When Michael Harnett talks about long term strategy, markets listen. Why? He is Mr. “Great Rotation,” the strategy that–In
October 2012–predicted that bond yields and stock prices would go way up. That turns out to have been a prescient call, and now he and the global investment strategy research team at Bank of America Merrill Lynch have some concerns about a “crash.” That could turn out to merely be an acronym for risks to the outlook or the inherent factors could actually produce a crash for equities. The implication for any sort of reversal of the Great Rotation would be benefit for bond markets.
In an investment letter the team points to leverage indicators they think suggest increased
speculation in the market of the sort that preceded the great financial crisis
in 2008 and the 9-12 months of excessive volatility in the bond markets.
Hartnett, who coauthored the article
with Brian Laung, Global Equity Strategist; John Bilton and Nupur Gupta, European
Investment Strategists; and Marish Kabra, Equity Strategist, notes that the equity
market is entering the seasonally weak period for risky assets and that U.S.
stocks which have not corrected even 10 percent in over two years, may be
suddenly facing a “buyers strike.” Could
this signal the onset of a C.R.A.S.H. for equities and a rally of some degree
for bond markets? He suggests investors
pay attention to that word, an acronym for Conflict, Rates, Asia, Speculation, and
Housing, all potential catalysts for a potentially contagious autumn event.
C is for Conflict
Things had been going pretty well for equities before the
situation in Syria escalated. Oil prices are already affected as they
were in 2008. The authors note that
equities underperform bonds during oil spikes and suggest the benchmark might
be the Brent oil price exceeding $125/barrel.
Policy conflicts in emerging markets are also a concern as
some try to stem capital outflows and currency loses as rates rise in the U.S
R is for Rates
Bottom line, rates are the punchbowl that’s been keeping the
global liquidity party going. The Great Rotation calls for this to dry
up, but if it dries up too fast, and if it coincides with weaker bank stocks,
it could be a sign of a damaged “carry trade” for the world’s largest
financial institutions where their cost of funding is rising faster than their
return on investment.
Another risk is potential mismanagement of the Fed’s tapering
of quantitative easing which must not carry a hint of too much
micro-managing. The impending announcement
of a new Fed chairman throws another wild card onto the pile.
A is for Asia
Hartnett notes that Asia and emerging markets are reliving
some of their past problems with account deficits. Emerging markets have
had a hard time with rising rates and if currency concerns spill over into the
Chinese economy, this could pose problems for global growth
S is for Speculation
Hartnett notes that leverage indicators suggest an increased amount of
speculation in the market–the same sort that preceded the 2008 financial
crisis and the 9-12 months of excessive volatility in bond markets.
H is for housing
The recovery in housing which has led
to tightening inventories tighten and prices reaching bubble status in some
locations appears to have stumbled over rising interest rates. Pending sales as well as construction
indicators have been down in recent weeks and mortgage applications are down to
levels last seen in 2011. The authors
ask if investors, who have been worried about tapering and liquidity, now have
to worry about the economy. To be
really confident that the recovery overall can be sustained we need to see
higher rates and higher growth coexist.
The housing market may be hinting at the opposite.
Despite their caution the authors
argue that there are several factors that argue against fears of any meltdown
in stocks of the magnitude seen in 1987, 1998, and 2008. First, short of a global recession, they do
not see stocks as being overvalued at a 13.5 price to forward earnings ratio. Second, they say it is impossible to argue
that the markets are significantly overweight in equities and underweight in
bonds. The latter market has seen a nearly
$1 trillion inflow of funds since 2000 while equities have seen $388 billion in
liquidations over the same period. The
authors say that while “the structural position in bonds and leverage is a risk
skewed towards fixed income, central banks do still control the bond market.”
Emerging markets may also be a
bright spot for those with a long-term perspective. “An improving long-term risk-reward trade-off
could make EM the comeback asset class of 2014,” the authors say.