ric overview the three “e”s...ric overview | 13 september 2016 3 the three “e”s martin mauro...

BofA Merrill Lynch does and seeks to do business with issuers covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Refer to important disclosures on page 20 to 21. 11660058

RIC Overview

The three “E”s

13 September 2016

Emerging Markets: near-term caution, long-term positive Our Asia/EM Equity Strategy team has turned neutral on EM stocks for the short term, but remains bullish longer term. We suggest that investors remain committed to the market. It may, however, make sense to reduce some of the beta and cyclicality in the portfolio. We have a similar view on bonds: cautious for the short-term, positive for the long term. We have a slight preference for local currency sovereigns over US dollar denominated bonds.

Election: wide-ranging impact With the US presidential election less than two months away, we highlight seven key election issues with significant implications for equity investors including the uncertainty shock, split government, and fiscal policy, among others. We also note the historical performance of stocks based on control of the White House and Congress.

Energy: raising to overweight Our commodity strategists estimate that most of the sell-off in oil prices is behind us as they look for the price of West Texas Intermediate oil to rise to $54/bbl (+17%) by the end of the year and $69/bbl (+49%) by next June. We believe that the rotation into energy stocks among both fund managers and individual investors may be in its infancy as supply/demand balances improve. Our US equity strategists have recently raised the sector to overweight. We provide a list of Buy-rated US Energy stocks that have a market cap of greater than $5 billion.

Chart 1: Returns on EM stocks and bonds (rolling 12 month % change) EM stock and bond returns move closely together

Source: BofA Merrill Lynch Global Research, Bloomberg

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Investment Strategy Global

Research Investment Committee MLPF&S Martin Mauro Fixed Income Strategist MLPF&S +1 646 855 2998 [email protected] Cheryl Rowan Portfolio Strategist MLPF&S +1 646 855 3105 [email protected] Matthew Trapp, CFA Investment Strategist MLPF&S +1 646 855 3084 [email protected] See Team Page for Full List of Contributors

This report is an abbreviated version of the full RIC report, provided for your benefit. It excludes our US and global client asset allocation tables, US and global market sector weightings and recommendations, our global stock lists, as well as global economic, interest rate, and FX forecast summaries.

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2 RIC Overview | 13 September 2016

Financial markets recap August 2016 review

• In contrast to 12 months ago, equity returns were fairly muted across much of the globe in August, except in EM and Hang Sang, which were up 2.5% and 5.3%, respectively. Those markets are on top for the YTD, with EM up 14.8% and Hang Sang at 8.0%.

• Small caps continued to outperform, gaining 2.5% in August, and they are now the best performing size segment for the year, at 8.6%. Value outperformed growth in all three size segments last month and so far YTD.

• Financials was the top sector in August, gaining 3.8%, but it has been a laggard this year. Telecom and Utilities gave back gains, falling 5.7% and 5.6%, respectively, in August; however, both sectors remain on top YTD.

• The riskier sectors of fixed income outperformed last month, led by high yield and EM corporate and sovereign bonds. This group is up double digits for the year and only trails 30-year Treasuries.

• Oil rebounded in August after a significant decline in July. Oil and gold are both up over 20% for the year.

Table 1: Equity indexes – total return (%) As of 31 August 2016 Asset class 1mo 3mo 12mo YTD 3yr2 5yr2 10yr2 Equity Indices (%, US dollar terms) S&P 500 0.1 4.1 12.6 7.8 12.3 14.7 7.5 Dow Jones Industrial Avg. 0.3 4.2 14.4 7.7 10.2 12.5 7.7 NASDAQ Comp 1.2 5.7 10.5 5.0 14.6 16.5 10.2 MSCI All Country World 0.4 4.2 7.9 6.4 7.3 8.9 5.0 FTSE 100 1.0 -0.3 -3.5 0.0 0.1 4.1 1.4 DJ Euro Stoxx 50 1.2 -0.7 -5.2 -2.5 0.6 3.4 -0.6 MSCI EAFE 0.1 1.7 0.4 0.9 2.9 5.5 2.2 TOPIX -0.4 3.4 3.7 1.6 6.6 7.3 1.2 Hang Seng 5.3 12.6 10.3 8.0 5.8 6.2 6.5 MSCI Emerging Markets 2.5 12.1 12.2 14.8 1.5 -0.1 4.2 Size & Style (%, US dollar terms) Russell 1000 0.1 4.2 11.7 7.8 12.0 14.6 7.6 Russell 1000 Growth -0.5 3.8 10.5 5.6 13.3 14.7 9.1 Russell 1000 Value 0.8 4.6 12.9 10.2 10.7 14.4 6.1 Russell Midcap -0.2 4.8 9.9 10.0 11.3 14.3 8.5 Russell Midcap Growth -0.3 4.6 7.0 6.9 10.7 13.4 8.8 Russell Midcap Value -0.2 5.0 12.9 13.2 11.9 15.0 8.0 Russell 2000 1.8 7.8 8.6 10.2 8.5 12.9 7.0 Russell 2000 Growth 1.1 7.2 3.6 6.0 8.5 13.0 8.2 Russell 2000 Value 2.5 8.3 13.8 14.6 8.5 12.6 5.8 S&P 500 Sectors (%, US dollar terms) Consumer Discretionary -1.2 2.0 9.3 4.0 13.6 18.5 11.2 Consumer Staples -0.5 3.9 18.1 9.1 14.1 15.0 10.9 Energy 1.2 2.5 7.7 15.2 -2.6 2.5 4.1 Financials 3.8 4.1 7.2 4.2 10.3 15.2 -0.9 Health Care -3.3 2.5 5.0 1.9 15.7 19.1 10.4 Industrials 0.8 5.3 17.7 11.0 12.5 15.3 8.1 Information Technology 2.1 7.1 18.7 9.8 17.6 16.7 10.6 Materials -0.1 4.1 14.7 12.9 8.5 9.0 6.9 Telecom Services -5.7 4.2 23.4 19.0 10.0 12.3 7.3 Utilities -5.6 1.0 20.3 15.7 13.9 12.0 7.7 Notes: * Performance is gross of foreign dividend withholding taxes, 2 3yr, 5yr, and 10yr returns are annualized Source: BofA Merrill Lynch Global Research, S&P, MSCI, Bloomberg

Table 2: Bond/currency/commodity/hedge fund indexes–total return (%) As of 31 August 2016 Asset class 1mo 3mo 12mo YTD 3yr2 5yr2 10yr2 BofA Merrill Lynch Global Research Bond Indices (%, US dollar terms) 2-Year Treasury -0.2 0.4 0.9 1.1 0.8 0.6 2.4 5-Year Treasury -0.6 1.2 3.4 3.7 2.8 1.8 4.7 10-Year Treasury -1.0 2.7 7.3 7.4 5.9 3.7 5.8 30-Year Treasury -0.8 9.4 18.5 19.3 13.0 8.5 8.5 US Broad Market Index -0.1 2.4 6.1 6.0 4.5 3.3 4.9 TIPS -0.4 2.7 5.7 7.1 3.0 1.9 4.5 Municipals* 0.2 1.8 7.1 4.6 6.9 5.1 5.0 US Corporate Bonds 0.3 3.9 9.4 9.4 6.0 5.3 6.0 US High Yield Bonds 2.2 5.9 9.2 14.6 5.4 7.3 7.7 Emerging Mkt Corp Bonds 1.2 5.0 10.0 11.3 5.8 5.3 6.5 Emerging Mkt Sov Bonds 1.7 6.4 12.6 13.2 7.2 5.6 7.0 Preferreds 0.6 3.1 11.3 7.0 10.4 7.7 3.6 Foreign exchange** (%, in local currencies) US dollar 0.8 -1.1 -3.2 -5.4 5.0 5.7 0.8 British pound -0.9 -10.4 -14.4 -13.1 -1.1 0.0 -2.7 Euro 0.4 2.3 2.3 3.4 -2.2 -1.4 -0.4 Yen -0.7 7.8 18.3 16.4 0.8 -3.6 2.0 Commodities** (%, US dollar terms) CRB Index -0.4 -3.2 -10.8 2.3 -14.8 -12.1 -5.8 Gold -2.9 7.7 15.4 23.2 -2.2 -6.5 7.6 WTI Crude Oil 7.5 -9.0 -9.1 20.7 -25.4 -12.8 -4.4 Brent Crude Oil 10.8 -5.3 -13.1 26.2 -25.6 -16.3 -3.9 Alternative Investments† (%, US dollar terms) Hedge Fund - CS Tremont¹ 1.1 1.4 -4.0 -0.5 2.6 3.0 4.3 Hedge Fund - HFRI Fund of Funds¹ 1.6 1.6 -4.1 -1.1 2.1 1.9 1.8 Notes: *Not tax adjusted. **BoE calculated effective FX indices. ¹Data lagged by one month; 2 3yr, 5yr,

