge higher in the USD was the logical outcome. Given that the biggest gapin intentions was relative to Japan it is perhaps not surprising that the JPY has been thebiggest victim, with the JPY falling some 10% against the USD since the election. TheDXY has broken out of the top end of the trading range it has been in since early 2014.The stronger USD is not just reliant on higher yields, but also other factors such as thelikely repatriation of money into the US under a new proposal for US corporates toreturn funds at a concessionary tax rate, generally referred to as HIA2.We had positioned long USD as well as short rates, not so much as an explicit play on aTrump victory but more against a more hawkish Fed in 2017. We were also of the viewthough that a Trump win would likely be positive for the USD and higher yields. Goingback to our fixed income strategists’ point that the dot plot should now perhaps be thebase case for the markets that does imply higher yields which should continue to bedollar supportive. Like their bond yield forecasts though our strategists call for amodest further appreciation of the USD rather than a huge surge. They have the USDpeaking at 1.02 vs the EUR, 120 against the JPY and 1.43 vs the CAD.So the big violent move has likely happened even if we still see the USD strengtheningfurther next year. Certainly our FX strategists are not calling for a surge in the USDsimilar to the one that happened in 2014/15.The reaction of the US economy to “Trumponomics” is keyThese two things are important for other asset classes. If we really thought 10YTreasuries were heading to 3%, the Fed likely to tighten above the dot plot and the USDto surge another 10% in quick order, the impact on other asset classes would likely bemore severe. That would undoubtedly exacerbate the trends we have seen out of EMand long duration equities. We also suspect it would make it much harder forcommodities to perform. We see holding USD and short rates positions as necessary tohedge against such an outcome with limited downside risk if it does not happen.8 Global Cross Asset Strategy – Year Ahead | 30 November 2016Chart 11: Dollar strength leads to immediate trade drag (inverserelationship)1.51.00.50.0-0.5-1.0-1.5Contribution of net exports to real GDP (lhs, pp)Real trade weighted USD, QoQ (rhs, % yoy)-2.0Q2-2013 Q1-2014 Q4-2014 Q3-2015 Q2-2016Source: Federal Reserve Board, Bureau of Economic Analysis6%4%2%0%-2%-4%Chart 12: Expected path of fed hiking cycle (bp)200180160140120100806040200Current market pricingMedian dot, Sep-16 SEPBofAML forecast0 4 8 12 16 20 24# of meetings into tightening cycleSource: BofA Merrill Lynch Global Research, Federal Reserve, BloombergNevertheless it is not our central scenario in part because there is a risk that much of aTrump surge could be bad for growth. As we noted above the fiscal stimulus is likely tobe back loaded as far as 2017 is concerned. In the meantime the FX and Rates teamspredict an 8-10% appreciation of the USD from pre-election levels and 10Y rates about80bp higher. Our economists note that a 10% appreciation of the USD is estimated toslice around 0.5% off of US GDP growth over two years. Higher mortgage rates fromhigher bond yields would also likely dampen growth. As a result, they have actuallylowered their forecast for US growth in the first half of next year to around 1.5% beforeseeing it rebound to around 2.3% in H2 and then 2.5% in 2018 as the fiscal stimulusfeeds through.Various Fed members, notably Bill Dudley of the NY Fed, have said this year that astronger USD would have an impact on monetary policy. So to some extent we see USDstrength as self-limiting as it would start to lower the profile of likely Fed tightening.Our economists are also cautious as to the extent of the impact of the Trump fiscalplans. Assuming that there is a compromise between the Trump administration andCongress our economists think the likely scale of tax cuts is $2-3tn over 10 years, with$200-300bn of this in 2017. Given the low estimated multiplier from any proposed taxcuts and a Congress likely to limit the amount of an increase in government spending,they look for a modest 0.5% boost to growth.Upside risk to growth and rates if Trump does more on fiscal, less on tradeIf Congress passes more of the Trump stimulus plan, particularly on the infrastructureside, and there are no significant changes to trade or immigration policies then our USeconomists think growth could potentially hit 3% in 2017 and 3.5% in 2018. That wouldlikely be accompanied by a faster pace of Fed hikes than they currently assume (which istwo hikes between now and end 2017 followed by 3 in 2018).Trade policy and its impact vitalThe other key factor of the new administration is going to be the direction on trade.President elect Trump has already said he will pull out of the TPP, TTIP looks likely toget the same treatment, while NAFTA is set to be renegotiated. Meantime Trump saidhe will label China a currency manipulator. This is the other side of the PeakGlobalisation/Peak Inequality coin and none of it looks good for global trade. Combinedwith the stronger USD and higher rates, it is easy to understand the knee jerk reactionof investors to sell EM asset, particularly given the gains of earlier this year.Global Cross Asset Strategy – Year Ahead | 30 November 2016 9Chart 13: China could be named a currency manipulator76.96.8CNY/USD6.76.66.56.46.36.26.16Source: BloombergChart 14: But world trade has slowed – would Trump make it worse?151050-5-10World Trade growth (%)-15Jan-72Jan-75Jan-78Jan-81Jan-84Jan-87Jan-90Jan-93Jan-96Jan-99Jan-02Jan-05Jan-08Jan-11Jan-14Source: WTO, BofA Merrill Lynch Global ResearchThe question for investors is whether Trump the candidate or Trump the deal makingbusinessman will eventually be the driver behind trade policy. It is not impossible toimagine