Goldman Says Overweight Cash On Mounting Global Risks

More and more are jumping on the "sell in May and go away" bandwagon but for good reason. As U.S. stocks base around in short term trading awaiting more cues about a potential June rate hike from the April FOMC minutes to be released later today, the big players have their eye on the bigger picture.

This is something we've talked about on these pages, and something we buy, on the caveat that technical factors turn conducive. The month of May has historically heralded volatility in the financial markets. Seasoned traders and investors understand the value in keeping an eye on the big picture, soaking it in, and making more informed decisions from there.

Only time will tell if a risk-averting strategy pays off well. What we can say is that many are throwing in the towel in this game of wait and see. Going on a summer vacation might honestly be more rewarding after all. 

Goldman stays "fat and flat" on equities

Today we bring you some thoughts from the vampire squid, in which the investment bank clearly believes the potential for a negative shock to valuations remains unusually high, or at least it doesn't expect upside in equities.

The key takeaways from Goldman are: Overweight cash, avoid equities, look to profit from up in quality carry, and perhaps buy some volatility.

From Goldman Sachs:

Markets have been calmer and cross-asset correlations with oil have fallen since our last GOAL on March 21. Declines in bond yields, owing to a continued dovish Fed, a weaker dollar and stronger commodity prices, have been the key cross-asset moves. This has lifted bond and credit returns, but equities have not benefited much.
Global earnings growth revisions have been negative and equity valuations remain high, with the equity risk premium a less useful predictor of returns owing to uncertainty over trend growth and normalisation of bond yields. We stick with our ‘fat and flat’ view for equities. After the rebound from the trough on February 11, and with the S&P 500 at the upper end of its recent range, we downgrade equities to Neutral over a 12-month horizon, in line with our 3-month view.
Until we see sustained signals of growth recovery, we do not feel comfortable taking equity risk, particularly as valuations are near peak levels.
Our equity strategists have become more defensive, owing to heightened drawdown risk and growth scarcity. While we see some upside to equities in local currency (particularly Japan), we expect the dollar to strengthen, resulting in poor USD returns over the next 12 months (Exhibit 1).
 Chart courtesy of Goldman Sachs

Chart courtesy of Goldman Sachs

We prefer to implement the divergence theme via FX rather than equities; equities are generally more volatile than FX and, while the equity/FX correlation for Europe and Japan remains negative, it has increased recently (Exhibit 2).
 Chart courtesy of Goldman Sachs

Chart courtesy of Goldman Sachs

For Europe, equity/FX correlations could become even less negative as political risks in Europe intensify.
We also move to Neutral across equity regions on a 12-month basis (in line with our 3-month basis) alongside these effects.
Risks abound, OW cash allocation still appears sound:
  • Given we do not see much value across asset classes and we see a variety of cross-asset risks, we remain Overweight cash near term.
  • We believe the market’s dovish pricing of the Fed increases rate shock risk, in which case both equity and bonds could sell off.
  • We are also not convinced the EM rally is sustainable, which could weigh on commodities, in particular metals.
  • China growth concerns could also come back into focus, as we think the support from policy will fade during 2H2016.
  • Finally, we continue to see elevated European political risk with uncertainty around the UK’s upcoming EU referendum.
Lost and found: Five conviction themes for a ‘fat and flat’ market
We highlight five conviction cross-asset themes for this volatile but trendless market:
  1. Generally, our focus is shifting to carry strategies across assets and relative value opportunities.
  2. We continue to prefer credit to equity, despite the strong rally in credit, with the potential for further spread compression high, in our view.
  3. We see some attractive carry opportunities in EM FX, credit and dividends.
  4. The main remaining directional conviction view we have is a continued upward trend in US inflation; once this trend becomes more established, we think there is potential for sector and style rotation within equities.
  5. On the relative value side, we continue to favour oil vs. metals in equity and credit.