and 10yr returns are annualized; CS AUM-weighted, HFRI equal-weighted; †AI data not comparable to

other asset classes because of reporting delays, lack of standardized reporting, and survivorship and self-selection biases. Crude oil prices are spot USD. Source: S&P, MSCI, Bloomberg, FactSet, BofAML

Bond Indices (US Treasury Current 10yr, Current 2yr, Inflation-Linked; Muni Master, US Corp Master,

US HY Master II, EM Corp Plus Index; EM External Debt Sovereign Index; US Preferred Stock Index).

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RIC Overview | 13 September 2016 3

The three “E”s Martin Mauro Fixed Income Strategist MLPF&S [email protected]

Cheryl Rowan Portfolio Strategist MLPF&S [email protected]

Matthew Trapp, CFA Investment Strategist MLPF&S [email protected]

US Equities have been surprisingly resilient US stocks have done much better than our low-single-digit expectations at the beginning of the year. Even since the Brexit vote in late June, the S&P 500 went higher in July and eked out a small gain in August until giving a little back so far in September. The lack of attractive alternatives in other markets, notably bonds, is one factor behind the resilience in stocks, but the fundamentals generally have been favorable, too. Better economic data in the US and globally has helped fuel the rally, as well as positive momentum in estimate revisions. The quick resolution of deciding a new prime minister in the UK initially helped calm the markets after the disappointing vote for Brexit.

US economic data generally favorable The US economy appears on a reasonably healthy path. US Economist Michelle Meyer recently raised her GDP forecast for the second half of 2016, after a weak first half. We expect 3.0% growth in the third quarter and 2.7% in the fourth quarter.

We expect the US housing market recovery to remain slow and bumpy, with housing starts of 1.175MM this year and 1.325MM next year. Home prices are running at an above-expectations pace of 5% year-over-year. Job growth has been solid over the last three months averaging over 230,000, despite a slightly weaker than expected reading in August. And wages have been rising, particularly at low income jobs, as many states have raised the minimum wage this year.

Two recent exceptions to the favorable stream of data were the August readings of the ISM index for manufacturing, which dipped below 50% to 49.4%, and the ISM reading for non-manufacturing, which slowed to 51.4 from 54.9. That mix of data and our forecasts lead our economists to believe that the Fed will hold off its next rate hike to the December 14 FOMC meeting.

Global Wave suggests improving conditions The Global Wave is the name that quantitative strategist Nigel Tupper gives to an indicator he uses that looks at trends in global economic activity to help predict equity market performance. It is an amalgamation of seven indices of economic data including confidence, unemployment, producer prices, earnings estimate revisions, credit spreads and capacity utilization. The Global Wave signaled a trough in global economic conditions in June and has been strengthening since then. A rising Global Wave suggests that stocks should continue to rally and stocks with more aggressive characteristics should outperform.

Global earnings revision ratio improving One of the components of the Global Wave that has contributed positively is the global earnings revision ratio, which measures the number of stocks for which the consensus EPS estimate has risen versus the number for which it has fallen. The one-month global earnings revision ratio jumped to a five-year high in August to 0.96, with improvement in every region except the US, which slipped 0.01. The less volatile three-month ratio,

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which shows the trend in earnings expectations, also strengthened for the sixth straight month, moving above its long-term average to 0.83 from 0.75.

Chart 2: Global Earnings Revision Ratio

Source: BofA Merrill Lynch Global Quantitative Strategy, MSCI, IBES

Good performance from EM fueling global cyclicals Many emerging markets stocks have had strong rallies so far in 2016. They have been fueled by improving commodity prices, a steady US dollar, and low global yields with expectations for further interest rate declines. In some markets, a new political environment and/or government reforms have added to the appeal. US stocks have also benefitted, as many domestic companies derive significant revenue from the global economy.

Laggard industry groups catching up The “catch-up” in performance by some of the former laggard industry groups has helped fuel US stocks recently. Oil prices have rallied over 20% in 2016, helping energy-related stocks to sharply recover from their dismal performance last year. Our US Equity Strategy team recently upgraded Energy to Overweight, as we expect demand for oil to outpace supply. For more on the upgrade, please turn to page 8. We think energy stocks are likely to continue to do well with further recovery in oil, although there may be a pullback in the near term.

Biotech stocks underperformed the broader market for much of the year, but turned the corner in late summer. Significant cost cutting that has led to earnings improvement, along with increased merger activity, has allowed the group to rally. We generally like biotechs because improved earnings have helped valuations, many stocks have valuable pipeline assets, the regulatory environment is favorable and cash flow generation is strong.

Financials struggled for the first half of the year and still lag overall market returns, but have been strong performers so far in 3Q, as focus on Fed action has intensified. We expect the Fed to raise rates by 25 basis points at the December meeting. That is now the consensus expectation as well. Beyond then, we expect two rate hikes in 2017 and two more in 2018. As it becomes more likely that rate increases will occur, Financials, particularly banks, should do well.

But what will it take for the momentum in the stock market to continue? For stocks to continue to move higher, we need corporate profits to continue to improve without the Fed raising rates too aggressively.

Our strategy team has some near term concerns US Equity Strategist Savita Subramanian maintains her year-end price target for the S&P 500 of 2000, versus today’s level of 2136. Subramanian believes that expectations for earnings growth in 2017 are too high. Wall Street is forecasting EPS growth of

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13.9% next year, compared to our strategy team’s forecast of 6.8%. Investors are not as bearishly positioned as they may seem, according to our strategy team. Hedge funds have the highest equity exposure since August 2015, and our Global Fund Manager survey shows that investors have their highest overweight to the US since January 2015. Also, the S&P 500 looks expensive vs history on most valuations metrics. Despite these risk factors, the US Strategy team maintains a favorable long-term view of stocks with a price target of 3500 for the S&P 500 by the end of 2025.

More selectivity on Emerging Markets Emerging Markets equities have done well so far this year, up 14.8% in US dollars through August month-end. In local currency, they are up far more. Markets that are more linked to commodities like Brazil, Russia and Chile have done particularly well. Along with strong performance, investors have shifted more capital toward EM and are now no longer underweight. Sentiment has become less negative, too.