the President-elect gaining some concessions from his hard line stance andthen claiming victory. After all, since one of his aims is to get the US economy growingat 4% a year, a prosperous global economy to export into is probably preferable to onethat is taking a hit from an aggressive US trade policy. That is the inclination of our EMstrategists and economists, so they are expecting the reality to be softer than therhetoric.At this stage we have to acknowledge that it is little more than an educated guess. Itmakes us less certain of our long EM equity position than we were. Nevertheless, wehad already switched it out of an MSCI position into an Asia ex Japan in part because ofUS election risks and our strategists are particularly upbeat about Asian markets. Theythink they are cheap, they are positive on China and they think growth and henceearnings will surprise on the upside.What about the rest of the world? Growth has been improvingGrowth indicators have been improving around the world of late. Data since the USelection would seem to support that with the PMIs in the Euro Area improving again andtheir equivalent in the US sustaining the gains seen last month. Our EM indicatorsremain robust and our China ACT indicator continues to indicate steady growth theretoo.Our economists forecast 3.5% global GDP growth with EM growth around 4.7%. OurEuro Area growth numbers have been nudged back up towards 1 ½% with Brexit notproving to be as much of a drag as feared. We still expect the UK economy to seesomething of a slowdown in 2017 as the lagged effect of the fall in the pound hitsconsumer incomes. Perhaps our most optimistic view of the world, relative toconsensus, comes from Japan where with fiscal policy turning more supportive (we putthe package at 1.5% of GDP) we see growth at 1.4% in 2017.10 Global Cross Asset Strategy – Year Ahead | 30 November 2016Chart 15: Eurozone PMI’s point to solid growth60.058.056.054.052.050.048.046.044.042.0EA Services PMI EA Manufacturing PMI40.0Aug-09 Aug-10 Aug-11 Aug-12 Aug-13 Aug-14 Aug-15 Aug-16Source: MarkitChart 16: Japanese growth expected to accelerate in 20173.02.0Forecasts1.00.0-1.0-2.02011 2012 2013 2014 2015 2016 2017Private demandPublic demandNet exportsReal GDP growth %YoYSource: BofA Merrill Lynch Global Research forecasts, CAOIt is a decent global growth picture and it is not impossible to imagine it being stillbetter should the US surprise on the upside and the impact on trade from a Trumppresidency prove to be modest.It certainly fits with the Peak Deflation theme since this stronger growth is expected tobe accompanied by a pick-up in inflation. We have core PCE in the US reaching 1.9%next year in our core scenario. Our headline inflation numbers are higher because of theexpected increase in the oil price from our commodity strategists. Indeed with oilexpected to reach $60pb (OPEC permitting) headline CPI inflation in the US could push3%. In the Euro Area we see headline inflation rising to 1.2%, albeit with core inflationonly nudging modestly higher. UK inflation is expected to move markedly higher care ofthe lower pound, again with headline inflation pushing towards 3%. In Japan driven byour more optimistic view of the economy we project core CPI at 1%.Chart 17: BofAML sees GDP accelerating into 2018…Global GDP growth % DM GDP growth % EM GDP growth %4.75.13.24.13.14.13.53.82.11.51.71.9Chart 18: …with inflation picking up tooGlobal CPI inflation % DM CPI inflation % EM CPI inflation %4.23.6 3.63.82.5 2.42.831.7 1.80.70.32015 2016F 2017F 2018FSource: BofA Merrill Lynch Global Research2015 2016F 2017F 2018FSource: BofA Merrill Lynch Global ResearchPolitics – does populism strike again, this time in Europe?Few would have predicted both Brexit and a Trump win in 2016. Both had something todo with the Peak Inequality and Peak Globalisation themes. Politicians on both sides ofthe Atlantic tapped into a deep disquiet, particularly amongst white male blue collarvoters that they were not benefitting from this new globalised world. If opinion polls areto be believed (something which we have all learnt to question) then Italy may well endthe year with another vote against the governing party - although that one is perhaps alittle more complicated to dissect. We recently added a put spread on the eurostoxx tohedge against such a bad outcome here, which would be the case if it is perceived to beGlobal Cross Asset Strategy – Year Ahead | 30 November 2016 11supportive of the 5 star movement or threatened the recapitalisation of the Italianbanks (see Strategy Insights: Italy risks elevated).In 2017 the focus turns to core Europe, especially France and Germany. Because of thewinner takes all system in France we find investors are more concerned with thesituation there. Marine Le Pen and the Front National look likely to make it to thesecond round of voting (again according to polls) and until the vote comes in we suspectinvestors will be cautious about European markets. A Le Pen victory could likely bringthe future of the EU and the Euro into question as she has talked about Francewithdrawing from both. That in turn has arguably the potential to be even more of anearthquake for the world’s financial markets. Our central case is that centre rightPresident is elected in France (with Francois Fillon now the official Republicancandidate) and Merkel is returned at the head of a coalition government in Germany.Chart 19: German polls show a consistent lead for Merkel’s CDU party4035302520151050100908070605040302010CDU SPD AfD 0Chart 20: Fillon well ahead of Le Pen in polls showing a potential run-off12-14April15-17April13-16May10-12June14-17June9-11SeptFrancois Fillon (%) Marine Le Pen (%)25-Nov 27-NovSource: Allensbach (15-Sept, 13-Oct), Emnid (7-Sept, 14-Sept, 21-Sept, 28-Sept, 5-Oct, 12-Oct, 19-Oct, 26-Oct, 2-Nov, 9-Nov, 19-Nov), Forsa (2-Sept, 9-Sept, 16-Sept, 23-Sept, 30-Sept, 7-Oct, 14-Oct,21-Oct, 28-Oct, 4-Nov), Forschungsgruppe Wahlen (22-Sept, 13-Oct, 27-Oct, 10-Nov), GMS (14-Sept,12-Oct, 12-Nov), Infratest dimap (21-Sept, 5-Oct, 19-Oct, 2-Nov), INSA (5-Sept, 12-Sept, 19-Sept, 26-Sept, 3-Oct, 10-Oct, 17-Oct, 24-Oct, 2-Nov, 7-Nov, 14-Nov, 22-Nov), Ipsos (10-Oct)Source: Ifop (12-14 Apr, 14-17 Jun), BVA (15-17 Apr, 13-16 Mar, 10-12 Jun, 9-11 Sept), Odoxa (25Nov), Harris Interactive (27 Nov). Note: all 2016.Were this to be the case then we think there may well be room for a significant reliefrally in European assets. Until then we think it likely investors will demand a higher riskpremium.Brexit was the big political topic for Europe going into 2016. Going forward we see it asan ongoing issue but mostly for the UK. The political uncertainty is likely to be extended,even after Article 50 is triggered as any significant negotiations probably need to awaitthe outcome of the French and German elections. We expect the UK economy tostruggle as the lagged effect of the fall in the currency hurts consumers and while theremay be contrarian trades available in the GBP during 2017, our strategists think it goeslower first on the triggering of Article 50.12 Global Cross Asset Strategy – Year Ahead | 30 November 2016X Asset Trade IdeasRates – short 5Y US nominal and 10Y real rates, short 5Y UKreal ratesAs discussed above on the rates side we keep our 2-5-10’s butterfly but add a 10Y shortreal rates trade, to reflect the view of our fixed strategists that if yields are to go higherthen real rates will need to move. So we will not repeat the analysis here.Chart 21: Markets do not expect the BOE to react…43210-1-2-35y UK nominal 5y UK real 5y UK inflation-4Chart 22: …to a sustained overshoot of its inflation target3.7UK 5y5y inflation swap fwd3.63.53.43.33.23.132.92.8Oct-15Nov-15Dec-15Jan-16Feb-16Mar-16Apr-16May-16Jun-16Jul-16Aug-16Sep-16Oct-16Nov-16Oct-15Nov-15Dec-15Jan-16Feb-16Mar-16Apr-16May-16Jun-16Jul-16Aug-16Sep-16Oct-16Nov-16Source: BloombergSource: BloombergThe other fixed income trade we continue to like is short 5Y UK real rates. The marketcontinues to discount the Bank of England consistently overshooting its inflation targetwithout a response on monetary policy. Yet Governor Carney and other members of theBOE’s MPC have said that while they are willing to look through a short term inflationshock they would not tolerate a sustained overshoot.The market therefore is pricing something which suggests that the BOE will sacrifice itscredibility on the inflation side to (presumably) support growth. We would rather takethe side of the Bank in this situation. It is worth bearing in mind too that those on theright of the Conservative party who have been critical of Governor Carney and the BOEhave tended to want higher not lower short rates. When the PM and Chancellor have toreplace the Governor at the end of 2018 it is unlikely that they are going to choosesomeone more dovish.FX – long USD, short GBP, AUD, CNHWe have been long USD since August believing the risk reward to be skewed in favourof a stronger currency because we saw more room for the Fed to tighten than othercentral banks. Given the fiscal stimulus expected from the new administration the riskson that tightening profile have been skewed to the upside. We think the FX and FixedIncome strategists are right to think of the dot plot as a floor now for markets. Withyields still needing to move higher to get there that should put further upward pressureon the USD. The scope for gains though depends on the currency. The Euro is alreadyjust 3.5% from the target for next year whereas both the GBP and the JPY have about 7-8% to fall to our FX team’s targets. The team also continue to like short AUD positionsas they think this also captures risk off in the event of concerns over China.Whilst the short GBP has only worked modestly since the US election, we continue tothink Brexit uncertainties will weigh on the currency into 2017 and our FX strategiststarget 1.15 in the aftermath of the article 50 decision.Global Cross Asset Strategy – Year Ahead | 30 November 2016 13Chart 23: AUD fell post US elections…Chart 24: …GBP has held up so far but article 50 looms in Q10.81.550.780.760.74AUD/USD1.51.451.41.350.721.30.70.68Oct-15Nov-15Dec-15Jan-16Feb-16Mar-16Apr-16May-16Jun-16Jul-16Aug-16Sep-16Oct-16Nov-161.251.21.15Oct-15Nov-15Dec-15Jan-16GBP/USDFeb-16Mar-16Apr-16May-…Jun-16Jul-16Aug-16Sep-16Oct-16Nov-16Source: BloombergSource: BloombergToday we add a CNH put (expressed as a USD/CNH call at 7.6 strike) partly because itfits with our positive USD call but also because it is a potential hedge against the traderhetoric of the new administration descending into something more meaningful. Giventhe stated intent to declare the Chinese as currency manipulators and the concern thatour currency strategists already have about the amount of reserves the Chinese hold, itis not impossible to imagine a much weaker CNY/CNH should the Chinese authoritiesallow a free float. We see this as a sensible hedge against our long EM equity position.Chart 25: CNH continues to weaken, risk of more on trade tensions?Chart 26: RUB/ZAR choppy on oil and SA politics6.96.8CNH/USD0.250.246.76.66.56.40.230.220.216.36.20.20.19RUB/ZAROct-15Nov-15Dec-15Jan-16Feb-16Mar-16Apr-16May-16Jun-16Jul-16Aug-16Sep-16Oct-16Oct-15Nov-15Dec-15Jan-16Feb-16Mar-16Apr-16May-16Jun-16Jul-16Aug-16Sep-16Oct-16Nov-16Source: BloombergSource: BloombergWe have two other standalone currency trades, short EUR/SEK and long RUB/ZAR. Theformer has dropped as the EUR has weakened against the USD. We continue to thinkthat the Swedish economy is more robust than the Eurozone and that the Riksbank willsooner or later have to adjust monetary policy accordingly. We see a lot more room forthis pair to move in 2017, particularly if there are