JPM, Citi, UBS, and now one of the Wall Street strategists whose perspective we respect the most, BofA's Michael Harnett, who quite clearly disagrees with the official BofA "straight to CNBC" mouthpiece Savita Subramanian, is out with a note in which he is telling reders to get out of stocks, go into cash expecting a short sharp pullbacks in risk assets (e.g. SPX to 1850-1900), and be long volatility.
From his report:
Investors should be long cash & volatility, and be prepared for a short sharp pullback in risk assets (e.g. SPX to 1850-1900), at least until one of the following conditions is met:
- PMI’s back over 50 in China & US
- 2-way risk emerges in CNY & oil inducing value buyers of HY & EM debt
- A spike in volatility and/or an asset price reset induces Fed to pause
Why the unexpectedly bearish stance? According to Hartnett, "cash is king" and defensives are to be bid because of the 3Ps: Positioning, Profits and Policy.
This is what he thinks:
3P’s say Cash is King
Ever since the end of QE3 in late-2014, leadership across asset markets has shifted sharply away from stocks & bonds, to the US dollar, volatility & cash. In 2015, cash outperformed both stocks (down 2%) & fixed income (down 3%), for the first time since 199 (Table 1).
The new leadership is unchanged in the early going in 2016. Cash, gold & government bonds are the sole assets in positive territory thus far. And we believe the three drivers of asset prices, Positioning, Profits, Policy, argue for further outperformance of defensive assets in the near-term.
On Positioning:
The best reason to be bullish right now is there are so few reasons to be bullish: our Bull & Bear Index has sunk back to a very bearish reading of 1.3; high yield bond funds experienced extreme outflows in December ($12bn outflows in just 3 weeks, a contrarian indicator which may help explain HY’s resilience in recent days), and equity markets start the year very oversold - our Global Breadth Rule is once again approaching a contrarian “buy” signal.
Three trends nonetheless point to lower Q1 demand for risk assets:
1. Private client allocations to cash are on the rise. BofAML GWIM cash as a % of AUM jumped to 12% in December, a 2-year high, while equity allocations have dropped to 59% from a Mar’15 peak of 63%.
2. The Sovereign Wealth Fund bid for risk assets is falling. The level of SWF AUM (currently $7.2 trillion) has stagnated in recent quarters. $4.4tn of all SWF AUM originates in commodity-producing countries. Given the new commodity price regime (oil averaged $90/bbl in the 10-years to 2014 but will average closer to $50/bbl in the 2015-2017 period), SWF AUM is likely to come under downward pressure. SWF exposures are notoriously opaque, but publicly available data shows equity allocations of around 50%, concentrated in consumer, financial, industrial & tech sectors. Table 2 shows the top stock holdings of the Norges pension fund, the world’s largest SWF.
3. Buybacks will be less of a tailwind for stock markets & EPS. Rising rates and spreads means lower debt issuance, which in turn means less money for stock buybacks. S&P’s recent downgrade of Yum was driven by its announcement of a stock buyback program to be likely funded by even more debt. If companies cannot now issue debt to fund buybacks, this marks an important turning point for the stock market.
On Profits:
1. Global corporate profits are falling. The latest YoY growth of global EPS is -5.8%. Profits are highly correlated with PMIs and in both the US & China PMI’s are weak, i.e. below the boom-bust level of 50 (Chart 2). Upward momentum in these indicators is desperately needed to prevent Q1 being a quarter of EPS downgrades: consensus forecasts 2016 EPS growth of 7.3% in the US & 9.9% for global profits.
2. Recession risk is rising. Classic cyclical signals such as the Dow Jones Transportation Index are in unambiguous bear markets, and are now dragging “new economy” indices lower (e.g. IXK – Chart 3). Thus fresh downside to PMIs would be very worrying: an ISM below the 45 level has coincided with an official US recession 11/13 times since WW2 (see front page chart), is historically associated with (at a minimum) a 5-10% drop in profits, and should it occur in coming months, would be entirely consistent with 1.5% on the 10-year Treasury yield and 1800 on SPX.
3. Long US dollar has morphed into a “risk-off” trade. A stronger US dollar threatens to darken the outlook for US manufacturing, exacerbate the death spiral in commodities, EM & resources, and induce expectations of worsening geopolitics in the Middle East.
On Policy:
1. US monetary conditions are tightening. The FOMC is raising rates, credit spreads are rising, and the US dollar is appreciating. The US economy is experiencing a considerable tightening of monetary conditions. Should strong US consumer spending allay fears of Quantitative Failure, all will be well – hence the importance of Friday’s payroll. If not, look for both equity and credit markets to reset lower until such time as the Fed says (even if temporarily) “pause”. Fed tightening is almost always associated with “events” (Chart 4), and markets have a habit of forcing policy reversals (e.g. Fed 1937, BoJ 1995, BoJ 2000).
2. The Great EM Devaluation continues. The Chinese, following all other EM’s, are now devaluing sharply (CNH offshore is down over 6% in less than 10 weeks). As we have said before, until there is 2-way risk in RMB, there is 1-way risk in oil, commodities and EM. BofAML remains long 6-month forward USD/CNH, and long 3-month USD versus a basket of KRW, TWD, MYR. Once Chinese exports react positively to the cheaper currency, a bid is likely to return to Chinese assets. Until then the greatest China threat could be via the Chinese corporate bond market, currently at multi-year highs versus Chinese stocks (Chart 5) despite a credit crunch.
3. The End of the Oil Age. The new oil price regime is likely to continue to create financial stresses in the Middle East (see stock prices in Iran & Saudi Arabia – Chart 6) and fears of regional currency pegs coming under pressure or speculative attack.