CIO REPORTS

ViewThe Chief Investment Officer Team • WEEK OF SEPTEMBER 09-13, 2013

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Asian Crisis Redux?As investor anxiety in the U.S. grows over the possibility of the Federal Reserve (Fed)

tapering in September, the biggest fallout appears to be taking place in the Emerging

Markets.

For years the Emerging Markets (EM) were a favored destination for investors searching

for yield. But as the Fed attempts to exit from its quantitative easing (QE) program and

long-term rates in the U.S. rise, an exodus of capital has hit EM financial markets and

currencies. Among the hardest hit have been the Asian markets, with the MSCI Asia ex-

Japan Index down 8.1% (see Exhibit 1). The Indian rupee, for instance, has dropped 18%

against the U.S. dollar since May, its biggest three-month plunge since 1991. Similarly,

the Indonesian rupiah

is down more than

10% over the same

period. Worse, the

uncertainty over

Fed policy comes

at a time when

regional giants,

China and India, are

already facing a

significant slowdown

in economic growth

amid rising structural

difficulties.

These developments

have raised fears

of another 1990s-style Asian financial contagion that plunged countries from Thailand

to South Korea into deep recessions. A similar crisis could have a pronounced impact on

global equities. Today, Emerging Asia accounts for 26% of the world’s gross domestic

product (GDP) based on purchasing power parity (PPP), twice its share in 1996. Moreover,

IN SUMMARY For years the Emerging Markets were a favored destination for investors searching for yield. But as the Fed attempts to exit from its quantitative easing program and long-term rates in the U.S. rise, many of those investors have been fleeing the Emerging Markets. The exodus of capital has hit Emerging Markets financial markets and currencies hard. The risk now is that the decline in Asian currencies will lead into a vicious circle of deteriorating capital accounts, rising inflation and worsening financial problems.

Asian economies are at once grappling with longer-term weaker growth and a short-term liquidity withdrawal reminiscent of their experience in the 1990s. While we recognize the similarities, we believe Asian economies have made substantial progress on macroeconomic fundamentals that should prevent a 1997-style contagion.

We believe predictions of a hard landing for China that sees GDP growth crashing to 4-5% and fears of social unrest breaking out are overblown. As the household sector gradually becomes the driver of the economy, China will settle on a comparatively slower, but more sustainable, growth trajectory.

-20% -18% -16% -14% -12% -10%

-8% -6% -4% -2% 0%

-6.5%

-8.8%

-5.8%

-17.2%

-2.8%

-13.5%

-2.4%

-8.5%

-3.7%

-17.1%

-8.8%

Asia

ex-Jap

an

China

Ind

ia

Indon

esia

Japan

Philip

pines

Malaysi

a

Singa

pore

South

Korea

Thail

and

Vietna

m

Exhibit 1: Equity Market Returns Across Asia, June-Aug 2013

Source: Bloomberg. Equity markets for Asia xJapan, Japan, South Korea, China, India, Japan, Malaysia, Philippines, Singapore, South Korea, Thailand, Vietnam represented by MSCI AC Asia xJapan, Shanghai Comp, Sensex, Jakarta Comp, Nikkei 225, FTSE Malay KLCI, PSEi, FTSE Straits Tim, KOPSI, and VN-Index indexes, respectively. Data as of August 31, 2013.

CIO REPORTS • View 2

greater linkages between Asian financial markets and the rest of

the world increase the potential for negative feedback loops.

At the same time, the deep pessimism surrounding Asian

markets may hold tactical opportunities for investors. In this

edition of the CIO View, we examine the macroeconomic

conditions in Asia and the implications for equity markets.

In particular we focus on China, Asia’s largest economy, as it

undergoes important economic changes.

Two issuEs, Two TimE framEs It’s important to understand that Asian economies face two

different challenges at the moment. One is the volatility their

currencies and financial markets face as a result of a cyclical

slowdown and short-term (“hot-money”) capital outflows. Since

May, when talk of the Fed tapering first began, more than $15

billion has left Asian markets. The other, and perhaps bigger,

issue reflects structural weaknesses as the end of a pan-Asian

credit boom exposes flaws in the economic growth model of

some of these countries.

The impact of the former has the potential to be sharp but is

ultimately short-term in nature. The latter, on the other hand,

reflects a longer-term decline in the growth potential of Asian

economies, which suggests to us that a broad re-rating of EM

economies relative to the developed economies is less likely to

occur over the next 18-24 months. We examine both of these

issues below:

Looking back: The 1997 Asian Financial Crisis

A good framework for analyzing the current stress in emerging

Asia is to examine the factors that contributed to the onset

and spread of the financial crisis in 1997. Fundamentally, there

existed deep structural imbalances in many countries across the

region. In the build-up to crisis, Asian governments had borrowed

heavily in foreign currencies to finance their deficits. Critically,

much of the debt was short-term, but corresponding assets

were longer-term (often large infrastructure projects), making

these countries vulnerable to a liquidity attack. Moreover, credit

was often poorly allocated and underperforming investments

increased the risks to local financial institutions. At the same

time, real estate and equity market valuations across the region

rose substantially in the years prior to the crisis, increasing the

risks of a sharp correction in asset prices.

