It has been a frustrating year for both bulls and bears.
On the bullish side an unprecedented fiscal stimulus, coupled with ongoing, if fading, central bank liquidity injections, and the best earnings season since 2010 has failed to push the S&P into the green for the year; meanwhile on the bearish side two 10% corrections in the S&P in just the past 4 months, a record surge in the VIX as the short-vol trade died a gruesome death on Feb 5, unprecedented geopolitical shocks and military escalations coupled with fears of imminent middle-eastern war, soaring commodity prices and a suddenly slowing global economy, and the S&P is... unchanged for the year.
In short, despite clear catalysts for both the bull and bear case, "asset markets are struggling" as BofA's chief investment strategist Michael Hartnett points out this morning, and gives a simple explanation for this confounding pattern: "Because it’s late-cycle, profits are peaking, and the Fed is tightening."
Here are the details:
- On Aug 22nd the S&P500 bull market will become the longest of all-time
- July 2019 US economic expansion will become the longest since the Civil War
- From Feb’16 low to Jan’18 highs global equity market cap soared $33tn (equates to one FedEx added each trading day)
- In 12 months IBES consensus forecasts the level of global corporate profits to be 1/3 higher than prior peak in 2008 ($3.3tn vs $2.4tn)
- US, UK, Germany, Japan unemployment rates are at multi-decade lows, and yet political populism is accelerating quicker than wage growth
- $1.45tn of tax cuts have been enacted in USA, and yet volatility & interest rates have risen more than stocks & GDP forecasts this year
- Government bond supply set to triple to $1.5tn by 2019, and yet 10-year UST yield can’t break 3%, stock of negatively-yielding global debt still >$10tn
- 2018 US corporate bond issuance on pace +$1.5tn, US equity supply -$0.9tn, and yet TINA theme (There Is No Alternative) to equities struggling
- By end-18 the Fed will be 8 hikes into a tightening cycle and central bank balance sheets, the dominant catalyst for credit & equity market bull markets, will be contracting (a point we underscored yesterday as part of the latest warning by Matt King)
While there are more reasons behind the market's rangebound pattern, what really matters for traders and investors is what could finally break this 2,550 - 2,850 range in the S&P. And here, according to Hartnett, are the answers, starting with a good old juxtaposition of good and bad news:
- The good news: BofAML Bull & Bear Indicator currently 5.1, i.e. in neutral territory, indicates investors no longer as directionally euphoric on credit & equity markets as they were late-January.
- The bad news: April BofAML Fund Manager Survey made clear that few are bearishly positioned for lower growth, lower yields, and lower cyclicals.
But first a tangent: it's not just the S&P that has been stuck in a tight range of 2550-2850: as the muted gains of bonds & equities YTD suggest credit, equity, volatility markets have been stuck in ranges: e.g. IG OAS 90-120bps, HY OAS 320-400bps, SOX 1200-1400, EEM $46-50, and the VIX 15-20.
So, looking first at the downside, what are the bearish triggers that could crack the 2550 SPX floor? According to Hartnett there are three:
- Weaker GDP & EPS: Chinese export growth slows to 0-5% (current 3MMA = >15%); political/geopolitical fear cause US ISM <55; US capex on back of US tax cuts fails to materialize
- Credit contagion: surge in US dollar causes EM asset volatility (e.g. BRL to 4) which, in turn, causes deleveraging and contagion across credit portfolios
- Policy impotence: ECB & BoJ QE and more dovish central bank rhetoric fails to suppress spreads & volatility (as we first remarked on Friday, this can be quantified by looking at the €70bn in annualized ECB purchases year-to-date which led to wider not tighter spreads in European high yield, an indication of what Hartnett called at the time "quantitative failure")
What about the other side? What bullish triggers could smash the SPX 2850 ceiling? Here is Hartnett's take:
- US policy makers “blink”: the Fed reduces its dot plot & the Trump administration backs away from protectionism
- Buybacks: math of US corporate bond issuance (annualizing $1.5tn in 2018) and US equity supply (on pace to fall $0.9tn via buybacks) kicks-in
- Tech bubble: “TINA to FAANG” narrative resumes; inability of global synchronized recovery, record EPS, US tax cuts and budget deficits, record low unemployment in US/UK/Japan/Germany, Fed balance sheet & surging commodity prices to induce higher wages & higher interest rates causes flows to surge back into deflationary tech disruption theme.
That's the framework in a nutshell, although to the BofA CIO the bearish case is more likely than the bullish one, as he explains below.
So for those wondering how Hartnett himself is trading this, his "contrarian" recommendation is as follows:
The BofAML 2018 base case is as follows:
- Global GDP growth 4%, global inflation 3%, 10-year Treasury yield 3¼%, i.e. slow normalization continues
- A full-blown bear market in 2018 unlikely (recession and/or credit event required); but peak Positioning, Profits & Policy stimulus = peak asset returns = big, fat trading ranges for credit & equities (analog is late-1960s)
- Play defense via rotation from QE winners to QE losers, from levered cyclicals to liquid defensives
Here, Hartnett admits that he continue to tilt bearish as 2018 consensus too skewed toward:
- A macro view of higher GDP growth, strong global EPS, and a “good” rise in interest rates
- The 9-year bull market leadership of scarce “growth” & scarce “yield” via US stocks, tech stocks, US & EU high yield bonds, EM bonds and so on
- The 2-year bull market “global synchronized recovery” leadership of short G7 government bonds, US bank stocks & global cyclical stocks
In conclusion, Hartnett recommends the following trades:
- Long AAA-rated assets, e.g. BofAML’s Best of Breed basket of stocks…as peak profits, stubborn deflation favors quality, monopolies
- Long T-Bills, e.g. GB6 yield >2%...as the Fed now sole hawkish central bank
- Long China stocks, e.g. SHCOMP, HSP…on China policy easing & credibility
- Long US Dollar, e.g. vs EUR, CNH, SGD, MXN…on stealth easing by global central banks
- Short EM local currency-denominated debt, e.g. LDMP…on peak positioning & reducing EM FX exposure, a traditional vehicle to reduce portfolio beta
- Short FAANG, e.g. NYFANG…tricky as tech bubble risk remains high, but crowded & 2018 consensus too strongly believes weaker global EPS will not hurt FAANG
- Short High Yield bonds, e.g. H0A3, HEOO, HEB0…we think the best hedge against policy impotence