One month ago, Blackrock's Larry Fink reincarnated the ghost of January 2018 past, when the CEO of the world's largest manager told CNBC that "we have risk of a melt up." While it wasn't quite clear why to Fink a melt up is risky, the last time the US stock market experienced the sheer, unbridled euphoria of price indiscriminate buying was January 2018 when just days later the S&P tumbled by 10% in the aftermath of the infamous Volmageddon blow up of levered inverse VIX ETNs.
Since then two things happened: the S&P did indeed stage a mini melt-up into the start of May, when the S&P hit a new all time high, only to suffer the worst week of 2019 immediately after, as global capital markets were rocked by the return of the US-China trade war.
It also prompted Bank of America's CIO, Michael Hartnett to ask "Where's my melt-up gone?"
As the BofA strategist writes in his latest Flow Show, the "risk pullback since May 1st highs follows furious rally, initiated by less-dovish PBoC/Fed, accelerated by trade trauma this week; peak-to-trough semis -10%, EM stocks -8%, oil -7% reflect fear that V-shaped recovery in equities & credit not being followed by V-shaped recovery in PMIs & EPS;" He also goes on to note that NASDAQ (8000) & Amazon ($2000) failed to break through 2018 highs.
But is the melt-up truly gone? The answer depend on who you ask: on one hand, the YTD Treasury bond volatility as measured by the MOVE index fell to an all-time low, 5-year Greek bond yields fell below US Treasuries, while the S&P500 surged 25% in 90 trading days, the fastest rally since the move off '09 low, helping global stock market cap soar by an epic $11.2tn.
And yet, as discussed every week since December, for various reasons, traders had very little conviction in this move which appears to have been driven by continued massive buybacks and bank dealer gamma hedging. As evidence look no further than the latest week fund flows, where as another $7.3 billion went into bonds, a whopping $20.5 billion was pulled out of equities - the 3rd biggest outdlow YTD - driven by redemption from US ($14.0bn), EU ($2.5bn), EM ($1.3bn) and resources (energy+mats $1.6bn) all of which reflect the latest trade deal trauma; but IG bonds ($6.0bn), EM debt & tech sector funds all saw inflows.
In fact, if one looks at the YTD number, it is simply staggering as equity fund redemptions now amount to $116 billion, the worst year since '08 & '16:
This ongoing equity boycott has been offset by the YTD flow winners, including MBS, EM debt, and HY bonds reflecting ongoing "lust for yield" amidst unanticipated drop in bond yields.
Yet even as investors continue to pull money out of stocks, they continue to levitate, at least until last week. That said, if the trade war fails to find a prompt resolution or at least delay, the equity rout will only get worse: recall that according to the latest BofA Fund Manager Survey, trade war was #1 "tail risk" past year, but the "fear" peaked in July'18.
Expect this to quickly change next Tuesday when the latest Fund Manager Survey is released, when in addition to a new "top tail risk", trade war panic would be revealed if Fund manager cash surges from 4.6% to >5.0%.
Additionally, despite a relatively low VIX for much of 2019, implied volatility in equities and credit markets remains significantly higher than realized volatility (17% vs 10% in US equities)...
... which all else equal, is bullish for stocks as the 3-month returns after such implied to realized spikes result in 7% outperformance for stocks (hit ratio = 80%), 7% for commodities (60%), and 3% for global HY (60%). Unless, of course, this time it is different.
Why would it be different? Well, so far the global economy has failed to catch up with the rebound in sentiment as telegraphed by the market. In fact, the BofA Global EPS growth model is currently at -6% versus consensus 1%, driven by depressed PMIs, poor Asian exports; weak China consumer data, where April auto sales tumbled -18% YoY:
In short, as Hartnett summarizes, "the lack of a an EPS rebound threatens equity re-rating, buyback boom, low credit spreads."
Also keep in mind that all that excludes a potential deterioration in the trade war, where the outcomes according to BofA would be roughly as follows:
- Deal: SPX rallies toward 3000; global stocks (MXWD) to 550; GT10 yield to 2.75%; TRAN/SOX/DAX/KOSPI/NKY & global banks = best upside.
- Postponed deal: SPX pullback to 2775 (200dma), then rallies; sell VIX.
- No deal: Fed cuts; GT10 to 2%; SPX <2600 (16X $160 of EPS); CNY to 7; investors de-risk their longs in IG bonds, EM debt, EU peripheral bonds, tech stocks.
So when and how will the market start pricing in either of these three outcomes? The answer, according to BofA is to keep an eye on the KOSPI (in dollar terms)...
where as Hartnett concludes, "a break below Dec lows would lead to contagion across high beta cyclical assets."