political concerns ahead of the Frenchpresidential elections as these will likely weigh on the EUR.RUB/ZAR has been quite erratic since we re-established the trade, reflecting bothvolatility in the oil price and developments in South African politics. The latest noconfidence vote against President Zuma underlines how tricky South African politics areat the moment. Concerns will remain on the economic progress of the country until thepolitical situation becomes clearer. In the meantime we expect a higher risk premium tobe associated with the currency.14 Global Cross Asset Strategy – Year Ahead | 30 November 2016Equities: Add long Nikkei to EM AsiaGlobal equity markets have gone in very different directions post the US election. EMhave fared worst, Europe little changed, S&P at new all-time highs, the Russell andNikkei on a tear higher. This is not how we were positioned so we need to ask thequestion of whether and what we need to change.Table 2: MSCI EM Asia at a 2PE point discount to other equity marketsMSCI EMAsia 12mfwd PEMSCI Japan12m fwd PEMSCI Europe12m fwd PEMSCI US12m fwd PELatest 11.9 14.1 14.3 17.0Min 7.6 9.7 7.4 10.4Max 18.5 44.5 23.9 25.2Av 11.5 18.2 14.0 15.9SD 1.8 6.8 3.4 3.2Z-score 0.2 -0.6 0.1 0.3%ile 68% 31% 60% 73%Source: BofA Merrill Lynch Global Research, MSCI, IBESChart 27: Japan relatively cheap at 14.1x fwd earnings50454035302520151050MSCI Japan 12m fwd PE20002001200220032004200520062007200820092010201120122013201420152016If we stand back from the noise and just look at the valuations, the US is the mostexpensive, MSCI Asia ex the cheapest in absolute terms. Our strategists see decentearnings growth likely to come through in EM Asia, and while there is upside to USearnings estimates from potential corporate tax cuts at least part of it is priced in.Savita Subrahamian has a target for the US of 2300 in her year ahead Euphoria or fiscalfizzle?, an upside of a less than 5%. Our European strategists have an upside of around6%. So that leaves EM Asia and Japan (given our 20k target) as the stand outs accordingto our equity strategists. Indeed, the PE of Japan is towards the bottom end of therange since 2000.Sticking with EM AsiaOne of our concerns on EM was a more hawkish Fed and therefore a stronger USD. Sowe regarded our positions in those asset classes as something of a hedge to our EMpositions. As we explained above we are keeping that stance as on our central scenariothere is more to go and on a risk scenario where bond markets overshoot the USD islikely to follow.In the equity world, if our fixed income and FX forecasts are right, then we do not seethem as being an impediment to our EM Asia position working again. Our EM strategistsremain upbeat and Ajay Kapur actually upgraded his call to buy from a tactical pausepost the election (A Call to Action: Time to BUY Asia/EMs). They think the right focus isone on growth rather than the USD and we continue to be upbeat on the prospects forEM growth, particularly in Asia. Ajay in particular makes the point that Chinese nominalGDP growth has been accelerating and that tends to be very good for Asian equitymarkets. Nigel Tupper’s global wave has continued to improve and he argues thatremains consistent with strong performance from Asia ex Japan equities.Source: BofA Merrill Lynch Global Research, MSCI, IBESGlobal Cross Asset Strategy – Year Ahead | 30 November 2016 15Chart 28: The world economy is improving – broad-based recovery –good for Asia/EMsChart 29: EM cyclicals outperform as China’s NOMINAL GDP recovers.More to go.100Based on 291200180MSCI EM cyclicals/EM defensives price index, LSChina Bloomberg Monthly GDP Estimate YoY +…24801100160Cyclicals = energy, materials, consumer1960100014014900120940Percentage of Countries with…MSCI EM, RS201/11 1/12 1/13 1/14 1/15 1/16800700100801/051/061/071/081/091/101/111/121/131/141/151/161/174-1Source: BofA Merrill Lynch Global Research, Haver, BloombergSource: BofA Merrill Lynch Global Research, Bloomberg. Assumed GDP estimate for October-16 to besimilar to that for September-16.The question then is whether the strong USD or trade tensions from the new Trumpadministration can outweigh the more positive macro backdrop. We are inclined to backthe view of our strategists and think that it will, so we are sticking with our long EMAsia position. We are doing so with hedges via a long USD and a CNH put.Long Nikkei: target 20,000We had previously paired our long EM position with a long US oil equity position, butwith our US strategists downgrading the sector ahead of OPEC we removed it earlierthis week. We were therefore looking for another pro-growth trade to run alongside ourEM position. Long Japanese equities seemed the logical place to look. While weacknowledge we have missed the lows and that today’s entry point may not be ideal, wesuspect investors are not particularly long Japan yet since it was still showing asmodestly underweight in the last Fund Manager Survey.Chart 30: Net % AA say they are overweight Japanese equities60Asset Allocation: JP Equities14040130120201100100-2090-402007 2008 2009 2010 2011 2012 2013 2014 2015 201680FMS Net% say OW JP Equities, lhsJP Performance vs World, rhsSource: Thomson Reuters DatastreamSource: BofA Merrill Lynch Global Fund Manager SurveyOur Japanese equity and FX strategist Shusuke Yamada has been arguing for a whilethat we would see both a weaker JPY and a rebound in Japanese equities. While arguablythe JPY had turned beforehand, the Trump victory turbo charged the move. As the chartshows below Japanese equities do well historically during a period of bear steepening ofthe US yield curve. Our economists are also more upbeat on Japan thinking the weakerUSD, the new policy stance of the BOJ and the fiscal stimulus will push growth andinflation higher next year.16 Global Cross Asset Strategy – Year Ahead | 30 November 2016The