12
CIO REPORTS The Monthly Letter Office of the CIO JULY 2014 Investment products offered through MLPF&S: Are Not FDIC Insured Are Not Bank Guaranteed May Lose Value Please see important disclosure information on the last page. Merrill Lynch makes available products and services offered by Merrill Lynch, Pierce, Fenner & Smith Incorporated (MLPF&S) and other subsidiaries of Bank of America Corporation (“BAC”). Mid-Year Update: A Review of Our 2014 Investment Themes The year started with high hopes for global economic growth, but the first quarter economic growth proved disappointing. This trend, however, appears to be in the rear-view mirror. We do not believe this underperformance is likely to persist and expect growth to pick up through the end of 2014. Recent reports suggest growth is slowly improving, led by a recovery in developed markets. We expect the U.S. and European economies to maintain their recent strength and improve slightly through the rest of the year. The outlook varies across Emerging Markets (EM), and we remain concerned about the need for fiscal adjustments in some economies there. In the second quarter, global equities continued to outperform bonds, but the big winners were real estate and EM equities (see Exhibit 1). Despite two negative revisions to first-quarter U.S. gross domestic product (GDP) and continued Fed tapering, equities continued to grind higher. The S&P 500 was up over 5% in the second quarter, reaching an all-time high of 1,963. In the U.S. it was a tale of two quarters; sector leadership in the first one was dominated by defensives, particularly utilities, while in the second one cyclicals regained leadership, led by the energy sector. Ashvin B. Chhabra Chief Investment Officer, Merrill Lynch Wealth Management Head of Investment Management & Guidance We’ve certainly seen some surprising developments in the markets and the macro environment in the first half of the year. The U.S. economy sputtered in the first quarter, interest rates and the dollar have eased and emerging markets have rallied. Geopolitical crises emerged, but haven’t shaken markets. The low level of volatility has itself been unexpected. Despite these surprises, we’ve seen some of our fundamental investment themes for the year play out – equities have outperformed bonds, with cyclically sensitive sectors showing strength. In this Monthly Letter we offer an update on those themes, including a scorecard, and review the year to date with an eye to what may transpire in the second half. Sincerely, Exhibit 1: 2014 year-to-date performance is a reversal of what worked in 2013 2013 1H 2014 YTD (as of 7/15) 60% S&P 500 / 40% Barcap U.S. Agg 18.6% 5.9% 6.2% Cash 0.0% 0.0% 0.0% Equities U.S. Large Cap Equities 32.4% 7.1% 7.9% U.S. Small Cap Equities 38.8% 3.2% -0.2% Developed Int'l Equities 23.6% 5.2% 4.3% Emerging Markets Equities -2.3% 6.1% 8.2% Global Equities 23.5% 6.5% 6.7% Fixed Income U.S. IG Fixed Income -2.0% 3.9% 3.7% U.S. High Yield 7.4% 5.6% 5.4% U.S. Munis -2.9% 6.6% 6.2% Global Fixed Income -2.1% 4.9% 4.6% Alternatives Hedge Fund Strategies 6.7% 1.8% 1.3% Real Estate 3.1% 16.1% 17.4% Commodities -9.5% 7.1% 3.0% Gold -28.0% 10.1% 7.3% Private Equity 41.0% 4.7% 3.4% Source: Bloomberg and ML GWM Investment Management & Guidance. Data as of July 15, 2014. Past performance is not a guarantee of future results.

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Page 1: CIO REPORTS The Monthly Letter - Merrill€¦ · Letter we offer an update on those themes, including a scorecard, and review the year to date with an eye to what may transpire in

CIO REPORTS

The Monthly LetterOffice of the CIO • JULY 2014

Investment products offered through MLPF&S:Are Not FDIC Insured Are Not Bank Guaranteed May Lose Value

Please see important disclosure information on the last page.

Merrill Lynch makes available products and services offered by Merrill Lynch, Pierce, Fenner & Smith Incorporated (MLPF&S) and other subsidiaries of Bank of America Corporation (“BAC”).

Mid-Year Update: A Review of Our 2014 Investment ThemesThe year started with high hopes for global economic growth, but the first quarter economic

growth proved disappointing. This trend, however, appears to be in the rear-view mirror. We

do not believe this underperformance is likely to persist and expect growth to pick up through

the end of 2014. Recent reports suggest growth is slowly improving, led by a recovery in

developed markets. We expect the U.S. and European economies to maintain their recent

strength and improve slightly through the rest of the year. The outlook varies across Emerging

Markets (EM), and we remain concerned about the need for fiscal adjustments in some

economies there.

In the second quarter,

global equities continued to

outperform bonds, but the big

winners were real estate and

EM equities (see Exhibit 1).

Despite two negative

revisions to first-quarter

U.S. gross domestic product

(GDP) and continued Fed

tapering, equities continued

to grind higher. The S&P

500 was up over 5% in the

second quarter, reaching an

all-time high of 1,963. In

the U.S. it was a tale of two

quarters; sector leadership in

the first one was dominated

by defensives, particularly

utilities, while in the second

one cyclicals regained

leadership, led by the energy

sector.

Ashvin B. Chhabra

Chief Investment Officer, Merrill Lynch Wealth Management Head of Investment Management & Guidance

We’ve certainly seen some surprising developments in the markets and the macro environment in the first half of the year. The U.S. economy sputtered in the first quarter, interest rates and the dollar have eased and emerging markets have rallied. Geopolitical crises emerged, but haven’t shaken markets. The low level of volatility has itself been unexpected. Despite these surprises, we’ve seen some of our fundamental investment themes for the year play out – equities have outperformed bonds, with cyclically sensitive sectors showing strength. In this Monthly Letter we offer an update on those themes, including a scorecard, and review the year to date with an eye to what may transpire in the second half.

