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Golden Diversity

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CHIEF INVESTMENT OFFICE

The Weekly Letter

SEPTEMBER 26, 2017

Authors
Golden Diversity: Elevated geopolitical and policy uncertainty underscores our advice to increase Rodrigo C. Serrano
exposure to less-correlated investments. We see gold as an appealing diversifier given its behavior Vice President

with respect to U.S. equities and fixed income and its potential attractiveness as a hedge against Emmanuel D. Hatzakis
Director
tail risks. Peaceful resolution of tensions amid economic expansion may, however, affect gold prices
negatively, judging by bullish positioning in managed money futures.
Markets in Review: Last week equities were modestly higher, with the S&P 500 up 0.08%
and international equities, as measured by the MSCI EAFE Index, up 0.42%. Bond prices moved Recent Publications
lower with the 10-year Treasury yield up 5 basis points to 2.25% from 2.20% the prior week. Weekly Letter
The Wild, Wild Web
Commodities as measured by the Bloomberg Commodity Index lost 0.4%, despite WTI crude
A Rising Tide of Debt
advancing 1.54% to $50.66 per barrel. Gold declined 1.73% to end at $1,297.30 per ounce. The Road Ahead
Electric vehicles rev up
Looking Ahead: On Wednesday the Commerce Department reports durable goods orders for
Monthly Letter
August and on Thursday it provides the final reading on 2Q gross domestic product. In Japan, Fixed Income Mid-year Outlook
consumer inflation and industrial production data for August will be released.
ISC Viewpoint
The Garden of Realists

Golden Diversity Exhibit 1: Inverse correlation: Gold prices up, real rate
down
For the longest time, markets have been insensitive to Spot gold
10-Y market implied real interest rate (rhs)
geopolitical flare-ups in the Korean peninsula. This may have
2000 4
changed, especially after North Korea’s firing of a missile into the 1800
Sea of Japan on July 4th. As Korean tensions escalated, and amid 3
1600
U.S. Dollars per ounce

the domestic political and policy uncertainty over the summer, 1400
2
1200
gold rallied, rising more than 11% from July 7th to September

Yield, (%)
1000 1
7th, bringing its year-to-date gain to 18%. Since then, the 800
precious metal has fallen by about 4% but has outperformed the 600
0

major asset classes this year, trailing only the equities of non-U.S. 400
-1
developed markets and emerging markets. 200
0 -2
The base case of the Chief Investment Office calls for
2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

a continuing synchronized global economic expansion,
alongside a gradual rise in inflation. However, geopolitical
and policy uncertainty that remains elevated underscores
our recommendation to increase exposure to less-correlated
investments. In this respect, we see gold as an appealing
diversifier for portfolios, given its behavior versus U.S. equities
and fixed income and its role in hedging tail risks, such as
those that could result from unexpected events.
Golden correlations
Correlation coefficients reflect the potential for diversification by
quantifying the relationship between movements in the prices of
two assets. A coefficient of +1.00 means when the price of one
2017
Source: Chief Investment Office; as of Sept 15, 2017
Past performance is no guarantee of future results.
asset moves up, the price of the other one moves up in lockstep,
yielding no diversification benefit. A coefficient of -1.00 means
the price of the other one moves by an equivalent amount but in
the opposite direction, so there’s maximum diversification, but
if the positions are held at equal weights, no benefit in terms of
the return. A coefficient of 0.00 means there is no relationship,
allowing for an optimal mix of diversification and return potential.
Versus the S&P 500 and the 10-year Treasury over a 30-year
timeframe, gold’s coefficients are -0.04 and +0.05 respectively,
making the precious metal an attractive diversifier.

