CIO REPORTS

The Monthly Letter

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LIFE PRIORITIES

JUNE 2016

Emerging Markets 2.0: New RealitiesAfter about a decade of strong performance, the last five years have been unkind to Emerging

Markets (EMs) as the tailwinds that propelled them faded (see box on page 2). A slowdown

in growth in China from the 8%-10% range to less than 7% pulled down demand for hard

commodities such as copper, steel and iron ore. This development, along with a precipitous

decline in oil prices, has been brutal for commodity-exporting nations such as Brazil, Russia

and Venezuela. Sentiment also soured due to a relentless rise in the U.S. dollar, lack of credible

reforms and economic mismanagement.

However, investors’ appetite for EMs has improved this year on the back of a weaker U.S. dollar,

recovering commodity prices and diminished concern over the pace of economic growth in China.

Valuations, particularly relative to developed markets, are one of the main attractions. As such

we have upgraded our view on EM equities, but we recommend being very selective. As long-

term investors we see the opportunities of the future in countries with strong commitments to

economic, financial and structural reforms and sectors providing exposure to consumer spending,

especially in China, India and Brazil.

We caution, however, that EMs will remain a volatile asset class. On June 23rd, the U.K. voted to

leave the European Union, creating economic and political uncertainty likely to be long-lasting.

In the short to medium term, market volatility may remain high and outflows in risk assets

such as equities may persist, with investors preferring high-quality bonds and gold. The UK

exit negotiations are likely to be messy and costly and lead to a contraction in that country’s

economy, creating headwinds along the way for the eurozone, the U.S. and Emerging Markets.

Investor sentiment therefore could remain fragile given this development.

Recent Publications

Weekly Letter“Brexit” now a realityRise of the “bottom billions”Remodeling REITsHome on the Range

Monthly LetterInvesting in a Range-Bound

Market

CIO OutlookThe Forces Shaping Our World

Chief Investment Office

Emmanuel D. HatzakisDirector

Niladri MukherjeeManaging Director

CIO REPORTS • The Monthly Letter 2

What drove EM growth during the golden years?In 2003, EM assets were at attractive valuations relative

to developed markets, as most of these countries were

coming out of periods of crisis. Coupled with that was

a favorable macroeconomic backdrop that included the

following factors, which often interacted and functioned in

combination with one another:

1. A secular decline in U.S. and global real interest rates

2. An environment of relatively benign inflation

3. Globalization, which helped several of these countries integrate into the global economy and trade; China is a poster child for this trend

4. A steady rise in commodity prices, fueled by a combination of strong global demand, especially from EMs, and a relatively muted U.S. dollar exchange rate during most of the period

5. Improvement of external balance sheets that included pay-down or other resolution of debts in most countries as they were leaving the crises of the 1990s behind them

Three catalystsIf EMs are going to continue growing at higher rates, more of

the gains need to come from improvements in productivity,

and innovation must play a bigger role. Emerging economies

need to improve in these areas to regain the competitiveness

they enjoyed against developed markets for several decades.

Another area that could lead to improvement, in part through

enhancing productivity, is reforms. Each country is unique in the

areas that need them, and faces its own idiosyncratic issues

and opportunities. The more effective the reforms, the faster

countries can return to a good growth path.

A third likely driver of faster growth is the rise of the middle class.

With increases in incomes and living standards, bringing more and

more people out of poverty, a significant middle class is taking

shape in EMs, which will have its own needs, and will shift the

focus from saving and investments to consumption.

Need for innovationDespite significant progress, when it comes to productivity

emerging economies are still lagging developed ones, where

it is still almost five times higher.1

Emerging market firms have a strong growth orientation,

and some argue that their ownership structure is a favorable

factor for promoting productivity-led competitiveness.2 In the

developed world, most of the largest firms are widely owned

and traded in public markets, which makes them accountable for

short-term (quarterly or semiannual) results, and restricts their

decisions for allocating capital to projects with a longer-term

horizon. By contrast, many large EM firms are privately held,

including many that are family-controlled, which enables them to

undertake longer-term projects with a more meaningful impact

on productivity growth and innovation, accepting lower rates

of return in the short run with the expectation that the gains in

future market share will more than make up for it.

Among EMs, China is well-positioned for strong increases

in productivity through innovation. The country has been

transforming from an importer of innovations to a leading

producer of them. Its R&D spending increased from 0.7% of

gross domestic product (GDP) in the 1990s to more than 2.0%

in 2014. It has exceeded the European Union average, and the

levels of several developed economies, but remains lower than

those of Japan, Germany, and the United States (see Exhibit 1).

Exhibit 1: China already spends more on R&D than several developed economies

0

1991

R&D

as a

% o

f GDP

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

3.03.54.0

2.0

1.00.5

2.5

1.5

Japan Canada European Union United States

China Germany Italy United Kingdom

Source: OECD and Merrill Lynch Chief Investment Office. Data as of 2013 for the United States, and as of 2014 for all other countries shown.

The number of patent applications in China has soared from

practically none in 1989 to the most in the world by 2014.

