Merrill Lynch looks to structured products

At Merrill Lynch, structured products will continue to represent the main source of revenue margins in 2007, said Khuram Chaudhry, chief European quantitative strategist at the American investment firm. “Structured products can be equity based, fixed income based but they are primarily derivative based,” he said. The identification of investment themes is the engine of the whole product manufacturing mechanism. Ideas of Merrill’s research analysts can be incorporated in stock recommendations such as Europe 1, a list of European stocks that are expected to deliver positive price appreciation, or Turbo dividend strategy, a high yield strategy with high growth and low pay-out ratios. Those ingredients are then wrapped to build alpha-generating structured products in order to meet specific clients’ needs. “That is a growth area,” stated Mr Chaudhry. Recent findings from Merrill’s global macro-team, including the views of the firm’s economists as well as the equity, fixed income, foreign exchange and commodity strategists, suggest that the year ahead will be characterised by greater market volatility, as global central banks are forecast to raise interest rates further in 2007 in an effort to dry up excess liquidity. But volatility, despite being so much feared by investors, has the economic function to draw investments back towards intrinsic or true economic value, said Merrill’s analysts. In this scenario, with a looming economic global slowdown, asset allocation has to shift towards higher-quality assets, which are expected to outperform. “Large caps tend to be preferred, because larger companies generally have easier access to capital and have the right sort of metrics compared to their smaller counterparts.” In terms of geographical coverage, oversees or international equities are those recommended to Merrill’s clients. However, some of the overweight in non-US companies will be reduced. “The US market is more high-quality, more defensive, there are more big blue chips companies, with solid brands,” said Mr Chaudhry and these types of assets are more attractive when risk appetite, which is exceptionally high right now, starts waning. Merrill Lynch believes that growth stocks, those which grow irrespective of the cycle, are to be chosen over value stocks this year. This is in view of the fact that a contraction of liquidity, which favours this type of stocks, has already started, as the US Federal Reserve has been raising interests since 2004. Moreover, growth stocks in Europe are the cheapest they have been versus value in 10 years, said Mr Chaudhry. “Some of the financials are showing best characteristics,” he said, “and growth characteristics are very high in the pharmaceutical sector.” Growth can also be dividend related and the telecoms sector, where fundamentals are strong, looks also attractive, he said. Another major investment area relates to the growth of the consumer sector in the emerging markets. Strategists at Merrill’s believe that this theme carries short-term risk if volatility rises, but may provide benefits over the long term for risk-oriented investors. “We are moving away from an export story to one that focuses on domestic demand,” said Mr Chaudhry. Total market capitalisation of consumer stocks in the emerging markets is about $30bn (e22.8bn), which represents only 0.4 per cent of the figure of more than $7,500bn in developed markets. This disparity suggests a “huge potential for growth.” In particular, investment opportunities lie in credit cards and mortgage lending, and other related areas of consumer finance, which is still in its infancy in most emerging markets, but set to develop strongly. As for commodities, they have long-term potential but they are likely to come under pressure and see returns erode in 2007, explained Mr Chaudhry. “Commodities have been in their own spectacular boom market and demand and supply dynamics are still favourable. But what we believe is that commodities are likely to take a breather this year.” As a consequence, some commodity-related emerging markets, such as BRICs (Brazil, Russia, India and China) might underperform. Performance of commodities is strictly connected to currency as most of the assets in this class are denominated in US dollars. As this currency is expected to weaken, especially in the second part of this year, commodity prices could rise simply because of this, say Merrill’s analysts. “This might please dollar-based investors, but it would not be good for non-dollar investors.” At Merrill Lynch, another key investment theme for this year will focus on gold, which is seen as an effective hedge against geo-political risks and a declining US dollar.

Chaudhry: commodities might take a breather this year