Posted by on November 21, 2016 4:08 pm
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Categories: Bear Market Bond Bond Volatility Book Value British Pound Business Central Banks China Deflation Demographics Economy European Central Bank flash g7 genetic engineering Inflation Interest rates Investment Grade japan Macroeconomics Main Street Mathematical finance Mexico Monetary Policy money NBI Nominal GDP Price Action Quantitative Easing Real estate Real interest rate Recession recovery REITs Renminbi US Federal Reserve Volatility

Over the past year, Bank of America’s chief investment strategist Michael Hartnett has often repeated that when looking at the “transforming word”, one core theme that emerges is the rotation away from monetary to fiscal policy, and from “Wall Street”-focused strategies to “Main Street.” Now, under the Trump presidency, his vision may be validated. On a report “peak returns, big rotations” he shares BofA’s asset allocation under the new regime for 2017 as follows: long stocks (except in North America where he is bearish), real
estate, commodities, and the U.S. dollar, while shorting bonds.

Among his suggested trades are long inflation, short deflation; long Main St., short Wall St.; long fiscal winners, short “ZIRP” winners; long real assets, short financial assets. Hartnett also lays out the expected returns these various trades: low/negative for bonds, with single-digits for U.S. stocks, commodities, U.S. dollar, EM; sees double- digits for Japan, Europe, U.K. stocks, oil.

Hartnett says. “we believe that for first time since 2006, there will be no big easing of monetary policy in the G7, and that interest rates & inflation will surprise to the upside.”

A summary of the bank’s 7 key themes and trade is shown in the table below:

When looking at 2017, Hartnett says that he expects a year of “peak returns and big rotations” and break out the divergence from 2016 as follows:

In 2016

  • Global interest rates fell to 5,000-year lows; central bank purchases of financial assets topped $25tn (i.e. >GDP of US & Japan); the stock of negatively-yielding global bonds surged to $13.3tn.
  • Quantitative Failure, BREXIT, US election caused policy leadership flip from monetary to fiscal stimulus.
  • A flash EPS recession in H1 was followed by acceleration in wage inflation in H2 (to 7-year highs in US).
  • The greatest bull market in bonds ever likely ended on July 11, 2016 with a 30-year Treasury yield of 2.088%.

In 2017

  • We believe that for first time since 2006, there will be no big easing of monetary policy in the G7, and that interest rates & inflation will surprise to the upside.
  • We forecast acceleration in nominal global growth: BofAML Economics forecast US nominal GDP up from 3% to 4%, non-US up from 6% to 7%.
  • We believe fiscal stimulus accelerates, trade and immigration policies tighten, and wage growth picks up, boosting domestic demand across the G7, and hardening our “buy Main Street, sell Wall Street” theme.
  • Bond losses likely will constrain gains in commodity and stock markets unless Japan, Europe, China GDP/EPS surprises meaningfully to the upside or US productivity surges.
  • We nonetheless expect strong returns from assets tied to inflation, Main Street, fiscal and real assets, despite losses from assets tied to deflation, Wall Street, “ZIRP” winners, financial assets (Table 4).
  • Finally, disruptive technology and aging demographics remain powerful secular forces; they won’t likely prevent a cyclical pick-up in inflation; but they are likely to constrain the magnitude of the rise in rates and inflation.

Which brings us to the seven top investment themes of 2017 according to BofA,virtually all of which seem to have a “Peak” preface – perhaps we have finally reached “Peak” peak.

  1. Peak Liquidity…era of excess liquidity is over
  2. Peak Inequality…more global fiscal stimulus to address inequality
  3. Peak Globalization…free movement of trade, labor, capital ending; FX wars starting
  4. Peak Deflation…secular low point in bond yields now behind us
  5. Trough Volatility…era of “flash volatility” and “pain trades” continues
  6. Peak Passive…active investors to outperform passive investors
  7. Transforming World…CRISPR, robotics, eCommerce constrain inflation upside

And the details:

* * *

Peak Liquidity:

– Long banks (GBKX), short bonds (W0G1)

We believe the era of excess central bank liquidity is ending (Chart 1): Fed will hike, BoJ/ECB “walking back” negative rate policies, central banks feeling political backlash for fueling inequality. In 2017 markets likely will not benefit from a big monetary easing for the first time since 2006. Assets that “lost” under the QE/ZIRP/NIRP regime, e.g. bank stocks, should benefit as central banks retreat and rates rise. Global banks trade on 1X book value versus 4X book for a “bond proxy” sector such as consumer staples.

