Rising Equity, Commodity Prices Likely In First Half, Merrill Lynch Says

Business Wire

January 8, 2004

NEW YORK, Jan 8, 2004 (BUSINESS WIRE) --

Merrill Lynch:

-- Investors Should Use a Barbell Approach To Investing In Equities Merrill Lynch Says In "2004-Year Ahead" Report

-- Central Bank Spigot For Liquidity Likely to Remain Open

Rising equity and commodity prices, along with improving global growth, are likely to continue at least for the first half of 2004, Thomas Sowanick, head of Merrill Lynch's Global Strategy and Economics department, said at the firm's "Year Ahead" press conference.

In addition, equities versus bonds, and emerging-market versus emerged-market securities, should continue to be the key investment themes, he said.

These expectations reflect the view that "the (central bank community) spigot for liquidity will likely remain open, at least for the first half of 2004."

"We cannot emphasize enough that central banks are willing to tolerate inflating assets as a cost to restoring general price inflation, which should lead to even higher commodity prices and a further weakening of the United States dollar," Mr. Sowanick said.

This view was based upon Merrill Lynch's special 76 page research report, "2004 - Year Ahead: Key Macro Drivers, Investment Implications," which represents commentary by more than 20 Merrill Lynch strategists on a wide range of economic, equity and bond market issues worldwide.

Barbell Strategy: Most Effective Investment Course

"A barbell strategy will be most effective" given the background of global growth and excess liquidity, Mr. Sowanick said.

On one side of the barbell would be emerging market equities, which offer the most compelling profit opportunity for the aggressive investor, he explained.

At the other end, aimed at more cautious equity strategies, should be high-quality, high-dividend-paying global stocks, to take advantage of favorable tax treatment of dividends versus interest income.

Federal Reserve: To Remain on Hold in 2004

If central banks are successful in bringing back inflation, 2004 could prove to be the secular low for inflation, with rising inflation in 2005, Mr. Sowanick said. Thus, "inflation-linked bonds, commodities and gold, should all be considered required assets for the cycle that is about to unfold."

"Our base case is for the Federal Reserve to remain on hold in 2004. Should they move sooner however, many portfolios may need to de-leverage high-yielding asset classes," said David Rosenberg, chief economist for North America.

Global Themes: For Equity, Debt Investors

Within the context of current factors, Merrill Lynch identified six key global concepts for equity investors, and provided bellwether stock recommendations, as well as more aggressive choices. The bellwether ideas are considered the more conservative, and the aggressive selections should be considered as more leveraged plays (operational or financial) on the concept. Merrill Lynch also identified several themes for debt investors, along with potential catalysts and investment ideas.

U.S. Markets: Fundamental, Technical Views

Examining the U.S. stock market, Richard Bernstein, chief U.S. strategist and quantitative strategist, said the fundamental and technical views still differ, "but we have reason to believe that by the second half of the year, (they) will be in the process of converging."

The fundamental views are closely linked to the increasing risk that the profit cycle will decelerate in 2004, he said.

He noted year-over-year comparisons are getting "tougher." Earnings surged in 2003, coming out of the worst profits recession in the post-war era. "They will continue to grow when measured by the dollar value of earnings - but the momentum will slow. We believe the roughly 70% growth rate of 2003 earnings is unlikely to be sustained."

"Another factor that could lead to a decelerating profits cycle could be the impact of rising interest rates on the consumer sector and rising energy prices."

Accordingly, Mr. Bernstein suggested that U.S. equity investors focus on later-cycle sectors such as Energy, Materials, and Industrials, and underweight early-cycle sectors such as Consumer Discretionary.

Fixed Income Markets: Higher Yields Expected

Exploring the debt environment, Ken Hackel, chief U.S. fixed income strategist, said the new year holds the prospect of higher yields, regardless of whether the Federal Reserve remains on hold for an extended period or chooses to respond to recent signs of growth.

On the fundamental front, much stronger business activity in the U.S., the risk of competition for funds due to global improvement, and the need to finance dual deficits, all support the contention that real and nominal interest rates are just too low, he said.

Two other points support the expectation for the bull market in treasuries to unwind, he said. First, real interest rates have historically risen well above 4 % as the markets overshoot in anticipation of a shift by the Federal Reserve. "This suggests that as the reflationary thesis gains greater acceptance, nominal 10-year yields could spike by more than 150 basis points by the end of 2004."

In addition, "investors have far less cushion against rising rates to protect against actual losses in the form of negative total returns."

Dividends: Continuing As Key Investment Theme

Meanwhile, Mr. Bernstein said, dividends will continue to be a key investment theme for some time.

He based his view on a range of factors, including the 2003 reduction in the dividend tax to 15% from 38%, and the capital gains tax cut to 15% from 20%. Those changes eliminate the tax bias toward capital gains over income, he explained.

Other key factors include a lower-growth environment, a desire for increased transparency, an aging population, and generally low-yielding securities.

Emerging Market Equities: Favored Over Sovereign Debt, Global Equities

Tulio Vera, chief emerging markets debt strategist, said he favored long-neglected emerging market equities over their sovereign debt, and over global equities. Emerging market equities still trade at a 35% discount, he noted.