Plenty of global risks

We discussed this partially in our last piece on insight. The following succinct analysis from Bloomberg should give readers an overview on what the financial markets are most likely to encounter in the near future. In short, a lot of uncertainty and therefore heightened chances for the markets to snap.

  "16 weeks. 16 unbroken weeks of straight out selling by "smart money", making this the longest ever streak on record. For the last 6 weeks we have been painstakingly documenting what this group of the so called "smart money" (made up of hedge funds, institutional clients, and private clients) have been doing with their money. They have been selling, and happily away as the broad stock market has gone just about no where in the last 4 months.    Honestly, we're sick and tired of reporting on this each week, where we'll almost certainly know next week brings the streak to 17, then to 18, and so on. You get the point. It's an incredibly stubborn trend, which although shows signs of weakening, should be not be turning anytime soon absent a huge swing in stock prices (which itself is not as likely as one might believe).    So, we leave you with BofAML's update via its weekly Client Flow Report:    "Last week, during which the S&P 500 fell 0.5%, BofAML clients were net sellers of US stocks for the 16th consecutiveweek—continuing the longest uninterrupted selling streak in our data history (since ’08).    Institutional and private clients were still sellers as well, but sales by these groups were both their smallest since Feb. Net sales were entirely in large caps last week, as both small and mid-caps saw net buying. Buybacks by our corporate clients decelerated last week, and month-to-date are tracking below typical May levels. Year-to-date, buybacks are tracking slightly above 2015 levels but below 2014 levels.    Net sales were led by Consumer Discretionary stocks, where misses from several retailers caused a sell-off in the sector last week. Health Care saw the next-largest outflows; this sector continues to have the longest selling streak at eleven consecutive weeks, hurt by a positioning unwind and political uncertainty in an election year Financials and Telecom stocks, plus ETFs, saw net buying last week; Telecom has the longest buying streak of any sector at three consecutive weeks (and is the only sector which has seen cumulative inflows year-to-date). Based on four-week average trends, where flows are less volatile, in addition to Telecom, Energy is now also seeing net buying after clients had sold this sector since late February.    The four-week average trend for buybacks by corporate clients suggests a bigger seasonal slowdown in buybacks than what we have seen the last few years at this time.    Net buying: Telecom since late April    Net selling: Tech since late Jan.; Staples since early Feb.; Industrials since mid-Feb.; Financials since late Feb; Materials and Health Care since mid-March; Consumer Discretionary since late March, Utilities since early April, ETFs since late April.    Notable changes in trends: Energy saw a reversal to net buying after net sales since late Feb.""    Business Of Finance on Facebook, 15 May 2016

"16 weeks. 16 unbroken weeks of straight out selling by "smart money", making this the longest ever streak on record. For the last 6 weeks we have been painstakingly documenting what this group of the so called "smart money" (made up of hedge funds, institutional clients, and private clients) have been doing with their money. They have been selling, and happily away as the broad stock market has gone just about no where in the last 4 months.

Honestly, we're sick and tired of reporting on this each week, where we'll almost certainly know next week brings the streak to 17, then to 18, and so on. You get the point. It's an incredibly stubborn trend, which although shows signs of weakening, should be not be turning anytime soon absent a huge swing in stock prices (which itself is not as likely as one might believe).

So, we leave you with BofAML's update via its weekly Client Flow Report:

"Last week, during which the S&P 500 fell 0.5%, BofAML clients were net sellers of US stocks for the 16th consecutiveweek—continuing the longest uninterrupted selling streak in our data history (since ’08).

Institutional and private clients were still sellers as well, but sales by these groups were both their smallest since Feb. Net sales were entirely in large caps last week, as both small and mid-caps saw net buying. Buybacks by our corporate clients decelerated last week, and month-to-date are tracking below typical May levels. Year-to-date, buybacks are tracking slightly above 2015 levels but below 2014 levels.

