Bank of America: Catalysts For The Next CRASH

At Business Of Finance, we try to be pragmatic on our views and approaches to the financial markets. The whacky ideas of yesteryear calling for a "doom and gloom" type of environment have never seen the light of reality; what they have however done is fostered sentiments of fear and the urgency to be overly prepared for an apocalypse.

Markets have gotten more fragile than ever before - with moves that are supposed to occur once in a few years happening at regular intervals now.
— Business Of Finance

Over the last couple of weeks, there has been a renaissance somewhat reminiscent of those times with mainstream news outlets proposing that global markets were overly egged and might be doomed for a major setback. We aren't at all surprised. 

We are in fact looking at this and asking ourselves if there are semblances of justice in these annotations, or whether they are an imaginary bluster buffeting on the receptors of the schizophrenic community at large.

Sentiment Lags Reality

BofAML's measure of the likelihood of corrections in various asset classes. They do this by counting the number of times the 3-month Z-scores of more than +/- 4 were registered for assets in the measured sample - which includes 57 10-year government bonds (sovereigns), 35 FX pairs (currencies), 80 equity indices (equity indices), and 27 commodities (commodities). Their analysis shows points to sovereign debt being he most prone for a correction followed closely by currencies, while commodities and equities trail farther behind. Perhaps the risk of a rate risk and heightened volatility in the fixed income sphere has placed government bonds in this awkward position. Chart courtesy of BofAML

BofAML's measure of the likelihood of corrections in various asset classes. They do this by counting the number of times the 3-month Z-scores of more than +/- 4 were registered for assets in the measured sample - which includes 57 10-year government bonds (sovereigns), 35 FX pairs (currencies), 80 equity indices (equity indices), and 27 commodities (commodities).

Their analysis shows points to sovereign debt being he most prone for a correction followed closely by currencies, while commodities and equities trail farther behind. Perhaps the risk of a rate risk and heightened volatility in the fixed income sphere has placed government bonds in this awkward position.

Chart courtesy of BofAML

Understandably, recent circumstances have analysts sitting at the edges of their chairs - seemingly inane volatility, broad derisking across asset classes, a smorgasbord of rather dim economic data, and commentary that fluttered like a flag flown at half-mast behind a setting sun. The incontinence can therefore be pardoned.

That being said, we wanted to put some meat on these bones and see if it all coalesced into logically plausible. Readers will recall that we were the first to explain how the end of the Fed's QE program roiled the volatility markets, and which hallmarked a cycle of greater idiosyncrasies (see our 1 April note).

However, as bad as the U.S. economy was disappointing expectations, we felt that the treasury market was signaling a generally normalizing economy, albeit admitting that one should continue to expect disappointing economic figures (see our 10 April note). The turn of the first quarter did give us some much needed perspective, that the U.S. economy was indeed slowing and the Fed had many reasons to remain patient.

More recently, we deconstructed the collapse in the German bund market, where the safest government bonds in Europe (arguably) sold of harder than any sovereign fixed income asset including defunct Greek Government Bonds (see our 30 April note). We, alongside other professional traders and dealers, believed that the selloff was technical and temporary in nature. Hindsight proved that we were correct in material but wrong on timing; bunds continued to collapse until the 10-year reached a blistering 0.84% yield from 0.04% 3 weeks prior.

In our experience, we can confidently reckon that bunds were the primary cause of volatility flares across the global markets. Traders were surprised when U.S. treasuries too began to selloff, along with the greenback and most other major currencies (for more of our post-April analysis and outlook, see our May 7 note).

While we wish to leave this discussion for a separate piece, the tangents of this episode prove that markets have gotten more fragile than ever before - with moves that are supposed to occur once in a few years happening at regular intervals now.

Bank Of America On The Next CRASH:

Without opining further, here is Bank of America Merrill Lynch on what it sees as highly plausible causes of the next CRASH .

In short, they are: Consumer, Rates, A-shares, Speculation, High Yield.

Via BofAML's Barnaby Martin:

Consumer

The number of job additions to the U.S. Labor market has tended to historically correlate with corporate profits growth. BofAML's premise is that as the labor market begins to cool down, corporate profits will grow at a slower pace albeit with a lag. They however do not mention the effect of positive real wage growth in the current climate, which has helped to steady private sector consumption despite weakening sentiment. Chart courtesy of BofAML

The number of job additions to the U.S. Labor market has tended to historically correlate with corporate profits growth. BofAML's premise is that as the labor market begins to cool down, corporate profits will grow at a slower pace albeit with a lag. They however do not mention the effect of positive real wage growth in the current climate, which has helped to steady private sector consumption despite weakening sentiment.

