Episodes of “corrections” are apparently happening more frequently according to BofAML's credit strategist Barnaby Martin...
... and given the extremities of liquidity, profits, technological disruption, regulation, and income inequality, BofAML warns 'gently' that the potential for a cleansing drop in asset prices cannot be dismissed.
Most likely catalysts: Consumer, Rates, A-shares, Speculation, High Yield
Investors are unambiguously positioned for the US consumer to once again lead the global recovery. Should US consumption, profits & payrolls (Chart 13) continue to disappoint, equity valuations will be forced to cheapen. Few are positioned for a contagious sell-off in US dollar, bonds & stocks if US GDP growth were to stumble once again in Q2 & Q3.
Investors are positioned for low and stable rates, anchored by central banks. Yet rate volatility (see MOVE index) is on the rise, expectations for a Fed hike in Sept have dropped sharply (3m Eurodollar rates have dropped from 0.865% to 0.540% in the last 3 months), and should growth or inflation surprise to the upside in the summer, rates (e.g. front-end in US, long-end in Europe) are mispriced.
Investors are not positioned for full-blown policy failure in China. Chinese growth expectations may be weak, but the A-share market hardly portends a collapse in Chinese activity. Should Chinese PMI or FAI data indicate a lurch lower in activity at a time of policy easing, the ripple effect via Chinese stocks, rates & FX into global markets is likely to be significant. David Woo argues investors are underestimating the cross-market implications of US-China policy divergence.
Investors are not positioned for cash to offer competitive returns. Yet cash has outperformed global fixed income in 2015. There is a risk that investors, in particular systematic macro funds, have crowded and levered positions that do not assume a rise in cash rates. In addition, the correlation coefficient of CTA returns and the DXY dollar index is currently 0.51, its highest level in the past 13 years, and CTA performance has also recently become correlated with German bunds (Chart 14), the Euro, and oil.
Investors are positioned heavily in high yield, high dividend yield and high PE strategies (Chart 15). The quest for high yield (relentless multi-year inflows to dividend funds, MLPs, REITS & HY bonds - $415bn inflows since Mar’09) remains the biggest Achilles’ Heel for positioning, in our view.
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These treacherous times continue to make us feel that reducing risk rather than maximizing return is the smarter mid-2015 strategy. We are cognizant of high cash levels and sentiment measures (e.g. BofAML’s Bull & Bear Index currently at 4.4) which do not signal “sell risk”.
Nonetheless the summer months offer a lose-lose proposition for risk assets: either the macro improves and the Fed gets to hike, which will at least temporarily cause volatility; or more ominously for consensus positioning, the macro does not recover, in which case EPS downgrades drag risk-assets lower. We advise selling risk into strength, buying volatility into weakness, advocate higher than normal levels of cash and would add some gold.
We continue to expect risk-off moves in the direction of 0.2% for 5-year German bunds, 2% for the Italian 10-year yield, 20 on VIX and 2000 for the S&P500 in Q2.