It surpassed the European Union in 2004, South Korea in 2005,

Japan in 2010 and the United States in 2011 (see Exhibit 2).3

The country also invests heavily in human capital, with an average

1 McKinsey Global Institute, “Global growth: can productivity save the day in an aging world?” January 2015. 2 See McKinsey Global Institute. “Playing to win: the new global competition for corporate profits,” September 2015. Also, the two McKinsey Quarterly articles: “The family-business

factor in emerging markets,” December 2014, and “Parsing the growth advantage of emerging market companies,” May 2012. 3 World Intellectual Property Indicators report, World Intellectual Property Organization, October 2015.

CIO REPORTS • The Monthly Letter 3

of 7.5 years of education for people older than 25, about double

the level in 1980.4 The McKinsey Global Institute argues that

China is ripe for a productivity revolution, and estimates that if

the country successfully shifts to a productivity-led growth model

it could add $5.6 trillion to its GDP by 2030.5

Exhibit 2: China’s patent applications have soared beyond those of other top areas

0

1989 1994 1999 2004 2009 2014

800,000

900,000

1,000,000

600,000

400,000

300,000

700,000

500,000

200,000

100,000

Pate

nt A

pplic

atio

ns

China

European Union

United States

South Korea

Japan

Source: Source: World Intellectual Property Organization and Merrill Lynch Chief Investment Office. Data as of 2014.

Our base case is that China can grow at a sustainable 6%

rate over the next few years. The government is promoting

balanced growth through the recently released five-year

plan, which aims to improve productivity growth through

approaches such as automation of factories and investments

in higher-end knowledge and skills.

Potential from reformsAnother way for EMs to gain a potential advantage is

structural reforms of the kind that enhance growth prospects.

Each country is unique in terms of areas that need reform,

and faces its own idiosyncratic issues and opportunities. The

fact remains, however, that the bolder the reforms, the more

effective they can be, and the faster they can help countries

return to a stronger growth path.

Among EMs, China has perhaps the strongest track record of

reforms, going back to the 1980s when it began transforming

from a centrally-planned economy to a market-oriented one.

The Third Plenum of 2013 set out a reform agenda with a

time horizon of five to 10 years that addressed environmental

policy, sustainable urban development, moves toward less

state control of the economy, a better fiscal framework and

financial liberalization, as well as anti-corruption measures,

which the country must implement at a careful pace, neither

too fast nor too slow, for optimum effect.

Brazil is a well-functioning democracy, but among the reforms

that it needs are short-term improvements to address fiscal

revenues and spending, as well as longer-term structural

changes aimed at more open markets, global integration and

greater investment in both physical infrastructure and human

capital. The country needs to reduce the government’s share

of economic activity, which at about 40% of GDP is very high

among Emerging Markets, and crowds out investments by the

private sector. It must also diversify away its outsize reliance

on commodities, which makes it vulnerable to downturns in

demand and prices, as the one that has been unfolding since

the middle of 2014 has demonstrated.

India is another reform-minded country, especially since

Narendra Modi’s administration came to power in 2014.

Historically, India’s political system has created a huge

and largely ineffective government bureaucracy from the

federal down to the state and local levels, which the new

administration has been focusing on streamlining. It has also

been working to create an investor-friendly environment,

with support for foreign investment in manufacturing and

infrastructure, along with reforms for fiscal policy, labor

markets and the energy sector. The latter had been plagued by

an inadequate legal and regulatory framework, making it prone

to breakdowns and leading to inefficiencies. For example, 18%

of power output is lost during transmission and distribution,

compared to 6% in China and the U.S.6 The world’s largest

power failure happened in India in 2012, a blackout that left

620 million people without electricity. Reform could also yield

large benefits where it can improve the transportation and

distribution of agricultural produce; according to the World

Economic Forum, a whopping 70% of the fruit and vegetables

produced there is wasted.

In Mexico, corruption and crime risks remain, but there has been

relative stability in the country’s political institutions. The political

4 Storesletten, K., and F. Zilibotti, “China’s great convergence and beyond,” UBS Center public paper #1, November 2013. 5 McKinsey Global Institute, “China’s choice: capturing the $5 trillion productivity opportunity,” June 2016. 6 World Bank. World Development Indicators, 2016 (data as of 2013 for all countries, accessed on June 20, 2016).

CIO REPORTS • The Monthly Letter 4

environment is making it easier to enact structural reforms, such

as those recently passed for the energy sector, which should

support private investment. Additionally, the arrest in January of

Mexico’s most notorious drug lord marks progress in the country’s

battle against organized crime.

Saudi Arabia is another case worth noting. With a resource-

driven economy dependent on petroleum revenue for decades,

it recently launched an ambitious program called Vision 2030

to diversify its economy.7 The program includes reduction of

public subsidies, fiscal reform, a more internationally open

society and, remarkably, the public listing of Saudi Aramco,

the world’s largest oil company.

The challenge of debtAnother area of concern that might be addressed by reforms

is the high level of debt in Emerging Markets, which has

remained on an increasing trend in several countries,

especially on the part of corporations and governments, with

China leading the way. (See the CIO white paper Global Debt: Challenges and Opportunities.) China’s overall debt-to-GDP

ratio increased from 121% in 2000 to 158% in 2007, and

exploded to 290% by the second quarter of 2015. In U.S.

dollar terms, it more than quadrupled from $6.9 trillion in

2007 to $30 trillion in the middle of last year.

