Investors should take a cautious approach towards asset allocation in 2009, with prudent investment choices including high-grade corporate bonds, and high quality, high yielding equities in defensive sectors, according to Gary Dugan, chief investment officer, Merrill Lynch Global Wealth Management. 

Mr Dugan foresees that a global equity rally is possible in 2009, but is likely to be short-lived and will “probably run out of steam by the second half of the year.”  A defensive stance on equities is advisable, but consumer and cyclical stocks are among the potential beneficiaries of a global equity rebound, he said.

In line with this view, Merrill is overweight on the healthcare sector, but in addition to this defensive investment call the firm is also positive on media, technology and telecomms, Mr Dugan said at a press briefing.  Merrill is particularly bullish on media equities as the cheapest cyclical sector, he added.

Investors in equities should however stay cautious and favour high quality dividend yield.  “Be prepared to take profits,” said Mr Dugan, although he also cautioned that companies might aggressively cut dividends as a means to shore up their balance sheets.

A bounceback in the first half of 2009 is also predicted for commodities, but Mr Dugan pointed out that again this is likely to be short-lived in the absence of strong US consumer demand.

One exception is gold, which Merrill views as having possible investment potential in 2009.  Gold, along with other precious metals, is likely to enjoy a more sustained rally, especially if the dollar weakens in the second half of the year.

Increased demand from clients for physical gold investments was also a trend highlighted by Mr Dugan, who attributed the increase to the metal’s psychological attraction as a portable, “safe haven” asset amid difficult economic times.

High-grade corporate bonds could also provide attractive returns, however quality is key and investment in this asset class should be highly selective, Mr Dugan said. 

Conversely, in Mr Dugan’s view investors should avoid high-yield and emerging markets debt, particularly since emerging markets may undergo a strong reassessment as developed economies such as the US and UK face recession.

Investors could also look to private equity, which produced strong returns in the downturns in 1991 and 2001, on an opportunistic basis.  Private equity presents several opportunities, among which are distressed companies which nevertheless have good fundamentals, and distressed financial assets.  Infrastructure could also have value in the light of the heavy spending planned by a number of governments, notably that of the incoming administration of US president elect Obama.

In foreign exchange, Mr Dugan believes fears of a protracted recession mean that sterling will remain under pressure against the US dollar in the first half of 2009.  However, the pound could stage a recovery by the second half of the year, he said.

Hedge funds received a final note of caution in Mr Dugan’s analysis.  While he maintains that some strategies may be worth following, investors should be wary of hedge funds as an asset class in their own right, he said.  One particular detractor is the prospect of increased regulation inhibiting the freedom of movement for which hedge funds are known.  He also added that Merrill had reduced its weighting to hedge funds in line with its portfolio liquidity requirements, since many funds have invoked redemption suspensions and gating policies.