NEW YORK, June 25 (Xinhua) -- Bank of America Merrill Lynch economists said Wednesday that they are optimistic about the U.S. economy and are bullish on U.S. equities.
Moreover, the economists expected the U.S. Federal Reserve to "tiptoe" to the exit of its accommodative monetary policy and not to hike federal funds rate until late 2015, they said at Bank of America Merrill Lynch's mid-year 2014 press conference held in New York.
OPTIMISTIC ON U.S. ECONOMY
The U.S. economy is coming out of rehab, said Ethan Harris, co-head of Global Economics Research at Bank of America Merrill Lynch.
"We are now healed enough. The economy can kind of start to have some growth on its own," he said.
Harris noted that there are four reasons to be optimistic about the U.S. economic growth. First, structural headwinds are fading.
"The structural improvement in the budget deficit over the last few years has been very dramatic. We've been tightening fiscal policy by one to two percentage points of GDP (gross domestic product). That's ended now, both at the federal, state and local levels," Harris said.
Second, there are many parts in the U.S. economy that have plenty room to recover from where they are here, such as capital spending, home construction and auto sales.
Moreover, there is no major shocks looming beyond the winter shock the country just had. "One of the shocks we are not seeing is brinkmanship in Washington. That I think it's very good for business confidence. But even more important, we don't have any fiscal austerity looming," he said.
The final reason for optimism is that low inflation keeps the Fed in a very gentle manner to exit its monetary easing.
"So the way to think about it is not that there is something great happening in the economy, but rather we are getting rid of this massive fiscal headwind. And that's the No. 1 reason for stronger growth," Harris stressed.
Commenting on the downward revision of the U.S. GDP to a 2.9-percent contraction in the first quarter, the worst performance in five years, Harris said "we just came off a very ugly first quarter" and the economists tend to look at it as a result of inclement weather and inventory adjustment.
In a research report released on Monday, Bank of America Merrill Lynch forecast that the U.S. real GDP growth will be 2 percent in 2014, 3.2 percent in 2015 and 3.4 percent in 2016.
Moreover, the economists expected the global economic growth to return to trend after having underperformed in the last two years, as Europe is recovering and the U.S. is picking up speed.
BULLISH ON U.S. EQUITIES
"We are optimistic on U.S. equities," said Savita Subramanian, head of U.S. Equity and Quantitative Strategy at Bank of America Merrill Lynch.
Subramanian said that 2,000 points is her year-end price target for the S&P 500, which is now just a few percentage points away from the target.
Looking ahead, she said "the second half of this year could be interesting. We think we are likely to see a little bit of volatility and a change in leadership around a change in the direction of interest rates. But we are seeking with our 2,000 target on the S&P."
"To give you a longer-term perspective on our outlook on equities, we are bullish," she said, noting that their 12-month price return forecast for the S&P 500 is about 10 percent at this point.
"We still think that there is more to be gained from equities than other asset classes," she added.
In terms of sectors, Subramanian said their sector overweights are Energy, Technology and Industrials, which are three of the most globally-exposed, GDP-sensitive sectors in the S&P 500.
"Within each of those sectors, we prefer larger-cap stocks to smaller-cap stocks," she said.
Meanwhile, their three recommended sector underweights are Consumer Discretionary, Utilities and Telecom.
Utilities and Telecom are trading at unusually high and unsustainable premia, she said, explaining that "because they are as close to bond as one can get within the equity market, ... as rates begin to rise, that could hurt the relative attractiveness of high equity yield."
Subramanian said they are a little bit worried about the Consumer Discretionary sector because these stocks look expensive and corporate earnings from the sector have started to disappoint the market.
"We've seen leadership transition from early-cycle consumption place to mid-cycle more corporate spending place. We think that consumer discretionary stock could suffer in that rotation," she said.
Subramanian debunked the notion that the stock market is too complacent at this point.
Recently, market watchers have talked a lot about complacency in the market, citing the CBOE Volatility Index (VIX), a gauge of fear in the market, now at very low levels suggested too much euphoria among investors and would mean more downside risk to equities going forward.
"I don't think they are complacent, I think they are confused and they are digesting the Fed that, against all odds, rates fell rather than rose. It's been a confusing year for investors," Subramanian told Xinhua, adding that "the low level of VIX reflects the fact that everyone is already hedged, everyone is already bought in trends."
"We are still climbing the wall of worry," she said, because the average Wall Street firm is recommending people to allocate just about half of their portfolio into equities, which is surprisingly low given that the competing asset classes like bonds don't look particularly attractive.
"This is far from the levels of euphoria that typically precede a bear market in equities. So that's one signal that I think we are not necessarily in a sort of euphoric bullish mood that would suggest a downside risk to the market," she said.
FED TO HIKE RATE LATE 2015, INFLATION TO REMAIN LOW
Harris suggested that people should "try to avoid getting lost in the noise out of the Fed" as a result of its "awkward communication structure."
Harris said that people should block out the noise and focus on Fed Chairwoman Janet Yellen's prepared remarks and policy meeting directive because that is where the Fed is really trying to be clear.
Harris noted that the message from the Fed right now is that it is going to "tiptoe to the exit" and keep doing quantitative easing until the end of this year. And then, only if the U.S. economy continues to improve and posts strong growth will the Fed start hiking rates late next year.
"I don't see any reason to change that. And I think that from a market's point of view, this means some upward pressure in bond market, but not a disaster. For the equity market, good news, Fed is giving us less liquidity but only in the contest of better growth," Harris said.
Echoing Harris' view, Subramanian said the real opportunity within the equity market today is "playing the rising interest rate trade."
"Our view is that they (rates) rise... I don't think there is a lot more money to be made playing the flat-to-down interest rate trade within the equity market," she added.
As for the outlook on inflation, Harris said inflation will continue to remain low, as the global backdrop does not support a significant acceleration of inflation, with Europe still facing the risk of deflation, and domestically, there is no sign of raw material inflation.