Many fear that a genuine Chinese corporate debt crisis —

a series of defaults — would be an unambiguously negative

development because it would call into question the ability

of companies there to carry their debt. These concerns are

alleviated to a certain degree by the understanding that

the debt of local governments and state-owned enterprises

(SOEs) in China carries the implicit guarantee of the central

government. Also, in contrast to the credit crisis of the

previous decade in the interconnected financial system of

developed economies, it’s more likely such an occurrence

would be contained within China since most of the borrowing

is domestic, used primarily to finance real estate and other

domestic investments.

The burgeoning middle classWith the rise in incomes and living standards, and more and

more people coming out of poverty, a significant middle class

is taking shape in EMs, leading countries to shift their focus

from saving and investment toward consumption.

A lot has been written about the Chinese consumer, and the

country’s shift away from investment toward consumption.

Investment will continue to expand, but at a more gradual pace.

The consumer’s share of GDP is projected to rise to about 40%

in 2017. This reflects progress, but to put it in perspective,

consumption represents about 60% of GDP in Emerging Markets,

and 70% in the U.S., implying that China still has a lot of distance

to cover. In contrast, investment in China is expected to fall to 41%

of GDP next year from 44% in 2015 and 47% in 2011. Consumer

confidence in China has remained resilient over the past few

years despite the economic slowdown and stock market volatility.

Chinese household debt is still relatively low, which could result in

robust consumer purchasing power. Consumer spending is shifting

from products to services, in-store to online purchases, and from

low-end to middle- and high-end.

Exhibit 3: The service sector is growing in prominence in China with rising income levels

20

45

50

60

35

25

55

40

30

Cont

ribu

tion

to R

eal G

DP (%

)

4Q94

1Q96

2Q97

3Q98

4Q99

1Q01

2Q02

3Q03

4Q04

1Q06

2Q07

3Q08

4Q09

1Q11

2Q12

3Q13

1Q16

4Q14

Service Sector Services: Excluding Financial Services

Source: Haver Analytics and Merrill Lynch Chief Investment Office. Data as of 1Q 16

The service sector’s share of China’s GDP has risen steadily over

the past decade to nearly 58% (see Exhibit 3). The manufacturing-

to-service transition promotes labor market stability as more

workers shift from capital-intensive manufacturing (especially in

heavy industries) toward service sectors. This should keep income

growth robust, supporting economic growth.

The rebalancing of the Chinese economy from investment

to consumption is critical to its long-term health and growth

trajectory, as the high investment and low consumption trends

of the past were unsustainable. However, if it doesn’t play

out successfully, the shift could lower the country’s long-term

growth potential.

7 Johnson, K., “Saudi Arabia Plans to Break Its ‘Addiction’ to Oil,” Foreign Policy, April 25, 2016. Also El-Katiri, L., “Saudi Arabia’s New Economic Reforms: A Concise Explainer,” Harvard Business Review, May 17, 2016.

CIO REPORTS • The Monthly Letter 5

Another long-term risk we see for China is falling into the

“middle-income trap,” a per-capita income range whose upper

limit is a little less than half of that in the U.S. This could happen

if China loses its competitive edge in manufacturing and exports

because labor costs, its historical driver, rise sufficiently to put

it at a disadvantage with respect to more developed economies

in production of high-value add goods and services. This

development has already been observed. The Boston Consulting

Group estimated that China’s productivity-adjusted manufacturing

wages rose 187% between 2004 and 2014, reaching a point

where it may be economical for certain industries to bring

production back to countries where the goods are consumed, a

phenomenon known as “re-shoring.”8

China’s rebalancing not only can propel its economy but also

create global demand for goods and services, most notably,

perhaps, tourism, which could have stimulative effects globally.

In the broader EM world, literally billions of people coming out

of extreme poverty are expected to form a gigantic consumer

market. BofA Merrill Lynch (BofAML) Global Research has

examined this trend, and concluded that the 4.5 billion people

who now earn less than $10 per day have $5 trillion in purchasing

power and $7.4 trillion in wealth. They are young, urban, digitally

connected and well-educated. More than three billion of them

are projected to be in the middle class by 2030, which could

represent the largest boost to the global economy since the

boom following the Second World War.9 A large percentage

of this consumer base is in India, where the majority remains

rural. This contrasts with China, where the percentage of the

population in rural areas has been falling rapidly, from 49%

in 2011 to 44% in 2015. In India it was still at 67%, or more

than 850 million people, in 2015, and has been dropping more

gradually, from 69% in 2011.10 Large numbers of this enormous

population are coming out of extreme poverty.

Another country with a strong consumer base is Mexico. Its

robust spending has been fueled to a large degree by remittances

from workers in other countries. Over the coming years, we

believe the country should see growth in jobs and consumption

as a result of rising wages in China, making it a more attractive

alternative for production. Greater use of banks and other

financial services on the part of the population should expand

the availability of credit, adding further to growth.

Reintroducing EMs to portfoliosMany investors have shunned EM assets, but we think this is a

mistake. They will remain a volatile asset class but we believe

they are likely to produce favorable returns for long-term

investors. Attractive valuations, competitive currencies and the

recent stability of Chinese economic activity are positives.