Merrill Lynch Wealth Management makes available products and services offered by Merrill Lynch, Pierce, Fenner & Smith Incorporated
(MLPF&S), a registered broker-dealer and Member SIPC, and other subsidiaries of Bank of America Corporation (BofA Corp.).
Investment products:
Are Not FDIC Insured Are Not Bank Guaranteed May Lose Value
Now let’s consider the correlation between gold’s price return when gold prices were at a similar level. Additionally, the
and the real (adjusted for inflation) 10-year Treasury yield. exchange rate between gold and the Japanese yen, which
Over a 15-year period, the coefficient stands at -0.87, implying many regard as a safe haven currency, suggests gold has
a strong inverse correlation. That is, an increase in the real become a more preferred choice, given the proximity of Japan
interest rate, which makes other investments potentially more to the latest epicenter of geopolitical turbulence, North Korea.
attractive, has typically acted as a headwind for gold prices
and vice versa (see Exhibit 1). Factors behind a gold rally
According to research by Evercore ISI, a rising gold price has
Gold prices began a multi-year downtrend in the 4th quarter of typically coincided with increased volatility of common equity risk
2012, generally coinciding with a bottoming for this 10-year factors. Factors are certain characteristics of equities that many
real, risk-free interest rate. Investor anticipation of a rebound in investment strategists target in constructing portfolios. Recently
real economic growth then was partly nurtured by the president gold’s month-over-month gains have been larger than usual,
of the European Central Bank vowing to do “whatever it takes” surpassing one standard deviation for the returns going back to
to preserve the integrity of the Eurozone. Another hit to gold January 1993. During these instances stock prices of companies
came in May 2013 when the Federal Reserve considered pulling with high variability in earnings, sales, cash flow or share price, as
back on bond purchases, triggering the “Taper Tantrum.” Gold well as smaller companies, have been going down more markedly
continued falling on anticipation of improving economic growth. as the price of gold has been going up, suggesting double-digit
negative correlations versus the precious metal (see Exhibit 3).
Gold has lived up to “safe haven” status
Historically gold has been a good hedge against tail risks. Exhibit 3: Rising volatile gold prices have affected
In eight of 10 periods we measured during which a low- companies with similar characteristics
probability negative shock occurred, gold outperformed the Gold and Factor Return Correlations
S&P 500 (see Exhibit 2). One note of caution is that during Style Factor 1 Stdev Moves 2 Stdev Moves
Earnings Risk -0.33 -0.16
the height of a shock, when correlations may, for brief periods,
Price Volatility -0.26 -0.21
defy their long-term values and liquidity dries up in the Small Size -0.10 -0.23
markets, the form in which gold is held becomes important, Traditional Value 0.00 -0.25
with physical gold held in a vault or securities backed by Accelerating Sales 0.02 0.08
Earnings Momentum 0.02 0.11
physical gold being the preferred method of exposure.
Earnings Quality 0.03 0.02
Relative Value 0.04 -0.09
Exhibit 2: A ray of light during dark times Price Momentum 0.06 0.20
Gold S&P 500 Financial Leverage 0.17 0.33
Black LTCM and Dot-Com Sept 11, 2002 2008 Global U.S. Fukushima Brexit *Current Source: Evercore ISI, Chief Investment Office; as of Sept 13, 2017
Monday Ruble Crisis Bubble 2001 Terror Recession Financial Credit Nuclear North
attack Crisis Downgrade Disaster Korea Past performance is no guarantee of future results.
50
40 A Yellow Brick Road Ahead?
30
According to BofA Merrill Lynch (BofAML) Global Research,
Cumulative return, (%)

20
absent a military conflict or “trade war,” the recent geopolitical
10
0
tensions should not notably affect the economic outlook. Its base
-10 case scenario calls for a continued gradual escalation of pressure
-20 aimed at curtailing North Korea’s nuclear ambitions. A peaceful
-30 resolution of the matter may affect gold prices negatively, given
-40 intense bullish positioning reflected in managed money futures
-50
data. In addition, a continuation of synchronized real global
87

7
9
8

6
2
/0

/0

/1

/1

/1
/0
/9

/1
/0
0/

31

30

30

31

22
31
30

30
31

economic growth may disadvantage gold.

/3

3/

9/

9/

3/

9/
3/
9/

6/
7/
11

0–

1–

1–

1–

7–
7–
8–

6–
2–
7–

/0

/0

/1

/1

/1
/0
/9

/1
/0
/8

31

31

30

28

30
31
31

31
28
30

3/

8/

6/

2/

6/
8/
7/

5/
2/
9/

Source: Chief Investment Office; as of Sept 22, 2017 An upside risk for gold lies in military action on the Korean
Past performance is no guarantee of future results. peninsula, or continued deterioration in U.S.-China relations that
We see signs that the recent appreciation in the price of spills over into trade policy. BofAML Global Research sees the
gold may be linked more to rising geopolitical tensions and latter as the greatest risk to the global economic and market
elevated political and policy uncertainty than a protracted outlook. Another potential protectionist hotspot may lie in
impediment to growth of the U.S. economy. Gold’s recent peak the ongoing renegotiation of the North American Free Trade
on September 7th coincided with a real interest rate notably Agreement (NAFTA). Growing anticipation of a more protectionist
higher than the one that prevailed on September 6, 2016, trade environment may raise inflation expectations, risking
spillover effects into other asset classes.