Our Asia/EM equity strategy team is taking a breather after the strong rally and is now tactically neutral on Emerging Markets stocks, but they retain a bullish longer-term view Our less bullish stance on EM in the near term arises from Strategist Ajay Kapur’s Global Risk/Love indicator (Chart 3), which has risen sharply and is now suggesting near-euphoric conditions. Risk/Love is a combination of several pieces of data, ranging from investor positioning and surveys to put/call ratios, technical, and volatility/correlations. Price declines or just the passage of time could cause sentiment to adjust downward again; that would likely trigger a more bullish stance from our strategy team.

Chart 3: Global Risk-Love is close to Euphoria

Source: BofA Merrill Lynch Global Research, Bloomberg

So what should investors do with EM holdings? We remain bullish longer term and we do not suggest that investors abandon their commitment. EM equities tend to well after Nigel Tupper’s Global Wave indictor troughs, which it did in June. While Kapur is tactically neutral, he believes that earnings expectations are easy to beat and the earnings revision trend in EM has improved. It may, however, make sense to reduce some of the beta and cyclicality in the portfolio. Countries that have done the best are likely to see the bigger pullback, so exposure to Latin American markets may be reduced in favor of markets like China. Kapur writes that China’s easier monetary policy has led to a boom in property and autos; property sales YTD are up 41% vs. last year. Real interest rates have fallen and earnings are beating expectations.

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Chart 4: 12 month total returns on EM debt EM debt reviving

Source: BofA Merrill Lynch Global Bond Indexes

Emerging market bonds: good long-term fundamentals Our view on emerging market sovereign bonds is similar to our view on stocks: some caution for the next month or so, but favorable for the next 12 months. Keep in mind, though, that returns on EM bonds are generally more volatile than most sectors of the US bond market.

Emerging market bonds have also revived in recent months, as Chart 4 shows. Over the past 12 months, returns have been in double digits for both dollar denominated and local currency sovereign bonds, as well as for corporate bonds.

In their September 1 GEM publication, David Hauner and our Emerging Markets team cite three positives for EM bonds:

• We expect economic growth in EM nations to outperform growth in developed nations in 2016-2017. Specifically, we expect EM GDP growth to be 4.0% this year and 4.8% in 2017, compared to 1.5% in each year for developed nations.

• A currency devaluation in China, provided it remains orderly, should ultimately be positive for EM growth, as it would improve prospects for international trade.

• We expect oil prices to rise in the next 12 months, which would generally be a positive for EM nations. Our commodity team projects Brent crude oil prices to be $52/bbl in the fourth quarter and $61/bbl in 2017, up from $45/bbl now.

The near-term risks revolve around the upcoming Fed and OPEC meetings, on September 21 and September 26-28, respectively. A Fed rate hike or an OPEC agreement to expand output would be negative for EM debt.

Sovereign debt: slight preference for local currency over US $ denominated We have a slight preference for local currency sovereign EM debt over US dollar denominated (external). For our Moderate Profile we assign a 6% weighting in the taxable fixed income allocation to local currency debt and 4% to dollar denominated.

One important consideration for dollar-based investors in the local currency versus dollar denominated decision is the course of EM currencies. A stronger dollar/weaker EM currencies would reduce the return on debt denominated in local currencies. Our strategists note that the current account balances for EM nations are improving versus developed nations, which is generally favorable for the currencies. The easy monetary policy from the European Central Bank also bodes well for EM currencies in our view.

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Present valuations also favor local currency debt, in our view. Table 3 shows that, based on the BofA Merrill Lynch Global indexes, yields on local currency bonds are higher by about 70 basis points, the duration is lower, implying less interest rate risk, and the credit quality is higher.

EM Corporate bonds The EM corporate market, most of which is denominated in dollars, has also revived, particularly in the wake of the decline in developed country yields. Anne Milne, head of the GEM Corporate Credit Research team, attributes much of the performance to higher commodity prices and limited supply. Milne believes that the rally in corporate EM debt can continue, although there are some near-term risks. Potential drivers for a pullback in the EM corporate bond market are a slowing in China, a downturn in commodities, a contentious US presidential election, and higher yields in developed markets.

Table 3: Profile of Emerging Market bonds Sovereign Corporate US $ denominated Local currency Size of Market ($billions) 1,339 600 1,342 Average yield (%) 4.15 4.86 5.56 Average duration (years) 4.94 7.40 5.50 Average credit quality BB2 BB2 BBB2 Source: BofA ML Global Bond Indexes

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Raising Energy to overweight Savita Subramanian Equity & Quant Strategist MLPF&S [email protected]

Positioning for the oil rally Our commodity strategists estimate that most of the sell-off in oil prices is behind us, as they look for WTI oil prices to rally to $54/bbl (+17%) by the end of the year and $69/bbl (+49%) by next June. Oil production continues to fall, as global oil & gas investment has been cut by nearly $300bn (41%) and rig counts have dropped by 37% since the 2014 peak. In contrast, low oil prices continue to drive healthy demand growth, putting the oil market on pace to see its biggest supply-demand deficit since 2011. Our commodities team estimates that the deficit will last through 2020.

Chart 5: BofAML oil price forecasts suggest a strong rebound S&P 500 Energy relative performance vs. WTI oil prices( April 2011-present and BofAML forecasts for 4Q16 and 1H17 period ends)

Source: BofAML Global Research, Bloomberg, S&P

Chart 6: US rig counts have fallen by 78% from the peak

Source: Baker Hughes, BofAML Global Commodities Research

Chart 7: Global oil demand growth remains solid

Source: BP statistical review, IEA, BofA Merrill Lynch Commodities Research

Chart 8: Global oil market balance moving into deficit

Source: IEA, BofA Merrill Lynch Commodities Research

Given this outlook, we expect the energy sector to outperform the S&P 500 and move the sector to Overweight from Marketweight. Historically, when oil has rallied over 25%, Energy has outperformed the market nearly 90% of the time, with average outperformance of 11ppt. The one time that the sector underperformed significantly amid a strong oil rally was when the stock market troughed in 2009, but the sector did recoup most of that underperformance in the subsequent year.

The rotation into Energy may still be in its infancy Back in late June, the Energy sector had rallied 26% since oil bottomed in February, outperforming the S&P 500 by 12ppt and leading investors to wonder whether they had

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missed the rally. Although fund managers have cut their Energy underweight from 35% to 19% since September 2015, it is still the fourth most underweighted sector in the S&P 500. And since June, Energy has underperformed the market, with client flow trends suggesting that selling had begun to reaccelerate.

Looking at its longer-term trend, Energy has been the worst-performing sector in this bull market, underperforming the S&P 500 by nearly 200ppt since March 2009. This underperformance pushed Energy’s weight in the S&P 500 below 7%, roughly half the level of its 1990 and 2008 peaks of 13%+ and at levels not seen since the Tech bubble, when its weight had dropped to 5.5%. There has never been a time when the Energy sector’s weight has dropped below 7% and the sector did not outperform the market over the subsequent three years.

Chart 9: Energy’s share of the S&P 500 is near a decade low

Source: BofAML US Equity & Quant Strategy, S&P, Bloomberg

Chart 10: Energy historically outperformed when its share was this low Energy weight in S&P 500 and subsequent 3yr performance, 1990-present

Source: BofAML US Equity & Quant Strategy, S&P, Bloomberg

Expensive on depressed earnings, but estimates moving up Currently trading at a forward P/E of 40x, the Energy sector remains expensive relative to its depressed earnings, but those earnings expectations are starting to move higher, with oil having rallied 75% from its February lows. Energy has seen its earnings estimates improve, with its three-month revision ratio at a five-year high. Given the oil outlook, we would expect Energy earnings expectations to continue to move higher. Meanwhile, on a P/BV basis, the sector trades at nearly a 40% discount to the S&P 500, which is still near a 30-year low, despite the roughly 20% fall in the sector’s book value due to asset impairments. Future impairments should be smaller and less widespread if oil prices trend higher.

