RISK-OFF FLOWS INCREASING - BONDS & GOLD BID - WATCH THE US$ FOR A "PANIC TO SAFETY"
One month ago, BofA's chief investment strategist Michael Hartnett predicted that the "most dangerous moment for markets will come in 3 or 4 months." So now that we are between 25% and 33% closer to said "moment", what does Hartnett think now? Perhaps not surprisingly, in a note released on Friday, the Bank of America analyst writes that with a surge in risk off flows, a "more imminent Aug/Sept risk-off trade" is looking plausible "if poor politics shows up in consumer confidence, US dollar rises despite lower UST yields and further drop in US presidential approval ratings" compounded by high yield credit spreads gapping toward 500bps and ending tech leadership reversal.
In short, the "humpty-dumpty" trade that Hartnett has been describing ever since he coined the "Icarus rally" term earlier in the year, is "staring to wobble" despite - as he calculates - the $1.69 trillion in central bank purchases YTD. Some of the main factors he lists why BofA, like JPM previously, is starting to tiptoe to the exits, are the following:
- Risk-off flows: There were $1.3bn weekly outflow from equities, $3.5bn into bonds, $0.5bn into gold
- North Korea: outflows clustered in "fire & fury" Thurs/Fri/Mon period; but North Korea redemptions ($7.4bn equity outflow) not particularly large (larger 3-day outflow in April)
- High Yield outflows: biggest HY bond fund outflows in almost 6 months ($2.3bn); HY spreads jumped 36bps last week from 364bps to 400bps
- Emerging Market outflows: 1st EM equity and debt outflows in almost 6 months ($1.7bn); coincides with bounce in oversold USD (EM reverse-correlated with DXY)
- BofAML Bull & Bear indicator drops: HY & EM outflows + more defensive hedge fund positioning via futures + Aug FMS cash flat at 4.9% = BB indicator drops from 7.7 to 7.2; no "sell signal" triggered but institutional sentiment on risk assets has been bullish, e.g. BofAML Aug FMS showed "Goldilocks" macro view at record high
- Private clients increase cash: BofAML GWIM allocation to cash rising to 10.6% in Aug, on course for 1st MoM increase this year, albeit from record lows (Chart 4)
It's not all doom and gloom: there is the possibility that the optimistic, i.e., "Icarus" scenario will persist:
- Summer Icarus: dovish CB policy (CB's buying of financial assets YTD now up to $1.69tn) + 12.9% global EPS growth (fastest since 2010 - Chart 2) best rationale for ongoing Icarus trade (targets remain SPX 2630, CCMP 6666, ACWI 510); Fed will reduce balance sheet in Sept but Fed so dovish that old market adage "buy the first rate hike, sell the penultimate rate hike" new adage may be replaced with "buy the first QT, sell the penultimate QT" (QT = "Quantitative Tightening")
And then there are the bearish outcome, and why the in addition to an autumn "humpty-dumpty" trade (see below), a summer one is also looking more imminent, and could come as soon as this month:
- Autumn Humpty-Dumpty: wider credit spreads and EPS inflection point our favorite catalysts for narrative shift from Goldilocks to Humpty-Dumpty (i.e. big fall in markets) in autumn
- Summer Humpty-Dumpty: more imminent Aug/Sept risk-off trade plausible if a. growing geopolitical/political/tax reform volatility shows up in weaker Aug US consumer confidence, EU/Japan business confidence; US high yield credit spreads (393bps today) gap further toward 500bps; d. tech leadership shows fatigue (SOX, DJECOM, EMQQITR, IBOTZ all roll over hard)
As for the key catalyst to time the big fall, i.e. "the important risk off signal", Hartnet proposes to just keep an eye on the dollar:
US dollar starts rising on risk-aversion, i.e. despite lower UST yields and further drop in US presidential approval ratings (dollar correlated with politics YTD);
In other words, once the US dollar start rising rapidly despite the ongoing chaos in Washington, sliding Trump approval rating and lower TSY yields, it will be a clear indication of capital flight into the US (accelerating unwind of this year's EM trades), which would then rapidly lead to something much uglier.