EM equities are trading at cheaper valuations compared with

their historical average and with developed market equities. This

is true for traditional metrics such as price-to-book ratios as well

as metrics such as market cap-to-GDP (see Exhibits 4 and 5).

Exhibit 4: EMs are trading at attractive long-term valuations compared to the developed market stocks

10%

20%

30%

50%

15%

40%

45%

35%

25%20

00

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2015

2014

2013

2012

2011

EM Market Cap (MXEF Index)/GDP DM Market Cap (MXEA Index)/GDP

Source: Bloomberg, IMF and Merrill Lynch Chief Investment Office. Note: EM and DM market caps as measured by the MSCI EM (MXEF) and MSCI EAFE (MXEA) Indices, respectively. EM and DM GDP as measured by IMF’s Emerging market & developing economies and Advanced economies categories, respectively. Data as of 2015. Past performance is no guarantee of future results.

Exhibit 5: EMs are cheap compared to U.S. equities

0.20

0.60

0.80

1.20

0.40

1.00

May

–96

May

–97

Jan–

98N

ov–9

8Se

p–99

Jul–

00M

ay–0

1M

ar–0

2N

ov–0

3Se

p–04

Jul–

05M

ay–0

6M

ar–0

7Ja

n–08

Nov

–08

Sep–

09Ju

l–10

May

–11

May

–16

Jul–

15Se

p–14

Nov

–13

Jan–

13M

ar–1

2Price-to-Book Ratio of MSCI EM Relative to S&P 500

Source: FactSet and Merrill Lynch Chief Investment Office. Data as of May 31, 2016. Past performance is no guarantee of future results.

8 Boston Consulting Group, “The shifting economics of global manufacturing: how cost competitiveness is changing worldwide,” August 2014. 9 BofAML Global Research, “Thematic Investing: Moving on Up – Bottom Billions Primer,” February 25, 2016. 10 World Bank data (accessed June 20, 2016).

CIO REPORTS • The Monthly Letter 6

Years of underperformance versus developed markets have

hurt investor confidence, and the group fell from the asset

class of choice in the 2000s to the asset class of scorn in

recent years. While a cheap valuation is not a catalyst in itself

to buy, it is a strong predictor of favorable returns for patient

long-term investors. Therefore most investors should consider

some allocation to EMs as the region is too big and prominent

to ignore (see Exhibit 6).

EM currencies have declined by roughly 40% since 2011. This

development is attributed to a stronger dollar as well as slowing

growth in countries like China, which have felt the pressure to

devalue their currencies in order to support growth. The end

of the commodity super cycle and the subsequent weakness

in exporting countries such as Brazil and Russia have also

diminished support for the currencies. However BofAML Global

Research EM equity strategist Ajay Kapur believes that currencies

for most EM countries are quite competitive and should boost

exports, which in turn should enhance corporate profit margins.

The recent pause in the relentless rise in the U.S. dollar, with

the stabilization of EM currencies, is a welcome sign of investor

sentiment toward the EM asset class and should help attract

capital back to it. While it is likely that China will take further

steps to depreciate its currency, our expectation is for this

process to be relatively controlled and well-communicated.

The Global Wave is an indicator developed by BofAML Global

Research that quantifies global trends in economic activity

and has a strong track record as a predictor of equity market

performance and rotation within equities. The Global Wave

has recently troughed11, and since it is highly correlated with

Emerging Markets Purchasing Managers Indexes (PMIs) that may

signal a pickup in the region’s economic activity (see Exhibit 7).

In recent months, China’s industrial production and retail sales

growth have steadied and the property market has continued to

recover, with home sales quite robust and growth in new home

starts continuing. Chinese authorities have deployed targeted

fiscal stimulus and the central bank has been aggressive in

cutting reserve requirement ratios for banks and in bringing

down lending rates throughout the system.

Exhibit 6: EMs are big except for market capitalization

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Land mass

Foreign-exchange reserves

Population below 30 years

Market cap (full)

GDP (market rates)

Market cap (float)

Foreign direct investment

Electricity consumption

Exports

Gross domestic product(Purchasing power parity)

Passenger vehicles sales

Oil consumption

62%

73%

81%

27%

38%

17%

61%

56%

48%

56%

51%

47%

Emerging Market Developed Market

Source: BofAML Global Research and Merrill Lynch Chief Investment Office. Data in Ajay Kapur’s report: “EM equities: If not now, then when? and why?” June 13, 2016. Past performance is no guarantee of future results.

11 BofAML Global Research, “Global Wave: The Global Wave has troughed,” June 21, 2016.

CIO REPORTS • The Monthly Letter 7

Exhibit 7: The Global Wave has just troughed, and EM PMIs appear to be bottoming too

25 38

30

40

60

50

55

45

35

404244

58

50525456

4648

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Glob

al W

ave

BofAML GEM

Composite PM

I

Correlation = 0.52

Global WaveBofAML GEM Composite PMI

Source: BofA Merrill Lynch Global Quantitative Strategy, MSCI, IBES, Bloomberg, OECD, IMF, and Merrill Lynch Chief Investment Office. Data as of May 31, 2016. Past performance is no guarantee of future results.