Chart 11: S&P 500 Three-Month Earnings Estimate Revision Ratio – 08/2016

Source: BofA Merrill Lynch US Quantitative Strategy

Chart 12: Energy is still close to all-time trough P/BV levels Relative Price/Book (vs. S&P 500) of Energy sector, 1986-7/2016

Source: BofAML US Equity & Quant Strategy, S&P, Compustat

Macro shocks and high leverage remain risks In the current environment, there is plenty of potential for geopolitical shocks, policy errors or credit issues that could cause the US dollar to surge and drag down global GDP growth. But our commodity team believes that the oil market would remain in deficit

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under most scenarios barring a recession or a major positive supply shock (i.e. a full return of Libyan production). High levels of debt also remain a concern, although high yield spreads have compressed significantly over the course of 2016 and investor appetite for energy offerings should improve as oil rebounds into year-end and in 2017.

Chart 13: Leverage is still close to decade highs

Source: BofAML US Equity & Quant Strategy, Compustat, S&P

Chart 14: But high yield Energy spreads have tightened since Feb highs

Source: Bloomberg, BofAML Global Research

Buy-rated US Energy stocks With the recent strategy upgrade of Energy, the RIC thought it useful to highlight the Buy-rated stocks. We screened for US Energy companies that are Buy-rated by BofA Merrill Lynch, and have a market cap over $5 billion.

Table 4: Buy-rated US Energy stocks over $5 billion Ticker Company Name Price 9/9/16 Market Cap Rating Analyst Industry APC Anadarko Petro 57.77 29,193 C-1-7 Leggate, Doug Oil & Gas Producers BPL Buckeye Partners 69.38 9,255 B-1-7 Moreen, Gabe Natural Gas-Pipelines COG Cabot Oil & Gas 26.06 11,522 C-1-7 Leggate, Doug Oil & Gas Producers XEC Cimarex Energy 130.61 12,848 C-1-8 Smith, Jason Oil & Gas Producers CXO Concho Resources 130.47 18,659 C-1-9 Smith, Jason Oil & Gas Producers COP ConocoPhillips 42.25 50,779 B-1-7 Leggate, Doug Oils CLR Continental Res. 49.95 18,882 B-1-9 Leggate, Doug Oil & Gas Producers DVN Devon Energy 43.36 23,148 B-1-7 Leggate, Doug Oil & Gas Producers EPD Enterprise L.P. 26.81 56,888 B-1-7 Moreen, Gabe Natural Gas-Integrated EQGP EQGP 25.70 6,859 C-1-7 Walker, Derek Natural Gas-Integrated EQM EQT Midstream 78.41 6,486 C-1-7 Moreen, Gabe Natural Gas-Pipelines HAL Halliburton Company 41.95 37,656 C-1-7 Tanners, Timna Oil Services HP HELMERICH & PAYNE 59.83 6,774 C-1-7 Tanners, Timna Oil Services HES Hess 49.92 16,223 B-1-7 Leggate, Doug Oils MMP Magellan Mid 70.66 16,154 B-1-7 Moreen, Gabe Natural Gas-Pipelines MRO Marathon 15.67 13,251 C-1-7 Leggate, Doug Oil Refining & Marketing MPC Marathon Petrol 42.24 22,721 C-1-7 Leggate, Doug Oil Refining & Marketing NFX Newfield 44.53 8,915 C-1-9 Smith, Jason Oil & Gas Producers OXY Occidental 76.11 59,586 B-1-7 Leggate, Doug Oils PE Parsley Energy 33.63 7,181 C-1-9 Smith, Jason Oil & Gas Producers PXD Pioneer 180.60 31,123 C-1-7 Leggate, Doug Oil & Gas Producers RRC Range 42.24 7,072 C-1-7 Leggate, Doug Oil & Gas Producers SXL Sunoco Logistics 30.32 9,256 B-1-7 Moreen, Gabe Natural Gas-Pipelines TSO Tesoro 79.14 9,105 C-1-7 Leggate, Doug Oil Refining & Marketing Source: BofA Merrill Lynch Global Research This list is not a recommended list either individually or as a group of stocks. Investors should consider the fundamentals of the companies and their own individual circumstances/objectives before making any investment decision,.

0%

10%

20%

30%

40%

50%

Jan-

86No

v-87

Sep-

89Ju

l-91

May-9

3Ma

r-95

Jan-

97No

v-98

Sep-

00Ju

l-02

May-0

4Ma

r-06

Jan-

08No

v-09

Sep-

11Ju

l-13

May-1

5Energy net debt/market cap

600

900

1,200

1,500

1,800

2,100

Aug-

15

Sep-

15

Oct-1

5

Nov-1

5

Dec-1

5

Jan-

16

Feb-

16

Mar-1

6

Apr-1

6

May-1

6

Jun-

16

Jul-1

6

Aug-

16

BofAML US HY Energy Index

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Election 2016: equity investor’s guide Savita Subramanian Equity & Quant Strategist MLPF&S [email protected]

Seven ways the election matters to equity investors With the US presidential election less than two months away, we identify key election issues and their implications to equity investors, from fiscal policy to the Fed to taxes.

This article is an excerpt from the report: Election 2016: the equity investor’s guide 16 August 2016. Please see the full report for a more detailed discussion, including an in-depth look at the impact on many industries.

Broad issues with significant implications for equity investors include:

1) Uncertainty shock: Amid heated rhetoric, a lack of clarity on many policy issues, and a newcomer running against a seasoned politician, the uncertainty factor is arguably heightened in the 2016 US presidential election. While uncertainty creates longer-term opportunities, in the near term it could both crimp growth and derail the S&P 500 uptrend. On growth, if companies adopt a wait-and-see attitude, this could slow the economy. And uncertainty is generally a negative for equities: policy uncertainty is strongly correlated with equity volatility.

2) Split government: A split Congress would limit the likelihood of more significant policy proposals of either candidate and may mitigate some policy uncertainty. And a split Congress could be a positive scenario for the S&P 500 given that the index has historically seen strong returns during Democratic presidencies with a split Congress – though there is not much historical precedent for this given this has only occurred in four prior years since 1928 (Chart 17). The next most positive scenario for markets has been a Democratic president with a Republican Congress, which has occurred in 10 years since 1928.

3) Fiscal policy: With monetary stimulus in the US seeming to have run its course, expectations have shifted. Fiscal spending has progressively increased over the past several years, becoming a positive contributor to real GDP growth in late 2015. But our Global Fund Manager Survey indicates a record net 44% of investors think global fiscal policy is still too restrictive, suggesting broadening support for additional fiscal spending initiatives.

The risk: expectations for fiscal stimulus are already at a post-crisis high, suggesting potential for disappointment relative to investors’ expectations. Both candidates are pro-stimulus via infrastructure spending and tax reform, but proposals – especially on taxes – differ significantly.

4) Protectionism: Brexit may be a sign of increasingly protectionist attitudes, and has been echoed in the US by Trump’s popularity among the working class, where he has won support from Americans who feel like they have lost out due to globalization and immigration. The post-crisis recovery has lifted the wealthy through stock market and real estate reflation, but has so far failed to induce a broad-based economic recovery, and the psychology of the US voter base may reflect that.

We view the impact of protectionism on the S&P 500 as negative in the short term, given the globally oriented nature of the benchmark (one-third of sales come from overseas). And longer term, margins are at risk: even without the benefits of labor arbitrage, effective taxes rates for the S&P 500 have fallen dramatically over the last 20 years, as companies generated more profits abroad where tax rates are

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lower. This has contributed an estimated 100bp to net margins over the same period.

