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December 1, 2010

Merrills lays out its 2011 vision

By Spear's

Merrill Lynch this morning presented their forecasts for 2011: Asia will continue to usurp Europe’s position. Freddy Barker reports
IT TAKES COURAGE for an Irishman to stand up and tell the world how to manage money at the moment. But this morning, Bill O’Neill, CIO of Merrill Lynch Wealth Management EMEA, did just that.

Addressing a seminar entitled ‘The Year Ahead’, he tackled the key question facing HNWs: if cash’s real return is -4% and bonds yield less than equities, is it time to put risk back on the table?

O’Neill’s audience may have been shivering from the Arctic temperatures outside, but they were soon warmed by his sizzling predictions. In 2011, global growth will be 4%. The driver will be the emerging markets – rising at 6%, relative to 2% in the developed world. ‘The defining theme of our age,’ the CIO announced, ‘will be the emergence of Asia, and the gap that has opened up between developed and developing market growth.’

But is he right to be so bullish? Is Merrill simply playing up to its equity-skew?

Take the topic du jour, Europe, for example. O’Neill said that ‘peripheral problems will persist’ and that ‘dysfunctional Euro debt and a currency collapse’ will be key downside risks. I am inclined to agree. On the surface we are told that the EU is an alliance of 27 countries eager to share the benefits of a $16 trillion free-trade zone. But the reality is quite different. It is an uneven union. Germany, a strong surplus nation, uses the Eurozone to finance the deficits of the peripheral nations, who in turn use the funds to buy German goods. It is classic vendor financing.

Consensus opinion currently focuses on Portugal, Ireland, Greece and Spain. That’s fair enough when you look at the stats. Greece is running a 15.4% budget deficit, Ireland 14.4%. It’s even more pertinent when you examine working practices. Roughly 30% of Greeks do not pay tax; only 6 people in 10 million filed a tax return showing income in excess of €1 million last year; and when the crisis hit, the first people to go on strike were the tax collectors.

But despite the gulf in economic strength, it is in no one’s interest to see the EU to break up. The stronger half of Europe would see their currencies rocket, thus destroying their export markets. Plus they would be hit by the cost of printing new banknotes.

Small surprise then that the Irish were forced to accept a €85 billion bailout at 5.8% interest (the Greeks got €110 billion at 5.2%). Their creditors would have been all too aware of the need to stuff the Celtic tiger full of frankfurters, for fear of a second banking crisis and the demise of the European project.

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The second issue that O’Neill tackled this morning was the US. He predicted that the country ‘will strengthen later in 2011 as the employment upswing emerges’ – resulting in 2.1% growth. Crucial to this would be policymakers’ responses. Although, in the CIO’s words, they are becoming increasingly ‘extreme’.

Will QE2 work, I hear you ask? The policy has three distinct benefits. First, it puts more cash in the economy and should stimulate consumption. Second, it devalues the dollar and makes US exports more competitive. Third, it inflates away the national debt.

It is unprecedented, but the remedy to get the US out of its current problems has to be. As Meg Woods at Veritas Asset Management points out that the country has a $1.6 trillion deficit, equal to 10% of GDP, and a debt to GDP ratio of 375% (before taking into account the future liabilities of Medicaid and Medicare).

The truth is that no one knows what will happen to the US. Big questions abate. If the 20th century was an Atlantic century, will the 21st be a Pacific century? Is the US merely one of a long line of empires to overstretch themselves militarily and financially? Is its increased interventionism symbolic of an empire clinging on to power by its finger nails?

For O’Neill’s third topic, he crossed the pond to Britain. Interestingly, from a market rather than an economic standpoint, he saw the MSCI UK as the most attractively valued region in the world.

This is a bold call as currently the country is in a state of flux. No one knows what will come of Osborne’s cuts. The Keynesians, for example, argue that the Chancellor’s current plan is catastrophic. They say that it’s 1931, and we’re making the same mistakes that we did back then: specifically hacking government expenditure away before the economy is on its feet; imploding demand and leading to deflation and depression. Where as Osborne’s camp, the Ricardians, believe that if you keep spending, you will have to pay it back eventually. They want to get a grip on expenditure, as they think this will give the private sector the confidence to take up the slack.

Whatever your political persuasion, it is clear that the UK has a lot to cut. 13 years of Labour government has seen the public sector expand from 40.6% of GDP to 52.5%. It has seen public sector employment rise 25% compared to 5% in the private sector. And it has seen public sector hourly wages rise by 22% despite a 3% fall in productivity.

My estimation is that Osborne is on the right course. His opponents’ recommendation of taking money out of the economy through taxation and respending it, changes nothing. It does not alter the amount of money in the economy. All it does is bring forward expenditure and lose a bit on administration costs along the way. To use an example, it’s like withdrawing blood from one arm, moving around the room to reinject it in the other arm, while spilling a bit along the way.

For heavyweight support, I call on Goldman Sachs. A recent report of theirs discovered that reducing expenditure by 1% a year boosted GDP growth by 0.6%. Moreover, equity markets in these countries beat those of the other advanced nations by 64% over a 3-year period.

To wrap up the presentation, O’Neill returned to his favourite theme: the emerging markets. He said that their savings, which are forecast to reach 33% of disposable income in five years, would ‘turbo-charge’ growth.

The regional superpower, China, he predicted, will grow 9.1% in 2011. The rise will be supported by ‘fast yuan appreciation’ which will ‘ease inflation fears and defuse protectionist urges’.

The forecast comes, coincidentally, at the very time when China has surpassed Japan as the world’s second largest economy. Since Deng Xiaoping scrapped the country’s communist policy purity in 1978, the economy has grown 90 times over.

However stock market growth in Asia will not be found in the bigger economies. No, just as in 2010, outperformance will lie in the smaller markets such as Thailand, Turkey and Indonesia.

There the reverse yield gap is alive and well. The equity culture thrives. Free cash flow yields push 7%. And to top it all, dividend payouts have doubled over the past decade.

So how to profit? ‘As the world economy recuperates, investors should favour commodities and equities over government and corporate debt,’ advised O’Neill. ‘Within equities the focus should be more on dividends than capital growth’. To illustrate the fact, he produced a chart showing that 60% of equity returns over the past 200 years have been attributable to dividends.

Merrill’s hunt for yield will not spread to government debt, however. ‘High grade corporate bonds are another matter,’ said O’Neill.’ We think they could be well-supported in the first half of 2011’.

As for commodities, the thundering herd foresees the price upswing to continue into 2011 as China avoids overheating. The top performers will be energy, copper and other industrial metals. Gold, however, has run its course. The yellow metal ‘is now back to where it was 22 years ago relative to U.S. equities,’ said O’Neill. ‘That anomaly has ended. Equities are just as good a hedge against inflation.’

And with this bullish outlook, the proceedings came to an end. HNWs should be warmed by Merrill’s predictions. For Christmas 2010 will be the happiest of the past three years.

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