ClO MID-YEAR 2016 A Transforming World er A Transforming World Themes shaping the investment landscape SUMMER 2016. Follow the (new) Leader oo Markets are transforming, reflecting sweeping, long-lasting demographic and economic Wary Aon Barels Shits the US, baby boomers are approaching retirement wien Japan, Europe fee Seeegy meer and China older looks to get bigger. Ths situation confronts a global economy on weak Rodrigo C. Serrano foundations, clouding profit outiooks, prompting episodic volatility in equity markets and Weemreisee forcing central banks to push Interest rates to historic laws. China continues to revamp its ‘economy. Europe confronts a three-pronged dilemma of high debt, negative inflation and Increased flaws of migrants from the wer-torn Middle East. SUMMARY Despite these changes, many investors remain anchored to the past. Some focus on the We believe new leadership is energy and material stacks that delivered strong returns commensurate with China's rapid emerging in the US. equity growth. For those approaching retirement, the shadow of the 2008 financial crisis looms market. Central banks have large, resulting in defensive investment postures. engaged in extraordinary monetary easing, which Is drying up the fixed income well, the traditional source of yield. The extraordinary but Ineffective monetary stimulus \We believe new leadership is emerging in US. equity markets, led by stocks of higher- ‘quality, dividend paying companies. The thirst for income, one of the drivers, should remain high as aging investors find little yield from tracitlonal fixed income investments, Meanwhile, an uncertain profit outlook and bouts of episodic volatility should continue to favor higher-quality companies with solid balance sheets, stable cash flows and ead oa has led to QE fatigue, raising the prospect ofa shift toa The Old Guard and the scarred cycle favoring fiscal policy. According to World Bank figures, from 2003 to 2007 China averaged real annual growth These developments requite in gross domestic product (GDP) nearing 12%. While this five-year growth spurt did not a prudent, risk-managed ‘surpass those of the mid-to-late 1980s (12.1%) or the mid-1990s (12.4%), its effect was approach when searching ‘more pronounced due to increased interconnectedness of the global economy coupled for yield, one that favors wit the larger absolute size of China's economy. supplying China infrastructure and high-quality, dvidend-paying "vade-orented growth, the Energy and Materials sectors enjoyed turbocharged returns. companies with strong From 2003 to 2007, Ereray was the top-performing sector, with a compound annual balance sheets, global brands, arowth rate (CAGR) of 27%, far ahead ofthe 119 rate ofthe S&P 50D index. Materials the ability to generate and Stocks also outperformed the S&? 500, with a CAGR of 16%. Asa result of their relatively Brow cash flows and low recent, prolonged outperformance, these sectors remain popular with many investors. payout ratios. We see them, however, as the Old Guard, esl ch Wes Maragret aes arable rots nd sees by Mel ignch, arc Fee Smith RCO (WIFE ategsterero eran ember SPC ander subudaresBnkot Aneta CopmationBtA Com) MICH invsrmertprecucts Merri Bank of Aric Grpration ‘re No FIC nai ‘re Not Bork Gerard ay Love Vat ‘© OTEK Ania Cupacacen Alvghs reseedMeanwhile, the 2008 financial crisis scarred many investors, significantly denting their expectations for investment returns at the start of the decade. This, long with the bursting of the tech bubble in 1989, has gradually reduced their appetite for equity investments. According to a recent Gallup Pall the percentage of Americans with equity holdings reached an 18-year law in April 2016, For the baby boomer cohort in particular, the most prominent scars from these setbacks are notable shortfalls in financial assets earmarked for retirement that have arisen at a very inopportune time, Aging populations find a drying well ‘Aging populations area werldwide phenomenon. According to United Nations statistics. 37% of Japars population is expected tobe over 60 years of age by 2030, up from 33% in 2015. n Europe, 30% of the population is projected tobe over 60, versus 2496 last year. In China and the US, the proportions are expected to be 25% and 26% up from 159% and 219 in 2015, respectively (Gee Exhibit 1) In aggregate these countries are expected to see £3 44% Increase inthe 60-and-older cohort from 2015 to 2030, ‘with China contributing the mostto this increase. These aging populations should drive a continued thirst fr income-producing investments over the coming yeas, Exhibit 1: People 60 and older ae projected vo acount fer growing ston of ttl pepe, i a Is be Fe j > « a Confronting this thirst, however, is a drying well According, to BofA Merrill Lynch (BofAML) Global Research, today's, erwironment features the lowest global interest rates in 5,000 years! (See exhibit 2) The organization also estimates that negative-yielding assets total roughly $13 tillon. This historic fall n global interest ates has resulted from major central banks scrambling to bolster economic growth by adopting Ulta-low policy rates and engaging in quantitative easing (QE), the buying of various types of fixed income Instruments aimed (CIO REPORTS - A Teansforming Wer Follow he (ew) Lear _ at lowering borrowing costs for the economy, This aggressive monetary stimulus has helped offset a lack of fiscal stimulus from governments since thelr initial response to the 2008 financial rss Exhibit 2: Global Interest rates have hit 5000 year lows! pep Sette — ptm an ie Be Sane BG ech Mech Cot heer ‘The Tortoise and the Hare ‘The US. Federal Reserve embarked on its frst QE program In November 2008, which was complemented by the US. government's fiscal stimulus package in February 2008. Both helped establish a floor for U.S. equity markets in March 2009, and sparked a bull market that continues to this day. Lower- quality companies, identified by S&P Capital IQ as those with subpar grades for long-term growth and stability of earnings and dividends, outperformed versus higher-quality companies. ‘Subsequent QE operations