Selectivity is key We believe investors should be very selective within EMs and

look for opportunities beyond the broad indexes weighted

based on market capitalization. Active management makes

sense along with a focus on quality — of balance sheets,

earnings and cash flows.

In most regions, there are significant differences between the

exposures that indexes offer and the underlying macroeconomic

fundamentals, making those indexes poor representatives of the

opportunities in the asset class. Take China, for example. Industrials

make up 34% of GDP but about 7% of market capitalization in the

MSCI China equity index. Similarly, financial services account for

only 8% of Chinese GDP but 35% of the index. The question of

reform of state owned enterprises (SOE) is important here. They

account for 50% of the EM market cap; in China it’s 65% and in

Russia it’s 54%.12 SOE reforms are rarely “big bang” events bringing

immediate change. Owing to their complex economic and political

circumstances, they usually take place over many years. Investors

sometimes feel that slow reform means no reform and avoid the

stocks, hence SOE valuations can hold back index returns.

Given the significant variations across EMs, it can make sense

to target specific themes and stocks rather than broad indexes.

For example, in China, there has been impressive growth in social

media and online spending, which now exceeds online sales in the

United States. Consumer spending in other areas, like tourism,

autos and personal care products, is also strong.

India and Brazil stand outAmong countries we recommend India as a core long-term

holding and Brazil as a turnaround story but one not for the

risk-averse investor. Indian stocks have done well relative

to the broader EM index since the end of 2013.13 Their

underperformance this year could be attributed to consistent

and significant overweights by EM investors, not-so cheap

valuations versus stocks of other EM countries and bad loans

in the banking sector. Some investors have also been impatient

with the Modi government for not making enough breakthroughs

when it comes to reform, but we contend that India has made

progress on several fronts; Modi’s anti-corruption campaign has

led to a cleaner and more efficient government, and infrastructure

development has picked up with the recent budget allocating

funds to roads and railways. Progress has also been made toward

introducing the vast swath of the population without a bank

account to the modern financial system. India’s estimated GDP

growth is 7%-plus for 2016, making it the fastest-growing EM,

and it has the potential to be the fastest-growing major economy

over the coming decade. We retain a positive long-term outlook

on the country.

Brazilian stocks have lost more than 60% of their value since

201114 but are higher this year on hopes for an economic and

political reboot. GDP declined 3.8% last year, and the recession

has continued into 2016. Following the removal of Dilma

Rousseff in May, new interim President Michel Temer is taking

steps to boost his government’s credibility with investors

and advance a pro-business reform agenda. The government

has a lot on its plate. It needs to execute on strict budget

reform to stabilize the country’s debt-to-GDP ratio as well as

a shake-up of the social security system. Navigating Congress

will be challenging for the interim government, as lawmakers

haven’t been open to austerity and spending cuts. Brazil has a

long history of political instability as the number and makeup

of parties have fluctuated, which could make its turnaround

volatile. On the bright side, the country’s democracy is

working, courts are active and corruption is being exposed

and cracked down upon. Investors here will need patience,

a long-term approach and tolerance for volatility.

12 BofAML Global Research, The Asia Inquirer; Ajay Kapur, April 17, 2016. 13 MSCI India Index. 14 MSCI Brazil Index.

CIO REPORTS • The Monthly Letter 8

Portfolio Considerations: We recommend that investors who have shunned EM equities in the last few years consider

reintroducing them to their portfolios. The weights depend on the individual’s risk profile and time horizon. Investors with

aggressive risk profiles and longer-time horizons could opt for higher allocations. For conservative investors, we recommend

considering developed market companies with exposure to EM economies. For all we advise being selective and prefer active

managers over passive investments. Opportunities in the long term will likely be in areas that benefit from consumer spending,

while near-term ones should be in beaten-down cyclical areas.

CIO InsightsInsights and the best thinking from distinguished investors around the world.

CIO REPORTS • The Monthly Letter 9

Chief Investment Office: What’s your outlook for the global economy and what are some of the key risks you see going forward?

Joachim Fels: The good news is that we see the global economic expansion continuing into its eighth year and beyond — a recession in the foreseeable future is quite unlikely. Both monetary and fiscal policies are supportive and we don’t see the typical imbalances that have led to recessions in the past – overconsumption, overinvestment or overheating. The bad news is that growth is bumpy, below-par and brittle and continues to rely heavily on policy stimulus. The key near-term risk we are focused on is a disruptive Chinese currency devaluation, which would be a global deflationary shock.

Market expectations for the U.S. Federal Reserve (Fed) to raise rates have bounced around on the back of considerable uncertainties in data and risk events abroad. What is your take on the Fed’s hiking cycle and what are some signals needed from the broader economy to reinforce this path?

The Fed learned the lesson last year and early this year that lift-off is hard to do when other major central banks are still easing. The resulting strength in the dollar hurt Emerging Markets (EM) debtors and led China to devalue, which created spill backs into the U.S. via tighter financial conditions. The Fed will probably only hike once this year and will try to run the economy a little hot to support a re-anchoring of inflation expectations, which are too low for comfort. We continue to believe the new neutral Fed funds rate is 2% to 3%, but it will take the Fed years to get to this level.

What is your rate and curve outlook for the end of the year?