CIO REPORTS • The Weekly Letter 2

 Marci A. McGregor

Markets in Review Director

Trailing Economic Releases Equities

Total Return in USD (%)
„„The members of a Federal Reserve (Fed) committee updated their dot
Level WTD MTD YTD
plot last week, showing a majority of them expect three interest rate
DJIA 22,349.6 0.4 2.6 15.2
hikes this year, leaving December in play for another one. The Fed is also NASDAQ 6,426.9 -0.3 1.4 20.4
eyeing three hikes in 2018, and two in 2019. The committee members S&P 500 2,502.2 0.1 1.6 13.4
also announced they will initiate balance sheet normalization in October. S&P 400 Mid Cap 1,768.7 0.8 0.7 7.7
Russell 2000 1,450.8 1.3 2.0 7.9
„„The National Association of Realtors reported that existing home sales
MSCI World 1,994.6 0.4 2.0 15.6
declined in August by 1.7% month-over-month to a seasonally adjusted MSCI EAFE 1,977.6 0.7 2.5 20.0
annual rate of 5.35 million. Excluding the greater Houston area, which has MSCI Emerging Mkts 1,102.3 0.0 3.7 30.2
been severely impacted by Hurricane Harvey and plunged by 25% year-
Fixed Income
over-year, the reading would have been flat.
Total Return in USD (%)
„„As expected, the Bank of Japan maintained its monetary policy, with its Yield (%) WTD MTD YTD
short-term rate remaining at -0.1% and the target for the 10-year bond ML US Broad Market 2.48 -0.2 0.5 3.3
yield at 0%. It also maintained its current pace of bond purchases. One ML 10-Year US Treasury 2.25 -0.4 0.5 3.2
surprise was a dissenting vote from a new board member, making it 8-1. ML US Muni Master 2.20 -0.1 0.7 4.9
ML US IG Corp Master 3.16 0.0 0.6 5.3
ML US HY Corp Master 5.55 0.2 0.6 6.7
S&P 500 Sector Returns (as of the 9/22/17 market close)
Commodities & Currencies
S&P 500 Sector Total Returns (as of the 9/22/17 close)
Total Return in USD (%)
Telecom 3.8% Level WTD MTD YTD
Financials 2.6%
Energy 2.0% Bloomberg Commodity 172.6 -0.4 0.7 -2.4
Industrials 2.0% WTI Crude $/Barrel1 50.7 1.5 1.0 -5.7
Materials 1.0% Gold Spot $/Ounce1 1,297.4 -1.7 2.2 12.6
Consumer Discretionary -0.1%
Information Technology -0.7%
Prior Prior 2016
Healthcare -1.2% Level Current Week End Month End Year End
Consumer Staples -2.3% EUR/USD 1.20 1.19 1.19 1.05
Utilities -2.7% USD/JPY 111.99 110.83 109.98 116.96
Real Estate -2.8%
Source: Bloomberg.1 Spot price returns. All data as of the September 22, 2017 close.
-4% -3% -2% -1% 0% 1% 2% 3% 4% Past performance is no guarantee of future results.

Looking Ahead
Upcoming Economic Releases BofA Merrill Lynch Global Research
Key Year-End Forecasts
„„On Wednesday, the Commerce Department reports durable goods
S&P 500 Outlook 2017 E
orders for August, and BofA Merrill Lynch (BofAML) Global Research
Target 2,450
expects them to have normalized following two volatile monthly
EPS $129.00
swings driven by aircraft orders. BofAML Global Research expects a
0.6% month-over-month increase. Real Gross Domestic Product 2017 E
Global 3.6%
„„On Thursday, the Commerce Department provides the third and
U.S. 2.1%
final release of U.S. gross domestic product for the second quarter.
Euro Area 2.1%
Consensus expectations are for an increase to 3.1% quarter-over-
Emerging Markets 4.7%
quarter, up slightly from the previous estimate of 3.0%.
U.S. Interest Rates  2017 E
„„In Japan on Thursday, consumer inflation and industrial production
Fed Funds (eop) 1.38%
data for August will be released. BofAML Global Research sees a
10-Year T-Note (eop) 2.85%
slight increase of 0.6% for the Consumer Price Index, and industrial
Commodities 2017 E
production rebounding by 1.6% from a previous decline of 0.8%.
Gold ($/oz-period average) $1,276
WTI Crude Oil ($/bbl-eop) $47.00
All data as of the September 22, 2017close.

CIO REPORTS • The Weekly Letter 3

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declining markets. Any investment plan should be subject to periodic review for changes in your individual circumstances, including changes in market conditions and your financial ability
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Past performance is no guarantee of future results.
Asset allocation, diversification dollar cost averaging and rebalancing do not ensure a profit or protect against loss in declining markets.
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