Sincerely,

Exhibit 1: 2014 year-to-date performance is a reversal of what worked in 2013

20131H

2014YTD

(as of 7/15)

60% S&P 500 / 40% Barcap U.S. Agg 18.6% 5.9% 6.2%

Cash 0.0% 0.0% 0.0%

Equi

ties

U.S. Large Cap Equities 32.4% 7.1% 7.9%

U.S. Small Cap Equities 38.8% 3.2% -0.2%

Developed Int'l Equities 23.6% 5.2% 4.3%

Emerging Markets Equities -2.3% 6.1% 8.2%

Global Equities 23.5% 6.5% 6.7%

Fixe

d In

com

e

U.S. IG Fixed Income -2.0% 3.9% 3.7%

U.S. High Yield 7.4% 5.6% 5.4%

U.S. Munis -2.9% 6.6% 6.2%

Global Fixed Income -2.1% 4.9% 4.6%

Alt

erna

tive

s

Hedge Fund Strategies 6.7% 1.8% 1.3%

Real Estate 3.1% 16.1% 17.4%

Commodities -9.5% 7.1% 3.0%

Gold -28.0% 10.1% 7.3%

Private Equity 41.0% 4.7% 3.4%

Source: Bloomberg and ML GWM Investment Management & Guidance.Data as of July 15, 2014. Past performance is not a guarantee of future results.

Page 2: CIO REPORTS The Monthly Letter - Merrill€¦ · Letter we offer an update on those themes, including a scorecard, and review the year to date with an eye to what may transpire in

CIO REPORTS • The Monthly Letter 2

Emerging Markets led the equity rally in the second quarter,

gaining 6.7% and reversing their first-quarter drop. However,

the U.S. has been one of the best-performing regions for

equities year-to-date, climbing 7.9%.

Most bond sectors were up in 2Q, with the ML U.S. Broad Market

Index rising 2.1%. A pickup in inflation in the U.S. supported

Treasury Inflation Protected Securities (TIPS), which rose 4.1%.

Finally, although the headline commodity index ended 2Q

flat, oil prices rose to the highest levels in nine months as

Islamic militants invaded northern Iraq, increasing the risk that

production would be compromised and fighting would escalate

in a regional war.

Revisiting Our 2014 OutlookOur 2014 outlook, developed in December 2013, has not

changed significantly. Our view is still for stronger economic

growth in the second half and equity returns for the second half

should be led by developed markets, particularly the U.S. and

Europe (see Exhibit 2).

This central bank driven growth is not without risk. At mid-year

the Bank of England (BoE) and the Federal Reserve (Fed) face

quickly diminishing labor market slack and a careful balancing

act between accommodative policy and restraint. Weak inflation

in the Euro zone pushed the European Central Bank (ECB) to

deliver a package of easing measures at its June meeting,

enhancing prospects for that area. In Japan, the consumption

tax that took effect April 1 has hurt economic growth, but we

expect a recovery in the latter half of the year, as business

capital expenditures accelerate.

In China, growth is likely to stabilize, according to our BofAML

Global Research Chief China Economist Ting Lu, supported

by the government’s mini-stimulus measures, which include

targeted monetary easing, greater fiscal spending and other

measures in selected sectors. Elsewhere in Emerging Markets,

tighter financial conditions in countries like Brazil and South

Africa have lowered expectations, while there is stronger growth

driven by external demand in places like Mexico and Korea.

Portfolio Themes Update

Growth Gap Developed Markets Emerging Markets

-5% -4% -3% -2% -1% 0% 1% 2% 3% 4% 5% 6% 7% 8% 9%

2008 2009 2010 2011 2012 2013 2014F 2015F

GDP

grow

th (y

ear-o

ver-y

ear)

-0.1%

-3.7%

2.6% 1.5% 1.4% 1.2% 1.6%

2.4%

5.6%

2.7%

8.0%

6.3%

4.8% 4.6% 4.5% 4.9%

Exhibit 2: Developed Markets growth is improving while Emerging Markets growth is stabilizing

Source: BofAML Global Economics Research and ML GWM Investment Management & Guidance. Forecasts as of June 27, 2014.Past performance is not a guarantee of future results.

Table 1: Office of the CIO – 10 Portfolio Themes for 2014

Source: ML GWM Investment Management & Guidance. Data as of June 30, 2014.

Portfolio Actions Rating

1) Equities again outshine bonds Stocks have outperformed bonds through the first

half and are now hitting all-time highs✔

2) Invest in ‘Team USA’ – Tech, Energy, Autos and Manufacturing

‘Team USA’ was supported by strong manufacturing activity domestically and robust auto sales

3) International equities prove resilient Developed international equities outperformed global

equities but underperformed U.S. markets

4) The equity rotation within the Great Rotation continues

Cyclicals stuggled as first quarter U.S. GDP growth disappointed but should benefit accordingly from stronger economic expansion.

5) Fixed income is challenged by greater interest rate volatility

A continuation of low bond volatility in a low-rate environment as first quarter economic growth disappointed and monetary policy remained accommodative

6) “Bigger bang for your buck” as the dollar strengthens The USD was flat in the first half of 2014, hampered

by the weather related economic softness in the first quarter and low Treasury yields in recent months

7) Be selective in Emerging Markets Smaller frontier markets outperformed broad

emerging markets, particularlly the BRICs✔

8) An expanded investment toolkit offers downside protection and diversification

Market volatility stayed low in the first half of the year, while markets rallied—this left little benefit for downside protection in the beginning of the year

9) Hedge funds and private equity beat commodities Commodities rebounded, supported by higher energy

prices from a cold winter, outperforming both hedge funds and private equity

10) Tax awareness pays off Taxes continue to be a drag on investment as tax

aware investing helps mitigate the drag✔

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CIO REPORTS • The Monthly Letter 3

Theme #1: Equities again outshine bondsEquities continue to outperform bonds and most other asset

classes; we believe this pattern will hold as monetary policy

remains accommodative and the economy continues to improve.