combination of these factors suggest Japanese equities have further to run. We alsosee the position as being complementary to our EM position since whereas a strongerUSD is a drag on EM performance, it is beneficial for the NKY position.Chart 31: Japan equities have outperformed during US bear-steepening led by cyclicals, banks andinsurance121086420-2-4-6-8-10-12Japan Sector = cyclical outperform onUST bear-steepeningUSDJPY DXY MSCI JP MSCI JP /ex JPDiscretionary Financials Materials IT Industrials Energy Telecom Staples Utilities Health careBear steep Bear flat Bull steep Bull flatSource: BofA Merrill Lynch Global Research, Bloomberg.Curve movements based on 2yr move and 2s10s move (Bloomberg US Treasury yield index), so includes twist movements, but even if we exclude these implications do not materially change.Bear steepening (2yr + 16bps, 2s10s +33bps) = 11 quarters, bear flattening (2yr +26bps, 2s10s -20bps) = 10 quarters, bull steepening (2yr -48bps, 2s10s +28bps) = 10 quarters, bull flattening (2yr -27bps, 2s10s -30bps) = 12 quartersLong Europe equities via yield stocks & index dividendsWe continue to run two yield related trades in European equities. First, we remain long abroad selection of high yielding European equities. The dividend yield on offer inEuropean equities is one of the asset class’s key attractions. Europe offers a higherdividend yield than the other regions, with a 1.1% yield pick-up versus the DM averageand 0.9% against EM equities. Those also look attractive relative to history: Europe’syield spread to DM ranks at the 87 th percentile of the 20-year range. Europe’s DY alsolooks attractive relative to sovereign and corporate bonds despite the recent sell off infixed income markets: the yield pick-up relative to investment grade corporates is still289bp. Given the concerns over European politics we prefer yield based strategies inEurope to those looking for capital appreciation at least in the short term.Chart 32: Equity DYs remain attractive relative to credit & sov bondyields543210-1-2Stoxx 600 DY less 10yr Bund yield-3Stoxx 600 DY less Euro IG credit yield2004 2006 2008 2010 2012 2014 2016Source: BofA Merrill Lynch Global Research, Bloomberg, DatastreamChart 33: Europe offers a yield premium vs global equities too2.01.51.00.50.0-0.5MSCI Europe less-1.0EM DY spread-1.5 MSCI Europe lessDM DY spread-2.012/80 12/84 12/88 12/92 12/96 12/00 12/04 12/08 12/12Source: BofA Merrill Lynch Global Research, MSCI, DatastreamEuropean Yield ScreenThe rising rates backdrop has left yield not quite as scarce as it has been, but wecontinue to think investors should own yield where they can get it at decent value, suchas in European equities. Last month we recommended investors rotate out of lower riskGlobal Cross Asset Strategy – Year Ahead | 30 November 2016 17defensive dividend stocks to take advantage of the improving cyclical backdrop andrising bond yields. That meant our November screen included a high proportion ofFinancials. This somewhat remains the case but we note the addition of severalindustrial companies in our latest screen. As a reminder, to qualify the stock must beSXXP listed stocks with at least €2bn market cap, 4% DY, 1.2x DPS cover, 0% DPS 2YRCAGR and qualifying stocks must be on a Buy rating from our fundamental analysts. Theyield on the basket is 5% with an average DPS CAGR of 7% and 1.8x covered.Table 3: European Yield Screen – December 2016Sedol BofAML ticker Company name Sector Divi Yield (>4%) DPS 2Y CAGR Div'd Cover426330 DNBHF DNB ASA Banks 4.2 23.9 2.0B545MG XERSF SWISS RE AG Insurance 5.4 5.2 2.1457481 MDIBF MEDIOBANCA SPA Banks 4.9 8.0 2.4B1LB9P SZCRF SCOR SE Insurance 5.3 4.3 1.9BZ5739 ING ING GROEP N.V. Banks 5.3 4.6 1.7538003 NRDEF NORDEA BANK AB Banks 6.6 2.1 1.3BDVZYZ ROYMF ROYAL MAIL PLC Industrial Goods & Services 5.0 4.2 1.8458882 DNSKF DANSKE BANK A/S Banks 4.4 5.5 2.0596651 SCGLF SOCIETE GENERALE Banks 5.6 0.6 2.0021623 AIVAF AVIVA Insurance 5.1 9.9 1.8B23K0M CTAGF CAPITA PLC Industrial Goods & Services 5.7 2.5 2.1522603 SAXPF SAMPO PLC Insurance 5.4 4.6 1.2481334 SVKEF SKAND ENSKILDA BKN Banks 5.8 3.7 1.4B17BBQ IVTJF INVESTEC Financial Services 4.4 10.0 1.9528983 EBKOF ERSTE GROUP BK AG Banks 3.6 12.5 3.1766716 ATASF ATLANTIA SPA Industrial Goods & Services 4.9 11.2 1.3B83VD9 MNGPF MAN GROUP PLC Financial Services 5.8 15.1 1.2B5ZQ9D EVKIF EVONIK INDUSTRIES Chemicals 4.4 2.9 1.7B01FLG GFSZF G4S Industrial Goods & Services 3.9 5.6 1.6BGLP8L IMIAF IMI Industrial Goods & Services 4.0 4.0 1.5Source: BofA Merrill Lynch Global Research, Factset. The European Quality Yield Screen identified as a screen above is intended to be an indicative metric only and may not be used for reference purposes or as a measure of performance for anyfinancial instrument or contract, or otherwise relied upon by third parties for any other purpose, without the prior written consent of BofA Merrill Lynch Global Research. This screen was not created to act as a benchmark.Long SX5E 2018 Index dividend futuresWith our second dividend related trade, we remain long SX5E 2018 index dividendfutures (DEDZ8), a trade where we continue to see value even with the future pricetrading close to the high for the year. The 2018 contract implies a 4% decline individends paid from the 2016 level. In the absence of a recession, we think that is toopessimistic – 2013 was the last year to see a material 2-year decline in dividends (in thewake of the sovereign crisis and recession). The 2018 contract also still trades at adiscount to the level implied by our stock analysts’ DPS forecasts. Our derivativestrategists using BofAML forecasts for 2018 estimate 8% upside from current prices.Although the upside is now more limited the risk around this trade is also much lowernow. The pull to par effect will become the dominant driver over the coming months andthe full year results