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Year Ahead 2012 Riders on the Storm: the rocky road to recovery in 2012 Bill O’Neill – Chief Investment Officer Merrill Lynch Wealth Management, Europe, Middle East and Africa Key points CIO View – key points for 2012 Global growth and profits weaker in 2012 Deleveraging – the contraction of debt held- to persist as key influence in developed economies Opposing this trend will be policy loosening or stimulus- its extent and timing are crucial Quantitative easing (money printing) will become a global phenomenon China will have a ‘soft landing’ in 2012 – again the key development is when policy eases • Look for portfolio diversification, focus on a strategic framework to respond to the ‘New Normal’ Equity outperformance versus corporate debt will be modest On equities, prefer U.S. and U.K. over Japan and Europe; stress theme of yield - quality - growth Little value in core sovereign bonds We shall see a weaker euro into 2012 especially if ECB buys government debt Upside on gold above $2000 p/oz.; oil price flat for first half, moving higher as demand improves 2 The pressing need for mature economies to contain debt burdens has taken us to the edge of a second global recession in less than 3 years Overview 2011 asset class performance % Source: Bloomberg. Data as of 30 December 2011. 3 Overview Eurozone sovereign crisis is also a banking crisis Cost of protection for European banks and sovereigns Basis points 400 European banks European sovereigns average* 300 200 100 0 2007 2008 2009 2010 2011 Source: Bloomberg. Data as of November 2011. *European sovereigns average is a simple average of French and Italian government debt credit default swaps (CDS) 4 U.S. bonds following Japan’s example so far, only this time real rates likely to remain low Overview Japan and superimposed U.S. 10 year real bond yield, 13 years later (%)* % 7 Japan U.S. (start and end dates shown) 6 5 4 3 2000 2 1 0 -1 1987 2011 1992 1997 2002 2007 Source: Bloomberg. Data as of November 2011. *U.S .10-year bond yield superimposed over Japan, with a lead . U.S. data from November 2000 to November 2011 5 The U.S. recovery in the ‘New Normal’ is very subdued compared to history Economics The Zarnowitz Law, looking at strength of recovery against peak-to trough fall in business cycle 8 quarter gain from recession trough (%) 16% 14% 1957 12% 2008 - where we should have been 1981 1960 10% 1953 1973 8.7% difference 8% 6% 2001 1970 2008 - where we were 1990 4% 1980 2% 0% 0% -1% -2% -3% -4% -5% -6% Loss from peak - to - trough (%) Source: Bureau of Economic Research, National Bureau of Economic Research, TrendMacro calculations. Data as of September 2011. 6 Reluctance of businesses to invest risks persistently higher structural unemployment Economics U.S. average number of weeks unemployed and business investment as % of GDP % of total % of GDP The Federal Reserve will respond to high unemployment with direct support to housing. No rate hike until at least 2014 Source: Absolute Strategy Research, Bloomberg. Data as of November 2011. 7 Optimistic growth forecasts still mark the path to debt stabilisation in the eurozone Economics Differing expectations for real GDP growth rates in several eurozone nations in 2012 % 4 Government trend growth assumptions Bank of America Merrill Lynch 2012 forecast 3 2 1 0 -1 -2 -3 -4 Germany Ireland Greece France Italy Source: Factset, Bloomberg, BofA Merrill Lynch Global Research. Data as at November 2011. 8 Economics European debt deleveraging has a large banking component Eurozone* and U.S. total debt to GDP as of Q1 2011**, with sectoral breakdown U.S. Eurozone* 23 15 24 33 21 29 Households Financial Non-financial General government Households Financial 27 28 Non-financial General government Source: BofA Merrill Lynch Rates and Currency Research. Created 15 December 2011. Data as at Q1 2011, except French household (2010). *Eurozone countries = Germany, France, Italy, Spain, Greece, Portugal, Ireland, Belgium, Netherlands & Slovakia ** Latest data available given lack of data from Greece, inter alia, since start of 2011. 9 China’s next 5-year plan to focus on supporting consumption following 2009 fiscal expansion Policy Chinese exports, fixed asset investment and retail sales as a percentage of GDP % Source: Absolute Strategy Research. Data as of October 2011. 