Equities remain supported by improving earnings driven by

stronger economic growth. However, relative valuations,

reflected in a large risk premium, remain another key argument

for holding equities as the high premium may translate into

higher absolute valuations (see Exhibit 3).

Earnings expectations for this year have stabilized in most

regions with the exception of Europe. Our colleagues on the

BofAML Global Research European Equity Strategy team

have downgraded their 2014 earnings growth forecast to 9%,

reflecting the weak economic growth at the beginning of the

year. Earnings expectations now seem reasonable given the

potential for growth from the operating leverage of European

companies.

Equities will likely remain susceptible to headline risks through

year-end and investors with significant gains or an overweight

equity positioning may consider taking profits off the table.

Investors who remain underweight equities might consider

using any sell-offs in the equity market to add to positions.

Theme #2: Invest in ‘Team USA’ – Tech, Energy, Autos and ManufacturingAn improving economy and accommodative monetary policy

suggest positioning equities toward cyclical U.S. sectors that

historically benefit from stronger household and corporate

spending. In our 2014 Outlook, we identified the areas of

Technology, Energy, Automobiles, and Manufacturing—what we

termed TEAM USA—as likely to benefit the most. A steadily

recovering labor market resulting in higher wages and a decline

in household debt levels should support consumer spending.

Corporate spending, meanwhile, has accelerated, with M&A

activity reaching pre-crisis levels.

Despite a selloff earlier in the year exacerbated by high-beta

Internet and social media stocks, technology has been one of

the best-performing sectors in the first half of 2014. Energy

sector performance has been impressive in the first half of

2014 as oil prices spiked amidst growing geopolitical risks in

the Middle East and Ukraine. We continue to see pockets of

opportunity in the auto industry. June’s seasonally adjusted

annual sales of 16.9 million light vehicles far exceeded industry

expectations, and are the highest since 2005. BofAML Global

Research expects the sales to surprise for the current quarter

too, with strong results across the production chain. Demand

stands to benefit from longer-term trends of an above-average

age of cars and trucks in the U.S. and growing consumer

demand in Emerging Markets.

Theme #3: International equities prove resilientWith U.S. equities at all-time highs, many investors worry

whether they should be chasing them further. It is increasingly

a relative value story and we believe investors can find

compelling relative value in international developed markets.

These markets are attractive to us for several reasons, including

slowly improving economies, favorable relative valuations and

growing investor support. Country-level Purchasing Managers

Indices (PMI) for both manufacturing and non-manufacturing

sectors can provide timely indications of the strength of the

current manufacturing cycle. While these indicators remain

tentative indicators, we are encouraged by the current data,

especially its strength internationally.

Within the international developed markets we continue to

prefer Europe and Japan. We see potential support for Europe

from stability in operating margins arising from a weaker

Euro, and domestic demand within the Euro zone seems to be

improving. Valuations in Japan continue to be attractive relative

to other developed markets and operational leverage remains

high, which is positive for earnings as global growth accelerates.

Currencies are likely to remain volatile over the shorter term as

the timing of the withdrawal of central bank liquidity creates

S&P 500 - Earnings Yield*

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

10.0%

-5.0% -4.0% -3.0% -2.0% -1.0% 0.0% 1.0% 2.0% 3.0% 4.0% 5.0%

1995 1998 2001 2004 2007 2010 2013

Moody’s Baa Corp Bond YieldDifference (Right)

Exhibit 3: Relative valuations remain a key consideration for holding equities

*Earnings yield is the inverse of the 12 month forward price-to-earnings ratio.Source: FactSet, Haver Analytics and ML GWM Investment Management & Guidance.Data as of 2Q 2014. Past performance is not a guarantee of future results.

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CIO REPORTS • The Monthly Letter 4

uncertainty. We believe investors should consider hedging

foreign currency exposure.

Theme #4: The equity rotation within the Great Rotation continuesOur advice on economically sensitive cyclical sectors

was based on a backdrop of accelerating global growth.

Unfortunately this view was challenged by a harsh winter

that contributed to U.S. GDP contracting by 2.9% on an

annualized basis in the first quarter. Combined with bond

yields that surprisingly have fallen since December, the

already-expensive defensive sectors of consumer staples

and utilities outperformed (see Exhibit 4). However, BofAML

Global Research expects growth to rebound to 3.2% in 2Q,

and to improve in the second half to 3.0%. Stronger economic

growth, supported by lower macro uncertainty, will likely help

revive the outperformance of cyclicals over defensives in the

second half.

We continue to favor U.S. mega-cap multinational companies

that should benefit from rising global trade. Large-cap stocks

handily outperformed small- and mid-caps year-to-date, and

according to the BofAML Global Research U.S. Equity Strategy

team, multinationals are still under-owned and their valuations

are relatively attractive. Large caps also tend to outperform

in periods of market turbulence, and we may see investors

“scale up” as equity volatility approaches multi-decade lows and

market complacency remains high.

Theme #5: Fixed income is challenged by greater interest rate volatilityThe fixed income environment continues to be characterized by

low interest rates and volatility, with credit spreads and volatility

having reached the levels of 2005 and 2006 and, by some

metrics, even 2007, and some strategists suggesting we are at

the peak of complacency (see Exhibit 5).

Our BofAML Global Research Rates Team expects interest rates

to rise into year-end. Its current forecast calls for the yield on

the 10-year Treasury bond to increase from today’s 2.5% to

3.5% by year-end. This projection assumes the U.S. economy

will continue its solid pace of expansion and grow at an annual

rate of 3.0% in the second half. The restrained volatility is

consistent with the current stage of the business cycle but

over the medium-term we expect it to increase along with the

gradual economic recovery. We agree that with higher rates

there will be periodic increases in volatility and spreads, but that

it’s unlikely that volatility will return to pre-crisis levels.