Chart courtesy of BofAML

Investors are unambiguously positioned for the US consumer to once again lead the global recovery. Should US consumption, profits & payrolls (Chart 13) continue to disappoint, equity valuations will be forced to cheapen. Few are positioned for a contagious sell-off in US dollar, bonds & stocks if US GDP growth were to stumble once again in Q2 & Q3.

Rates

Investors are positioned for low and stable rates, anchored by central banks. Yet rate volatility (see MOVE index) is on the rise, expectations for a Fed hike in Sept have dropped sharply (3m Eurodollar rates have dropped from 0.865% to 0.540% in the last 3 months), and should growth or inflation surprise to the upside in the summer, rates (e.g. front-end in US, long-end in Europe) are mispriced.

A-shares

Investors are not positioned for full-blown policy failure in China. Chinese growth expectations may be weak, but the A-share market hardly portends a collapse in Chinese activity. Should Chinese PMI or FAI data indicate a lurch lower in activity at a time of policy easing, the ripple effect via Chinese stocks, rates & FX into global markets is likely to be significant. David Woo argues investors are underestimating the cross-market implications of US-China policy divergence.

Speculation

Correlations across asset classes have risen to highs not seen since the last financial crash in 2009. Nothing surprising. Correlations tend to increase during turbulent times.  Chart courtesy of BoAML

Correlations across asset classes have risen to highs not seen since the last financial crash in 2009. Nothing surprising. Correlations tend to increase during turbulent times. 

Chart courtesy of BoAML

Investors are not positioned for cash to offer competitive returns. Yet cash has outperformed global fixed income in 2015. There is a risk that investors, in particular systematic macro funds, have crowded and levered positions that do not assume a rise in cash rates. In addition, the correlation coefficient of CTA returns and the DXY dollar index is currently 0.51, its highest level in the past 13 years, and CTA performance has also recently become correlated with German bunds (Chart 14), the Euro, and oil.

High Yield

Cumulative flows into dividend funds, MLPs (master limited partnerships), REITs (real estate investment trusts), and HY (high yield credit) have never taken a breather from its hyperbolic rise since the depth of the 2009 crisis. Retail demand for yield has led to another manic boom in HY and structured funds as cash continues to pile in at record pace. This, according to BofAML is a potential landmine in terms of positioning. What happens when all $415bn rushes for the exits at once? The answer is quite clear, and not one bit pretty. We share very similar sentiments. Chart courtesy of BofAML

Cumulative flows into dividend funds, MLPs (master limited partnerships), REITs (real estate investment trusts), and HY (high yield credit) have never taken a breather from its hyperbolic rise since the depth of the 2009 crisis. Retail demand for yield has led to another manic boom in HY and structured funds as cash continues to pile in at record pace.

This, according to BofAML is a potential landmine in terms of positioning. What happens when all $415bn rushes for the exits at once? The answer is quite clear, and not one bit pretty. We share very similar sentiments.

Chart courtesy of BofAML

Investors are positioned heavily in high yield, high dividend yield and high PE strategies (Chart 15). The quest for high yield (relentless multi-year inflows to dividend funds, MLPs, REITS & HY bonds - $415bn inflows since Mar’09) remains the biggest Achilles’ Heel for positioning, in our view.

These treacherous times continue to make us feel that reducing risk rather than maximizing return is the smarter mid-2015 strategy. We are cognizant of high cash levels and sentiment measures (e.g. BofAML’s Bull & Bear Index currently at 4.4) which do not signal “sell risk”.

Nonetheless the summer months offer a lose-lose proposition for risk assets: either the macro improves and the Fed gets to hike, which will at least temporarily cause volatility; or more ominously for consensus positioning, the macro does not recover, in which case EPS downgrades drag risk-assets lower. We advise selling risk into strength, buying volatility into weakness, advocate higher than normal levels of cash and would add some gold.

Since the turn of the year, the dynamic between equity flows and equity performance has taken a radical shift. Although cumulative fund flows into U.S. equities have declined from highs in October 2014, the SPX has co tunes rallying higher, baffling the market. Chart courtesy of BofAML

Since the turn of the year, the dynamic between equity flows and equity performance has taken a radical shift. Although cumulative fund flows into U.S. equities have declined from highs in October 2014, the SPX has co tunes rallying higher, baffling the market.

Chart courtesy of BofAML

We continue to expect risk-off moves in the direction of 0.2% for 5-year German bunds, 2% for the Italian 10-year yield, 20 on VIX and 2000 for the S&P500 in Q2.