BofA Merrill Lynch On FX In 2010 & S&P500 Targets

Year's end is approaching and everyone is preparing obligatory 2010 predictions. No exceptions for FX team at BofA Merrill Lynch(ed) as they write in a summary today:

Overview: USD rallies but the JPY may steal the show
The macro economic backdrop is, in our view, set to become less USD negative in 2010. Middle-way conditions should gradually give way to a right of middle environment that is more challenging for high beta currencies and risky assets. Our forecasts embody several important correlation breaks. The USD is likely to become less negatively correlated with risk appetite as reserve manager flows weaken. The JPY is expected to strengthen broadly even as global equities gain. Cross rates are set to become more volatile.

Theme 1: Time to share the burden
Reserve accumulation by EM central banks has, in our view, created a significant distortion in the relative valuation of EM and G10 currencies. The current system of exchange rate management is, however, now encountering limits. As China embarks upon reform, other EM countries will also likely reduce their FX intervention. This will eventually reduce reserve manager demand for EUR allowing the valuation distortion to start to unwind.

Theme 2: Asia’s granddad stirs
We have changed our view and become contrarian JPY bulls. The change is motivated by our expectation that the US Federal Reserve will remain on hold through 2010 as well as a flow of funds based assessment that demand for JPY from longer-term investors and trade flows is likely to strengthen in the quarters ahead.

Theme 3: Differentiation at last
We believe 2010 will bring a more discerning approach among both underlying asset market and currency investors. A receding liquidity tide may expose currencies that have rallied on excess liquidity rather than fundamental strength.

Theme 4: Know your limits
Recent USD weakness is not, in our view, a precursor to an accelerated secular decline. We believe the risks from the policy response to the financial and economic crisis are both manageable and non-unique. USD downside risk is also curbed, in our view, by a likely aggressive policy response to further weakness that is concentrated against G10.

Volatility viewpoint
We expect G10 implied volatility to continue its trend downwards throughout much of 2010 based on declining risk aversion and realized volatility. Nevertheless as markets transition from middle-way to the right of middle-way, we expect vols. to settle into a higher regime compared to the pre-crisis environment.

Click on picture to enlarge, courtesy of BofA Merrill Lynch.

BTW, the US equity bulls at BofA Merrill Lynch, led by David Bianco, raised S&P500 targets yesterday:

We raise our 2009, 2010 and 2011 S&P 500 EPS estimates to $63, $73, and $83 from $61.50, $70 and $80, respectively. We also raise our “2010 normalized EPS” estimate to $79 from $76. Hence, we raise our 12-month S&P 500 target to 1275 from 1200 on higher “2010 normalized EPS” and moving forward in time.

And they cannot see a correction in the near-term:

We expect the S&P 500 to finish 2009 at a little over 1100. We do not expect a yearend correction because the earnings and interest rate support is very strong.

Final 3Q09 S&P 500 EPS came in at $16.80, above our $16.00 estimate set in late September. This 3Q09 quarterly EPS represents 6 - 7% sequential growth achieved against a real US GDP backdrop that is likely to be revised down to ~2.5%. We now expect 4Q09 EPS to be $17.32 or about $70 annualized against ~3.5% BofAML 4Q09E US GDP. If the S&P 500 is capable of generating ~$70 in annualized EPS just 1-2 quarters into the recovery than we feel very comfortable that EPS can be $73 and $83 in 2010 and 2011 with several more quarters of slow economic growth. EPS will be highly levered to growth in 2010 and 2011.

At about 1100 the S&P 500 is trading at 15.5x annualized 4Q09E EPS of ~$70. At 15-16x current quarter annualized EPS, the market should climb as quarterly EPS climbs because 15-16x immediate EPS is undemanding when the 10yr Treasury bond yields less than 5% and especially with it under 3.5%. As confidence rises in this being the start of a multiyear expansionary cycle, investors will think more about 2011 and even 2012 S&P 500 EPS and this will provide the market ample headroom to appreciate in 2010.

So, everyone is invited now ...