10 Policy Debt reduction options Solution Growth Explanation Higher growth leads to lower government debt Examples Feasibility South Korea High household/financial debt likely to weigh on activity Fiscal support weakens Fiscal Adjustment and Austerity Governments adopt strict fiscal austerity adopted alongside economic reform Eurozone (especially periphery), U.K., not the U.S. Unpopular with voters and correct spending/tax mix challenging Sovereign Default/Debt Restructuring Governments write off their debts A restructure involves an adjustment in the terms of existing debt Default: Russia, Argentina, possibly Greece Would lead to inability to access capital markets for funding, adverse effects on banking sector Currency Devaluation Devaluing the currency of issue makes debt easier to repay Hungary, Finland, Iceland U.S. QE2 (quantitative easing) Risk is higher inflation / social upheaval Cannot work for all but needs to happen to G7 vs. emerging markets esp. China Inflation A rise in domestic price level reduces the real burden of domestic denominated debt United Kingdom Would be attempted via printing money to pay off debt – QE Financial Repression – measures taken by governments to force investors to hold more assets with lower returns and higher risk, than otherwise desired 11 ECB’s QE* response tiny compared to other central banks, will have to change in 2012 Policy Central banks’ holdings of their nation’s government bonds, as a percentage of relevant GDP % of GDP €1 trillion more would take ECB action to same size as Fed’s response 20% 18% 16% 14% 12% 10% 19.3% 16.8% 8% 6% 11.5% 4% 2% 2.3% 0% Eurozone U.S. U.K. Japan Source: Bank of England, Bank of Japan, European Central Bank, U.S. Federal Reserve, Bloomberg. Data as of 15 December 2011 *QE = quantitative easing 12 Divergence in bond yield spreads suggests ECB already confronted with Euro disintegration Potential risks Cash spreads of selected European 2 year bonds over Germany Spread over Germany (basis points) 1100 1000 Peripheral ex Greece** Triple AAA* 900 800 700 600 500 400 300 200 100 0 -100 2005 2006 2007 2008 2009 2010 2011 Source: Bloomberg. Data as of 24 November 2011. *arithmetic average of France, Austria, Netherlands and Finland ** arithmetic average of Spain, Italy and Portugal 13 German export story vulnerable to an investment slowdown in China Potential risks German exports to China and German capital goods orders, in millions of euros €m China should experience a soft landing next year. Lower inflation will see policy focus on growth again. The risk is that the shift in stance fails to head off a sharp slowdown in investment spending €m Source: Bloomberg. Data as of November 2011. 14 Potential risks Softer Chinese residential property activity may signal weaker investment in 2012 Chinese residential investment growth and sales growth (year-on-year) Growth rate Investment growth Sales growth 60% 50% 40% 30% 20% 10% 0% -10% -20% 2005 2006 2007 2008 2009 2010 2011 Source: Gavekal. 3 month moving average data, as of 14 December 2011 15 Higher inflation remains the key area of vulnerability for emerging economies Potential risks Inflation across developed and developing economies Good news is that consumers’ purchasing power will be supported by easing inflation, but limited to mature economies Projection %, year-on-year 12 Developed economies Emerging and developing economies 9 6 3 0 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Source: International Monetary Fund. Data as of September 2011. 16 Israel economics Israeli GDP growth should be resilient in 2012, despite weakening net exports Israel GDP growth, decomposed into consumption, investment and net exports Estimates Solid domestic consumption should cushion GDP in 2012 amid external headwinds from the eurozone % 10 Consumption 9 Investment Net exports GDP growth ()% 8 7 6 5 4 3 2 1 0 -1 -2 -3 -4 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Source: BofA ML Global Economic Research. Data as of 3 January 2012. 17 No global recession in 2012 but G5 growth sluggish and China below 9% growth Forecast update Growth forecasts 2011-2012 2011 Forecast (%) 2012 Forecast (%) Global 3.8 3.5 G5* 1.4 1.1 United States 1.8 1.9 Eurozone 1.5 -0.6 Germany 2.7 -0.5 France 1.5 -0.6 Japan -0.3 2.3 Italy 0.6 -0.7 United Kingdom 0.9 0.3 Israel 3.9 3.5 Brazil 3.1 3.4 Russia 4.0 3.6 China 9.2 8.6 India 7.0 6.8 Source: BofA Merrill Lynch Economics Research. Data as of 1 December 2011. *G5 refers to the Group of 5, namely Eurozone, Canada, Japan, the United Kingdom and the United States . 18 Macro summary CIO View - macro summary for 2012 We expect a worldwide slump to be avoided in 2012 but the scene is set for a fragile expansion, with U.S. growth at only 2% and emerging economies again the mainstay of the advance A persistent failure to address the systematic issue in the Euro debt crisis - risk of default - means Europe will see a contraction in activity in 2012 The dominant policy story in 2012 will be stabilising the euro zone and a global pattern of monetary stimulus involving monetisation in the developed world We do expect US to avoid a recession but weak recovery in business spending will limit pace of expansion China’s GDP growth rate should bottom out at around 8% per annum. Easy money stimulus will