There were two exogenous factors as well. The first was a

recession in Japan following a consumption tax hike in 1997

from 3% to 5%. At the time, Japan was the world’s second-

biggest economy and the most important trading partner for

East Asian economies. (Interestingly, the government of Japan

Prime Minister Shinzo Abe is considering increasing the same

consumption tax from 5% to 8% in early 2014.) The second

factor was a sustained appreciation in the U.S. dollar. The

currencies of many Asian economies were effectively pegged

to the dollar. As the value of their currencies rose there was

a substantial slowdown in exports―a key component of their

growth strategy.

Once the crisis began, the deteriorations in the above economic

fundamentals were significantly amplified by market panic and

investor herding, leaving Asian economies in a deep recession.

Indonesia, for instance, suffered a 13% decline in GDP in 1998.

Back to the future: Where do things stand in 2013?

The 1997 financial crisis was a deeply painful experience for

Asian economies, prompting substantial changes in economic

policy. While there are strong shades of crisis in the current

environment―rapid credit growth, unproductive investments

and rising equity and property prices―most Asian economies

are generally better equipped to avoid a similar fate. Some

of the key differences between 1997 and now that make a

contagion unlikely are as follows:

1. Current account balances: The current account measures

the differences between a country’s exports and imports.

Economies running current account deficits rely on foreign

capital to finance their budgets. This was a widespread

problem in 1997 as shown in Exhibit 3 (on the next page).

While India and Indonesia have deteriorating current account

conditions at present, most Asian economies today are

running current account surpluses and have less need to

borrow from abroad to maintain investment and spending.

IDR (Rupiah)INR (Rupee) 10-Yr Treasuries

1.5%

51.5%

101.5%

151.5%

201.5%

251.5%

301.5%

351.5% 95

100

105

110

115

120

125

130 2-May 2-Jun 2-Jul 2-Aug 2-Sep

Curre

ncy

Valu

es In

dexe

d to

100

Trea

sury

Yie

lds

Exhibit 2: Taper Tantrum and Currency Movements

Source: Bloomberg

CIO REPORTS • View 3

2. Level of external debt: A key component of the crisis in

1997 was the level of short-term foreign debt assumed by

governments and financial institutions. While liabilities were

in dollars, assets were usually long-term and the revenues

they produced were in local currencies. This created

both currency and duration mismatches that ultimately

undermined the financial stability of these economies and

led to speculative attacks on their currencies.

Although borrowing by Asian economies has increased

in recent years (in part to stimulate growth following the

2007 global financial crisis), the level of external debt is

significantly less than two decades ago (see Exhibit 4). An

important reason for this has been the development of local

bond markets. Thriving local currency debt markets allow

governments to borrow in their own currencies―often at

lower costs and at longer maturities―mitigating the asset-

liabilities mismatches that plagued Asian institutions in the

1990s. In many cases local bonds markets are two to three

times the size of corresponding dollar-denominated debt

markets. (Rapid growth of domestic credit, however, can bring

about its own set of risks, as we see in the next section.)

3. Foreign Reserves: Many Asian central banks beefed up

their foreign currency reserves following the speculative

attacks in 1997. As seen in Exhibit 5, reserves are uniformly

and substantially higher across countries today, giving

these countries greater flexibility to manage payments and

stabilize their exchange rates. For instance, the Reserve

Bank of India’s (RBI) decision on August 28 to provide dollars

directly to the country’s big oil-importing firms (to prevent

them from selling rupees in the spot market) helped lessen

the currency’s sell-off.

4. Flexible exchange rates: Unlike in 1997, most Asian

economies no longer maintain currency pegs. While that

certainly adds to currency volatility and short-term financial

stress, floating exchange rates generally act as automatic

stabilizers against economic shocks (depreciation increases

cost competitiveness) and allow central banks to manage

their own money supply.

These generally positive developments across Asian economies

reduce the likelihood of a broad-based 1997-style contagion.

Of course, pockets of weakness exist, most prominently in

India where foreign exchange (FX) reserves now cover just 7.1

months of imports versus 25 months in May. However, Bank

of America Merrill Lynch (BofAML) India economist Indranil

Sen Gupta, feels the worst may be over, even as the rupee is

likely to stay weak into 2014. And so far, China―the world’s

second-largest economy―has avoided the currency volatility

racking other Asian economies. This is partly because of its

closed quasi-capital account, but also due to the fact that its

investments are predominantly financed by domestic savings.

