Merrill Lynch Targets Return of Inflation and Picks Beneficiaries Ahead

Jon C. Ogg

Inflation has not been a concern for quite some time. Perhaps too long. Now that some inflation has started to look a bit more close, and with the Federal Reserve presidents continuing to jawbone about the need to raise interest rates, 24/7 Wall St. could not ignore the October 2016 RIC Report from Merrill Lynch.

It turns out that Merrill Lynch is seeing that the trend toward inflation is for it to creep higher. They are also telling investors to tilt their portfolios toward assets which would do well in a period of higher inflation.

The underlying trends behind the move are improving economic growth and a broadening of the policy (including fiscal stimulus) will lead toward inflation creeping higher in the coming months. Creeping is one thing, but the RIC Report sees inflation surpassing market expectations.

As far as what to expect for the inflation beneficiaries one such beneficiary would be Treasury Inflation Protection Securities (TIPS). These have yet to perform as many strategists have hoped by the interest rate hawks in the most recent years, but that is their call.

Merrill Lynch is also calling for investors to look towards emerging market stocks and bonds. This sector was pounded during the currency issues in the last year or so, but maybe they can come back this time.

As far as where to go for sectors in the United States, Merrill Lynch is calling for investors to focus on the inflation winning sectors. This calls for investors to focus on healthcare, and in the energy and materials sectors. They are also viewing this positively for bank stocks due to their ability to make more on the float and on the yield curve.

For U.S. equities in general, Merrill Lynch’s Savita Subramanian has the following targets and expectations:

  • 2016 year-end S&P 500 target is 2000.
  • 10-year S&P 500 target is 3500.
  • 2016 EPS of $117 (flat vs 2015) for S&P 500.
  • 2017 EPS of $125 for 2017, up 7% from 2016.

Equity valuations are shown as being above historical levels across most metrics, but most metrics are far from stretched. Stocks are also called as looking attractive relative to bonds. The firm prefers large caps over small caps, and likes high quality over low quality. They also like stocks with strong balance sheets and like yield at a reasonable price. Additional overweight views on top of the above mentions are for telecom, real estate and technology.

Before thinking the market will win big, understand that the RIC Report is quite cautious on a broad market bias — We expect slim returns from bonds and stocks in coming quarters; but double-digit upside likely for “ZIRP losers” in 2017. As far as Emerging Market losers, Merrill Lynch’s Ajay Kapur said:

Emerging Market 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 U.S. 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. … Emerging Market GDP growth is still likely to continue improving versus developed markets in 2016 to 2017.

Stay tuned.