The term premium appears depressed relative to fundamentals;

we expect a higher one in the front-end of the U.S. yield curve

MOVE Index (Right)10 Year Treasury Yield

40

50

60

70

80

90

100

110

120

130

1.5

1.7

1.9

2.1

2.3

2.5

2.7

2.9

3.1

Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 Apr-14 Jul-14

Exhibit 5: Fixed income volatility has subsided since rising with higher bond yields in Spring 2013 as taper talks rose

Source: Bloomberg and ML GWM Investment Management & Guidance. Data as of July 11, 2014. Past performance is not a guarantee of future results.

1Q 2014 2Q 2014

-4.0 -2.0 0.0 2.0 4.0 6.0 8.0

10.0 12.0 14.0

ConsumerDiscretionary*

Industrials* Telecom^ ConsumerStaples^

Energy* S&P 500 InformationTechnology

Financials Materials* Health Care^ Utilities^

Tota

l Ret

urn

(%)

Exhibit 4: A tale of two quarters; defensives led in the first quarter, while in the second quarter cyclicals started to outperform

*Denotes a cyclical sector. ^Denotes a defensive sector.Source: FactSet and ML GWM Investment Management & Guidance. Data as of 2Q 2014. Past performance is not a guarantee of future results.

Page 5: CIO REPORTS The Monthly Letter - Merrill€¦ · Letter we offer an update on those themes, including a scorecard, and review the year to date with an eye to what may transpire in

CIO REPORTS • The Monthly Letter 5

with an uptick in volatility caused by the Fed’s reliance on

economic data in planning interest rate increases. To manage

fixed income risk, we recommend investors consider absolute

return strategies and bond laddering. We continue to see value

in municipal securities, particularly given their attractive tax-

equivalent yields.

Theme #6: “Bigger bang for your buck” as the dollar strengthensOur initial 2014 outlook for a stronger dollar has been

challenged. On a trade-weighted basis, the USD is flat so

far this year, having steadily declined from its peak in early

February. This move can be explained in part by the weather-

related economic softness in the first quarter and low Treasury

yields in recent months, but stands in stark contrast to the

market’s bullish view going into the year.

The June employment report strengthened the outlook of

our BofAML Global Research FX team, which calls for a

stronger dollar in 2014. It’s based on continued labor market

improvements alongside a pickup in growth leading to increased

inflation and less accommodative monetary policy in the U.S.

than other G10 countries.

An often-overlooked benefit of a stable dollar is the help it

provides U.S. multinational companies in managing their foreign

exchange exposure. If exchange rates hold at current levels, we

could see a modest boost to earnings growth from the strong

Euro and British Pound.

Theme #7: Be selective in Emerging Markets Another one of our key themes at the beginning of the year

was to be selective in Emerging Markets, and it has been

borne out as smaller frontier markets have done well while

the BRICs (Brazil, Russia, India and China) have struggled

(see Exhibit 6). After a rapid acceleration of growth in 2010

and 2011, the pace of expansion of many EM economies

has slowed considerably. This softer economic activity in

the developing world, combined with considerable political

uncertainty and potentially rising U.S. interest rates, has

weighed on returns from EM assets. The dispersion of country

performance within EMs and their broad underperformance,

especially within the BRIC markets, has left these regions

trading at modest valuations.

We see some positives over the medium term, but also many

risks, including rising U.S. rates, which could create a speed

bump for nations with weaker fiscal balances. However, higher

rates, variations in domestic demand and differentiated export

volumes will not have the same effect on growth for each

country. Positioning by country will be more important going

forward, but the cost of being wrong is very high. An active

manager with the research expertise to go beyond index

exposure and currency overlay remains our preferred approach.

Those investors who want to pick specific countries and sectors

should consider sticking to macro and corporate fundamentals.

With our BofAML Global Research Emerging Markets Strategist,

we prefer countries with strong fiscal positions and resilient

demand for their goods and services abroad. We still believe

frontier markets provide a more attractive growth opportunity

than the larger countries.

Theme #8: An expanded investment toolkit offers downside protection and diversificationOur optimism for equities comes with a cautious tone, as

stocks have had a nearly uninterrupted run in the last few

years. We believe the markets may be particularly sensitive

to disappointing headlines, either macroeconomic or political,

given that indicators of market stress and financial stress

remain close to all-time lows (see Exhibit 7). Anticipation of

the Fed’s next move could result in higher volatility for asset

classes that have benefited from the central bank’s ultra-

accommodative policies and where valuations have diverged

from underlying fundamentals.

Investors can protect against adverse policy shocks in

accordance with their investment goals by expanding the

breadth of their investment toolkit. One direct approach

MSCI BRICsMSCI Frontier MarketsMSCI Emerging Markets

85

90

95

100

105

110

115

120

Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14 Jul-14

Norm

alize

d to

100

(1/1

/201

4 =

100)

Exhibit 6: Emerging Markets, especially BRICs, have underperformed developed and Frontier Markets

Total return data in USD.Source: Bloomberg and ML GWM Investment Management & Guidance. Data as of July 11, 2014. Past performance is not a guarantee of future results.

Page 6: CIO REPORTS The Monthly Letter - Merrill€¦ · Letter we offer an update on those themes, including a scorecard, and review the year to date with an eye to what may transpire in

CIO REPORTS • The Monthly Letter 6

to downside risk management is to include holdings with

explicit downside protection, through option strategies, where

appropriate, or through market-linked investments. Another

technique is adopting a core-satellite approach to portfolios,

where the core represents the high-conviction set of positions

and the satellite the more tactical positioning.

