Michael Hartnett, Chief Investment Strategist, BAML is out with a new report titled ‘When Genius Fails, Madness Succeeds & EMs Crash.’ The report is not about Roger Lowenstein’s famous book on LTCM crash, but rather on emerging markets and Ben Bernanke. Michael notes that bond managers were convinced of Bernanke’s monetary largesse, groggy economic growth and the profitability of the carry-trade. The end of a 30-year bull market in bonds and a 5-year bull market in central bank liquidity has thus been very damaging to excess positioning in fixed income (record losses & outflows). He believes that the H2 risk remains of an Asia/Russia/LTCM-repeat in which funding problems for excessively levered countries, corporates or investment companies cause deleveraging and forced selling across asset classes. Watch the MOVE index. More details from the report below.

When Genius Fails Bond Market

When madness succeeds…

Amid the market turmoil, US house prices rose 12.2% YoY in June, the fastest house price appreciation since the bubble of 2006. Few investors were positioned for the bond crash and fewer still are positioned for higher rates to have a POSITIVE impact on economic activity. Bank stocks remain the ultimate barometer of future growth expectations. The relative resilience of US, Japanese and core European bank sectors bolsters our conviction of equity upside in 2013 for the cheap cyclical areas of equity markets, particularly US banks and Japanese and European stocks.

When Emerging Markets crash…

Despite some signs of market capitulation and bad news from China already having been discounted, the EM risk is a further unwind of EM debt positions, forcing EM equity investors to unwind their consumer stock winners. In our view, true capitulation will occur when investors are forced to sell their beloved winners. A weaker than expected payroll report (say less than 120K), and Emerging Markets are likely to build upon their tentative trading rally (see EEM, EMB, ADXY). But investors looking for a cyclical entry point should wait for policy makers to ease, or for a weaker US dollar.

On Flows & Sentiment

Four days of fund flows show some stabilization in redemptions, as HY bonds are on course for their first weekly inflows in 6 weeks, EM debt funds eked out its first daily inflows in 27 trading days and EM equities saw inflows. However, our Bull & Bear Index has deteriorated further over the past week, from a level of 4.0 to 2.5, indicating that broad investor sentiment has become more bearish, and is now approaching an extreme level. Together with our Breadth Rule and EM trading rule, this reaffirms that the trading risk remains a bounce in oversold risk assets.

When Genius Fails… Bond Investors At Their Worst

This year, bond investors are experiencing their worst (annualized) losses in Treasuries since 1978, in Municipals since 1999, in EM debt since 1998. Fund redemptions have been similarly brutal: global bonds have seen a record $58bn of outflows in the past four weeks, equivalent to 2.2% AUM. Bond managers were convinced of Bernanke’s monetary largesse, groggy economic growth and the profitability of the carry-trade. The end of a 30-year bull market in bonds and a 5-year bull market in central bank liquidity has thus been very damaging to excess positioning in fixed income. The H2 risk remains of an Asia/Russia/LTCM-repeat in which funding problems for excessively levered countries, corporates or investment companies cause deleveraging and forced selling across asset classes. Just this week the Brazilian equity market tumbled, partially in response to concentrated bank exposure to Xcompanies. Investors should continue to monitor the BofAML MOVE index, which measures Treasury market volatility, and has always been faithful indicator of large financial market crises (Chart).

Investors worried about further market turmoil should note that commodity and Asian equity puts are cheap ways to hedge contagion, and Analyst Ben Bowler also recently identified a number of attractive put spreads on ETFs.

When madness succeeds… Bond Bulls

Amid the market turmoil, US house prices rose 12.2% YoY in June, the fastest house price appreciation since the bubble of 2006. The strength of the US housing market is the most obvious reason for upward pressure on interest rates

“Buy-the-dip” say the bond bulls, and buy they will if Friday’s payroll fails to meet expectations, the bulk of which fall in the 150-190K range. But what if the higher US interest rate expectations engendered by Bernanke cause an INCREASE rather than decrease in H2 economic activity? Could not economic behavior change if households and business STOP believing rates would stay at zero forever? Few investors were positioned for the bond crash and fewer still are positioned for higher rates to have a POSITIVE impact on economic activity. And yet, the 120bps jump in fixed mortgage rates has thus far coincided with HIGHER applications for home purchase mortgages (BAC data as of June 28th –

Bank stocks remain the ultimate barometer of future growth expectations. When interest rates rise and bank stocks fall, markets are becoming more pessimistic on economic activity. Conversely, when rates rise and bank stocks also rise, that is a positive sign. The league table of bank performance since the May 21st FOMC shock, clearly shows who is most and least vulnerable to rising rates. The relative resilience of US, Japanese and core European bank sectors, bolsters our conviction of equity upside in 2013 for the cheap cyclical areas of equity markets, particularly US banks and Japanese and European stocks.

When Emerging Markets crash…

In contrast, bank stocks in Turkey, Brazil, China India and Russia (Table, page 3) have crashed. The bursting of the EM debt bubble and the China growth bubble have been the catalyst, and once again Emerging Markets have yet to escape the history of crisis and contagion. Marketing in Rio and Sao Paulo this week revealed an investor mood that was unambiguously bearish on local markets, with some now viewing a recession in Brazil as a good thing if it forces necessary political and policy change. But despite some signs of market capitulation and bad news from China already having been discounted, the EM risk is a further unwind of EM debt positions, forcing EM equity investors to unwind their consumer stock winners. In our view, true capitulation will occur when investors are forced to sell their beloved winners. As the chart below shows, this has yet to happen in Brazil and elsewhere.

A weaker than expected payroll report (say less than 120K), and Emerging Markets are likely to build upon their tentative trading rally (see EEM, EMB, ADXY). Investors looking for a cyclical entry point into Emerging Markets should wait for the following catalysts:

  • Unemployment, which is very low in many EMs, rises to levels that force policy makers to panic.
  •  Chinese policy makers ease as exports, employment and growth threaten social instability. Watch the RMB for signs of a shift.
  •  Anything that harms the US dollar; EM currencies are the lead indicator for risk aversion in EM and no recovery is possible until they rally and become less volatile.

This would

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