Investors should position for the “great rotation” out of fixed income and into equities, which is forecast to begin in 2013, according to recent research from Bank of America Merrill Lynch.

A slump in 2012 saw investors erring on the side of caution, with issues like the US fiscal cliff, the eurozone crisis and the dip in global economic confidence at the forefront of their concerns. While the latest research from BofA Merrill highlights specific areas of improvement and those of continued concern, for 2013 the overall picture looks set to improve, according to the bank’s findings.

“The story about 2013 is that markets now purely want to be delivering, in terms of the effectiveness of policy,” Bill O’Neill, chief investment officer for Europe, Middle East and Africa at Merrill Lynch Wealth Management, told journalists at a media briefing yesterday.

“Growth should begin taking over from policy as the key focus for investors next year. This leads us to favor equities over bonds in 2013. The notable valuation gap between the two asset classes, now at its most favorable level for stocks in over 25 years, adds to our conviction here,” said O’Neill.

The economic and market outlook for 2013 appears brighter than 2012. “The interesting, and I think the encouraging story in the developed markets is clearly the US,” explained O’Neill. Referring to increased evidence of the Federal Reserve’s progress, he believes the US economy will reawaken, and even suggests that although it will face a “challenging first half”, a gradual eurozone recovery is predicted for the second half of the year also.

China is set to improve slightly, with BofA Merrill Lynch predicting Chinese GDP growth of 8.1 per cent in 2013, up from 7.7 per cent in 2012.

Power of politics

While great emphasis remains on growth, policy and politics are vital aspects of the 2013 investment dynamic. O’Neill believes central banks’ avoidance of “basic price inflation”, should act as a supportive backdrop to next year’s improved equities performance.

With the recent US election, fiscal cliff resolution is expected to follow, with bipartisan agreement a “likely consequence of a second-term president,” said O’Neill. The US, by way of its “growing” housing and domestic sectors, offers potential for a positive macroeconomic growth story. However, fiscal cuts are likely to weigh on US GDP growth during the first half of 2013, according to Merrill Lynch, which predicts a modest 1.4 per cent increase in GDP later in the year.

Meanwhile it seems there is “still trouble in Europe”, with the core eurozone facing a difficult first half of 2013. However, with the Italian general election on the horizon and Germany’s federal election scheduled, O’Neill expects this should be a positive for the eurozone, as it removes political uncertainty, allowing for growth in the second half of next year.

Although growth is forecast, O’Neill acknowledges a risk of heightened volatility within the eurozone region during the first half of 2013, if Spain continues to resist external support and if the Italian general election leads to political instability.

Growth is forecast for China, as recent policy stimulus measures take effect. India is also expected to see growth: GDP is expected to climb to 0.9 per cent next year, from 5.6 per cent for 2012, as we see an overall “acceleration” in trade within emerging markets.

Legitimacy and risk are likely to weigh heavily, with credible leaderships attracting investor support and weak ones having to rely on stimulus measures alone. As China continues to manage its major social and governance challenges, it is likely to fall between the two, according to O’Neill.

Edging towards equities

With equities expected to outperform fixed income investments in 2013, arguably investors already have adequate grounds to justify reversing overweight bond positions and underweights in equities.

While a full cyclical rotation away from bonds is not necessarily on the cards, equities are trading at their most appealing level relative to high-grade credit in over two decades, according to BofA Merrill Lynch.

Meanwhile, sovereign debt continues to have a negative outlook, which should leave investors with less appetite for investment grade bonds than in 2012. The high yield sector continues to show strong income potential, while the US dollar looks set to outperform other major currencies in 2013.

A look to the future: 2015 and beyond

Ultimately, BofA Merrill Lynch foresees an eventual “great rotation” out of fixed income and into equities. Citing areas of “over-investment”, low income generation in the fixed income markets, and “excessive optimism”, O’Neill points to an “end of the bull market in bonds”.

For 2015 and the three years following it, the focus will be on new sources of income and consumer power within emerging economies. Improvement in technology and in energy and labor costs will support multi-year growth themes, while oversold assets, such as European equities, have a likelihood of returning to favor as solutions to the European crisis.