China

Ind

ia

Indon

esia

Philip

pines

Malaysi

a

Taiwan

South

Korea

Thail

and

Vietna

m -10%

-5%

0%

5%

10%

15%

19971996 2012 2013E

Exhibit 3: Current-Account Balance as a Percentage of GDP

Source: International Monetary Fund (IMF)

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

1997 2011

China India Indonesia Malaysia Thailand Vietnam Philippines

Exhibit 4: External Debt Stocks % Gross National Income

Source: World Bank WDI. Data as of Dec. 31, 2011.

China

Ind

ia

Indon

esia

Philip

pines

Malaysi

a

Thail

and

Vietna

m

1997 2011

0%

100%

200%

300%

400%

500%

Exhibit 5: Total Reserves as % of External Debt

Source: World Bank WDI. Data as of Dec. 31, 2011.

CIO REPORTS • View 4

TacTical opporTuniTiEs amid bEarish sEnTimEnTDespite differences in vulnerabilities between countries across

Asia, the markets in the region have largely moved downward

in tandem. Sentiment across the region overall is quite poor.

According to the latest BofAML Global Fund Manager Survey,

EM is the least-owned asset class. This is a dramatic shift in

opinion from just a few months ago when EM (including Asian

markets) was one of the most popular sectors among investors.

Such bearishness makes some Asian markets tactically

attractive.

Beyond sentiment, valuations also support the case for Asian

equities on a tactical basis through the end of the year. Exhibit

6 shows a valuation composite developed by colleagues in

the BofAML Asian Equity Strategy team consisting of six

normalized metrics―Price/Book (P/B), dividend yield, Enterprise

Value (EV)/Earnings Before Interest, Taxes, Depreciation

and Amortization (EBITDA). While levels are not at the same

deep discount as in 1997 or 2008, Asian markets do appear

attractive; Asia ex-Japan is trading at the lowest 14th percentile

of observations since 1973. Furthermore, according to BofAML

Chief Asian Equity Strategist, Ajay Kapur, Asia ex-Japan equity

markets are 20% undervalued, after adjusting for the gap in

current return on equity (ROE) and cost of equity (COE).1

At the same time, it is important to recognize that Asian

equities and local yield curves are closely related to interest rate

expectations in the U.S. Higher rates increase Emerging Market

vulnerabilities, as does an improving U.S. current account

balance, which effectively reduces global liquidity. On the other

hand, a postponement of tapering or a smaller-than-expected

decline in bond purchases could be bullish for Asian markets.

Given the potential volatility ahead, our advice is to wait on the

sidelines on many Asian markets, such as Indonesia, Malaysia,

Philippines, and Thailand, where valuations are not attractive

enough relative to the risks. Instead, we would look to the

more developed markets in Asia, such as China, Korea, Taiwan

and Japan, to play any tactical trading rallies. Moreover, we

recommend hedging currency risks, as we are constructive on

the U.S. dollar.

portfolio strategy: Asian economies are at once

grappling with longer-term weaker growth and a short-

term liquidity withdrawal reminiscent of their experience

in the 1990s. While we recognize the similarities, we

believe Asian economies have made substantial progress

on macroeconomic fundamentals that should prevent a

1997-style contagion. That suggests to us the broad sell-

off in Asia equities is overdone and that there are pockets

of value. China, Korea, Taiwan and Japan are markets

that appear to be undervalued and look appealing to us

in the short-term. We suggest avoiding the Southeast

Asian economies, such as Indonesia, Malaysia and the

Philippines, on the other hand, which look to be stretched.

We advise that any allocation be hedged.

ThE longEr-TErm ouTlook for asia is challEngingWhile we believe a trading bounce in Asian equities is possible

in the short-term, more strategically we think Asia ex-Japan

markets are likely to underperform the developed markets. The

primary reason for this is the maturity of the credit cycle in

emerging Asia.

In recent years an extensive credit boom developed across a

wide range of Asian economies from China to Singapore, as

QE and loose monetary policies in developed markets helped

flood EM with cheap credit. Leverage has risen alongside this

easy money. During this period, many Asian markets made

substantial cumulative fixed-asset capital investments.

1 For details on this methodology see the August 15th, 2013 report, A lotus in murky waters, from BofAML Global Research.

Asia ex-Japan composite valuation metric (S.D.)MSCI AxJ 12m forward return (%, Right)

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

1973 1980 1987 1994 2001 2008 -70

-50

-30

-10

10

30

50

70

Expensive

In 14th percentile Cheap

Exhibit 6: Asia ex-Japan Composite Valuation Metric Points to Asian Equities Being Undervalued

Source: BofA Merrill Lynch Global Research, I/B/E/S, MSCI.Note: Composite valuation metric consists of trailing P/E, 12m forward P/E, P/BV, Dividend Yield, EV/EBITDA and EV/sales, normalized over entire history.