Theme #9: Hedge funds and private equity beat commoditiesAt the beginning of the year our BofAML Global Research

Commodity Team expected a modest decline in a broad array of

commodity prices in 2014, caused by Fed tapering, higher U.S.

rates, a stronger dollar, slowing economic growth in China and

oversupply. So far, however, commodities have surprised as a

top-performing asset class. Below headline index levels, returns

for various commodities are widely dispersed. Oil and industrial

metals have performed well, while agricultural commodities

have struggled, constrained by concerns with oversupply.

Some of the strength in the broad commodity indexes this

year can be attributed to weather disruptions, particularly gains

in energy prices, and we think the out-performance may not

continue for long. The BofAML Global Research Commodity

Team expects discrepancies to continue, with flat to slightly

higher prices for energy commodities but more strength for

base metals.

The increase in the dispersion of returns within equity sectors

indicates that stock-picking is again becoming more important

than sector allocation. Equity long/short funds that focus on pair

trading and relative value within sectors and countries could

benefit from such periods of low correlation.

With strong M&A activity this year, event-driven has been one

of the top-performing hedge fund styles, rising 4.4% vs. 1.8%

for the hedge fund index, and we think it is likely to continue to

capitalize on such activity going forward.1

Theme #10: Tax awareness pays offTaxes can significantly erode returns, costing investors

approximately two percentage points annually (see Exhibit 8).

Last year brought a new regime of tax rates, including a 3.8%

Medicare surtax on most investment income. Of our themes

for 2014, tax-aware investing remains at the top of the list. We

believe tax management can be an effective way of enhancing

after-tax returns as long as it is accomplished as part of a

disciplined portfolio management process rather than in isolation.

Asset allocation and wealth structuring should be addressed

before moving on to the tax management decision.

We don’t intend to provide an exhaustive list of tax strategies,

but advise investors to speak with their financial advisor and

tax advisor, and highlight three starting points: tax-advantaged

asset classes, tax-efficient investment vehicles and tax planning

strategies. Just focusing on these three areas may go a long

way toward improving after-tax returns.

Summary: While weak economic data in the first half of the

year resulted largely from weather and one-off factors, going

forward markets will look for improvement in fundamentals

to support price appreciation. While there is the potential for

1 Event driven hedge fund index = HFRX Event Driven Index. Hedge fund index = HFRX Global Hedge Fund Index. Data as of June 30, 2014.

10.1%

7.3%

5.4%

3.1%

Stocks Stocks after taxes Bonds Bonds after tax0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

Exhibit 8: Tax drag on investment returns (1926-2013)

75% of the stocks’ return is assumed to be taxed at long-term capital gains rate of 23.8% and 25% of the return taxed at the short-term income rate of 43.4%.Bonds are assumed to be taxed at the short-term income rate of 43.4%. Tax rateincludes the new 3.8% health care tax. Stocks are represented by the S&P 500Index. Bonds are represented by the 10-year Treasury bond.Source: Bloomberg, Robert Shiller, ML GWM Investment Management & Guidance.Past performance is not a guarantee of future results.

S&P 500 Realized Volatility (30 Day)

0 10 20 30 40 50 60 70 80 90

100

1928

19

31

1934

19

37

1940

19

43

1946

19

49

1952

19

55

1958

19

61

1964

19

67

1970

19

73

1976

19

79

1982

19

85

1988

19

91

1994

19

97

2000

20

03

2006

20

09

2012

4th Percentile

Exhibit 7: The economic landscape continues to point to low volatility, but change in sentiment or a policy misstep could bring a shift

Source: Bloomberg and ML GWM Investment Management & Guidance. Data as of June 30, 2014. Past performance is not a guarantee of future results.

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CIO REPORTS • The Monthly Letter 7

concern over the U.S. mid-term elections to be felt in the

markets, we believe the impact of politics will be more limited

than in previous years due to improving economic growth,

employment and fiscal conditions.

Our outlook continues to be guided by our belief the U.S.

economy is gradually strengthening and the Fed is committed

to keeping monetary policy accommodative, as long as data

is supportive, into 2015 and the first half of 2016 to nurture a

sustainable recovery. However, investors may consider taking

profits off the table given the large volatility in equity gains over

the past couple of years, particularly if their positioning has

drifted away from strategic allocations. For investors who are

underweight equities, any pullbacks could be used to rebalance

into them and bring their positioning back to strategic allocations.

Portfolio Positioning: For the rest of 2014, we continue

to prefer equities over fixed income and corporate

balance sheets (equities and high yield bonds) along with

municipals over government balance sheets (Treasuries

and other sovereign holdings). Within equities, we have

benefitted from our bias towards the U.S. but we continue

to re-allocate towards international developed markets.

While we see opportunities in equities abroad, we also

see risks rising as select indicators, such as valuations

in Europe, look less attractive than six-to-twelve months

ago. We believe the market rotation towards cyclical

sectors that began last year will persist through 2014 and

advise investors who have not already done so to consider

repositioning there. Within bonds, our focus remains on

low duration, taking credit risk over interest rate risk and

employing opportunistic active managers focused on total

returns rather than benchmarks.

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CIO REPORTS • The Monthly Letter 8

Continuing our interviews with distinguished investors, we spoke with Larry Fink, Chairman and Chief Executive Officer of BlackRock, the largest money-management firm in the world by assets under management. Prior to founding BlackRock in 1988, he was a Managing Director of The First Boston Corporation, which he joined in 1976, quickly becoming one of the first mortgage-backed securities traders on Wall Street. He is a trustee of New York University and the NYU Langone Medical Center and serves on the boards of The Museum of Modern Art and the Council on Foreign Relations.