Net sales were led by Consumer Discretionary stocks, where misses from several retailers caused a sell-off in the sector last week. Health Care saw the next-largest outflows; this sector continues to have the longest selling streak at eleven consecutive weeks, hurt by a positioning unwind and political uncertainty in an election year Financials and Telecom stocks, plus ETFs, saw net buying last week; Telecom has the longest buying streak of any sector at three consecutive weeks (and is the only sector which has seen cumulative inflows year-to-date). Based on four-week average trends, where flows are less volatile, in addition to Telecom, Energy is now also seeing net buying after clients had sold this sector since late February.

The four-week average trend for buybacks by corporate clients suggests a bigger seasonal slowdown in buybacks than what we have seen the last few years at this time.

Net buying: Telecom since late April

Net selling: Tech since late Jan.; Staples since early Feb.; Industrials since mid-Feb.; Financials since late Feb; Materials and Health Care since mid-March; Consumer Discretionary since late March, Utilities since early April, ETFs since late April.

Notable changes in trends: Energy saw a reversal to net buying after net sales since late Feb.""

Business Of Finance on Facebook, 15 May 2016

There must be some strong reasons for the record "smart money" outflows from U.S. equities over the last 4 months, right?

From Bloomberg's Market Analysis Team:

Traders Pull ‘Singed Fingertips’ From Markets as Risks Escalate
Investors are fleeing and volumes are falling due to extreme valuations amid global uncertainties related to monetary policy and political decisions made in wake of the 2007-2009 financial crisis. It’s a flight that’s creating a negative feedback loop.
  • "First it’s China, then Japan, then the ECB. When you singe the fingertips of speculators, they don’t like to play anymore," says Brean Capital managing director Russ Certo
  • Major banks worldwide are paring trading operations as part of a push to cut costs amid rising regulatory requirements
    • Investors "are stewards of other people’s money and they don’t want to allocate capital to a pyramid scheme": Certo
  • Speculators in China have retreated as fast as they advanced as trading volumes across nation’s three biggest exchanges are now less than half of what they were at April 22 peak
  • Volume of shares changing hands on FTSE 100 Index -21% since Feb.; total volume on U.S. stock exchanges 7.1m May 12 vs 12.5m Jan. 20
  • CME Group’s recent monthly trading volume shows m/m declines across interest rate, FX, equity futures and options
    • FX futures -6.2% y/y, ~699k contracts/day, -16.2% m/m; FX options -22.5% y/y, ~70k contracts/day, -7.7% m/m
    • Rate futures +8.3% y/y, 4.2m contracts/day, -14.2% m/m; options +6.3% y/y, 1.33m contracts/day, -11% m/m
    • Equity index futures +31%, ~2.15m contracts/day, -16.5% m/m; equity index options +20.9% y/y, ~544k contracts/day, +0.5% m/m
POLICY RISKS
  • Primary risk is that global financial markets are more vulnerable to policy shocks as many assets are reaching extreme valuations; stock indexes near all-time highs and sovereign bond yields near record lows
  • Market participants are losing confidence, especially during unexpected central bank decisions like when the BOJ failed to expand monetary stimulus April 27
  • Fed: Risk Fed convinces markets it will hike in face of fragile global economic environment or hikes before market prices move; first development would increasingly weigh on risk assets, while second would create a negative shock
  • ECB: Risk QE program continue to be ineffective as O/N current account holdings, excess liquidity are near record highs
  • BOJ: Risk BOJ loses control of an appreciating JPY, still unable to generate growth or inflation and burdened with Abe’s fiscal policies that continue to be ineffective
  • Ongoing risk Basel III, sovereign regulatory rules continue forcing commercial banks to hold more high quality liquid assets (HQLA), exacerbating global liquidity shortage
POLITICAL RISK
  • Brexit
  • Uncertainty overshadowing Brexit’s impact on markets, GBP or economic policy; Treasury analysis of short-term Brexit impact will be published this month
    • Average of half of respondents in Belgium, France, Germany, Hungary, Italy, Poland, Spain and Sweden believe their own country should hold a referendum on staying in the EU, according to a poll by Ipsos Mori published May 9