CIO REPORTS • View 5

Now, the threat of tapering has inflicted a credit shock across

EM and Asian markets. Exhibit 7 highlights the sharp increase

in borrowing costs for EM sovereigns and corporations. As the

global tide of liquidity recedes, there will likely be a period of

painful adjustment for these economies. Specifically, places with

high capital expenditure (capex) spending relative to GDP are

likely to feel pressure on earnings before interest and tax (EBIT)

margins going forward (see Exhibit 8). By that token, countries

with low capex-to-GDP ratios, such as Japan, are likely to

experience a boost in EBIT as they benefit from lower capacity,

less competition, and higher pricing power (see Exhibit 9).

portfolio strategy: As recent events indicate, investors’

decade-long enchantment with EM may be waning.

Strategically, we believe over-investment and rising

leverage across many emerging Asian countries is likely

to be a drag on profit margins. As such, we think Asian

markets ex-Japan are likely to underperform developed

markets longer-term. Our advice for investors interested

in Asia is to focus on individual countries over broad-

based indexes. In particular, we are bullish on Japanese

equities, particularly companies in the export sector. We

believe Japan has a significant currency advantage globally.

BofAML’s currency strategy team’s year-end forecast is for

the yen to weaken to ¥105/$.

in focus: china’s rEbalancing challEngEThat brings us to China, which is facing its most serious

slowdown in decades. China’s rising capital-output ratio, growing

corporate leverage and frothy property market are all concerns

for its equity markets. Even more worrisome, cyclical policies to

stimulate growth are proving to be less effective than before.

We can see this from Exhibit 10 (on the next page), which

displays the relationship between GDP growth and credit

supply. While a surge in Total Social Financing (TSF) in 2009,

China’s widest measure of credit, helped to offset the economic

shocks arising from the global financial crisis and quickly set

the economy back on track, a similar attempt at monetary

accommodation in 2012 has proven to be less successful.

Even as TSF has risen 20%, year-over-year GDP growth has

continued to decelerate, falling to 7.5% year-over-year.

EM Sovereign (Local FX)EM Sovereign (USD) EM Corporate (USD)

Effe

ctiv

e Yi

eld

(%)

2%

4%

6%

8%

10%

12%

14%

16%

18%

2005 2006 2007 2008 2009 2010 2011 2012

Exhibit 7: Borrowing Costs Have Risen Sharply Since May

Source: BofAML Global Research, IMG. Data as of August 31, 2013.

Asia ex-Japan EBIT margins (2y avg) (%, Right)

Asia ex-Japan capex/GDP %, pushed forward by 4yrs,2y avg (inverted scale)

8

10

12

14

16

18

1/90 1/95 1/00 1/05 1/10 1/15 1/20

27

29

31

33

35

37

39

41

?

Exhibit 8: Asia ex-Japan – Prior Over-investment Projected to Pressure Future EBIT

Source: BofA Merrill Lynch Global Research, Worldscope, IMF

Japan EBIT margins (2y avg) (%, Right)

Japan capex/GDP %, pushed forward by 4yrs, 2y avg (inverted scale)

1/85 1/91 1/97 1/03 1/09 1/15

18

22

26

30

34 3

4

5

6

7

8

9

Exhibit 9: Japan – Prior under-investment likely to boost EBIT margins

Source: BofA Merrill Lynch Global Research, Worldscope, IMF

CIO REPORTS • View 6

Exhibit 11 provides a more direct linkage between TSF and

GDP by measuring the credit intensity of GDP, or the additional

credit creation associated with additional GDP. This rise in

credit intensity indicates that investments are likely running into

diminishing rate of returns, i.e., ever more debt is needed to

produce the same amount of output.

That has profound implications for China. For nearly two

decades China’s economy has grown at a remarkable rate on

the back of its credit and investments-driven economic model.

Compared to most economies, China has a lopsided balance

between investment and consumption.2 Exhibits 12 shows

China’s unusually high investment rate, even by the standards of

Asian economies.

Now that that model appears to be reaching its limits, increased

consumption has to compensate. The rebalancing agenda is

critical if the nation is to keep growing fast enough to maintain

its goals of employment, poverty alleviation and urbanization.

The alternative could be social upheaval and political instability.

china’s savings conundrumBut pivoting an economy as large as China’s onto a new path

is easier said than done. And the biggest challenge may simply

be getting the Chinese to consume. China’s current savings

rate is exceptionally high both relative to other countries and

to its own history. As shown in Exhibit 13, China’s savings

rate routinely exceeds its imposing investment levels and

recently soared to 53% of GDP in 2010. This positive savings-

investment gap is an important contributor to its large current

surplus (that helps finance U.S. debt).

Moreover, household consumption as a share of GDP has steadily

declined, as shown in Exhibit 14 (on the next page). That’s not to

say consumer spending hasn’t risen with economic development.