should provide clarity on where the 2018 contract will settle.18 Global Cross Asset Strategy – Year Ahead | 30 November 2016Chart 34: SX5E dividends: 2-yr implied growth in 2018 still lookscautious10%5%0%-5%-10%2 year growth implied / realised %-15%2011 2012 2013 2014 2015 2016 2017 2018 2019Source: BofA Merrill Lynch Global Research, BloombergChart 35: BofAML’s SX5E Dec18 div forecast implies 8% upsideESTX50 Div (index points)15014013012011010090807089.089.383.471.483.399.0ESTX50 realised dividendsDividend futuresConsensusBofAML121.9146.5158.6Source: BofA Merrill Lynch Global Research, Bloomberg123.1117.1115.2112.8124.3115.6109.8114.1114.9118.520002001200220032004200520062007200820092010201120122013201420152016201720182019124.8117.3divpts paid in2016 YTDEuropean equities: switch to outright long HealthcareWe switch our European sector pair trade preferring Healthcare over Food & Beverageinto an outright long in Healthcare. Both sectors have suffered versus the market fromthe rotation out of defensives and bond proxies. That has reduced the valuation of theFood & Beverage sector to less extreme levels. Meanwhile Healthcare looks veryattractively valued and we see compelling risk reward in the sector on an outright basisat current levels.The fundamental bull case for Health rests on the strong pipeline of new products forthe big cap pharma universe. Our sector analysts forecast EU Pharma to deliver a 2018-21E EPS CAGR of 11%, up from mid-single digit levels in recent years. Historically thatwould justify a PE re-rating and a multiple for the pharma sub-sector nearer 17-18xthan the current 13x 2018 PE.Chart 36: Extreme overvaluation in Food & Bev has moderated1.801.701.601.501.401.301.201.101.000.90Food & Bev 12m fwd PE relative0.802001 2003 2005 2007 2009 2011 2013 2015Source: BofA Merrill Lynch Global Research, Datastream, IBES, BloombergChart 37: Healthcare PE – back near market multiple and patent clifflows1.701.601.501.401.301.201.101.000.90HealthCare 12m fwd PE relative0.801999 2001 2003 2005 2007 2009 2011 2013 2015Source: BofA Merrill Lynch Global Research, Datastream, IBES, BloombergWe believe the Republican clean sweep in the US elections represents a positivecatalyst as it significantly decreases the potential for legislative initiatives toaggressively control drug pricing in the US. The catalyst for the sector to re-rate willcome progressively from newsflow around new products. The next 12 months shouldsee progress on this front with several of the European large caps expected to announcekey data on important drugs in 2017.Global Cross Asset Strategy – Year Ahead | 30 November 2016 19Healthcare’s forward PE is now down to just a 7% premium relative to the market andnearing the valuation lows recorded in 2010-12 when the patent cliff was at its worstand pipelines were very weak. Today pipelines are twice the size they were in 2011 andinnovation is the key to growth in the sector - pricing power remains strong in drugcategories with differentiated products.Credit: Long Spreads in Europe and USEurope: Long Xover short MainRate cuts are off the table it seems, as central banks are starting to recognise the sideeffects of NIRP. This reinforces our view that a continuation of CSPP, entails that thereach for yield will extend to those assets that have not seen it yet; long Crossover vsiTraxx Main.The beta outperformance has already started in the cash market. We look at syntheticsand we see that Crossover has not mirrored that performance. Even though XO hasoutperformed recently, it still has further to go to close the gap vs cash market’sperformance.Ioannis Angelakis thinks that rising political risks in the following twelve months aremore likely to weigh on iTraxx Main performance than Crossover, as Main has higherconcentration vs XO on names domiciled in countries with elections.Buy 30y US IG Industrial spreadsUS high-grade is the market our colleagues in Credit Strategy are most bullish into2017. Hans Mikkelsen thinks IG corporate spread maturity curves super-flatten as globalcredit investors do the twist - i.e. sell shorter maturities and buy the long end. Foreigninflows are now concentrated in the back-end, as credit spreads have rallied while thecost of currency hedging increased. That means that only the back end of the steep UScorporate spread curve offers enough spread to overcome the high cost of currencyhedging. The flip side is that the front end of the US credit spread curve is veryunattractive and we expect domestic and foreign investors to accelerate their selling ofshorter maturity US corporate bonds. Overall, Hans expects the 30yr corporate bondpart of the market to generate 8%-9% total returns next year.Chart 38: High grade spread forecast250 HG Spread (bps) Forecast200150135120115100Chart 39: High grade returns forecastExcess Return (%) Total Return (%)6.05.24.03.8 3.52.00.0-2.0 -1.6-0.64.0Source: BofA Merrill Lynch Global ResearchSource: BofA Merrill Lynch Global ResearchLong AT1s basketContingent capital continues to offer a compelling premium to European HY and lowervolatility than bank equity. The asset class also received a boost last week when theEuropean Commission submitted a proposal for AT1 coupons to be prioritized overcommon dividends and bonuses if the bank breaches its combined buffer. This placatesone of the main concerns investors have, i.e. that banks could decide to skip a couponpayment but maintain their dividend. The confirmation of the role of AT1s in Pillar 2capital is another example of regulators providing clarity on how contingent capital fitswithin the overall capital structure. The main short term risk for the trade is the fate ofthe Italian banks recap, so we will be watching closely to see how that develops.20 Global Cross Asset Strategy – Year Ahead | 30 November 2016Chart 40: European AT1s offer a compelling