Ashvin Chhabra: Let’s start with the world we live in today—many investors have the view that bond yields are too low, and ask, “Isn’t holding bonds risky in the long term compared to the returns we’re getting?” Our belief is that bonds are expensive, but that just means that the price of insurance has gone up. The world is uncertain, and is demanding a very high premium for safety.

Larry Fink: That’s true, but it’s not just insurance; the equilibrium as we know it has changed. When you take into account the amount of bond purchases from central banks, the vast growth of holdings by sovereign wealth funds and governments like China, and the vast deleveraging from banks, you have a huge shrinkage of outstanding bonds. Once central banks begin to change course, you will have more supply, but that will be mitigated as the fiscal deficit is shrinking dramatically at the same time, and low rates in Europe will keep downward pressure on yields in the U.S. So you have these incredible trends which will keep interest rates low for a long time.

Ashvin: One of our initiatives at Merrill is “A Transforming World”—themes that we think will last over a decade or two. One can think of the world as three big revolutions: the agricultural, the industrial, and now the digital revolution. That speaks to a whole different set of ways of measuring the economy, including looking at the jobless rate and job retraining. Do you believe this is one of the reasons why it’s so hard to get the unemployment figure down—that there is a fundamental dislocation between the kinds of jobs that are required and the unemployed?

Larry: There’s no question that technology is killing jobs, particularly among less-skilled workers. At the same time, technological change creates a demand for different jobs, and there is actually a labor shortage among certain skilled trade segments. One of the flaws of the Federal Reserve’s policy is that they have not admitted that there is structural unemployment, meaning these headwinds are not likely to be tangibly improved by continued monetary policy. While the Fed has spent $4 trillion, we still have not seen as robust growth in the economy as we expected.

Ashvin: Quantitative easing is a very blunt instrument to push down the unemployment rate. In fact, the Fed can keep spending more money, and if unemployment is a structural issue, they’re not going to be able to push it down.

Larry: Central bankers have worked hard to put us in the place that we are in today and that’s a massive positive. However, going forward, the Fed’s ability to really spur employment is going to be limited, and we are going to need better, more proactive fiscal policy. And this is true globally as well. We’re likely to see a lot more divergence among central bankers, and for the global economy to grow at a faster rate, it’s going to require good government policies. Of course, fiscal policy is a lot more unpredictable, and that is going to create much more of a fragmented world as those countries that implement successful reforms will outshine those that don’t.

Ashvin: Can you give us some examples of countries that have been successful in implementing reforms?

Larry: Sure. Mexico is a good example of a country that appears to be doing the right thing. They have initiated some tremendous reforms. If they all go through, we could see Mexico become one of the real beacons of growth in the world. India’s Prime Minister Narendra Modi is another example of a potential leader who is now trying to break a 50-year tradition of economically stifling bureaucracy. In Japan, if Shinzo Abe is successful in fully implementing his program of reforms, the nation could finally break out of its long doldrums.

A conversation with Larry Fink* CIO InsightsInsights and the best thinking from distinguished investors around the world.

Larry Fink

Chairman and Chief Executive Officer of BlackRock

Ashvin B. Chhabra

Chief Investment Officer, Merrill Lynch Wealth Management

* The views and opinions expressed are those of the speaker, are subject to change without notice at any time, and may differ from views expressed by Bank of America Corporation, Merrill Lynch, Pierce, Fenner & Smith Incorporated, or any affiliates. This interview is presented for informational purposes only and should not be used or construed as a recommendation of any service, security or sector. Before acting on the information provided, you should consider suitability for your circumstances and, if necessary, seek professional advice.

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CIO REPORTS • The Monthly Letter 9

Ashvin: What about governments that are behind the curve?

Larry: The US economy could grow at 4%-4.5% if Washington was actually doing things to stimulate the economy beyond the Federal Reserve’s accommodative monetary policy. If you had proper immigration reform, that could free up 11 million people to be more productive in society. If you could allow those who are graduating to have green cards, that could be quite additive to the economy. If real tax reform were pursued, that would stimulate more companies coming into the US. China is another example of a country in desperate need of reform. It needs to develop a domestic economy, as it cannot rely on its export economy anymore. However, it is hindered by an extremely high savings rate, because the safety nets for retirement and healthcare are inadequate. China has initiated 10 years worth of reforms, but the first thing they’re tackling is corruption. They have to focus on corruption before they can move forward. I’m confident they’ll be able to do so, but it’s not without a lot of risk.

Ashvin: You’ve gone around the world and given a picture of countries with very different demographics. The U.S. has good demographics relative to other developed economies, which of course brings us to the flip side of the success of healthcare. People are living longer, and the math of retiring at 65 and the current level of savings don’t add up. Do you foresee this to be an issue longer term?

Larry: I would contend that the two biggest problems in the economy we face going forward are retirement and student debt, and they have very important correlations. One of the drags on retirement is that parents reduced their long-term savings because of their children’s education. The average levels of student debt have increased over time, which is also delaying the ability of college graduates to buy a home. That is why homebuilding is not growing at the same level as it was. The bottom line is that there’s just not enough savings beyond Social Security and because of this inadequacy of savings, people are working longer.

If you expect that you’re going to live to 90, that changes your savings and investment patterns. Even if you’re 50, you should have a reasonable allocation to equities, unless you are getting something that earns you 6% or 7% in bonds. This is hard to achieve unless you’re investing in something pretty risky.

Ashvin: At the firm, we’ve embraced the idea of goals-based investing. Instead of being market-centric and trying to beat a market benchmark, we advise clients to understand their life priorities and then create an appropriate investment strategy.