China’s market penetration for consumer goods—TVs, appliances,

TSF (%YOY) GDP (%YOY, Right)

Cred

it Su

pply

Gro

wth

(%)

GDP

Grow

th R

ate

(%)

6%

7%

8%

9%

10%

11%

12%

13%

10%

15%

20%

25%

30%

35%

40%

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

Exhibit 10: China GDP Growth and Credit Growth

Source: CEIC, Wind, BofA Merrill Lynch Research, Bloomberg. Data as of June 30, 2013.

0.0 0.5 1.0 1.5 2.0 2.5

2004-2006

2010-2012

Exhibit 11: Credit Intensity of GDP Has Risen Sharply in Recent Years

Source: IMG, Bloomberg

2 These are the two largest components of GDP, which also include government purchases and net exports.

ChinaKorea

BrazilJapan

GermanyRussia

IndiaU.S.

10%

15%

20%

25%

30%

35%

40%

45%

50%

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

Exhibit 12: Investments as % GDP Across Select Countries

Source: IMF. Data as of December 31, 2012.

Gross savings (% of GDP)Gross capital formation (% of GDP)

20%

25%

30%

35%

40%

45%

50%

55%

1982 1986 1990 1994 1998 2002 2006 2010

Exhibit 13: Chronic Excess of Savings Over Investments in China

Source: International Monetary Fund, World Economic Outlook Database, April 2013

CIO REPORTS • View 7

personal computers, etc.—has quadrupled in the last 20 years

and China is now the world’s largest market for automobiles and

luxury goods. Rather, what we see is that consumption has failed

to keep up with economic growth.

It’s not entirely clear why China’s savings is so high, but most

academic explanations point to a complex interaction of

historical, cultural and demographic forces accentuated by the

lack of developed insurance and credit markets. For instance, in

the absence of readily available health or life insurance options,

precautionary savings is necessary. Similarly, undersupplied

credit markets means large purchases, such as automobiles,

homes, etc. are not possible without substantial savings.

Regardless of the reasons, easing China’s high savings rate is

essential to successfully rebalancing the economy and a huge

challenge for policymakers.

whaT can policymakErs do?While there is no consensus on the way forward, most

economists agree that reforms in China’s bloated state-owned

corporate sector, support for fledging services industries,

as well as mobilization of financial surpluses away from

infrastructure toward social safety net programs for households,

as demographic pressures build (see Exhibit 15), are critical.

China has more than 100,000 state-owned enterprises (SOEs),

that receive government subsidies and cheap financing. A

substantial portion of corporate profits remain stuck at the

enterprise level or are recycled back into investments, not

benefiting ordinary citizens. As a result, China’s Gini ratio, or

measure of inequality, has risen from 39.2 in 1999 to 42.1 in

2009.3 Liberalizing and privatizing SOEs and extracting greater

dividends payments out of profits will help reduce corporate

savings and ease some of the imbalances discussed earlier.

China will also need to rely more on market forces to allocate

credit and resources to where price signals indicate the highest

returns. Those efforts will be boosted by financial market

reforms, including interest-rate deregulation and broadening

household credit availability.

slowEr growTh may bE betterIn the past, China’s leaders delayed undertaking major structural

reforms fearful of a measurable decline in growth arising from

comparatively lower productivity from the service sectors.

Yet, a key dividend of a services-based economy is that it

tends to be more labor-intensive and more inclusive than

manufacturing. That means China could potentially reach its all-

important employment and stabilization goals with less growth.

Encouragingly, the People’s Bank of China’s tightening of short-

term rates in June to curb speculation and excess lending in

the country’s vast shadow banking sector shows the country’s

leadership is willing to tackle difficult structural problems.

We believe predictions of a hard landing that sees GDP growth

crashing to 4-5% and fears of social unrest breaking out

are overblown. BofAML China economist, Ting Lu, forecasts

annualized GDP growth rates of 7.7% and 7.6% for 2013 and

2014, respectively―in both cases higher than the Chinese

government’s 7.5% target rate. In that context, investor

bearishness and still favorable valuations suggests to us that

the current bounce in Chinese equities still has legs.

Household consumption (% of GDP)GDP, constant prices (Right)

Cons

umpt

ion

(%GD

P)

GDP

Grow

th (y

oy%

)

0%

2%

4%

6%

8%

10%

12%

14%

16%

0%

10%

20%

30%

40%

50%

60%

1982 1986 1990 1994 1998 2002 2006 2010

Exhibit 14: Chinese Consumption Has Failed to Keep Pace with GDP Growth

Source: International Monetary Fund, World Economic Outlook Database, April 2013

3 World Bank Poverty and Inequality Database

Dependency Ratio Growth in Working-Age Population

Depe

nden

cy R

atio

% C

hg in

Wor

king

-Age

Pop

ulat

ion

-0.10

-0.05

0.00

0.05

0.10

0.15

0.20

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

0.80

0.90

1975

1980

1985

1990

1995

2000

2005

2010

2015

2020

2025

2030

2035

2040

2045

2050

Exhibit 15: As Demographics Shift, China’s Dependency Ratio* is Rising

Source: World Bank Development Indicators, United Nations Population Division. Dependency ratio measures the number of dependents in a country (persons under 15 and over 65) supported by its labor force.