come sooner than expected but the price will be persistent higher inflation A weak consumer and ripples from the eurozone sovereign debt crisis should push the Bank of England into further quantitative easing (QE) - this should limit the rise in sterling through 2012 We expect the euro to weaken as ECB offers a back stop to euro bonds and U.S. consumer gains from lower inflation Global coordinated response is crucial to re-balance the global economy, as political differences pose ongoing threats to the recovery Risks in 2012: Positive: Rebound in business spending/ ECB support/ stronger U.S. housing/ China pro -growth Negative: Euro disintegration/ government defaults/ bank runs/ currency wars/ excess austerity 19 Strategy Household equity holdings look set to continue shrinking despite better value, earnings growth Households’ direct holdings of listed equities as a % of total financial assets % Investors are deeply sceptical about the recovery, worried about the risks of even greater disappointment 35 U.S. 30 U.K. 25 20 15 10 1987 1990 1993 1996 1999 2002 2005 2008 2011 Source: U.S. Federal Reserve, BofA Merrill Lynch Global Research. Data as of December 2011. 20 Strategy More assets performing in the same way a huge challenge for true diversification Correlation heat maps for 2005 and 2011 2005 2011 Source: Bloomberg, HSBC. Data as of November 2011 21 A strategic framework for navigating the ‘New Normal’ Strategy 2012 may be characterised by low returns, high risk and a polarised environment Low returns Polarised environment Overpriced safe-haven assets Risky assets suffering from uncertainty Strategy: sector selection (high dividends, high quality stocks) Shift between “risk-on” and “risk-off” environments Deeply divided currencies, industries and countries /regions Strategy: separating markets and currency management (funds of currencies) High risk More frequent high volatility bubbles Increasing correlations Strategy: macro/CTA hedge funds Source: CIO, EMEA Merrill Lynch Wealth Management 22 Optimism on earnings growth fades, especially in Europe – any improvement modest in 2012 Equities U.S. (S&P 500) and European (Stoxx 600) 2012 earnings per share (EPS) forecasts € per share $ per share 114 30 112 29 110 28 108 27 106 26 U.S. Europe 104 25 102 24 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Source: Factset. Data as of November 2011. 23 Market valuation discounts a 10-20% decline in profits Equities 12 month forward price to earnings ratio for the MSCI AC World equity market % 20 Valuation of equities and positioning reflect the multiple dangers ahead. Upside limited by level of profits’ growth slowdown 18 30% reduction in earnings 16 20% reduction in earnings 14 10% reduction in earnings 12 10 8 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Source: Factset. Data as of 17 November 2011. 24 Relative to developed, emerging equity markets are at cheapest valuations since 2009 Equities 12 month forward relative price to earnings ratio for the MSCI Emerging Markets Index* Ratio Prefer U.S., U.K. equities over Japanese and European stocks Source: Factset. Data as at 17 November 2011. * relative to the MSCI World Index 25 Tech, consumer staples and discretionary stand out – focus on yield, quality and growth Equities U.S. S&P 500 sector ranking model BofA-ML Research Position* Combined Ranks Price Momentum Rank** Estimate Revisions Ranks** Valuations Rank** Information Technology Overweight 9.3 9 9 10 Consumer Staples Overweight 8.0 8 10 6 Healthcare Neutral 6.7 6 5 9 Consumer Discretionary Neutral 5.3 5 8 3 Industrials Neutral 5.0 4 6 5 Utilities Neutral 5.0 10 4 1 Energy Neutral 4.3 3 2 8 Materials Underweight 4.0 2 3 7 Financials Underweight 4.0 1 7 4 Neutral 3.3 7 1 2 Telecommunications Source: BofA Merrill Lynch Global Research. Data as of November 2011. *Sector position (overweight/neutral/underweight) reflects the sector weighting of BofA-ML US Equity Strategy Research.**Price momentum ranked by 3 month change in the sector’s relative price versus the S&P500; Estimate revisions ranked by 3 month change in relative next 12 month’s consensus earnings estimates versus S&P 500; Valuation ranked by the ratio of current relative Price/Earnings ratio of the sector compared to its long-term average relative P/E. Combined rank is the equal weighted average of individual ranks. 26 Large-cap stocks favoured styles for next year, favouring high quality Equities Growth versus value* relative performance and large versus small ** cap stocks in the U.S. Relative Performance Relative Performance Growth outperforms value Source: Bloomberg. Data as of 17 November 2011. *MSCI US Growth total return vs. MSCI US Value total return indices ** S&P 500 total return vs. Russell 2000 total return indices, 3 month moving average 27 Equities In periods of decelerating profit, continue with dividend yield theme in the U.S. Performance of dividend yield and dividend growth in different profit environments for S&P 500 12% 11% High Dividend Yield High Dividend Growth 8% 6% 4% 0% -1% -4% -8% -9% -12% Profits Decelerations Profits Accelerations Source: Factset, Bloomberg., BofA Merrill Lynch Global Research. Data as of October 2011. 