5) Tax treatment of income: This could drive a divergence in desirability across asset classes. Current law favors income from equities and municipal bonds over corporates and Treasuries. Under Trump’s proposals, the equity vs bond advantage would likely narrow, while under Clinton’s proposals, advantages of equities and municipals over corporates and Treasuries could be diminished.

6) The Fed: In the very near term, political concerns will likely rule out a hike at the November meeting, and is one of the reasons that our economists forecast a December rate hike. Longer term, a key question is whether Fed Chair Janet Yellen will be reappointed at the end of her term in 2018. Presidents have generally opted for continuity, allowing chairs and vice chairs to serve multiple terms. And given that Yellen was appointed by a Democratic president, we would expect Clinton to offer Yellen reappointment.

Trump may be more likely create a break in Fed policy, as he has said he would replace Yellen at the end of her term. While Trump has made some comments that would suggest he is in favor of a more hawkish stance (low rates, in his view, have created asset bubbles), other comments have suggested he is a proponent of low rates. But risks of a more hawkish Fed are likely elevated under Trump, which could have a significant impact at a sector level – in particular, Financials, levered sectors and those with higher dividend yields. And bigger picture, discontinuous Fed policy could roil the already fragile recovery.

7) Health Care: The sector has been in the crosshairs this election year, de-rating significantly on political risk. Our analysts note significant differences between the two presumptive US presidential nominees’ positions on health care reform – which influences hospitals and managed care companies – as well as other health care issues, including drug pricing – where comments from Clinton around drug pricing have pressured Biotechnology and Pharmaceuticals stocks. We think this valuation overhang represents an opportunity, and are overweight Health Care.

History suggests strongest returns under Dem administrations Historically, the economy and the health of the corporate sector have been much bigger drivers of S&P 500 returns than politics. Based on data since 1928, S&P 500 returns have been stronger under Democratic presidents than under Republicans (though the initial post-election market reaction was historically more positive under Republicans). When considering the make-up of Congress, the market has seen the highest returns under a Democratic president with a split Congress, but we note that this has occurred in only four years since 1928, with the next-highest returns under a Democratic president with a Republican Congress (which has occurred in 10 years since 1928).

Historical trends: elections vs. stocks

The profits cycle historically has been a more important determinant of S&P 500 returns than the political cycle (Chart 15). But below we provide historical context on market returns under various political scenarios.

• Based on data since 1928, S&P 500 returns have been stronger under Democratic presidents than under Republicans (Chart 16).

• But the initial post market reaction (from October-January of election years) was modestly higher for Republicans (Table 6).

• When considering the make-up of Congress, the market has seen the highest returns under a Democratic president with a split Congress, but we

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note that this has occurred in only four years since 1928, with the next-highest returns under a Democratic president with a Republican congress (which has occurred in 10 years since 1928 – see Chart 17.

• Returns historically have been strongest in election years with a leadership change but not a political party change (Chart 18 and Chart 16). A Clinton win would represent a leadership change with no party change.

• Both a leadership and a party change, as would occur if Trump were elected, historically has resulted in the lowest returns.

Chart 15: Percentage of years from 1928-2015 where returns were positive based on political party and S&P 500 profits cycle

Note: based on total returns 1936-prsent and price returns prior to that (1928-1935) Source: S&P, FactSet, BofA Merrill Lynch US Equity & US Quant Strategy

Chart 16: Average annual S&P 500 returns based party in control of the White House, 1928-present

Note: Based on 41 years of Republican control and 48 years of Democratic control since 1928 (or 36 and 33 years, respectively, post WWII). Total returns 1936-prsent and price returns prior to that. Excl. 2008, avg. under Republicans was 8.2% (11.1% post-WWII)—still weaker than under Democrats. Source: S&P, FactSet, BofA Merrill Lynch US Equity & US Quant Strategy

Chart 17: Avg. annual S&P 500 returns based on control of White House & Congress, 1928-present

Note: Excluding 2008, average for Republican President, Democratic Congress is 10.2% (still the second-weakest period). Total returns 1936-prsent and price returns prior to that. Source: S&P, FactSet, BofA Merrill Lynch US Equity & US Quant Strategy

42%

65% 58%

34%

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Political Party Profits Cycle

% o

f yea

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Republican DemocratAvg. 1928-2015 Post-WWII Avg.

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Republican,Republican

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Chart 18: Average annual S&P 500 returns during presidential election years (1928-present) based on various scenarios

Note: Of the 23 elections since 1928, based on 9 where there was a leadership and party change (8 post WWII), 4 where there was a leadership change with same party (2 since WWII), and 10 where President was re-elected (8 since WWII). Total returns 1936-prsent and price returns prior to that. Excl. 2008, avg. for Leadership & party change is 8% (and 11% since WWII)—still the weakest period. Source: S&P, FactSet, BofA Merrill Lynch US Equity & US Quant Strategy

Chart 19: Average annual S&P 500 returns during the year after a presidential election (1928-present) based on various scenarios

Note: Of the 23 elections since 1928, based on 9 where there was a leadership and party change (8 post WWII), 4 where there was a leadership change with same party (2 since WWII), and 10 where President was re-elected (8 since WWII). Total returns 1936-prsent and price returns prior to that. Source: S&P, FactSet, BofA Merrill Lynch US Equity & US Quant Strategy

On average, the market has been up 11% in election years (Chart 20 and Chart 18)—the second-best return year of the presidential election cycle. During all presidential election years, the market has been up in 88% of those years (Table 5) versus up 73% of the time in general (based on annual returns since 1928).

Chart 20: Average S&P 500 total returns by year, 1928-2015

Note: Excluding 2008, average for “Presidential election years” is 12.9% (still the second-highest). Total return data available since 1936; price return data from 1928-1935 Source: S&P, FactSet, BofA Merrill Lynch US Equity & US Quant Strategy

Table 5: S&P 500 returns during presidential election years Election year Total return Election year Total return

1928 38% 1972 19% 1932 -15% 1976 24% 1936 34% 1980 33% 1940 -10% 1984 6% 1944 20% 1988 17% 1948 5% 1992 8% 1952 18% 1996 23% 1956 6% 2000 -9% 1960 0% 2004 11% 1964 16% 2008 -37% 1968 11% 2012 16%

Note: Data based on total returns 1936-present and price return data 1928-1935 Source: S&P, FactSet, BofA Merrill Lynch US Equity & US Quant Strategy

Staples fares best under Republicans, Tech fares best under Democrats Consumer sectors, Materials, Telecom, Utilities and Energy have outperformed on average during years when a Republican was in office, and underperformed during Democratic presidencies. Tech, Health Care, Industrials and Financials have outperformed during Democratic presidencies.

4%

24%

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13%

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Leadership & partychange

Leadership change,same party

President re-elected

Year of election: Returns

Avg. 1928-present Post WWII

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16.5%

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Year beforePresidential

election

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Chart 21: Avg. relative sector performance during Republican vs Democratic presidents,1973-2015

Source: S&P, FactSet, BofA Merrill Lynch US Equity & US Quant Strategy

Post-election S&P reactions initially favored Republicans We also looked at the historical market reactions to election outcomes from the start of October prior to the election through the following January (four months). In contrast to the performance during historical administrations, we found that the initial market reaction to Republican presidential victories was modestly higher than for Democratic victories. Elections resulting in split Congress still had better performance, although not in the one instance when a Democrat was elected president. It is important to note that the sample size of elections since 1936 is quite small (20) and becomes even smaller when adding in additional criteria. For instance, the strongest market performance was reported during the three elections that resulted in Republican sweeps (1952, 2000, 2004), although returns were still negative in one of those three instances.