We think U.S. rates will be range-bound and we are broadly neutral on duration right now. The equilibrium interest rate is globally low due to an excess of desired saving over desired investment, which we expect to persist. Moreover, negative yields in core Europe and Japan will lead to continued demand for (relatively speaking) high-yielding U.S. bonds and will continue to compress the term premium.

The recent jobs data indicated a modest rise in wages coupled with a fall in the unemployment rate; are you seeing upside risks to inflation at this stage?

We expect a delicate handoff from employment growth, which is inevitably going to slow as we reach full employment, to wage growth, which has started to pick up from very low levels. Stronger wage growth should support core services inflation, but with shelter inflation now slowing, we see core inflation broadly flat for the remainder of this year. Yet, headline CPI inflation is likely to double to roughly 2% or higher by the end of this year as the base effects from last year’s oil price drop dissipate. The TIPS market is only priced for 1.5% inflation, which is why we find TIPS attractive relative to nominal bonds.

Productivity has been low for several years now. Do you have concerns that this is a permanent state, or do you expect it to improve?

U.S. productivity growth is low because, first, business investment has been slow in this cycle, second, many high productivity/high wage jobs have been exported, and third, the low-productivity service sector is expanding rapidly relative to high-productivity manufacturing, which dampens measured average productivity growth in the overall economy. Forecasting productivity is tough and the best economic minds disagree on this. I’m in the optimistic camp longer-term because we’ve never had this many well-educated scientists in the world and they’ve never been as well connected. Therefore, I expect the pace of knowledge-creation and innovation to be exponential, which should also affect productivity. But whether this will show up in the data next year, in five years or in 10 years is impossible to say.

Joachim Fels

Global Economic Advisor, PIMCO

Joachim Fels is a managing director and global economic advisor at PIMCO based in Newport Beach, Calif. He co-leads the firm’s quarterly Cyclical Forum process and currently serves as a rotating member of the Investment Committee and a member of the Americas Portfolio Committee. Prior to joining PIMCO in 2015, he was global chief economist at Morgan Stanley in London. Previously he was an international economist at Goldman Sachs and a research associate at the Kiel Institute for the World Economy. Mr. Fels was also a founding member of the European Central Bank shadow council, and a member of the economic and monetary committee of the Association of German Banks as well as the Asset Allocation Advisory Board of Volkswagen Foundation. He has 29 years of macro research experience and holds a diploma in international studies from the Johns Hopkins University School of Advanced International Studies in Bologna, Italy; a master’s degree in economics from Universität des Saarlandes in Saarbrücken, Germany, and an undergraduate degree from Christian-Albrechts-Universität in Kiel, Germany.

A Conversation with Joachim Fels*

CIO InsightsInsights and the best thinking from distinguished investors around the world.

CIO REPORTS • The Monthly Letter 10

* The views and opinions expressed are those of the speaker as of June 22, 2016, are subject to change without notice at any time, and may differ from views expressed by Bank of America Corporation, Merrill Lynch, Pierce, Fenner & Smith Incorporated, or any affiliates. This conversation is presented for informational purposes only and should not be used or construed as a recommendation of any service, security or sector. Before acting on the information provided, you should consider suitability for your circumstances and, if necessary, seek professional advice.

Europe is facing some existential threats, from Greece last year to Brexit. What is your outlook for the resiliency of the European Union and euro area?

The European Union and the euro area are at risk because of the rise of populism, nationalism and dissatisfaction with the existing governments and institutions. I expect these projects to be tested again and again, and given the possibility that anti-European forces get a majority here or there, a departure of some member states cannot be ruled out. However, Europe usually progresses through crises, so the system will likely respond by moving to ever closer union with those member states willing to go along. But we have to factor in a higher political risk premium on European assets in coming years.

You’ve written in the past about the limits of central bank tools to address the current problems facing many advanced economies. Do you think helicopter money is a realistic option?

Yes, I think there is high probability that helicopter money – defined as money-financed fiscal policy -- will be used in the next downturn. Central banks and governments have learned that negative interest rates and quantitative easing cause all kinds of distortions and have unintended consequences. Closer coordination of fiscal and monetary policy is desirable as it would be much more effective in lifting aggregate demand and inflation.

In addition to the possibility of central banks working with responsible fiscal agencies, what scope do you see for central banks to work together?

Global central bank coordination is already a reality. The lesson of last year was that an overly divergent path of policies in the large economies creates problems in the form of excessive exchange rate moves. That’s why we now have what I call the ‘Shanghai co-op’ in place, with a more dovish Fed, and the European Central Bank and the Bank of Japan refraining from aggressively pushing interest rates more negative. Spillovers and spill backs from monetary policy are very high on central bankers minds these days. I view this as a very encouraging development.

What does that mean for the dollar?

Very simple: the big dollar bull run is behind us and the greenback is now likely to trade in a broad range against other major currencies. In terms of positioning, we favor a short dollar position versus high-yielding commodity currencies and long the dollar against a basket of Asia EM currencies as a hedge against a potential disruptive Chinese devaluation.

You’ve just completed your Secular Forum. What are some of the more out-of-consensus views to emerge from that discussion?

