"After a Jan/Feb wobble, we believe stocks & commodities will have one last 10% meltup in H1," explains BofA's Michael Hartnett in his latest note, but, he adds, by the end of 2017 we will see a "meltdown." BofA awaits the endgame of the so-called "Icarus Trade" amid unambiguous signs of bullish investor Positioning, bullish Profit expectations & hawkish Policy from Fed/ECB, as well as outperformance from laggard risk assets; before calling for the Big Short.
The Icarus Trade
Our tactical view: after a Jan/Feb wobble, we believe stocks & commodities will have one last 10% melt-up in H1. Call it the “Icarus trade”. The current melt up, which started back in Feb 2016, will be followed by a meltdown later in ’17.
The current rally started in Feb 2016 with…
- bearish Positioning (BofAML Bull & Bear indicator = 0, cash = 5.6%, big >2SD underweights in Emerging Markets & energy)
- excessively bearish Profits (credit spread blowout, PMI's crashing toward 45, global EPS negative)
- and Policy impotence ("Quantitative Failure").
Thus the rally is likely to end with…
- bullish Positioning (BB indicator = 8, cash = 4%, unambiguous long positions in stocks, Japan & banks)
- excessively bullish Profit expectations (global PMI's >55, US wage growth >3%)
- and Policy hawkishness (Fed jacks up short end of yield curve, ECB tapers).
Are we there yet? No.
- We believe Positioning is bullish but not dangerously euphoric (B&B indicator is 3.6, FMS cash @ 19-month lows of 4.8% but elevated versus 15-year history, global equities trade just 3% above 200-day moving average).
- Profits likely to be revised higher following strong Dec’16 ISM print (implies 10% US EPS growth – Chart 2 below); credit spreads well-behaved with US & European spreads at 18-month lows; however PMI’s getting closer to “peak” and US wages close to 8-year highs.
- And bond market yet to aggressively price-in hawkish monetary Policy: US financials conditions in “easy” territory according to our simple model; US yield curve has stopped steepening but yet to see a “bear flattening”; ECB “taper” = key catalyst for rates volatility, but our economists say no taper in 2017.
Sure, you can get a wobble in coming weeks. Investors are partial to the “buy the election, sell the inauguration” argument. Fed anxiety could pick-up between the two winter FOMC meetings: Feb 1st & March 15th, especially given December surge in US wage growth. And Trump/Mexico/China headlines/tweets have the ability to rattle sentiment as the new President seeks to immediately boost his ratings via populist trade policies & legislation (…from Occupy Wall Street to Occupy Detroit or Occupy Silicon Valley).
But we don’t see Positioning, Policy & Profit arguments for a big Q1 correction. The conventional wisdom has flipped from “Davos Man” portfolios to “Joe Six-Pack” portfolios in recent quarters. But let’s not forget the extremity of the starting point of this Great Rotation: global interest rates were at 5,000 year lows in Jul’16 and this induced acute dislocations in asset/sector/regional valuations…
- $1.5 trillion inflows to bond funds in past 10 years vs $0 to equity funds
- Real assets at 90-year lows versus financial assets
- US stocks at 60-year highs versus European stocks, and so on.
Thus we should expect the ongoing rotation out of entrenched Wall Street to Main Street (Table 1) assets to be violent, extreme, and ultimately overshoot.
The Icarus Trades
The core Wall Street to Main Street trade remains long banks, short bonds. A few laggard risk trades:
- Global small cap stocks…they’re at 20-year lows relative to US small cap (Chart 3)
- European & Japanese banks…note that even today, after a decent banks rally, the combined market cap of Google & Apple ($1,167bn) exceeds that of all the banks in the Eurozone & Japan combined ($1,149bn)…and that despite (or because of) an avalanche of bad news and bearish positions, financials are the best performing sector in the US in the past 5 years
- UK assets…the world’s favorite underweight.
The contrarian should be tempted by EM assets, but they remain hampered by China’s currency devaluation. China’s currency is likely to remain under pressure due to capital outflows & deteriorating rate differentials with the US. When Asian currencies depreciate (the renminbi is the largest component of the Asia Dollar Index “ADXY” which is currently close to its 2008 lows), EM underperforms (Chart 4).
Finally, in term of 2017 tactics, the signals that the Big Top in risk assets is approaching in coming quarters will likely be fatigue in high yield & US banks, a contrarian rally in gold, and rates volatility as the era of excess liquidity reverses.
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