Table 6: Median S&P 500 total returns from Oct preceding elections to the following Jan (1936-present) All Presidential Election Democratic President Elected Yes No Yes No All 5.9 5.4 6.0 4.9 6.0

Democratic House Elected Yes 9.8 4.9 14.7 4.9 5.4 No 6.2 6.6 5.9 9.9* 6.6

Democratic Senate Elected Yes 9.5 4.9 14.3 4.9 3.5 No 6.4 7.9 5.9 15.1* 6.6

House change (elec) Yes 8.3 4.8* 8.3 0.4* 9.2* No 5.8 5.4 5.8 5.4 5.4

Senate Change (elec) Yes 6.2 4.9 7.2 0.4* 7.1* No 5.8 5.9 5.8 5.4 6.0

Split Congress Elected Yes 9.8 4.9 18.0* 4.8* 7.4* No 7.9 5.9 14.0 5.4 6.0

* Indicates less than three instances Source: S&P, FactSet, Bloomberg, BofA Merrill Lynch US Equity & US Quant Strategy

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

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Performed better under Repulicans Performed better under Democrats

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RIC asset class views Table 7: Research Investment Committee asset class views Asset Class RIC view Comments

(+ / = / –) Equity markets

US equities = Low but rising rate expectations, modest inflation and a strong dollar are good for stocks, but concern about high valuations and high expectations for earnings growth keep us neutral. Focus on larger cap, high quality stocks that are dividend growers.

Consumer Discretionary – Home to some “disruptors” but sector overowned and demographics work against it. Apparel malaise likely to continue. Consumer Staples = High quality stocks with combination of attractive dividend yields plus dividend growth; good hedge against recessions but expensive.

Energy + Oil price forecasts suggests significant upside to estimates and stock prices; sentiment remains poor; larger cap stocks have good dividend yields.

Financials – Sector U/P when yield curve flattens; lower for longer rates hurt banks and life insurers; regulatory risk remains but sector inexpensive on P/B. Health Care + Good hedge against volatility; funds less O/W; close to all-time low on valuation. Biotech offers secular growth; pharma a good yield play. Industrials = Highest quality sector, beneficiary of higher commodity prices and improving global growth; many multinationals have good div yield/div growth. Information Technology + Earnings have become more stable; balance sheets strong; less dollar sensitive than other sectors with global sales; hurt by slowdown in capex. Materials – Sensitive to commodity prices and driven more by macro events; most exposed sector to China; leverage is high. Real Estate + U/W by large cap funds; expect significant fund flows to sector as PMs reduce U/W; good dividend yield plus div growth. Telecom Services + Yield at a reasonable price; good hedge against lower interest rates and macro uncertainty. Opportunities for growth as data usage rises. Utilities = Good dividend yield but expensive and payout ratios high; good hedge against macro uncertainty but leverage is high.

Growth – Growth may lose momentum as profits growth accelerates, but we like exposure to Technology and cheap Industrials. We prefer “half growth, half yield” stocks

Value + Value tends to outperform when profits are accelerating as we believe they are today. Value indices have high exposure to Energy and Financials.

Small cap – Small caps have done better as credit spreads have narrowed. Relative valuations have also improved and are now back to historical averages. But volatility works against small caps and they are highly levered; we still favor higher quality and larger cap.

Large cap = Prefer high quality stocks with good dividend growth potential.

Europe (ex. UK) = We think equities can grind higher as inflows return, as long as macro data improve. Shift gears toward more cyclical bias –O/W industrials, energy, materials that benefit from EM growth.

United Kingdom − Looks like UK will avoid recession but expect long period of soft growth—expect 0.6% economic growth in 2017. Fall in pound likely to squeeze UK consumer; limit UK exposure to large cap multinationals with global reach—avoid stocks exposed to GBP.

Japan + Expect near-term weakness due to macro events and strong yen. But we think yen weakens in 2017 as oil prices rise and Fed adopts a more hawkish stance. Policy moves suggest reflation under new economic package and sentiment appears to be bottoming out. Buy cyclicals and banks.

Asia Pac (ex. Japan) + Region is underowned, valuations are attractive and interest rates are expected to fall. ROEs could rise as profit margins improve. Easier monetary and fiscal policies will help profit margins. Strong commodity prices should also help – Australia a favored market.

Emerging markets + Limited upside for the dollar, firmer commodity prices, improved Chinese monetary policy boost EM view. However, tactically neutral within long term O/W as markets have risen sharply in 2016. EM currencies competitive and valuations attractive. Brazil, China, Russia, Taiwan, Korea favored.

Fixed income markets

Treasuries - Treasuries will benefit from risk-off trades as they occur, but we see better yield opportunities elsewhere. One risk is a pullback in global monetary easing.

Agencies / MBS = Historically, MBS have had a good mix of returns and volatility. Potential regulatory changes are a risk for GSEs. TIPS + Inflation will likely rise modestly in the coming 12-18 months; breakevens on TIPS look attractive. US IG Corporates + Investment grade (IG) debt offers a good yield pickup over Treasuries, while still high quality. US HY Corporates - High debt levels and weak earnings pose a risk. Rising defaults and further spread widening is likely this year. Preferred securities = Favor $1000 par QDI payers and fixed-to-floating structures. Non-US DM Sovereigns – Yields are low, and currency translation should work against dollar-based investors if the dollar strengthens as we expect. EM $ Sovereigns - Economic growth is likely to outpace that in developed nations. One risk is a decline in commodity prices. EM local currency Sovereigns + Favorable growth prospects. Threat of a stronger dollar has diminished.

Commodities/FX Gold + Global crises favor gold, while a very hawkish Fed would be a risk. We expect the price to average $1,475/oz in 2017. Oil + Prices should rise irregularly, and finish the year at $54/bbl for WTI. We see global crude oil prices averaging $55-75 over the next five years. US dollar = A modest path of Fed rate hikes could limit further gains in the dollar. Source: BofA Merrill Lynch Global Research

Notes to RIC views Ratings designations are as follows: (+) favorable view; (=) neutral view; (-) unfavorable view. Ratings reflect the Research Investment Committee’s view for an investment time horizon of 12 months. Typically, the RIC view will agree with regional/product strategists, but at times there may a difference of opinion based on investor suitability or time frame.

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Fixed Income, Economics, Commodities, Currencies: views and risks Table 8: Regional strategist views and associated risks

Views Risks Global Economics (Ethan Harris) • US growth should rebound in 2H after an unexpectedly weak first half. Job growth remains decent

after an earlier soft patch. We expect one Fed rate hike this year, in December. • The UK is likely to just skirt a recession following Brexit, in our view, and has cut 2017 Euro area growth by

one-half percent to 1.1%. We expect a 0.2pp drag on avg. to other parts of the globe from Brexit. • We forecast EM GDP growth of 4.0% in 2016, matching the pace in 2015. We look for activity to

bottom out in 2H 2016 and then improve. EM monetary policy divergence should widen this year. Inflation remains subdued in most of EM.

• • Downside risks: heightened uncertain and weaker global trade in the aftermath of the Brexit vote. Chinese debt accumulation, policy uncertainty and geopolitical concerns also threaten.

• Upside risks: clear signs of stabilization in Chinese growth, solid gains from US consumers, and more rapid acceleration of EM growth as commodity prices stabilize.