by the U.S. and other countries hhelped prolong this relative outperformance. The hare has sprinted ahead. However, a turing point may be at hand, Since late-2014, global equity markets have experienced increasing bouts of episodic volatility, despite the extraordinary monetary stimulus. Outlooks for corporate profits have been clouded by generally subpar US, growth, China's continued push to rebalance its economy and the ceurozone's integration effort in the face of deficient growth, creeping deflation and high debt. Diminished retuins from ‘monetary stimuli have shifted policy discourse from Federal Reserve officals, suggesting fatigue with monetary stimulus may be setting in. BofAML Global Research suggests that the combination of this QE fatigue, with the increased global uncertainty and resulting episodic volatility, plays in favor of the tortoise, or higher-quality companies. Indeed, recent market performance suggests the tortoise Is beginning to catch up (see Exhibit 3).Exhibit 3: Performance of low-quality and high- quality Merril Lynch indexes indicates a second wind for the tortoise Hencatty tow tly o00s Spreads w % Ste Bota Merl lyre Portfélio Considerations: We believe new leadership is ‘emerging in the US. equity market consisting of higher-quality, larger capitalization companies with sturdy balance sheets and stable cashflows. These characteristics should help provide sustainability of dividends and their growth Central banks, by embarking on extraordinary monetary easing, hhave suppressed interest rates to record lows. This Is dying up the traditional fed incame well in the face of a histori thirst for income on the par ofthe swelling ranks of older investors. ‘These trends have resulted in higher demand for some sectors ‘that have historically paid dividends, which has resulted in stretched valuations. Despite unprecedented monetary stimulus, continued uncertainty In the global economy has resulted in episodic volatility In ‘equity markets and has shifted policy rhetoric in a way that Suggests increasing QE fatigue and the growing possibilty of a shift towards fiscal stimulus. This development may add to the uncertainty and volatility, which requires a prudent, isk- ‘managed approach when searching for yield. The “get paid to Wal” approach espouses income as a greater contributor to total retum and favors high-quality, dvidend-paying companies with strong balance sheets, global brands, the ability to generate and {ron cash flows and low dividend payout ratios. While the trend favoring dividend payers and growers is not new, we expect it to continue (see Exhibit 4). Watch your yield \Wihile aging populations and ultra-low interest rates have been powerful drivers in the outperformance of dvidend- paying stocks, we acvise investors to exercise prudence in pursuing yield, particulary in ligt of elevated valuations in pockets of the equity market benefitting from these trends We advise following a “get paid to wait” strategy Investors should embrace income as a more substantial contributor to total returns while favoring companies that can raise dividend payout ratios over time by expanding cash flows through competing in secuiar growth industries. We recommend a risk-managed approach incorporating diversification among. asset-classes and equity sectors, wth an emphasis on higher- ‘quality companies, to mitigate volatility 25 we transition from a cycle dominated ay central bank policy to @ new one supported by Fiscal policy Exhibit 4: Performance of S&P Dividend Aristocrats shows long-term dividend growers benefiting throughout market cycles je ‘Hii Sowrce: oobergan Weir Chie estret ce aos ove aos ‘While te focus toy is on the search for ye, even mare Important i ring stable and growing cash flows to sustain I Equly markets maybe staring to reflec his Higher-qualty companies, after year of lagging lwer-qualty ones, are begining to catch up. According to BofAML Global Research in the wake ofthe Financial css in 2008, we have seen significant shit inte sector composition of higher-quality companies. Inpartuar, there has been large Increase inthe nubs oF Tech and Heath Care companies atthe enenseof Franc ‘and Consumer Discretionary companies. Given the selsmic and persistent nature ofthese demographic and economic trends, \webelve te sito core income: prodhcng and higher quaty eqs is key to continue for yeas to come. (10 REPORTS A Taner Mor Flow he Ire) LeaerCHIEF INVESTMENT OFFICE Christopher Hyzy Chit investment Ofer Bank of America Global Welt a Iuestment Management Mary Ann Bartels Karin Kimbrough Niladri Mukherjee Head or Mera nen Wesen | atof Macro and Economic Poley | Managing Oector NaragementPortolo Stategy | Merl yeh Weakn Waragement | chief ivesiment Ofc Emmanuel D. | Rodrigo C. John Hatzakis Serrano Veit Diector vce Present | Vee President, ‘The Mel iych Chef lvestment fice provides industry leading vestment salations porte construction avis and wealth management guidance, This materi ws prepare bythe Merillynch Chie Investment Ofc ands nota pubatin of BofA Mel Lynch Gcbl Research The views expressed re thar ofthe Mein Che Investment Ofce only and are subject change This information shuld not be construed as investment adic. is presented for formation purposes oly nd net Intended tobe ehera specif by any Mel iynch ently tsl or provide oa specification fra consumer to spp e, ay particular real andl producer sevice hat maybe aaiabe ‘This eformation an ay scusion should ot be construed a5 2 personalized and individual cent recommendation which should be bse on ach cot’ Investment objectives, sk tolerance, gidity needs and franca tuaton. Ths fermion and any dscssion also tnt intended asa speci efer by Merl yachts lates ny elated ent sel or provide, or aspeccintation fra consume to appl for, any pata etal ran rod or service. nvestnents and opinions are subject. {ea change duet maret conditions andthe opinions and guidance may nt be profile or ealied Any nfrmation presented in comection with ofA Meri yc bal Research general in natre ane not intended to provide personal investment advice. 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