yield for total return investors8Stoxx Banks 12m fwd DY (%) Coco Index yield (%)76543Source: BofA Merrill Lynch Global Research, Bloomberg, Datastream, IBESVolatility: Sticking with Relative tradesWhile 2016 started off with a bang volatility wise it has ended with a whimper. NeitherBrexit nor the US presidential election proved to be anything more than a blip. Realisedvol in the S&P 500 over the last 100 days is just 9.5%. That compares to 13.6% for theEurostoxx 15.1% for the Russell and 21.8% for the NKY.Chart 41: Neither the Trump election…454035302520VIX IndexChart 42: …nor Brexit led to a sustained period of higher volatility45403530252015101510V2X IndexSource: BloombergSource: BloombergThat is why we prefer relative variance trades. They tend to carry flat to positive buthave convexity to the downside. We are happy to continue to run these trades into 2017and then use shorter term instruments to hedge specific events.We did this around Brexit and have recently bought a 3000-2850 Eurostoxx put spreadto hedge our European exposure around the Italian referendum. While a No vote isexpected we are not sure what the aftermath will look like and there is considerableuncertainty over the bank recapitalization of the banks afterwards.We also have a calendar put spread in eurostoxx which tends to pay off best around the2500-2600 levels so that remains something that we will look to keep for now givendownside risks in Europe over the first half of next year.One trade we are taking off today is our Kospi forward vol position. We had held that asa hedge against a China hard landing. Our derivative strategists no longer like it and wehave no opted for a currency hedge for our China risk, as discussed above.Global Cross Asset Strategy – Year Ahead | 30 November 2016 21Risks to tradesEquity trades• The risks to long divi basket & Pharma trades are a steepening of rates curves andbetter than expected growth outside of Europe causing investors to rotate out ofbond proxies. Plus our analysts’ expectations of improved earnings from thehealthcare pipeline not coming through.• The risks to trade dividend future trade is lower than expected profits for majorEuropean sectors, e.g. Banks, Oils, causing a correction in dividend expectations.• The risk to EM Asia ex-Japan is from a stronger USD and faster than expected USrates hiking cycle. Trade tensions with the new US administration an additional risknow.• Risk to long Nikkei trade is a reversal of JPY weakness or a change in policy by theBOJ.Fixed income trades• The risks to the US rates trades are a dovish Fed responding to a tightening ofmonetary conditions before the fiscal boost kicks in. Disappointment on the fiscalstimulus also a risk. The risk to the UK inflation trade is that the BoE doesn’trespond to expected rising inflation by raising rates faster.• The risks to the Industrial spreads trade is a deterioration of US industrial growthand step away from credit purchasing by ECB/ BoE.• The risks the AT1 trade are the ECB pulling out of the credit markets causing acorrection in the riskier portion of the market and bank profitability deterioratingraising concerns about default.• The risks to our XOVER trade are Eurozone growth disappointing and a risk-offevent in markets causing a flight to quality amongst credit investors.Volatility trades• Our equity vol trades are hedges, the risks are that they expire worthless due to thelack of a financial event in China and persistent low vol spread in equity marketssupported by higher growth.FX trades• The main risk to our FX trades is of a more dovish than expected Fed, a morehawkish than expected BOE, improved politics in South Africa/weaker oil price anda more dovish Riksbank.22 Global Cross Asset Strategy – Year Ahead | 30 November 2016Appendix 1: MethodologyThis publication is aimed at multi-asset institutional investors who tend to have a longerterm time horizon for their investments. As such, we will be looking to come up withideas that will have a minimum six month horizon and ideally longer than a year. Theindividual trade ideas will be sourced from our strategists across BofA Merrill LynchGlobal Research.This publication is not meant to be an agglomeration of all the trade ideas published byBofAML Global Research strategists, but instead represents those that fit with ourlonger term themes (as opposed to shorter term tactical trades). In addition, there maybe several different trade ideas published by BofAML Global Research strategists acrossdifferent asset classes that seek to leverage off of the same theme. In most cases wewill seek merely to take the trades that have the best risk adjusted return. By riskadjusted we mean the risk undertaken in a trade vs the likely return on that trade. Inconsidering that we will look at the underlying volatility in the individual asset class. Thiswill be combined with our own view of what the likely downside is in an adversescenario vs the payoff in the expected scenario and our own assessment of thelikelihoods of such scenarios.Once selected it is assumed that the trade would likely be retained for a minimum of sixmonths (as per the selection rationale). Should any analyst change their view on the tradeand cease to recommend it, then it will be immediately removed from our list 1 . Equallyshould our target be met for a trade and the relevant strategist feels it has run its coursethen it will also be removed (see footnote). Otherwise we will review our trades on amonthly basis in this publication. If we feel a new trade idea has a better risk adjustedreturn than an existing one in the same asset class then we would replace it.The objective of the trades is that they would be suitable for a typical objective of themulti-asset fund managers, which is typically framed in terms of a Libor+ benchmark(this can be anything from Libor +300bp to Libor +700bp). That return is also coupledwith a target volatility, for example half MSCI ACWI volatility. The volatility target will,of course, be a function of the expected return, but there is a general focus onproducing lower volatility returns. Our set of trades should not be regarded as aportfolio but a collection of ideas to implement in a multi-asset portfolio.Appendix 2 – Recommended COCO bondsTable 4: COCO basketISIN Bond Issuing entity Price Mid YtMXS1055037177 ACAFP 6.5% EUR Perp-21 CREDIT AGRICOLE SA 100.5 5.4XS1002801758 BACR 8% EUR Perp-20 BARCLAYS PLC 100.9 7.1XS1033661866 BBVASM 7% EUR Perp-19 BANCO BILBAO VIZCAYA ARG 91.1 7.1XS1073143932 NYKRE 4% EUR 2036-21 NYKREDIT REALKREDIT AS 102.4 2.7XS0972523947 CS 5.75% EUR 2025-20 CREDIT SUISSE 107.6 3.6DE000DB7XHP3 DB 6% EUR Perp-22 DEUTSCHE BANK AG 78.3 6.7XS1043545059 LLOYDS 6.375% EUR Perp-20 LLOYDS BANKING GROUP PLC 97.5 5.7XS1171914515 RABOBK 5.5% EUR Perp-20 COOPERATIEVE RABOBANK UA 98.5 5.5XS0867620725 SOCGEN 6.75% EUR Perp-21 SOCIETE GENERALE 98.8 5.9XS1107890847 UCGIM 6.75% EUR Perp-21 UNICREDIT SPA 84.5 7.7Source: BofA Merrill Lynch Global Research *As of 28/11/2016 close1Under these circumstances, we will publish a note immediately.Global Cross Asset Strategy – Year Ahead | 30 November 2016 23Appendix 3 – Indicative pricing/ levelsTable 5: Latest indicative pricing/ levels for cross asset tradesAsset Trade idea Indicative price / levelLong European Quality Yield Screen (yield) 5%Long SXDP Index 681.6EquitiesLong Nikkei 18307Long European index dividend futures 113.4Long MSCI Asia ex-Japan 525.7Long RTY short SPX 2y variance swap 3.7**3000-2850 SX5E put spread Dec 16 expiry 1.20%Equity volLong NKY short SPX Dec 18 variance swap6volsLong SX5E short SPX Dec 18 variance spread6volsEurostoxx 2y/3y put calendar 1.99Short EUR/SEK 9.762Long USD/CNH call0.56%USDFXShort GBP/USD 1.250Long USD/AUD 1.342Long RUB/ZAR 0.2132s-5s-10s fly (bp) 11Fixed IncomeShort US 10y real rates (bp) 50Paying 5y GBP real rate swap (bp) -254Buy 30y US IG Industrial spreads (bp) 187CreditBuy basket of Euro AT1s 5.80%Long Xover short Main (ratio) 4.22xSource: BofA Merrill Lynch Global Research, Bloomberg. Note: *all levels and prices as of 29/11/2016 at ~3pm or most recent local marketclose. **This is a theoretical level which may differ from actual tradable prices. ***This level is obtained by bootstrapping At-the-moneyforward volatility levels, does not represent a tradable instrument. The tradable strike of an FVA will likely differ considerably.Appendix 4 – Closed tradesTable 6: Closed tradesAsset Trade idea Strategist Open dateCloseddateLong Nikkei Kenji Abe 22/01/2016 01/04/2016Long MSCI EM 1x 1x call ratio Ajay Kapur 01/03/2016 18/04/2016EquitiesLong MSCI EM 1x 1x call ratioLong US EnergyAjay KapurSavita Subramanian01/03/201607/09/021618/04/201628/11/2016Long MSCI EM Ajay Kapur 19/04/2016 30/09/2016Long SXDP Index vs Short SX3P Index Ronan Carr 22/01/2016 28/11/2016Long June V2X call spread collar Abhinandan Deb 01/04/2016 18/04/2016Long Kospi fwd vol 6M/18M William Chan 22/01/2016 28/11/2016Equity volShort June V2X put Abhinandan Deb 01/04/2016 ExpiredLong (30-35) V2X Jul call spreads Abhinandan Deb 18/06/2016 ExpiredLong 2050-1950 S&P 500 Jul put spread Abhinandan Deb 18/06/2016 ExpiredLong NOK/USD Kamal Sharma 01/03/2016 04/05/2016Long RUB/ZAR David Hauner 22/01/2016 17/05/2016FXShort EUR/SEKLong JPY/KRWKamal SharmaAdarsh Sinha22/01/201622/01/201608/07/201631/03/2016Long USD/CAD Ian Gordon 28/07/2016 07/07/2016Short EUR/JPY Athanasios Vamvakidis 21/01/2016 30/09/2016Short EUR/USD Athanasios Vamvakidis 08/07/2016 04/11/2016Short EUR 5Y5Y inflation breakevens Ralf Preusser 22/01/2016 23/01/2016Buy 30y real rates (bp) Ralf Preusser 22/01/2016 24/05/2016Receive EUR pay US 5y5y fwd (bp) Ralf Preusser 22/01/2016 27/05/2016Fixed Sell 6m 2s-5s-10s OTM receiver fly Shyam R. Rajan 07/09/2016 08/09/2016IncomeUS +15y IG credit (total return) Hans Mikkelsen 22/01/2016 04/05/2016US +15y IG credit (Govt OAS) Hans Mikkelsen 04/05/2016 28/07/2016Paying 2y3y GBP real rate swap Mark Capleton 02/09/2016 12/10/20163y 2s-10s US flattener Shyam R. Rajan 27/05/2016 10/10/2016Source: BofA Merrill Lynch Global Research. Trades closed in this report (or recently) in bold.24 Global Cross Asset Strategy – Year Ahead | 30 November 2016Options Risk StatementPotential Risk at Expiry & Options Limited Duration RiskUnlike owning or shorting a stock, employing any listed options strategy is bydefinition governed by a finite duration. The most severe risks associated withgeneral options trading are total loss of capital invested and delivery/assignmentrisk... all of which can occur in a short period.Investor suitabilityThe use of standardized options and other related derivatives instruments areconsidered unsuitable for many investors. Investors considering such strategies areencouraged to become familiar with the "Characteristics and Risks of StandardizedOptions" (an OCC authored white paper on options risks). U.S. investors should consultwith a FINRA Registered Options Principal.For detailed information regarding the risks involved with investing in listed options:http://www.theocc.com/about/publications/character-risks.jspAnalyst CertificationWe, James Barty, Abhinandan Deb, Barnaby Martin, Benjamin Bowler, Claudio Piron,David Hauner, CFA, Hans Mikkelsen, Ian Gordon, Ioannis Angelakis, Kamal Sharma, MarkCapleton, Ritesh Samadhiya, CFA, Shusuke Yamada, CFA and Shyam S.Rajan, herebycertify that the views each of us has expressed in this research report accurately reflecteach of our respective personal views about the subject securities and issuers. 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It may not be distributedto BofA Merrill Lynch Financial Advisors, retail clients orretail prospects.28 Global Cross Asset Strategy – Year Ahead | 30 November 2016