Global Rates (Shyam Rajan, Ralf Preusser) • US: Even in an environment of improving US data, a shortage of global positive yielding govt. bonds

and heavy inflows into the US will keep a lid on the ability of long end nominal yields to rise materially. Uncertainty stemming from the Brexit vote and the US election should also bias rates lower over the near term. That said, we think the 5y point on the rate curve looks vulnerable in either direction. Record long manager positioning and increased expectations of fiscal stimulus and/or higher inflation targets will likely lead to a cheapening of the 5y point on the curve, in our view.

• Europe: While the lack of ECB action at the Sep meeting put bear steepening pressure on core curves, the tightening in monetary conditions that this represents and the risks it entails for the periphery suggest the selloff in Bund should ultimately reverse. The pick-up in ECB purchases with increased front-loading ahead of the Dec lull also supports lower rates.

• US: A long end VaR shock in JGBs/Bunds or an upturn in global growth is a risk to our view of contained nominal yields and curve flatteners.

• Europe: The major risk comes from Japan, namely the possibility that the BoJ changes the way it implements QE and engineers a sharp selloff in long-dated JGBs, leading to further bear steepening of EUR curves. Large long-end supply in the EZ is another risk.

Global Commodities (Francisco Blanch) • With Aramco pumping close to 10.7 million b/d in August and Saudi Arabia no longer trying to

moderate seasonal price swings, lower driving demand coupled with the ongoing autumn refinery turnaround recently pushed WTI prices back down to $39/bbl, in line with our 3Q16 target. Past maintenance, however, we continue to see prices picking up steam again. After all, global oil demand was down by about 0.5 million b/d due to weather in 4Q15. So assuming a normal winter, we see the first sizeable global oil market deficit in 10 quarters coming up in 4Q16 and we thus reiterate our 2016 year-end WTI target of $54/bbl.

• For gold prices, upside may be limited at present, reinforcing our average 3Q16 forecast at $1,350/oz.

• Following an abysmal 2015, commodity returns have outpaced equities and bonds YTD on the back of improved micro fundamentals. Looking into 2H16, we see commodities being much more affected by the broader market reaction to upcoming Fed rate hike(s). Commodities may outperform if rate hikes trail inflation, but higher real rates and flatter curves would hurt the asset class.

• Looking to the next five years, technical and political challenges in large oil producers such as Kazakhstan, Russia, Iran and Iraq, combined with capex cuts in response to recently low oil price, put investments in oil production growth here at risk. This should continue to put upward pressure on long-dated crude oil prices.

Global Credit (Michael Contopoulos, Hans Mikkelsen) • We expect US high grade spreads to tighten to 135bp this year and to 120bp in 2017. However,

most of the total return for this year is now behind us. • We remain bullish on high grade spreads for two reasons: 1) big foreign inflows on top of bond fund

and ETF inflows; 2) expected improving fundamentals as M&A and share buyback volumes decline. Valuations are attractive only a spread basis as we find yields unattractive.

• In high yield, fundamentals remain lackluster, but strong technicals from global QE have the capability to tip the scale in HY’s favor in the near to medium term. Therefore, we remain neutral HY into the year end. However, we think a big negative catalyst such as an unexpected bankruptcy outside commodities, an oil slide, or a turn in economic data can alter HY’s current course and bring weak fundamentals back to the forefront. We also think that loss given default in this cycle will be higher than past cycles due to lower than usual recoveries, even outside of commodities. We like new issues coming to the market today and Fallen Angels that enter the HY index as both tend to outperform their respective rating indices.

• The biggest risk to US investment grade is the possibility of wider credit spreads following a rates shock, likely prompted by a rebound in the global economy, leading to fund outflows and institutional repositioning.

• If the magnitude/duration of global QE continues to increase, credit markets open for the riskiest issuers, and we don’t get significant negative catalysts, this could extend the current credit cycle and go in favor of owning risky assets such as HY. This could induce a risk-on behavior amongst investors and HY could outperform Loans as a result.

Municipals (Philip Fischer) • We are bearish on muni rates to year-end and January 2017 as the Fed and ECB are in an

indefinite waiting mode. Muni supply/demand factor is also unfavorable. Muni credits in general are benign except for those special situations such as Puerto Rico, Illinois, etc.

• Muni money market has experienced large outflows. 1-5 year part of the curve are being affected. • Balanced federal budget amendment and the states: The possibility of a federal balanced budget

amendment is real and growing. The US Constitution provides that 34 states (two-thirds) are required to call a convention to propose an amendment to the Constitution. The states are six short at this time. State budgets appear able to handle the likely decreases in federal funding.

• The risks to our bearish call are: (1) Fed hikes earlier than December or (2) the Fed declares the end of its tightening cycle due to a dramatically deteriorating economy or external shocks before the end of January 2017.

Global FX (David Woo) • We continue to look for further broad USD strengthening, with a year-end EUR-USD target of 1.05

for end-16 and 1.10 for year-end 2017. • Given our expectations of one Fed hike this year and two in 2017, we see the magnitude of USD

moves more limited relative to 2015, implying that investors need to be more selective in where they play USD strength.

• Even in the face of Fed hikes, easy ECB policies as well as an improving EM vs DM current account differential are likely to underpin EM currencies. Moreover, the recovery in commodity prices and domestic demand in Asia bodes well for reflation in some of the most undervalued currencies in Central Eastern Europe as well as Asia.

• An upside surprise to persistently low US inflation could induce expectations of faster Fed normalization, higher yields and thereby a higher USD.

• Downside risk for EUR-USD comes from the possibility of more aggressive QE moves from the ECB and falling oil prices.

• Downside risks in China pose a significant risk for EM. A pick-up in US inflation that leads the Fed to hike faster than anticipated could be negative for EMFX.

Source: BofA Merrill Lynch Global Research

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Global equity markets: views and risks Table 9: Regional strategist views and associated risks

Views Risks Global Equities (Michael Hartnett) • The MSCI All-Country World Index is up 8% YTD (TR). Cyclical upside modest amidst deflationary forces of

excess Debt, aging Demographics and tech Disruption. • Asset allocation skewed toward long volatility, long stocks>bonds, long IG>HY, long Main Street, short Wall

Street. Stronger macro/hawkish Fed would warrant allocation to value, banks, cyclicals. • Real assets (commodities, collectables & real estate) now at all-time lows relative to financial assets (stocks

and bonds).

• Policy baton is shifting from monetary to fiscal stimulus in 2016/17. Clearer fiscal commitment and/or further declines in US$ would pose upside risks.

• Quantitative Failure (BoJ/ECB), continued downgrades in US EPS growth estimates, continued underperformance of banks & lackluster macro data pose downside risks to asset prices.

United States (Savita Subramanian) • Our 2016 year-end S&P 500 target is 2000 and our 10-year S&P 500 target is 3500. • We forecast 2016 EPS of $117 (flat y/y) and 2017 EPS of $125 (+7% y/y). • Valuations are above historical levels across most metrics, but most metrics are far from stretched, and

stocks still look attractive relative to bonds. • We prefer large caps over small caps, high quality over low quality, stocks with strong balance sheets, and

“YARP” – yield at a reasonable price. • Overweight Health Care, Telecom, Real Estate, Energy, and Tech; Underweight Materials, Consumer

Discretionary and Financials.

• Risks: global growth disappoints, economic shock tied to credit, global recession, oil prices fall, corporates continue to hoard their cash, or another round of QE, suggesting $4.5tn was not enough to prop up the economy.

• We expect volatility to rise in the near-term and see elevated risk of a correction, given risks around the US election, FOMC tightening amid a profits recession, a seasonally weak period for the market, elevated leverage and tightening credit conditions, and high expectations for growth and stimulus that could disappoint.

