Posted by on October 13, 2017 4:33 pm
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Categories: 8.5% B+ bank of america Bond Bond Volatility Business Central Banks Economy European Central Bank Market Sentiment Mexico Monetary Policy Money On The Sidelines MOVE stock market U.S. Treasury US Federal Reserve Volatility

One week ago, BofA chief investment strategist Michael Hartnett laid out his reasoning for why a market correction is imminent:

  • Global stock market cap up a massive $18.5tn (= US GDP) since Feb’16 lows
  • 3P’s (Positioning, Profits, Policy) thus closer to peak than trough: BofAML Bull & Bear Indicator was 0 in Feb’16, now 6.9; global EPS growth was -6% YoY in early- 2016, now 14% YoY; $2.0tn of asset purchases by central banks YTD but Fed & ECB will taper next 6 months
  • Q4 “top” in equities and credit driven by:
    • a. pricing-in of US tax reform (= peak Policy),
    • b. rise in MOVE index (= peak Positioning),
    • c. rally in oil + trough in Chinese RMB + upgrades to global GDP (= peak Profits)
  • Tax reform = “peak policy” = buy rumor, sell fact; passage of reform or cuts = quicker Fed balance sheet reduction + less share buybacks as capex accelerates; US equities lose 2 big tailwinds next year (since 2009 lows S&P equity market cap up $15.3tn, Fed’s balance sheet up $4.5tn, share buybacks up $3.5tn)
  • Big jump in the MOVE index of US Treasury market volatility (i.e. “bond shock”) catalyst for cross-asset volatility (QE has neutered impact of bond volatility on equity prices but the negative correlation will return as monetary policy normalizes)

Fast forward to today when… nothing at all has happened, again: stocks are at new all time highs, the VIX is back to a whisker above 8, junk bonds issued by “emerging” countries with unpronouncable names are 5x oversubscribed, and complacency abounds despite the world being one tweet away from nuclear war.

There are two discrete reasons for this:

The first is that the great rotation – of bagholders – is in its final stretch as institutions dump in near record volume to retail investors. According to EPFR data cited by BofA, last week saw a “big” $11.6 billion in inflows to equities (largest since Jun’17), as well as $5.5bn into bonds, $0.4bn into gold.  One caveat: it wasn’t just institutions selling to retail (ie. the active to passive rotation) as last week also saw the first inflow into active funds after 10 weeks of outflows, amounting to $2 billion (chart 2) although Passive still remains king, with $9.6 billion into ETFs.

The second reason is that contrary to popular opinions, fighting the Fed is not only accepted, but extremely profitable. In fact, as Hartnett notes, the “Most Consensus Trade in the World right now is “no fear of the Fed…Fed dots to 2019 = 2.7% vs 1.8% market-implied Fed Funds rate.” The saying may go “don’t fight the Fed” but fighting the Fed’s dots has been the most profitable trade for the past 5 years.

To Hartnett this “lack of fear in the Fed” means that the Bubble in Yield (and stocks) will continue until investors, via inflation, begin to fear the Fed (& ECB…). Judging by bond yields, this is not happening: $0.98tn inflows into IG+EM debt funds past 10 years (Chart 3); this week sees 42nd consecutive week of IG bond fund inflows; inflows to EM debt funds 37 of past 38 weeks.

As an example of this fear manifesting itself, the BofA strategist reminds us of 1994: “Most obvious catalyst for sell-off is wage/inflation data that brings back “fear of Fed” in 1994-redux (“payroll” shock…Fed hikes 50bps…yields & MOVE index soared…risk assets tanked…until Orange County/Mexico defaults caused Fed to stop tightening – Chart 4); Sept 0.5% MoM AHE = stronger wage growth

However, it’s not just a sudden burst of inflation that can upset the cart, and according to BofA there are two other 11th hour catalysts that can lead to the “Humpty Dumpty scenario.” Hartnett calls them “Tick Tocks” and they are both positioning related: in the first case, the BofA “Bull and Bear” indicator is just shy of hitting a “sell signal.” This would be notable as the indicator’s hit ratio is flawless, resulting in a selloff on 11 out of 11 previous cases, as follows:

  • Tick-tock I: BofAML Bull & Bear Indicator rises to 7.4 on more bullish positioning in each of the 5 components; drop in FMS cash next week to 4.4% + acceleration of current $5bn flows a week to HY +  equity funds to >$10bn would trigger B&B “sell” signal; note since 2001 there have been 11 BB “sell signals”; hit ratio = 11/11; median MSCI ACWI losses thereafter 5.9% (1-month), 8.5% (2-month), 12.0% (3-month)

The second “tick tock” reason is simpler: investors are about to run out of cash, which may come as a surprise to all those who still believe the “money on the sidelines” falacy.

  • Tick-tock II: Global Wealth Management private client equity allocation up to 60.6%, just shy of 63% all-time high; GWIM cash falls to new low of 10.3%

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