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BofA Merrill Lynch Global Research forecasts the return of value investing on rising rates.

BofA Merrill Lynch Global Research today released its outlook for the markets in 2016, forecasting a year of modest global and U.S. economic growth, the start of a slow, emerging markets recovery and single-digit stock returns led by high-quality cyclicals. However, with the world's two largest economies - U.S. and China - set to diverge on monetary policy and a contrarian expectation of further weakness in China, next year's market outlook is fraught with credit, rates and currency risks.

BofA Merrill Lynch presented their 2016 Year Ahead Outlook today at events held in New York and London, with similar events this week in Tokyo, Hong Kong, Sydney, Singapore, Sao Paulo, and Mexico City. Analysts from the top-ranked global research firm summarized their views on the U.S. and global economies with tempered optimism. When the Federal Reserve begins raising the Federal funds rate, monetary policy is expected to take center stage as the key theme for 2016. However, low inflation, improving fundamentals and supportive policy should bode well for global economic expansion, consumers and opportunistic investors.

Cautiously bullish, the firm's house view is for stronger growth and higher rates; however, virtually every sector is facing macro risks and innovation disruptors. Value investing is expected to outperform growth beginning in 2016, and Main Street is expected to outperform Wall Street as the tailwind of low rates, oil prices and rising employment continues to benefit consumers.

"We're seeing an aging bull market with a lot of upside potential in it, but also the beginning of slow, steady growth in the capital markets and innovation-led shifts in business cycle," said Candace Browning, head of BofA Merrill Lynch Global Research. "The greatest opportunities for investors may be found among carefully selected, healthy dividend-paying stocks and thematic investments in innovators reshaping market dynamics over the next decade."

Against this backdrop, the BofA Merrill Lynch Global Research team made the following 10 macro calls for the year ahead.

1. S&P 500: The ultimate "anti-credit play." The Standard and Poor's 500 Index is expected to reach 2200 by the end of next year, beginning a slow trajectory toward 3500 in 10 years. Gains in the year ahead imply a 5 percent return for the S&P, roughly equivalent to earnings growth or a 2016 EPS forecast of $125. With credit-sensitive investments the biggest risk in 2016, the S&P 500 could be viewed as the ultimate anti-credit play: large, liquid stocks with healthy balance sheets and above average cash balances.

2. Modest U.S. and global economic growth. Global GDP is forecast to grow by 3.4 percent, up from 3.1 percent in 2015, which is slightly below trend. Growth of about 0.5 percent faster than trend is forecast for Europe, the U.S. and Japan. In the U.S., GDP growth is expected to remain steady at 2.5 percent next year as a solid labor market offsets weak productivity growth.

3. Gentle rise in inflation. Globally, headline inflation is expected to inch up to 2.8 percent as the effects of commodities price drops begin to fade. Underlying inflation should remain stable, with key differences between developed and emerging markets. By year-end, U.S. unemployment should reach 4.5 percent, causing a gentle rise in inflation next year, including wage and price inflation at 0.5 percent and 0.2 percent respectively. Emerging market inflation could decelerate to 3.8 percent, down from 4.3 percent in 2015. The strongest El Nino weather pattern in 18 years represents a potential upside risk to inflation, particularly in Asia and Latin America.

4. Start of emerging markets recovery. For the first time since 2010, average annual growth in emerging markets should begin rising to 4.3 percent in 2016 from 4.0 percent in 2015. Excluding China, growth should pick up to 3.1 percent in 2016 from 2.6 percent in 2015. About three-quarters of emerging market economies could show signs of recovery by the middle of 2016, whereas Brazil could contract further to -3.5 percent as it struggles to climb out of recession. Investment likely will become the key driver of the emerging market recovery. Asset price returns of roughly 2.7 percent for external sovereign debt, 2.5 to 3.5 percent for emerging market corporate debt, and 1.0 percent for local currency debt are expected in 2016.

5. Interest rates: up from zero. The Federal Reserve is expected to carefully calibrate a rate hike over the next two years, with a 0.25 percent hike this month and three or four 0.25 percent increases in each of the next two years. Meanwhile, further quantitative easing is expected in Europe and Japan and a mixed bag of policies in the rest of the world. U. S. 10-year Treasuries could reach 2.65 percent, and the dollar should remain strong, rising by four percent to six percent. The confluence of modestly higher rates, a Fed liftoff, and more regulatory pressures will likely keep liquidity risks in bond markets at the forefront.

6. Divergent monetary policies: U.S. and China go separate ways. With the Federal Reserve set to raise rates and the People's Bank of China likely cutting rates, divergent monetary policies will shape the rates and currency markets in 2016. More weakness in the renminbi (RMB) is expected, with the currency depreciating over seven percent against the U.S. dollar in 2016. This could have negative effect spillovers on emerging Asian currencies and commodity markets.

7. Commodities under pressure. A strong U.S. dollar and restrained global growth could create downward near-term pressures on commodity prices - not just in metals, but also in energy and grains. Overall, commodity returns could be flat to down by as much as 3.7 percent next year. Oil balances are set to improve in the second half of the year, with the combination of global demand and lower non-OPEC output potentially pushing crude oil back up to $55 a barrel. Meanwhile, natural gas demand should remain robust, with the spread between gas and crude oil widening. Base metals will likely stay soft, with gold continuing to struggle as the dollar strengthens and rates rise.

8. Credit is complicated. Fundamental trends in the global credit markets are divergent, and there appears to be no single global credit cycle. Optimism is highest for U.S. high grade, with three to four percent of excess returns expected next year. The bear market for U.S. high yield continues, with expected total return losses of two to three percent. Persistent yield differentials between U.S. and global corporate bonds are expected to force global investors into the U.S. market, and with potential returns as high as six to seven percent, 30-year corporate bonds could deliver equity-like returns in 2016. It could be a tough year for credit in emerging markets, with stark divergence in returns from nation to nation. Still, the overall forecast for emerging market credit is positive, with a 4.0 percent total return for high yield and 2.5 percent for investment grade.

9. Global investment strategy. Global stocks are expected to rise by four percent to seven percent in the next year, with equity markets in Japan (strength across the board), Europe (banks) and the United States (high-quality cyclicals) among the standouts. BofAML's asset allocation calls are long U.S. dollar, volatility and real estate; short commodities and other credit sensitivities; stocks over bonds; developed markets over emerging markets; and investment-grade over high-yield bonds. And with Main Street bulls and Wall Street risks, the best ways to invest could be to buy what the middle class buys: mass retailers, regional banks and investment grade bonds.

10. U.S. housing recovery continues. Further expansion of the U.S. housing market is forecast for 2016, with housing starts of 1.275 million, reflecting a recovery in household formation. Existing home sales could increase by five percent in 2016, while new home sales see a more robust 10 percent growth rate. Home price appreciation could slow in 2016, with prices up by only one percent, a reflection of home price overvaluation relative to income. Though the rise in interest rates poses some risk to the U.S. housing recovery, the Fed's go-slow approach should prevent a painful rise in mortgage rates. Long term, there are signs of a structural shift in the housing market toward renting over home ownership, and, in turn, an increase in multi-family housing construction.

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Publication:CPI Financial
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Date:Dec 9, 2015
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