We characterize the secular – three- to five-year – outlook as ‘stable but not secure.’ The current stability in the global economy, which may well prevail for a while longer, is deceptive, for three reasons. First, total debt in the global economy has not declined, which raises the specter of defaults and/or inflation longer-term. Second, diminishing returns to current monetary policies will lead to ever more extreme actions, including helicopter money, debt cancellation and large-scale central bank purchases of private sector assets such as equities, with unpredictable consequences. And third, populism is on the rise almost everywhere, leading to a politicization of economies and markets. This ‘insecure stability’ means that investors need to focus on capital preservation and guard against capital impairments and inflation.

China continues to be a source of uncertainty, driving many of our financial markets with concerns about the slowdown. With the recent more calm news from China, do you see more scope for concern or opportunity?

The key question for global markets is whether China will be able to control capital outflows and a large disruptive currency devaluation. This is a bigger concern than the economic slowdown — China’s old economy has already hard-landed, as we see in falling exports/imports and low commodity prices.

What are your views on emerging markets, and where do you see opportunities for the medium term and long term?

Emerging market equities have become more attractive recently given low valuations, the stabilization of the dollar and the recovery in commodity prices. However, given the idiosyncratic risks in many countries, we favor a highly selective approach.

A Conversation with Joachim Fels*

CIO REPORTS • The Monthly Letter 11

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

ASSET CLASSCHIEF INVESTMENT

OFFICE VIEW COMMENTSNegative Neutral Positive

Global EquitiesFuture returns are likely to be lower than history. Risks are balanced between rising political uncertainty and monetary policy exhaustion versus reasonable valuation compared to bonds and weak investor sentiment.

U.S. Large CapHigher quality preferred given fuller valuations, political uncertainty, improving but subdued economic growth and earnings picture.

U.S. Mid & Small CapValuation multiples for small caps remain slightly extended; select opportunities within higher-quality can be considered.

International Developed

Weak organic earnings growth and heightened risk related to central bank policies in Europe and Japan (NIRP) offset improving economic environment.

Emerging MarketsValuations are cheap and stability in commodity prices and Chinese economic activity have lead to better investor sentiment. However risks remain from a potentially stronger U.S. dollar and heightened volatility.

Global Fixed IncomeBonds continue to provide diversification, income and stability within total portfolios. Interest rates remaining lower for longer limit total return opportunities in bonds.

U.S. Treasuries Current valuations are stretched, especially on longer maturities. Consider Treasury Inflation-Protected Securities as a high-quality alternative.

U.S. MunicipalsValuations relative to U.S. Treasuries remain attractive, and tax-exempt status is not likely to be threatened in the near term; advise a nationally diversified approach.

U.S. Investment GradeRisk of rates rising subsiding. Stable to improving fundamentals expected to attract high-quality foreign investors as yield differentials are supported by divergent monetary policy.

U.S. High YieldWe remain cautious, as defaults expected to increase; spreads to remain range-bound until further economic growth.

U.S. CollateralizedHigher rates and Federal Reserve tapering are likely to increase spread volatility. A shortage of new issues should counter the effects of tapering.

Non-U.S. CorporatesSelect opportunities in European credit, including financials; however, any yield pickup likely to be hampered by a stronger dollar.

Non-U.S. Sovereigns Yields are unattractive after the current run-up in performance; prefer active management.

Emerging Market DebtVulnerable to less accommodative Federal Reserve policy and lower global liquidity; prefer U.S. dollar-denominated Emerging Market debt. Local Emerging Market debt likely to remain volatile due to foreign exchange component; prefer active management.

Alternatives**Select Alternative Investments help broaden the investment toolkit to diversify traditional stock and bond portfolios.

Commodities Medium-/long-term potential upside on stabilizing oil prices; near-term opportunities in energy equities /credits.

Hedged StrategiesEquity Event-Driven & Distressed gain from recent event selloff and increasing default potential. Global Macro a timely diversifier, given higher expected volatility across equity, fixed income and foreign exchange markets.

Real EstateStrong fundamentals driving increased investment; cap rates continue to compress; favor global opportunistic.

Private Equity Strong fund raising and high valuations; special situations, energy, and private credit favored.

U.S. DollarStronger domestic growth and a less dovish Federal Reserve policy (relative to the monetary policies of other Developed Market central banks) support a stronger dollar going forward.

CashMonetary policy by Developed Market central banks reduces the attractiveness of cash, especially on an after-inflation basis.

* Boxed section, updated since last month.** Many products that pursue Alternative Investment strategies, specifically Private Equity and Hedge Funds, are available only to pre-qualified clients.

CIO REPORTS • The Monthly Letter 12

Appendix

Index Definitionsa

Standard and Poor’s (S&P) 500 Index: A market capitalization-weighted free float-adjusted index of 500 large-capitalization U.S. stocks. It captures approximately 80% of available market capitalization. The index was developed with a base level of 10 for the 1941-43 base period.

MSCI EAFE Indexb: Captures large and mid cap representation across 21 Developed Market (DM) countriesc around the world, not including the US and Canada. With 925 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country. It was developed with a base value of 100 as of December 31, 1969.

MSCI EM Indexb: Captures large and mid cap representation across 23 Emerging Market (EM) countriesd around the world. With 837 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.