* * *

Peak Inequality:  

– Long Main St e.g. US homebuilders (S5HOME), short Wall St e.g. REITs (BBREIT);
– Long small cap value (RUJ), short small cap growth (RUO)

Electorates are demanding a new “War on Inequality” by policy makers, which means less taxpayer money being spent on bonds and more money on people via fiscal spending or tax cuts to boost wage growth. We estimate that fiscal easing in Japan, Canada, Korea, Europe, and the US could total more than $1tn of stimulus in 2016/17. And note G6 public investment as a share of GDP is currently at its lowest level since 1948 (Chart 2). As fiscal stimulus accelerates, trade and immigration policies tighten, and wage growth picks up, domestic demand is likely to surprise on the upside. This supports our “buy Main Street, sell Wall Street” theme. A broader recovery in global residential real estate would allow a “good” rise in rates to occur and cause a big rotation to homebuilders from REITs, a huge beneficiary under the QE regime. “Secular stagnation” was similarly highly beneficial for “growth” stocks versus “value” stocks: small cap growth has massively outperformed small cap value since 2006; we expect reversion in 2017.

* * *

Peak Globalization

– Long global small cap (MXWOSC), short US tech (IXK)
– Buy 1-year USDCNH vol
– Long basket of UK, Japan, China, Mexico exporters, short US multinationals

The 1981-2015 era of free trade, capital & labor mobility appears to be coming to an end. Electorates are shifting in an anti-immigration direction. Anti-trade populism is on the rise (a recent poll showed 65% of Americans say trade policies have led to a loss of U.S. jobs, versus 13% who believe trade policies created jobs). BREXIT and the US election represent populist repudiations of the globalist status quo.  Anti-globalization means less deflation, a big positive for global small cap stocks versus the “architects of deflation”, US tech. The rise of populism means trade and FX wars are more likely. To hedge against an escalation of trade tension between China and the US own 1-year offshore Chinese renminbi volatility. And own exporters that will or are likely to benefit from currency devaluations (UK, Japan, China, Mexico) versus US multinationals, which are likely to be pressured by dollar appreciation in 2017

* * *

Peak Deflation

– Long real assets, short financial assets
– Long TIPS (G0QI) vs Investment Grade bonds (C0A0)
– Long Japanese banks (TPNBNK) FX-hedged

The trade of the past 35 years has been lower inflation and interest rates (Chart 3). We believe the greatest bull market in bonds ever ended on July 11, 2016 with a 30-year Treasury yield of 2.088% and “peak” expectations of deflation. In 2017 investors likely will experience a backdrop where inflation surprises to the upside leading to further rotation from entrenched long positions in “deflation assets” to assets that benefit from higher rates and inflation. Real assets should outperform financial assets (the price relative of real estate, commodities, collectibles to stocks and bonds is currently at its lowest level since 1926). Investment grade bonds have been big deflation winners and are currently trading close to 2 standard deviations expensive relative to both Treasuries and TIPS. We expect this excess valuation to unwind. Japanese banks (trading at 0.7X book), the world’s deflationary poster child, have the most to gain from “peak deflation.”

* * *

Trough Volatility

– Buy bond volatility via 2yr Treasury Note 1yr straddles
– Long British pound (GBP), short Brazilian real (BRL)

Price action at secular inflection points tends to be big and violent. Between July 1980 and October 1981 US bond yields surged from 10% to 16%. By October 1982 they were back at 10%. The lowest interest rates in 5,000 years in 2016 represented an “undershoot” that can be quickly unwound. Bond volatility is very likely to rise in 2017 (note Treasury market volatility surged from 5% to 31% in 1980).

Volatility means the era of “flash volatility” and “pain trades” continues. 2017 is likely to be another year where being contrarian works at moments of extreme price action and positioning. Heading into 2017, the most contrarian global “long” is the UK equity market and sterling. In contrast, EM debt and EM FX, most particularly the Brazilian real, benefitted greatly in 2016 from lower-than-expected growth and yields in developed markets. Buy GBPBRL. Our EM strategists are cautious EM near-term on higher rates volatility and low liquidity, but expect buying opportunities to emerge as 2017 progresses as EM fundamentals assert themselves and US real rates stabilize

* * *

Peak Passive

– Long dispersion via short SPX vol & long equity sector vol

Based on projection of trailing five-year growth rates, passively managed equity assets could exceed actively managed equity assets by 2023 (Chart 4). The 2017 “inflection point” backdrop of higher rates & EPS is positive for stock pickers and macro managers, while peak returns mean less upside for passive investors and closet indexers. We expect active investors to outperform passive investors. A play on this theme is to own dispersion (the range of expected returns) via buying volatility at the sector level while selling volatility at the index level.

* * *

Transforming World

– Long Robots (ROBO), long Biotech (NBI)

Finally, disruptive technology and aging demographics remain powerful secular forces; they won’t prevent a cyclical pick-up in inflation; but they are likely to constrain the magnitude of the rise in rates & inflation.

The rise of robots will continue. The global robot population is expected to rise from 1 million in 2010 to 2.5 million in 2018…you can’t build a wall to keep robots out (Chart 5). Meanwhile, CRISPR is making enormous leaps in genomic editing and genetic engineering, and has the potential to repair genetic mutations that cause hereditary disease, cure disease, and extend life expectancy. Our analysts are bullish on biotech given reduced regulatory risk post-election and cheaper valuations after the 40% selloff 2015-16. A breakout in NBI index above 3200 would signal the end of the biotech
bear market.

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