CIO REPORTS • View 8

Of course, longer-term, China will slow and settle on a

comparatively lower, but more sustainable, growth trajectory

as households become the new engine of the economy.

A rebalanced Chinese economy will be a more stable and

less risky destination for investors. For portfolios, it will

mean a change in allocations away from infrastructure-tied

investments and toward consumer sectors, such as durables

and discretionaries.

portfolio strategy: China’s economy is at a crossroad

and faces deep structural issues. To ensure sustainable

growth China needs to rebalance its economy from one

that is investments-driven to one that is consumption-

driven. While China’s growth will be slower in the future,

worries over a “hard landing” are vastly overdone.

Moreover, this transition is long-term and likely to be

volatile, but has important implications for investor

portfolios. For investors, this will mean a change in

allocations away from infrastructure and heavy industries

and toward consumer sectors.

Contributing Authors: Ahmed Shan Hasnat and

Mary Ann Bartels

CIO REPORTS • View 9

When considering your portfolio in light of our current guidance, consider the tactical positioning around asset allocation suggested below in reference to your own individual risk tolerance, time horizon, objectives and liquidity needs. Certain investments may not be appropriate given your specific circumstances and investment plan. Certain security types, like hedged strategies and private equity investments, are subject to eligibility and suitability criteria. Your Financial Advisor can help you to customize your portfolio in light of your specific circumstances.

asset class

Benchmark strategic asset allocation

from ric*

tactical Positioning relative to strategic

asset allocation oPPortunities and risks

cash 2% UNDERWEIGhT Current returns are negative on a real basis in developed markets; we want to get paid to wait, and the perceived safety of cash may be overstated in an age of financial repression.

global equities 45% OVERWEIGhTIn developed markets, valuations are fair and they are becoming attractive in Emerging Markets. Corporate fundamentals are excellent. Income generation remains a major theme within portfolios and dividend growth continues to play a major role.

u.s. large cap

21%

OVERWEIGhTConsider sector rotation toward cyclicals as the U.S. economy improves; these sectors still offer attractive dividend opportunities. Reduce utilities and telecom. Financials remain an opportunity.

u.s. mid & small cap NEUTRALSmall caps are likely to continue benefiting from ongoing domestic recovery. Valuation dispersion in small caps remain high and an opportunity for active management. Positive M&A outlook is constructive for small caps.

international developed 18% NEUTRAL

BoJ committed to continue quant easing and valuations are fair. The yen remains the key consideration; Eurozone in recession but stabilizing; valuations remain favorable and liquidity actions of the ECB are supportive. See opportunities through 2h 2013 but volatility likely to remain. The bias remains for euro weakness, therefore, hedge euro equity exposure.

emerging markets† 6% NEUTRAL

the prospect of slower growth combined with the withdrawal of fed liquidity reduces previous optimism on the region. short term, prefer countries with stable capital account positions, which may tactically outperform on the back of weak sentiment. Longer-term, look beyond index like exposure to focus on smaller emerging countries and frontier markets.

global fixed income 33% NEUTRAL In a rising rate environment, seek differentiation in returns across sub-segments. Duration management remains paramount in portfolio positioning. Prefer credit risk over duration risk.

u.s. treasuries

N/A

UNDERWEIGhTNegative real returns and Fed intervention have created highly overvalued and unattractive conditions. We see better risk/return elsewhere. Within Treasuries, prefer short and intermediate duration.

u.s. municipals OVERWEIGhT

Valuations relative to Treasuries remain attractive and tax-exempt status is not likely to be threatened anytime soon. Prefer essential service revenue bonds and high-quality, actively selected credits. Consider positioning toward short to intermediate duration and state over city GO (general obligation) bonds.

u.s. investment grade NEUTRALSome opportunities remain here, but in the final stage of the investment grade rally. U.S. bank bonds may have more room to rally. Very sensitive to a rise in rates, positioning should focus on shorter duration.

u.s. high Yield & collateralized OVERWEIGhT

Corporate fundamentals remain supportive of investors taking credit risk and default rates will likely remain low. Valuations will overshoot this cycle on quality of balance sheets. hY plays a role in diversifying sources of income, as the search for yield continues. Look to new credit opportunities such as senior loans.