    • ICM poll shows 40% of Britons would vote to remain in EU, 41% to leave; last week’s poll showed 44% stay, 45% leave
    • GBP pricing out Brexit risks may be premature; some analysts say the pound’s gain reflects greater certainty the electorate will back the “Remain” camp, though others warn this may reflect a misreading of recent opinion polls
    • Core CEE may be most vulnerable to Brexit risk as Poland largest net recipient of EU funds while U.K. 3rd largest net contributor
EUROPEAN UNION
  • Rising risk EU nations are unable to stem the flow of migrants creating rising nationalistic fervor and domestic civil strife
  • Increased risk European peripheral finances become problematic amid increasing political uncertainty, rising nonperforming loans and slowing economic growth
  • Italy: Fails to meet its debt-reduction goal, economy growing less than govt estimates; bank asset quality continues to deteriorate and Atlante fund proves to be ineffective, fund size EU4.25b, gross NPLs EU360b end-2015
  • Greece: Risk Greeks prove unable to meet terms of debt relief agreement, forces another series of renegotiations
  • Spain: Risk June 26 election creates another stalemate; also risk an anti-establishment coalition is created, unseats Prime Minister Rajoy
CHINA
  • Risk China may allow a harder landing than expected; China’s Communist Party mouthpiece, the People’s Daily, said China should put deleveraging ahead of short-term economic growth
    • China may lose control of deleveraging, which would increase risks of increased financial market volatility and/or economic hard landing
    • China may either lose control of capital outflows or be forced to allow CNY to depreciate more quickly; imports from Hong Kong surged 204%, indicated significant capital outflows
    • Risk China FX reserve selling continues; reserves rose $11b to $3.316t, though most may have been related to valuation changes to drop of USD
    • Intensity of futures trading on Chinese commodities exchanges is making some of the world’s most liquid markets look leisurely; iron ore in free fall as trading frenzy ebbs
    • Chinese companies in metals and mining or coal operations industries must repay 239.6b yuan ($36.9b) of notes in the three months through June, the biggest quarterly amount on record, according to data compiled by Bloomberg
OIL
  • Low prices may further pressure U.S. oil firms and cause more defaults that cascade into credit problems for smaller banks, private equity firms/hedge funds; this raises potential for downward pressure on other assets sold to cover losses
  • OPEC may fail to revive limits on crude output at its June meeting after the failure of talks to freeze production last month, resulting in renewed oil price weakness
    • New Saudi boss seen chasing record output to defend market share vs higher-cost shale
    • Oil price decline may force Saudis to continue selling reserves to protect FX peg, which increases speculation that the peg may fail; reserve assets are $587b from $745b in Aug. 2014
    • Russian economy, which is already enduring the longest recession in two decades, may come under more protracted stress, as oil represents the country’s chief export earner
  • EM sovereigns may face increasing pressure as public energy companies have been some of the most profligate borrowers
UNITED STATES
  • Political uncertainties aside, there’s risk that U.S. growth may slow further, causing risk asset prices to fall, which would then transmit back to more economic weakness and create downward spiral
    • With more than two-thirds of S&P 500 companies having reported earnings this season, outcome has failed to suggest a speedy recovery from what’s shaping up to be a fourth straight quarterly decline
    • S&P 500 reported earnings share through May 6 shows 1Q earnings down 7.9%; companies have churned out more than $2t of share repurchases since 2009, though grew less than 4% in 2015
    • There have been 40 corporate defaults in the U.S. as of end-April, fastest pace since 2009; there have been 53 global defaults this year vs 67 in 2009
    • Puerto Rico Governor Padilla warned bond investors face a cascade of defaults starting in July unless Congress passes legislation; concurrent concern is municipal funds like Oppenheimer that allocated 43% of its Maryland portfolio to Puerto Rican securities