A rise in volatility will drive investment opportunities this year according to Merrill Lynch. In its annual appraisal of the financial m...

A rise in volatility will drive investment opportunities this year according to Merrill Lynch. In its annual appraisal of the financial markets, Merrill said greater market volatility is forecast if, as expected, central banks in Japan and Europe raise interest rates in a bid to mop up excess liquidity. According to Merrill, five themes that international investors should consider in 2007 are: the attractiveness of global telecoms; a shift to higher quality assets; consumer-facing stocks in emerging markets; an easing of commodities growth; and the role of gold in geo-political risk. “Higher volatility can make for alarming headlines, prompting investors to shift their allocations towards assets with true or intrinsic value,” said Richard Bernstein, chief investment strategist at Merrill Lynch. “We believe investors should look towards assets that will avoid, be relatively immune to, or benefit from volatility,” he said. Merrill says that US telecom companies still seem to be conservatively valued despite a strong performance in 2006 but the new theme is how the sector is poised to perform well globally. Persistently low sector valuations in Europe may provide potential investment opportunities and Merrill Lynch quantitative models rank telecoms as the fifth most attractive sector globally and fourth in Europe. And if volatility increases, higher quality assets should outperform. Merrill thinks that conditions are ripe for a period of P/E multiple expansion. In the past 20 years lower-quality stocks have never outperformed higher-quality stocks when P/E multiples grow, which should lead investors to look to high quality common and preferred stocks and AAA-rated corporate debt, which is in short supply. Merrill Lynch strategists believe that investors should start positioning their portfolios to take advantage of growing emerging markets consumer activity. This is a theme that carries short term risk if volatility rises, but may provide benefits over the long term for risk-orientated investors. With China’s “generation Y” (those under 27 years old) being much more consumption oriented that many investors realise, investors should also consider opportunities in consumer finance such as credit card operators and other lenders, as the use of consumer credit is in its infancy in many parts of emerging markets. According to Merrill, commodities are likely to come under pressure and see returns erode in 2007, partly due to the extreme amounts of speculation, causing commodity prices to lose touch with weakening fundamentals. With oil supply outside of OPEC slated to grow at its fastest rate in 30 years, demand seems poised to slow. And Merrill’s research points to a 30 per cent fall in the price of copper by the end of the year. Investors who have commodity exposure for long-term asset diversification should hold their positions, but investors who recently took a short-term position for quick, high returns are likely to be disappointed, say Merrill. Merrill Lynch believes investing in gold or gold shares is an effective hedge against these risks, and also against a declining US dollar. For investors with an appetite for risk, investing in a global mix of defence-related companies may provide a useful long-term strategy for growth.