One month ago, and well before the latest market swings and turmoil, bank of America joined the chorus of "late cycle" warnings, writing that its proprietary "Global Wave" indicator just peaked for only the tenth time in 25 years, noting that in the last month, five of the seven components deteriorated including confidence, market, and real economy indicators.
Commenting on the implications of this inflection point, BofA said that a peak in the Global Wave tends to come with a period of more mediocre returns in equity markets but noted that sustained negative returns are only evident in those episodes that lead to global recession. In the global recessions of 2000 and 2007, the peak in the Global Wave was very close to the peak for the global equity market. Sharply negative returns followed (averaging -14% after six months and -36% after a year).
So what are the consequences for markets? Well, there are good and bad news.
The good news is, or rather would be, if the current global wave peak is not like the peaks observed in 2000 and 2007, in other words if what follows is not a recession. Here is BofA:
Ex of recessions Global Wave peaks point to a pause not end of equity rallies: Stripping out those two recession periods, the average profile for MSCI ACWI shows a market that moves sideways for 6-12 months around the peak in GW. In 2018, we are so far tracking reasonably closely to that pattern, with global equities trading in a range since the correction from the January highs. The typical profile then suggests a bias to the upside six months subsequent to the peak in the Global Wave. 12 months after the non-recessionary peaks MSCI ACWI was on average 11.6% higher.
That said, the average non-recessionary post-peak profile masks a wide range in outcomes historically. As BofA admits, material drawdowns were not uncommon in the non-recession episodes. Notably there were sizable (20% plus) corrections in 1998, 2002, 2011 and 2015. 2002 was really the continuation of the post TMT-bubble bear market so is very different to the other observations or indeed the current episode which all saw strong returns in the preceding 12 months. Additionally, two of the other three episodes were associated with stress in EM (1998 and 2015), while 2011 was centered on the European sovereign debt crisis. Nevertheless, as shown in the chart below, global equities were 10-20% higher 12 months after the peak in Global Wave in five of seven non-recessionary episodes.
Obviously, this implies that the "bad news" is if we are currently trading through a 2000/2007 scenario, because as the next chart shows, in those two scenarios, the average global market return 12 months after the peak was hit, are a chilling -36%: a crash of such a magnitude in the current environment - without central bank intervention - would unleash a global recession, if not depression.
And most importantly, the next overlay chart which compares the current pre/post peak inflection point to all the prior ones, suggests that there are two possible outcomes of what happens next: markets either "shrug it off", and proceed to rise another 10%, as they did across all historical episodes except 2000 and 2007, or they crash as they did in those two years.
Here, BofA also notes that some notable parallels exist in the current market backdrop to other, more turbulent prior episodes: monetary policy is becoming less accommodative as was the case in the early or intermediate-stage Fed tightening cycles in 1995, 1998 and 2005. Volatility and some instances of financial stress are found in EM, which was also a feature in 1995, 1998 and 2015.
The question, therefore, is what will determine which of two paths the markets take?
And the answer, according to Bank of America, is simple: "whether we get a trade war or not."
We see two potential paths for markets. The first is where there a full-blown trade war which damages global growth and markets have to correct significantly to adjust for lower profits. The second is where a full-blow trade war is averted (albeit after some initial skirmishes) and markets return to focus on a decent growth and earnings backdrop and equity markets spike sharply higher.
This simple "binomial tree" will impact all asset classes:
- Bond markets are likely to take the opposite side of this with a full blown trade war likely to force central banks to (eventually) take a more accommodative stance. That and a flight to safety are likely to force bond yields lower.
- EM is likely to follow a similar, but probably more accentuated path, to equity markets with the avoidance of trade wars likely to trigger a significant bounce given the oversold state of markets. Equally, a full-blown trade war is likely to see the exodus from the asset class continue.
- Vol speaks for itself. A full-blown trade war means weaker growth and profits, more uncertainty and risk asset sell-off. Vol has to go higher across most asset classes in such a situation. Fixed income might be the exception due to the flight to safety.
To summarize: BofA's global "late cycle" indicator has just been triggered, and both the economy and markets are now set to stagnate for the next year, or worse, if more adverse developments emerge. The best case scenario is one in which there are no additional stresses on the global economy - in this case, markets will recover and resume rising. The worst case scenario envision the trade war between the US and China escalating progressively in tit-for-tat fashion, ultimately pushing global growth low enough to prompt a recession. In this case, the 2000/2007 scenario become the dominant one, and what happens next could be a market crash of roughly 40% in the next 12 months.
Which scenario the markets will follow will depend on how the US-China (and global) trade war develops; in other words, the fate of the stock market is now in Donald Trump's hands.