For reflation trades, Mr. Vera said he favored Indian and Thai equities; for disinflation trades shares from Turkey, Brazil and domestic South African shares; and for cyclical trades equities from South Korea and Taiwan.

In the emerging market debt sector, he said he favored the external debt of Venezuela, Uruguay and the Philippines. Mr. Vera also said, for the early part of the year, investors should explore debt from Brazil, Russia and Colombia.

Asia: New Year Seen As Critical For Region's Global Economy

In addition, TJ Bond, chief Asia-Pacific economist, said 2004 should be a critical year for Asia in the global economy. Among the developments, he noted Japan could exit deflation, while China should continue as a pillar of global growth and emerge as a source of global inflation.

Elsewhere in the region, economic growth should pick up as Asia's extremely supportive policies take hold, he said.

These trends have significant implications for regional and global investors: positive for Asian equities and currencies against the U.S. dollar, and negative for regional and global bonds, Mr. Bond said.

Turning to the threat of inflation in Asia, Mr. Bond noted above-trend growth, the weak U.S. dollar, and higher commodity and shipping costs, conspire to bring Asia's five-year struggle with deflation to an end.

More importantly, the visible costs of Asian deflation have transformed the worldwide politics of inflation, he said.

"Global central banks want to get inflation up. Although inflation is still falling in the U.S. and Europe, the death of deflation in Asia, combined with a sustained global recovery, raises the prospect of higher global inflation in the years to come," he said.

Asia's Macro Backdrop: Supportive For Pacific Rim Equity Markets

On the outlook for Pacific Rim equity markets, Mr. Bond said Asia's macro backdrop will be very supportive in 2004, but equity gains are likely to be much more modest than 2003.

He said he anticipates greater divergence between country-level returns, and that sector-led thematics will be far more important.

The key investment themes for Asia will be infrastructure, financials, pricing power plays, and consumer discretionary, he said.

He said his top market selections are India, South Korea and Thailand because domestic growth is rising and valuations remain attractive.

European Equities: "Geared Play" On U.S.-Asian Economic Recovery

David Bowers, chief global strategist and chief European equity strategist said, the macro fundamentals for European equities remain mixed.

European economic growth is expected to accelerate, but nominal gross domestic product growth of about 5% for the United Kingdom and just under 4% for the Eurozone, suggests European top-line sales growth will be subdued, he said.

European equities remain a "geared play" on a successful and sustained U.S.-Asian economic recovery.

He said his view is that this will continue into 2004, but negatively impact long-term interest rates. A world that is increasingly in the grip of global reflation is good for cyclical companies, at the expense of defensive ones, he noted. Higher long-term interest rates also may mean that some financial stocks may under perform.

Currently, investors are focused on finding European companies exposed to China. Exposure to Japan also will be important, he said.

With corporate Japan low on manufacturing inventory and looking to increase investment spending, European basic material and industrial companies could find themselves well placed in 2004, the strategist said.

"The catch, and it is an important one, is that European institutional investors are already cyclically positioned."

If there is one factor that could differentiate Europe, it is the enlargement of the European Union (E.U.) when 10 countries will join. Between them, they will add 20% to the E.U.'s existing population, but contribute only 5% to the E.U's gross domestic product.

"While this is a landmark event, unless European companies are able to take advantage of the cheaper cost base these countries offer, or find new sources of end-user demand, this expansion may only have a limited impact on the long-term growth prospects for corporate earnings."

Trade-Weighted Dollar: Expected To Decline Another 10%

Merrill Lynch's chief global foreign exchange strategist, Yianos Kontopoulos, reported he believes the case for further dollar weakness is compelling and expects another 10% decline in the trade-weighted dollar in 2004 and an overshooting through 2005.

To many investors, he said, the cycle of dollar weakness is at a mature stage. While most see the risk of further weakness, the degree of the dollar's decline is expected to be extremely modest from this point forward.

Further, he said, the path of dollar weakness needs to be viewed in the context of structural and cyclical dynamics. On the structural side, Merrill Lynch's valuation models are definitive: the dollar is still significantly overvalued. On the cyclical side, the redistribution of global growth, a byproduct of dollar weakness, is expected to extend the adjustment in currency markets into 2005.

"We see an additional 18 months of dollar weakness, putting the currency's cycle at 3 1/2 years," he said.

Merrill Lynch is one of the world's leading financial management and advisory companies with offices in 36 countries and total client assets of approximately $1.4 trillion. As an investment bank, it is a leading global underwriter of debt and equity securities and strategic advisor to corporations, governments, institutions, and individuals worldwide. Through Merrill Lynch Investment Managers, the company is one of the world's largest managers of financial assets, with assets under management of $473 billion. For more information on Merrill Lynch, please visit www.ml.com.

SOURCE: Merrill Lynch

CONTACT: Research Communications

Susan McCabe Walley, 212-449-0389

susan_mccabe@ml.com

Customize your Business Wire news & multimedia to match your needs. Get breaking news from companies and organizations worldwide. Logon for FREE today at www.BusinessWire.com.

Copyright (C) 2004 Business Wire. All Rights Reserved