28 U.S. high yield debt in favour, as long as defaults remain low High yield price index and default rate for the U.S. % Fixed income Estimates Index level Source: Bloomberg. Data as of November 2011. 29 Extending duration will not pay in 2012 unless deflation fears rise or Fed is aggressive with QE3* Fixed income U.S. Treasury real yield curves for January and November 2011 % Core sovereign bonds unattractive in all scenarios other than a global recession Source: Bloomberg. Data as of 17 November 2011. *QE3 = third round of quantitative easing 30 Unless there is another global recession in 2012, copper prices look unusually cheap Commodities Ratio of gold price to copper price (average shown by dotted line) Ratio 0.3 0.2 0.1 0.0 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 Source: Bloomberg. Data as of November 2011. 31 Rebound in industrial metals in coming months, with energy prices following in second half of 2012 Commodities Oil, base and precious metal forecasts into 2012 Spot June 2012 (Forecast) December 2012 (Forecast) Brent Crude Oil ($/barrel) 113.41 104.00 116.00 WTI* Crude Oil ($/barrel) 102.64 96.00 110.00 Aluminium ($/metric tonne) 2,065 2,250 2,500 Copper ($/metric tonne) 7,540 8,000 8,500 Lead ($/metric tonne) 2,060 2,000 2,200 Nickel ($/metric tonne) 18,795 18,500 18,000 Zinc ($/metric tonne) 1,869 2,100 2,300 Gold ($/oz) 1,613 1,750 2,000 Commodity Source: BofA Merrill Lynch Global Commodity Research estimates. Data as of 5 January 2012. * WTI = West Texas Intermediate 32 Although interest rates will likely fall in 2012, the shekel should remain supported by fundamentals Currencies Israel Israeli shekel (ILS) per U.S. dollar (USD) exchange rate and real effective exchange rate We expect modest shekel appreciation versus the U.S. dollar by end of 2012, with USD-ILS at 3.65 from around 3.85 currently. ILS per USD Index 140 5.0 ILS real effective exchange rate ILS per USD (right hand scale) 130 4.5 120 4.0 110 3.5 100 90 3.0 2005 2006 2007 2008 2009 2010 2011 Source: BofA ML Global Economic Research. Data as of 3 January 2012. 33 A good first six months for the dollar - renminbi appreciation to continue Currencies Developed majors Currency Spot June 2012 (Forecast) December 2012 (Forecast) EUR – USD 1.32 1.25 1.30 USD – JPY 78 73 76 EUR – GBP 0.85 0.82 0.85 GBP – USD 1.56 1.52 1.53 USD – CHF 0.93 0.99 0.97 BRIC (Brazil, Russia, India and China) group USD – BRL 1.83 1.90 1.85 USD – RUB 31.63 32.00 30.00 USD – INR 52.84 53.00 49.00 USD – CNY 6.36 6.35 6.20 Source: BofA Merrill Lynch Global Research. Data as of 12 December 2011 34 CIO View - market outlook for 2012 Market outlook The task of ensuring diversification across investment portfolios is complicated by a shrinking set of ‘safe havens’ We continue to stress the need for a strategic framework to deal with ‘New Normal’ (sluggish growth, higher risks), including managing for scenarios involving big losses (drawdown); volatility bubbles and constant switching between ‘risk on /risk off’ Equity outperformance relative to higher risk corporate debt will be modest We stress yield, quality and growth in selecting equities, supporting: Large caps Dividend growth U.S. and U.K. equities M&A and corporate cash flow Secular themes such as the emerging market consumer and infrastructure Too early for financials and Europe and we await China’s policy easing to add to emerging markets Within fixed income, bias to investment grade credit, particularly the U.S., persists. Tight control of supply and inventories limits a possible fall in the crude oil price. Copper would benefit from China’s easing. Upside to gold price above $2,000 Risks in 2012 + Positive: Better performance for U.S. banks, M&A pick up, recovery in U.S. housing and cyclical stocks − Negative: Profits contraction, tax raids on corporates, financial repression, protectionism 35 Questions and answers 36 Important information Issued in the UK by Merrill Lynch International Bank Limited (“MLIB”) and Merrill Lynch Portfolio Managers Ltd ("MLPM"). − Merrill Lynch International Bank Limited (“MLIB”) is authorised by the Central Bank of Ireland and subject to limited regulation by the Financial Services Authority. Details on the extent of MLIB's regulation by the Financial Services Authority are available from us on request. MLIB is a member of the London Stock Exchange. Registered Office: Central Park, Leopardstown, Dublin 18, Ireland. 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