• Do not forget the bull risks: a sentiment and technically driven bull market in which skepticism shifts to optimism and perhaps euphoria. Note that the average S&P 500 returns in the last two years of a bull market is 60%.

• Five percent pullbacks happen three times per year on average; 10% corrections occur 1x per year on average.

Europe (James Barty) • We think European equities have modest upside but can grind higher into year-end assuming weak macro

data in August is an aberration from the generally improving trend. Positioning is supportive and a return of inflows to Europe could drive outperformance. With 3.5% global GDP growth, capex discipline supporting margins and resource sector EPS recovering we look for a return to mid-single digit EPS growth in 2017 albeit not enough for an upgrade cycle.

• Bullish EM – o/w Basic Resources, Oil, Industrials. All three are strongly correlated with and have above average exposure to EM as well as the strongest earnings momentum currently. That can continue with our analysts seeing oil at $60+ in 2017 and cost curves now steepening.

• Positioning can drive Europe higher. From the most loved market 18 months ago, it is now one of the least. The sharp sector rotation post-Brexit may continue for similar reasons. We are generally o/w where consensus is not and vice versa (o/w Basics, Oil, Utilities and u/w Food & Beverage and tactically so in Tech). Positioning is still short Banks. We would consider adding on a pullback if we see evidence that global bond yields are troughing and recent softer growth data is temporary.

• Maintain DY stories with EPS upside; avoid UK consumer. We continue to like yield in Europe (given there is so little in fixed income now) - we maintain exposure to DY stories with EPS upside - Oil, Utilities, big Pharma, some Industrials. Higher oil and the lagged effect of weak GBP leave us cautious consumer sectors (especially UK) - u/w Travel & Leisure and Retail.

• Recent softer data presages a stalling US economy. More hawkish CB policy without a complementary pick-up in growth and inflation expectations. Political risk in Italy around the Constitutional referendum. Near-term markets may be vulnerable to any shift in asset class correlations particularly with volatility in many asset classes so low recently.

Asia-Pac ex-Japan (Ajay Kapur) • Remain structurally bullish on Asia - China’s monetary easing is gaining traction - autos sales and house

prices are robust, PPI is up to -0.8% from 5.9% in Dec’15; SOEs - the low ROE underperformers are much smaller part of the China Indices; Q2’16 earnings and sales beats are healthy at 58%

• AxJ’s ROE could rise from 11% to 14% in next 3-4 years as profit margins would improve due to lower prior capex and competitive currencies; asset turns will improve due to easier monetary & fiscal policies. Also, asset turns are correlated to China nominal growth, which is picking up sharply.

• Overwgt: Korea, China, Taiwan and Australia; Underwgt: Philippines, India, Malaysia and Hong Kong.

Downside risks • China does not continue with its easing cycle. • Stronger USD

Emerging Markets (Ajay Kapur) • EM valuations are attractive, currencies are competitive, prior capex cuts would lead to higher profit

margins, earnings expectations are easy to beat, China’s monetary easing is gaining traction, the low ROE underperformers are much smaller part of the indices and the US dollar may have limited upside, if any. Our long-term structural bullishness on Asia/EMs remains intact. However, we are pausing for breath, turning tactically neutral.

• EM GDP growth is still likely to continue improving vs DM in 2016-17. Oil price base effects mean rising inflation globally in 2H16, but a dovish Fed limits USD strength.

• David Hauner, our EEMEA cross asset strategist, likes Russia as earnings revisions remain strong there while slowing in other large EEMEA markets and the expected GDP growth is high at 15% for 2017.

• Felipe Hirai, our LatAm strategist, remains positive on Brazil equities post impeachment of President Dilma Rousseff as Despite the unprecedented rally in Brazil equities, an overbought market is not consensus based on technical indicators and investor positioning.

• Overweight: Russia, Korea, China, Turkey, Taiwan and Chile; Underweight: the Philippines, India, Malaysia, South Africa, and Mexico.

• Downside risks • China does not continue with its easing cycle. • US growth is weaker and inflation is higher than what consensus expects.

Source: BofA Merrill Lynch Global Research

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Disclosures Important Disclosures

FUNDAMENTAL EQUITY OPINION KEY: Opinions include a Volatility Risk Rating, an Investment Rating and an Income Rating. VOLATILITY RISK RATINGS, indicators of potential price fluctuation, are: A - Low, B - Medium and C - High. INVESTMENT RATINGS reflect the analyst’s assessment of a stock’s: (i) absolute total return potential and (ii) attractiveness for investment relative to other stocks within its Coverage Cluster (defined below). There are three investment ratings: 1 - Buy stocks are expected to have a total return of at least 10% and are the most attractive stocks in the coverage cluster; 2 - Neutral stocks are expected to remain flat or increase in value and are less attractive than Buy rated stocks and 3 - Underperform stocks are the least attractive stocks in a coverage cluster. Analysts assign investment ratings considering, among other things, the 0-12 month total return expectation for a stock and the firm’s guidelines for ratings dispersions (shown in the table below). The current price objective for a stock should be referenced to better understand the total return expectation at any given time. The price objective reflects the analyst’s view of the potential price appreciation (depreciation). Investment rating Total return expectation (within 12-month period of date of initial rating) Ratings dispersion guidelines for coverage cluster*

Buy ≥ 10% ≤ 70% Neutral ≥ 0% ≤ 30%

Underperform N/A ≥ 20% * Ratings dispersions may vary from time to time where BofA Merrill Lynch Research believes it better reflects the investment prospects of stocks in a Coverage Cluster.

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Research Analysts Additional Research Investment Committee (RIC) Contributors James Barty >> Investment Strategist MLI (UK) +44 20 7996 3291 [email protected] Francisco Blanch Commodity & Deriv Strategist MLPF&S +1 646 855 6212 [email protected] Jill Carey Hall, CFA Equity & Quant Strategist MLPF&S +1 646 855 3327 [email protected] Michael Contopoulos HY Credit Strategist MLPF&S +1 646 855 6372 [email protected] Philip Fischer Municipal Research Strategist MLPF&S +1 646 743 1446 [email protected] Christina Giannini, CFA Portfolio Strategist MLPF&S +1 646 855 1444 [email protected] Ethan S. Harris Global Economist MLPF&S +1 646 855 3755 [email protected] Michael Hartnett Chief Investment Strategist MLPF&S +1 646 855 1508 [email protected] Ajay Singh Kapur, CFA >> Equity Strategist Merrill Lynch (Hong Kong) +852 3508 7753 [email protected] Hans Mikkelsen Credit Strategist MLPF&S +1 646 855 6468 [email protected] Ralf Preusser, CFA Rates Strategist MLI (UK) +44 20 7995 7331 [email protected] Shyam S.Rajan Rates Strategist MLPF&S +1 646 855 9808 [email protected] Savita Subramanian Equity & Quant Strategist MLPF&S +1 646 855 3878 [email protected] Stephen Suttmeier, CFA, CMT Technical Research Analyst MLPF&S +1 646 855 1888 [email protected] Dan Suzuki, CFA Equity & Quant Strategist MLPF&S +1 646 855 2827 [email protected]

Nigel Tupper >> Strategist Merrill Lynch (Hong Kong) +852 3508 7887 [email protected] Mark Ulrich Portfolio Strategist MLPF&S +1 646 855 5206 [email protected] David Woo FX, Rates & EM Strategist MLPF&S +1 646 855 5442 [email protected] >> Employed by a non-US affiliate of MLPF&S and is not registered/qualified as a research analyst under the FINRA rules. Refer to "Other Important Disclosures" for information on certain BofA Merrill Lynch entities that take responsibility for this report in particular jurisdictions.

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