There is just one word to describe the thought process of the "smartest guys in the room", those who manage trillions in assets and respond to BofA's monthly Fund Manager Survey: confused.
As BofA's Michael Hartnett summarizes the confusion, while on one hand only 7% expect a "recession" in the coming year...
... expectations for flatter yield curve - that surest leading indicator of a recession - just hit the highest since June of 2011:
... while respondents who believe that the US economy is in a late cycle just hit the highest since September 2008!
Furthermore, while most expect a rate hike to be announced tomorrow, a majority of respondents, or 58%, believe there will be at least 3 rate hikes in the coming 12 months.
... rate hikes which respondents believe will hit government bonds the most, stocks modestly, but the notable jump has been in corporate bonds which 24% now believe will be most vulnerable to Fed tightening, up from 13% a month ago, and surely the result of the recent volatility in the junk bond market.
Further compounding the confusion is that while only a sliver expect a recession, the outlook on corporate profitability and growth continue to decline. In fact, the percentage of investors expecting +10% earnings growth over the next 12 months is now the lowest since July 12 (net -66%).
Few expect help from China: there has been a renewed slump in Chinese growth expectations which means the projection for China’s GDP growth in 3 years’ time has fallen to 5.5% from 5.9% last month.
At the same time, there is also a revulsion to the single biggest drive of equity upside, stock buybacks. As BofA observes, "credit crunch fears inducing a sudden, remarkable investor repudiation of stock buybacks/dividends in favour of balance sheet improvement...
... FMS demand for "improved balance sheets" jumps to highest since Jul’10; investors saying payout ratios “too high” biggest since Mar’09.
So how are these "smartest guys" positioned? Simple: the biggest consensus trade, perhaps in history, is the one we showed earlier. This is how BofA frames it: "Bulls are long the dollar, bears are long the dollar" with the "long USD" trade 3x more crowded than any other trade.
What do they think will end the USD bull market? Nothing less than the end of the Fed rate hike, with ongoing negative EPS growth in second place (although note this has been the case for 2 quarter already and the USD has continued to rise):
When it comes to equities, at least according to their responses, managers are the most underweight to US stocks they have been in 8 years.
As a result of this, FMS report that their average cash balance has risen from 4.9% in November to 5.2% in December.As BofA comically notes, "As a reminder, the FMS Cash Rule works as follows: when average cash balance rises above 4.5% a contrarian buy signal is generated for equities. When the cash balance falls below 3.5% a contrarian sell signal is generated." And yet, as the chart below shows, never in the history of the FMS have cash levels actually dropped below 3.5%, so... never sell?
Looking at the future, an increasing number of respondents bet on high quality, large cap and low volatility, but the survey also shows first sign of shift from “growth” stocks to “value” - a move which would be a seachange over the past 7 years when growth stocks have dramatically outperformed value. Net 65% expect high-quality stocks to outperform low-quality stocks, 36% expect large-cap to beat small-cap, while 30% expect low-volatility to outperform high-volatility. If correct, say goodbye to high beta, momo, "dash for trash" stocks.
Looking at the shorter term, how are the smartest guys positioned headed into the Fed meeting? The survey shows the biggest MoM drop in Tech since Jan’08 with respondents most bearish on Industrials since Sep’12. BofA's take: "So high quality and large cap = consensus favourites." In other words, while the majority expectation is for a rate hike, while many also hope for "dovish language", few are willing to put their money where their hopes are.
Finally, for those who wish to fade the consensus, BofA has the following reco: "Contrarians would go long EUR, EM, commodities, resources & bonds; and would short banks, real estate, discretionary, Eurozone & Japan."
In short: nobody really has much grasp how to trade an economy that will see ongoing substantial profit contraction, finds itself in a late cycle, suffer more curve inversion, and yet where everybody is long the dollar - the biggest catalyst for slowing profits - on expectations of Fed rate hikes which, by tightening financial conditions, will unleash the next recession.
The hope of course, being that while everyone realizes the next recession is just around the corner, and the Fed's rate hike will bring it even closer, nobody dares to stand apart from the herd and to put on any contrarian trades, especially when it comes to the biggest consensus trade of all, the USD.
After all, the same Fed which may well be the catalyst for the recession, has also been the primary driver for stock levitation over the years.
No surprise then that nobody has any clear idea how to be positioned for 2016 when the link between rising markets and the deteriorating economy may finally hit its breaking point.