Larry: I agree. Every investment strategy should pertain to the client’s goal. If you’re saving for your children’s education, that’s an 18-20 year outcome if your child was just born. If you’re saving for a down payment on a new house, that’s a 5- to 7-year timeline. If you’re saving for retirement, that’s a 40-year outcome. That’s what we need to get our clients to think about, not the hot topic of the moment. We as humans are so connected to information, we are having a hard time figuring out how to use that information and apply it to different time horizons. And the problem is that most of that information is just noise.

Ashvin: What other asset classes do you like and what are you cautious on, when it comes to constructing long-term portfolios?

Larry: When people talk about risk management, no one discusses the cost of being in cash for the past five years. Inflation has been very low for a long time, and people can easily forget how much it can devalue their cash holdings. Cash is not risk-free; if your timeline is 40 years, cash is a very risky instrument.

I like real estate, but in some of the non-core areas of the world. Real estate in some of the larger cities has become a store of wealth. Although much of the excess leverage that has depressed home prices since 2008 has been stripped out; as I mentioned before, two factors inhibiting home ownership are student debt and our immigration policies. In order for real estate prices to move higher, the demand component needs to change.

I also like agriculture as a long-term theme. We’re losing arable land, we have a rising middle class worldwide, and people’s dietary preferences have changed to favor proteins, which has boosted the demand for grains as feedstock. It’s an easily investible theme; you can invest in large multinational companies involved in agriculture.

Ashvin: Larry, what do you perceive to be the secret to your success?

Larry: The relentless thirst for information—and interacting with people in ways so I get the most out of that information. You learn more from open conversations, because you have to have the ability to triangulate information. The problem is people are too dependent on emailing. When someone emails me, I pick up the phone and call them back. Emails are one-dimensional, you don’t get an understanding of the intent and nuance underneath the words.

A conversation with Larry Fink* (cont’d)CIO InsightsInsights and the best thinking from distinguished investors around the world.

* The views and opinions expressed are those of the speaker, are subject to change without notice at any time, and may differ from views expressed by Bank of America Corporation, Merrill Lynch, Pierce, Fenner & Smith Incorporated, or any affiliates. This interview is presented for informational purposes only and should not be used or construed as a recommendation of any service, security or sector. Before acting on the information provided, you should consider suitability for your circumstances and, if necessary, seek professional advice.

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CIO REPORTS • The Monthly Letter 10

10

1 Equities again outshine bonds Accommodative monetary policy, lower fiscal drag, strong corporate fundamentals and low interest rates should enable equities to outperform bonds once again.

6 “ Bigger bang for your buck” as the dollar strengthens Stronger growth and a less dovish Fed (relative to other developed market central banks) should support a stronger U.S. dollar. The unsynchronized withdrawal of central bank liquidity likely will cause greater foreign exchange market (FX) volatility. Investors should benefit from hedging foreign currency exposure.

2 Invest in ‘Team USA’ – Tech, Energy, Autos and Manufacturing In the U.S., drivers of the next leg of growth should include secular factors such as energy independence and the resurgence of domestic manufacturing as well as cyclical ones such as the business investment cycle and pent-up household demand.

7 Be selective in Emerging Markets We favor EM equities over EM bonds on more supportive valuations. Lower central bank liquidity could hurt countries with the greatest dependence on external creditors. Weaker currency would present headwinds for EM bond returns.

3 International equities prove resilient Despite strong performance recently, these markets should continue to benefit from recovering economies and earnings growth along with further central bank easing.

8 An expanded investment toolkit offers downside protection and diversification As sentiment and consensus forecasts are bullish, investors should consider protecting against adverse events with option strategies, market-linked investments and non-traditional mutual funds.

4 The equity rotation within the Great Rotation continues Within equities, there should be more of the rotation that began in April 2013, which supports select cyclicals over defensives. In the U.S. we also favor large cap over small cap and multinationals.

9 Hedge funds and private equity beat commodities a. Equity Long/Short is poised to benefit in an

environment of reduced correlation. Relative value and Global Macro enhance diversification and are less correlated with traditional asset classes.

b. While the bank lending environment will be restrained, private lending may fill that gap. Investors should be sufficiently compensated for lack of liquidity.

5 Fixed income is challenged by greater interest rate volatility Driven by tapering from the Fed, bond volatility is likely to increase, favoring asset classes that can absorb higher rates, specifically high yield and municipals.

10 Tax awareness pays off A combination of moderate returns and higher tax rates increases the value of tax-aware investing.

PORTFOLIO THEMES FOR 2014

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CIO REPORTS • The Monthly Letter 11

* Many products that pursue Alternative Investment strategies, specifically private equity and hedge funds, are available only to pre-qualified clients.

ASSET CLASSOFFICE OF

THE CIO VIEW COMMENTS

Global EquitiesFurther upside expected in 2014, based on improving economic and earnings growth and valuations, which remain close to fair value. However, return expectations for 2014 should be lower than 2013.

U.S. Large CapFair valuation and improved economic growth to support globally exposed cyclical sectors; preference for energy, tech and industrials.

U.S. Mid & Small CapSmall cap valuations, both absolute and relative to large cap, are extended. Select opportunities for active managers remain. Prefer mid-caps over small-cap stocks.

International DevelopedPositive on Europe as growth improves and profit margins expand from depressed levels; Japan to benefit from continued reflationary “Abenomics”.

Emerging MarketsStructural headwinds remain as global liquidity eases; go beyond index and BRIC exposure to include frontier markets.

Global Fixed IncomeBonds continue to provide diversification, income and stability within total portfolios. However with higher prospective fixed income yields and volatility, our preference is to remain flexible.

U.S. TreasuriesPrefer to be short duration as longer maturity yields rise on better global growth. Current valuations are stretched especially on longer maturities.

U.S. MunicipalsValuations relative to Treasuries remain attractive and tax-exempt status is not likely to be threatened in the near term; advise a nationally diversified approach.