MSCI Brazil Indexb: Measures the performance of the large- and mid-cap segments of the Brazilian market. It was developed with a base value of 100 as of December 31, 1987. With 61 constituents, the index covers about 85% of the Brazilian equity universe.

MSCI China Indexb: Captures large and mid cap representation across China H shares, B shares, Red chips and P chips. It was developed with a base value of 100 as of December 31, 1992. With 153 constituents, the index covers about 84% of this China equity universe.

MSCI India Indexb: Measures the performance of the large- and mid-cap segments of the Indian market. It was developed with a base value of 100 as of December 31, 1992. With 73 constituents, the index covers about 85% of the Indian equity universe.

MSCI Mexico Indexb: Measures the performance of the large- and mid-cap segments of the Mexican market. It was developed with a base value of 100 as of December 31, 1987. With 27 constituents, the index covers about 85% of the free float-adjusted market capitalization in Mexico.

MSCI Russia Indexb: Measures the performance of the large- and mid-cap segments of the Russian market. It was developed with a base value of 100 as of December 30, 1994. With 20 constituents, the index covers about 85% of the free float-adjusted market capitalization in Russia.

a Index definitions in this Appendix are based on information available at the index providers’ websites and on Bloomberg as of May 31, 2016.

b The MSCI EAFE, MSCI EM and all MSCI Country indices defined in this Appendix are free-float market capitalization-weighted.

c DM countries include: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the UK.

d EM countries include: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, Philippines, Poland, Russia, Qatar, South Africa, Taiwan, Thailand, Turkey and United Arab Emirates.

This material was prepared by the Merrill Lynch Chief Investment Office and is not a publication of BofA Merrill Lynch Global Research. The views expressed are those of the Merrill Lynch Chief Investment Office only and are subject to change. This information should not be construed as investment advice. It is presented for information purposes only and is not intended to be either a specific offer by any Merrill Lynch entity to sell or provide, or a specific invitation for a consumer to apply for, any particular retail financial product or service that may be available.

This information and any discussion should not be construed as a personalized and individual client recommendation, which should be based on each client’s investment objectives, risk tolerance, and financial situation and needs. This information and any discussion also is not intended as a specific offer by Merrill Lynch, its affiliates, or any related entity to sell or provide, or a specific invitation for a consumer to apply for, any particular retail financial product or service. Investments and opinions are subject to change due to market conditions and the opinions and guidance may not be profitable or realized. Any information presented in connection with BofA Merrill Lynch Global Research is general in nature and is not intended to provide personal investment advice. The information does not take into account the specific investment objectives, financial situation and particular needs of any specific person who may receive it. Investors should understand that statements regarding future prospects may not be realized.

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

Alternative investments, such as hedge funds and private equity funds, are speculative and involve a high degree of risk. There generally are no readily available secondary markets, none are expected to develop and there may be restrictions on transferring fund investments. Alternative investments may engage in leverage that can increase risk of loss, performance may be volatile and funds may have high fees and expenses that reduce returns. Alternative investments are not suitable for all investors. Investors may lose all or a portion of the capital invested.

Investments have varying degrees of risk. Some of the risks involved with equities include the possibility that the value of the stocks may fluctuate in response to events specific to the companies or markets, as well as economic, political or social events in the U.S. or abroad. Bonds are subject to interest rate, inflation and credit risks. Investments in high-yield bonds may be subject to greater market fluctuations and risk of loss of income and principal than securities in higher rated categories. Income from investing in municipal bonds is generally exempt from federal and state taxes for residents of the issuing state. While the interest income is tax exempt, any capital gains distributed are taxable to the investor. Income for some investors may be subject to the federal alternative minimum tax (AMT). Investments in foreign securities involve special risks, including foreign currency risk and the possibility of substantial volatility due to adverse political, economic or other developments. These risks are magnified for investments made in emerging markets. Investments in a certain industry or sector may pose additional risk due to lack of diversification and sector concentration. Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates, and risk related to renting properties, such as rental defaults. There are special risks associated with an investment in commodities, including market price fluctuations, regulatory changes, interest rate changes, credit risk, economic changes and the impact of adverse political or financial factors.

No investment program is risk-free, and a systematic investing plan does not ensure a profit or protect against a loss in 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 to continue purchases.

Reference to indices, or other measures of relative market performance over a specified period of time (each, an “index”) are provided for illustrative purposes only, do not represent a benchmark or proxy for the return or volatility of any particular product, portfolio, security holding, or AI. Investors cannot invest directly in indices. Indices are unmanaged. The figures for the index reflect the reinvestment of dividends but do not reflect the deduction of any fees or expenses which would reduce returns. Merrill Lynch does not guarantee the accuracy of the index returns and does not recommend any investment or other decision based on the results presented.

© 2016 Bank of America Corporation ARQDC66B

Mary Ann BartelsHead of Merrill Lynch Wealth

Management Portfolio Strategy

Karin KimbroughHead of Macro and Economic Policy Merrill Lynch Wealth Management

Niladri MukherjeeManaging Director

Chief Investment Office

Emmanuel D. Hatzakis

Director

Jon LieberkindVice President

JohnVeit

Vice President

Christopher HyzyChief Investment Officer

Bank of America Global Wealth and Investment Management

CHIEF INVESTMENT OFFICE