It's The Fed, Stupid

While the mainstream media were quick to blame the recent demise of US equity markets on Trump's trade-war rhetoric, BofAML's Michael Hartnett disagrees, correctly pointing out that risk assets have been struggling because of Fed tightening.

Higher rates and a shrinking balance sheet has shifted investors' appetites from 'buy the dip' to 'sell the rip'...

Via BofAML,

It’s the Fed, stupid

We believe the simple reason that risk assets are struggling in 2018 is the Fed. Investors have been forced to acknowledge a tightening cycle is well underway.

Since Oct last year the Fed has been reducing the size of its balance sheet; by the end of this year the Fed will have hiked 8 (maybe 9) times. History shows that once the Fed starts to tighten financial conditions it requires a major “event” to reverse course (Chart 1).

The tightening cycle, which the ECB & BoJ are set to join in coming quarters, follows 9 years of unprecedented global monetary easing & asset price returns. Table 1 below shows the biggest winners & losers as global interest rates have been cut 712 times and $12.2bn of assets have been purchased by central banks since 2009.

The QE winners have been US stocks, tech stocks, US & European high yield bonds, Emerging Markets(themes of scarce growth, high yield & leverage).

The QE losers have been cash, commodities, government bonds and volatility (themes of inflation, low yield & liquidity).

But, as BofAML's Hartnett warns, that is all about to change as the market is forced to admit the regime shift from Quantitative Easing to Quantitative Tightening.

  • We believe investors will slowly rotate from QE winners to QE losers, but the pace will be contingent on how quickly profit growth slows; YTD returns indicate that the rotation has begun

  • Peak positioning, peak profits, peak policy stimulus imply peak asset returns, and a trading mantra of sell-the-rip not buy-the-dip

  • If Q1 was about volatility, Q2 will be about rotation within a big, fat trading range,  rotation specifically from levered cyclical plays to liquid defensive plays

  • It’s too early to advocate a“Full Bull Detox” and overweight bonds/cash (where yields continue to be meager) and sell equities (the “TINA”argument); but a surge in US dollar/credit spreads could cause fresh lows; key deleveraging levels... GT30 <3%, DXY >93, CNY >6.5, US HY CDS >4%, SPX <2500, SOX <1200, DAX <12,000

Hartnett sees good, and bad, news under each of his Positioning, Policy, and Profits factors driving Q2 investment themes.

Positioning

Good news: BofAML Bull & Bear Indicator has retreated from the dangerous “excess bullish” levels of late-Jan to a neutral levelof 5.4.

Bad news: investors have only partially unwound their crowded Goldilocks positions...short vol/Treasuries/US$, long tech/banks/EAFE/EM.

Policy

Good news: policy tightening has not led to a significant widening of credit spreads, i.e. corporate bonds not signaling a decisive crack in equities(Chart 3).

Bad news: yield curve implies monetary & fiscal stimulus maxed out; only policycards left to play are growth-negative protectionism & populism.

Profits

Good news: global EPS estimates are very strong.

Bad news: global PMIs, the key driver of EPS, are rolling over; EPS rarely this strong for this long when yield curve this flat (Chart 4); longer it takes for 10-year Treasury yield to breach 3% in Q2, the more aggressive the rotation from cyclicals to defensives and bond sensitives in Q2 is likely to be.

So either the bond market is entirely wrong or expectations for forward EPS will have to tumble dramatically.