U.S. Investment GradeCurrent valuation doesn’t offer much room for spread tightening and leaves investment grade more susceptible to rising rates.

U.S. High YieldHigh yield still offers a relatively attractive profile given a low corporate default outlook. One of our preferred segments within fixed income.

U.S. CollateralizedHigher rates and the start of Fed tapering are likely to increase spread volatility. Continued improvement in housing to present select opportunities in non-agency MBS.

Non-U.S. CorporatesSelect opportunities in European credit, including financials, however recent strong performance has moved valuations to fair.

Non-U.S. Sovereigns Yields are unattractive after the current run-up in performance; prefer active management.

Emerging Market DebtVulnerable to Fed tapering and lower global liquidity; preference for countries with current account surpluses. Local EM debt likely to remain volatile due to FX component; prefer active management.

Alternatives*Select alternative investments help broaden the investment toolkit to diversify traditional stock and bond portfolios.

CommoditiesOil prices are likely higher, influenced by geopolitical concerns this year. The balance of risk is to the downside for gold and oil prices.

Hedged Strategies

Equity long/short and event driven and credit strategies should benefit from reduced correlation among equities and an increased trend of corporate deal-making. Relative value and global macro strategies offer enhanced opportunity for diversification and uncorrelated profit-making. Event driven from busy deal making environment.

Real EstatePrefer direct real estate investments. Within REITs volatility is likely to increase as rates rise, opportunities remain in industrial and office sectors.

Private EquityThe combination of an improving economy and banks still reluctant to lend provides attractive opportunities that compensates for reduced liquidity.

CashMonetary policy by developed market central banks reduces the attractiveness of cash, especially on an after-inflation basis.

When assessing your portfolio in light of our current guidance, consider the tactical positioning around asset allocation in reference to your own individual risk tolerance, time horizon, objectives and liquidity needs. Certain investments may not be appropriate given your specific circumstances and investment plan. Certain security types, like hedged strategies and private equity investments, are subject to eligibility and suitability criteria. Your Financial Advisor can help you customize your portfolio in light of your specific circumstances.

Negative Neutral Positive

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GWM Investment Management & Guidance (IMG) provides industry-leading investment solutions, portfolio construction advice and wealth management guidance. This material was prepared by the Investment Management & Guidance Group (IMG) and is not a publication of BofA Merrill Lynch Global Research. The views expressed are those of IMG only and are subject to change. This information should not be construed as investment advice. It is presented for information purposes only and is not intended to be either a specific offer by any Merrill Lynch entity to sell or provide, or a specific invitation for a consumer to apply for, any particular retail financial product or service that may be available.

This information and any discussion should not be construed as a personalized and individual client recommendation, which should be based on each client’s investment objectives, risk tolerance, and financial situation and needs. This information and any discussion also is not intended as a specific offer by Merrill Lynch, its affiliates, or any related entity to sell or provide, or a specific invitation for a consumer to apply for, any particular retail financial product or service. Investments and opinions are subject to change due to market conditions and the opinions and guidance may not be profitable or realized. Any information presented in connection with BofA Merrill Lynch Global Research is general in nature and is not intended to provide personal investment advice. The information does not take into account the specific investment objectives, financial situation and particular needs of any specific person who may receive it. Investors should understand that statements regarding future prospects may not be realized.

Asset allocation and diversification do not assure a profit or protect against a loss during declining markets.

The investments discussed have varying degrees of risk. Some of the risks involved with equities include the possibility that the value of the stocks may fluctuate in response to events specific to the companies or markets, as well as economic, political or social events in the U.S. or abroad. Bonds are subject to interest rate, inflation and credit risks.

U.S. Treasury inflation-indexed securities are subject to interest rate risk. While you may be able to liquidate your investment in the secondary market, you may receive less than the face value of your investment. Investments in high-yield bonds may be subject to greater market fluctuations and risk of loss of income and principal than securities in higher rated categories. Investments in foreign securities involve special risks, including foreign currency risk and the possibility of substantial volatility due to adverse political, economic or other developments. These risks are magnified for investments made in emerging markets. Investments in a certain industry or sector may pose additional risk due to lack of diversification and sector concentration. Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates, and risk related to renting properties, such as rental defaults. There are special risks associated with an investment in commodities, including market price fluctuations, regulatory changes, interest rate changes, credit risk, economic changes and the impact of adverse political or financial factors. Investment returns may fluctuate and are subject to market volatility, so that an investor’s shares, when redeemed or sold, may be worth more or less than their original cost. Market-Linked investments have varying payout characteristics, risks and rewards, and investors need to understand the characteristic of each specific investment, as well as those of the linked asset. MLIs can be complex, involve fees and expenses, and may not be suitable for all investors. Options involve risk and are not suitable for all investors. Before engaging in the purchase or sale of options, investors should understand the nature of and extent of their rights and obligations and be aware of the risks involved in investing with options. Prior to buying or selling an option, clients must receive the options disclosure document Characteristics and Risks of Standardized Options.

Alternative Investments are speculative and subject to a high degree of risk. Although risk management policies and procedures can be effective in reducing or mitigating the effects of certain risks, no risk management policy can completely eliminate the possibility of sudden and severe losses, illiquidity and the occurrence of other material adverse effects.

© 2014 Bank of America Corporation. All rights reserved. AR4VKK5R

Mary Ann Bartels CIO, Portfolio Solutions, U.S. Wealth Management

Christopher J. Wolfe CIO, Portfolio Solutions,

PBIG & Institutional

Ashvin B. ChhabraChief Investment Officer, Merrill Lynch Wealth Management

Head of Investment Management & Guidance

OFFICE OF THE CIO

Hany Boutros

Vice President

SarahBull

Vice President

Niladri “Neel” Mukherjee

Director

JohnVeit

Vice President