non-u.s. corporates NEUTRALWe continue to want to be cautious on Eurozone debt, despite the improving liquidity environment as we expect rate volatility to remain above average and indices have high weight to European banks, which still need to re-capitalize.

non-u.s. sovereigns NEUTRAL We like opportunities in this space but advise active manager exposure. Country specific domestic policy to dominate rates and currency performance.

emerging market debt† NEUTRAL

more value in higher quality em credits that too have sold-off, however, fed liquidity withdrawal introduces uncertainty for the aggregate market. short term, avoid current account countries susceptible to investor outflows and a stronger u.s. dollar. Stress the need for management of currency exposure. Active managers can better exploit the opportunity set.

alternatives** OVERWEIGhT

commodities/currencies Included in Real Assets NEUTRAL Oil provides a hedge against political instability and select agriculturals looking short term

oversold. Industrial metals remain dependent on growth in China.

hedged strategies 9% NEUTRALIn a total portfolio, prefer low vol and non-directional strategies such as global macro to provide diversification from our preferred equity overweight. Within more directional strategies prefer equity long/short and relative value.

real assets 4% OVERWEIGhT TIPS attractive after Q2 sell-off.

Private equity 7% OVERWEIGhT high conviction in private equity as the combination of an improving economy yet banks still reluctant to lend provides attractive opportunities.

**Moderate Global Allocation Tier 2 Liquidity. **Alternative Investments are available only to pre-qualified clients. † Revised from previous report.

Source: Merrill Lynch Investment Management & Guidance, September 2013.

CIO REPORTS • View 10

Information in this material is not intended to constitute tax advice. You should consult your tax advisor before making any financial decisions.

Tax-Aware Portfolio Implementation Tactics for 2013

1. Assess current tax exposures, especially in taxable bond portfolios; and weigh options in dividend-paying stocks.

2. Consider adding tax-overlay strategies in 2013.

3. Leverage tax-advantaged status of exchange-traded funds (ETFs) in asset classes where appropriate, and assess the tax management policies of mutual funds for their efficiency and turnover.

4. Revisit using separately managed accounts (SMAs) for tax management and tax-aware portions of portfolio.

5. Consider Roth IRA conversions for traditional IRAs and eligible 401(k)s.

6. Aggressively pursue estate planning, wealth structuring, wealth transfer and gifting strategies.

CIO REPORTS • View 11

1. Increase overall exposure to global equities, which are preferred to bonds. We see the “Great Rotation” from fixed income to equities occurring in 2013 as global economic growth reaccelerates by the end of the year and most global central banks remain stimulative. Superior corporate earnings and balance sheet dynamics should support increased capital spending and shareholder-friendly returns of cash (dividends and buybacks). Income from dividends, especially “growers,” remains preferred.

2. Broaden geographic preferences within global equities—adding to exposure in Europe and Japan. International developed portfolios should be hedged as the U.S dollar will likely strengthen versus the yen and the euro. The global debt crisis is entering a new and more stable phase; this should favor a more balanced geographic approach. While we remain very constructive on the prospects for U.S. companies and in turn U.S. equities, valuation and catalysts are improving meaningfully in other major regions; and underweights should be closed. Winners are likely to be multi-nationals with high leverage to global trade and exports.

3. Reduce purely defensive stock exposures; and embrace value in more cyclical sectors like technology, industrials and energy. As economic fortunes, global growth and global trade improve through the year, we see a more positive outlook for stocks leveraged to reflation. Many companies in these sectors are of high quality and offer the potential for dividend growth.

4. Within Emerging Markets, focus on smaller countries and Frontier Markets. To access this theme, we prefer active managers to ETFs and other passive strategies. Most Emerging Market ETFs remain skewed to commodities, materials and infrastructure. Active managers can focus on strategies more likely to outperform in the years ahead, including growth in the middle class and the resultant surge in spending.

5. Aggressively manage risk around a potential turn in the bond market and take a total return, after-tax perspective in fixed income portfolios. Tax-advantaged municipals and global fixed income managers are preferred. We see the tax-advantaged status of municipals increasing in relative value as 2013 tax rates rise. In addition, we look for highly diversified and broad global mandated managers to continue to deliver the best results in 2013.

– Reduce duration in fixed income portfolios. As 2013 unfolds, the risk to interest rates and thus bond principal is likely to rise, with longer-duration securities most

vulnerable. Reduce long maturities of U.S. Treasuries and municipals. Utility equities—sometime bond substitutes—are also no longer preferred.

– Credit risk preferred to duration risk—but time to reset expectations. The strong returns experienced by corporate bond investors over the past few years are unlikely to be repeated, and we would not extend durations or move to lowest quality high yield bonds in a reach for yield. High yield bonds may act much more like equities, doing poorly if market volatility rises. Other credit opportunities include residential mortgage-backed securities and mortgage-backed securities.

