Hold Off Reactions To Poor Start

OCEAN CITY — Since the start of 2013, our advice has been for clients to consider broadening their exposure to developed market equities beyond the U.S., with Japan being a favored region. Japanese equities have fallen approximately 5% year-to-date in U.S. dollar terms, among the worst performance within developed markets.

Despite this poor start, we remain positive on the region. We believe that strong capital spending throughout 2014, easier monetary conditions and relative valuations that are still favorable remain key supports for further upside during the year.

Fourth quarter 2013 gross domestic product (GDP) was well below expectations at a headline level, but in taking a closer look we see evidence of continuing strength within the domestic economy. Overall, the Japanese economy grew just 0.3% quarter-on-quarter compared to expectations of 0.7%.

The softness was primarily due to a rise in imports resulting from higher energy prices. Domestic demand, however, grew 0.8%. Corporate (non-residential) investment helped, rising

at the fastest rate since the fourth quarter of 2011. Our positive outlook is based on expectations of continued growth in domestic demand as improving business conditions and confidence drive investment, including spending on wages, which should in turn support household consumption. Despite the softer GDP number, there remain encouraging signs of this trend. We believe fiscal policy will be one of the key pillars of

support for stronger business investment and domestic demand.

Although the April consumption tax increase will weigh on household spending temporarily, Masayuki Kichikawa, Chief Japan Economist at Bank of America Merrill Lynch (BofAML) Global Research, believes that government spending will rise to limit the immediate cutback in GDP.

Yet there remain risks when investing in Japan, most notably with the currency. Easier monetary policy in Japan should lead to a weaker yen. BofAML Global Research forecasts the yen to weaken to 108 versus the U.S. dollar by the end of 2014, from 102 currently. It expects higher economic growth and inflation expectations, and in turn lower real interest rates, especially relative to the U.S., to prompt domestic investors to sell yen. Such a risk highlights the importance of hedging currency exposure when investing in Japanese equities, in our view.

Japanese equity performance has likely been hampered by indications of softness in the global economy, led by signs of weakness in the U.S. and China. We believe this softness is temporary and expect the U.S. and global economies to continue recovering through 2014, supporting growth in Japanese corporate sales and earnings. Naoki Kamiyama, BofAML Global Research Head of Japan Equity Strategist, emphasizes that Japanese corporations have prioritized margin expansion as they focus on efficiency rather than size. Kamiyama believes Abenomics and the global economic recovery will drive further improvement in corporate fundamentals.

Encouragingly, earnings projections continue to be revised upward at the fastest rate among developed markets. Earnings have been exceptionally strong, with operating profits for April through December 2013 growing at over 32% year-over-year. The weaker yen has provided a big boost to the growth, a trend expected to continue.

(A Merrill Lynch Wealth Management Advisor who can be reached at 410-213-8520.)