Analysts at BAML have been confused by the markets lately. In a report authored several days ago, BAML noted that their ‘model’ could only account for a 2 percent drop in the price of Gold. The analysts could not understand/explain how the price of gold dropped 16 percent (never did they think that maybe their model is worthless like the financial crisis proved to the world regarding banks). However, gold is not the only asset which has the analysts at loss for an explanation. They also cannot understand why stocks and credit are doing so well.
In a new report titled ‘The curious cases of stocks and credit’ the analysts note ‘Everybody is getting worse but stocks and credit are getting better. US economic data is deteriorating, there are global growth concerns in Europe and most recently in China reflected in sharply dropping commodities, and inflation expectations are coming down hard. Yet stocks and credit are moving back toward their peaks. Every time over the past several years when inflation expectations have eased significantly stocks have declined and credit spreads widened meaningfully. But not this time.’ The analysts offer some explanations for the phenomenon, but still believe that credit might be due for a correction. Below is the report on ”The curious cases of stocks and credit’ along with some commentary from BAML on the most crowded and least crowded asset classes.
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Research Overview — The Situation
The curious cases of stocks and credit
Everybody is getting worse but stocks and credit are getting better. US economic data is deteriorating, there are global growth concerns in Europe and most recently in China reflected in sharply dropping commodities, and inflation expectations are coming down hard. Yet stocks and credit are moving back toward their peaks. Every time over the past several years when inflation expectations have eased significantly stocks have declined and credit spreads widened meaningfully. But not this time. We continue to side with the weakening macro backdrop and retain our tactical (short-term) short positioning in investment grade credit.
Perhaps stocks and credit are holding up on the perception that US and Japanese QE will push investors into US risk assets regardless of fundamental weakness – in other words, that strong technicals will overcome weak fundamentals. That appears uncharted territory, as what we have seen in the past is that QE can work to push investors into risk assets when perceived to boost economic activity and thus create inflation. We have little evidence that QE alone can do the job, without being perceived to improve fundamentals. Thus, again, we expect the weakening macro backdrop to prevail. However, in the meantime the technicals are undeniably strong despite the lack of retail inflows to long and intermediate high grade bond funds. Clearly we are seeing foreign institutional investors – especially from Asia – moving into US corporate bonds. However, this process has been ongoing for at least a year and is unrelated to the expansion of Japanese QE.
Perhaps the US economy is strong enough to overcome the recent adversities. This argument is close to our view and consistent with consensus expecting a rebound in the economy in the second half of the year. However, the current slowdown in the economy is clearly worse than expected at this stage, as evidenced by the declining Economic Surprise Index. Moreover, on top of surprising domestic weakness we are faced with a number of important external risks such as those emanating from North Korea and Europe. Thus if stocks and credit are counting on the economy to pull through the near-term challenges they must believe strongly in an underlying more independent source of growth – such as the housing market recovery. This is our view and the reason we position for higher interest rates in the second half of the year. However, still we expect credit spreads to widen in the near term.
Capitulation in Commodities
FMS takeaways: unambiguous capitulation in commodities, energy & materials; cash levels jump as the exuberant investor optimism of Q1 dims; Japan equity exposure up to 6-year high. April FMS shows investors positioned for good news from US real estate & bad news from Chinese real estate.
On the macro & policy: FMS expectations for stronger growth drop from 61% to 49%; more investors (52%) believe Fed will not sell any MBS assets when it unwinds QE, a clear risk for markets should that prove wrong; meanwhile just 7% now see US fiscal policy as the biggest “tail risk” (down from 37% in Jan).
On risk: FMS cash up sharply, from 3.8% to 4.3% of AUM; our FMS Risk Index dips from 47 to 45; hedge fund net exposure drops from 40% to 33%.
On equity regions: FMS investors go UW euro zone, increase US exposure to a 10-month high, reduce EM allocations close to multi-year lows and raise Japan weighting to highest level since 2006 (note % saying yen most likely FX to depreciate at 13-year highs).
On AA & sectors: the April reduction in risk exposure most concentrated in commodities, where allocations dropped to their lowest since Jan ’09; positioning in Energy stocks drops to all-time low, in Materials to lowest level since Jan’09; visible rotation away from other cyclical sectors (Tech, Banks, Discretionary) toward the Telecom sector.
Contrarians would… buy Commodities, Energy & particularly EM Materials stocks, and sell US Banks & Industrials, Japanese Autos and EU Insurance stocks. (Last month’s long Telco, short Tech trade worked well in the past 4 weeks; the Resources trade is still lagging).