– Consider low volatility/total return alternatives strategies as potential substitutes for low-yielding, increasingly vulnerable bond holdings. Market neutral and “absolute return”; LIBOR-plus funds with low volatility may have place in a diversified fixed income portfolio along with exposure to floating rate instruments like bank loans.

– Increase vigilance on closed-end funds with strategies focused on leveraging high yield instruments.

– Consider annuities as a source of guaranteed minimum income draw.

6. Consider using hedge funds to complement positioning by diversifying portfolio risk. Within diversification strategies, we prefer global macro. For more directional strategies, we favor equity long/short.

7. Gold’s role as a diversifier in portfolios remains as its ability to hedge policy error has been diminshed as economic conditions have improved. Still see value in a multi-asset diversified portfolios, although short-term price catalyts are less evident.

8. Refocus on portfolio tax efficiency by utilizing high quality ETFs for a part of your strategic asset allocation and by reconsidering the use of SMAs versus mutual funds for tax management and transparency.

9. Exploit the low rate environment by building exposure in direct real estate and private equity. 2013 remains a year of balance sheet releveraging, benefiting private equity investors. Prefer infrastructure and direct lending to SME (Small Medium Enterprises).

10. Get back into the markets and reduce cash holdings, which are earning compounding negative real rates of return. Be mindful of potential changes to FDIC insurance limits.

CIO Office’s Top 10 Portfolio Actions for 2013 (after managing tax liabilities)

GWM Investment Management & Guidance (IMG) provides investment solutions, portfolio construction advice and wealth management guidance.

The opinions expressed are those of IMG only and are subject to change. While some of the information included draws upon research published by BofA Merrill Lynch Global Research, this information is neither reviewed nor approved by BofA ML Research. This information and any discussion should not be construed as a personalized and individual recommendation, which should be based on your investment objectives, risk tolerance, and financial situation and needs. This information and any discussion also is not intended as a specific offer by Merrill Lynch, its affiliates, or any related entity to sell or provide, or a specific invitation for a consumer to apply for, any particular retail financial product or service. Investments and opinions are subject to change due to market conditions and the opinions and guidance may not be profitable or realized. Any information presented in connection with BofA Merrill Lynch Global Research is general in nature and is not intended to provide personal investment advice. The information does not take into account the specific investment objectives, financial situation and particular needs of any specific person who may receive it. Investors should understand that statements regarding future prospects may not be realized.

Asset allocation and diversification do not assure a profit or protect against a loss during declining markets.

The investments discussed have varying degrees of risk. Some of the risks involved with equities include the possibility that the value of the stocks may fluctuate in response to events specific to the companies or markets, as well as economic, political or social events in the U.S. or abroad. Bonds are subject to interest rate, inflation and credit risks. Investments in high-yield bonds may be subject to greater market fluctuations and risk of loss of income and principal than securities in higher rated categories. Investments in foreign securities involve special risks, including foreign currency risk and the possibility of substantial volatility due to adverse political, economic or other developments. These risks are magnified for investments made in emerging markets. Investments in a certain industry or sector may pose additional risk due to lack of diversification and sector concentration. Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates, and risk related to renting properties, such as rental defaults. Market-Linked investments have varying payout characteristics, risks and reward, investors need to understand the characteristic of each specific investment, as well as those of the linked asset. There are special risks associated with an investment in commodities, including market price fluctuations, regulatory changes, interest rate changes, credit risk, economic changes and the impact of adverse political or financial factors. Exchange Traded Funds are subject to risks similar to those of stocks. Investment returns may fluctuate and are subject to market volatility, so that an investor’s shares, when redeemed or sold, may be worth more or less than their original cost.

Alternative Investments are speculative and subject to a high degree of risk. Although risk management policies and procedures can be effective in reducing or mitigating the effects of certain risks, no risk management policy can completely eliminate the possibility of sudden and severe losses, illiquidity and the occurrence of other material adverse effects.

Some or all alternative investment programs may not be suitable for certain investors. Many alternative investment products, specifically private equity and most hedge funds, require purchasers to be “qualified purchasers” within the meaning of the federal securities laws (generally, individuals who own at least $5 million in “investments” and institutional investors who own at least $25 million in “investments,” as such term is defined in the federal securities laws). No assurance can be given that any alternative investment’s investment objectives will be achieved. In addition to certain general risks, each product will be subject to its own specific risks, including strategy and market risk.

© 2013 Bank of America Corporation ARU55K4L

Spencer Boggess, CIO, Alternative Investments212-449-3043

Anil Suri, CIO, Multi-Asset Class Modeled Solutions212-449-3385

Chris Wolfe, CIO, PBIG and Ultra-High Net Worth Customized Solutions212-236-3159

Jim Russell, CIO, Portfolio Construction and Multi-Manager Solutions201-557-0079

Mary Ann Bartels, CIO, Portfolio Strategies646-855-0206

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