Champion of the Great Rotation Warns of C.R.A.S.H.

When Michael Harnett talks about long term strategy, markets listen.  Why?  He is Mr. “Great Rotation,” the strategy that–InrnOctober 2012–predicted that bond yields and stock prices would go way up.  That turns out to have been a prescient call, and now he and the global investment strategy research team at Bank of America Merrill Lynch have some concerns about a “crash.”  That could turn out to merely be an acronym for risks to the outlook or the inherent factors could actually produce a crash for equities.  The implication for any sort of reversal of the Great Rotation would be benefit for bond markets.</p

In an investment letter the team points to leverage indicators they think suggest increasedrnspeculation in the market of the sort that preceded the great financial crisisrnin 2008 and the 9-12 months of excessive volatility in the bond markets. </p

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Hartnett, who coauthored the articlernwith Brian Laung, Global Equity Strategist; John Bilton and Nupur Gupta, EuropeanrnInvestment Strategists; and Marish Kabra, Equity Strategist, notes that the equityrnmarket is entering the seasonally weak period for risky assets and that U.S.rnstocks which have not corrected even 10 percent in over two years, may bernsuddenly facing a “buyers strike.”  Couldrnthis signal the onset of a C.R.A.S.H. for equities and a rally of some degreernfor bond markets?   He suggests investorsrnpay attention to that word, an acronym for Conflict, Rates, Asia, Speculation, andrnHousing, all potential catalysts for a potentially contagious autumn event.</p

C is for Conflict</p

Things had been going pretty well for equities before thernsituation in Syria escalated.  Oil prices are already affected as theyrnwere in 2008.  The authors note thatrnequities underperform bonds during oil spikes and suggest the benchmark mightrnbe the Brent oil price exceeding $125/barrel. rn</p

Policy conflicts in emerging markets are also a concern asrnsome try to stem capital outflows and currency loses as rates rise in the U.S</p

R is for Rates</p

Bottom line, rates are the punchbowl that’s been keeping thernglobal liquidity party going.  The Great Rotation calls for this to dryrnup, but if it dries up too fast, and if it coincides with weaker bank stocks,rnit could be a sign of a damaged “carry trade” for the world’s largestrnfinancial institutions where their cost of funding is rising faster than theirrnreturn on investment.  </p

Another risk is potential mismanagement of the Fed’s taperingrnof quantitative easing which must not carry a hint of too muchrnmicro-managing.  The impending announcementrnof a new Fed chairman throws another wild card onto the pile. </p

A is for Asia</p

Hartnett notes that Asia and emerging markets are relivingrnsome of their past problems with account deficits.  Emerging markets havernhad a hard time with rising rates and if currency concerns spill over into thernChinese economy, this could pose problems for global growth</p

S is for Speculation<br /<br /<br /Hartnett notes that leverage indicators suggest an increased amount ofrnspeculation in the market–the same sort that preceded the 2008 financialrncrisis and the 9-12 months of excessive volatility in bond markets.  </p

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H is for housing</p

The recovery in housing which has ledrnto tightening inventories tighten and prices reaching bubble status in somernlocations appears to have stumbled over rising interest rates.  Pending sales as well as constructionrnindicators have been down in recent weeks and mortgage applications are down tornlevels last seen in 2011.  The authorsrnask if investors, who have been worried about tapering and liquidity, now havernto worry about the economy.   To bernreally confident that the recovery overall can be sustained we need to seernhigher rates and higher growth coexist. rnThe housing market may be hinting at the opposite.</p

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Despite their caution the authorsrnargue that there are several factors that argue against fears of any meltdownrnin stocks of the magnitude seen in 1987, 1998, and 2008.  First, short of a global recession, they dornnot see stocks as being overvalued at a 13.5 price to forward earnings ratio.  Second, they say it is impossible to arguernthat the markets are significantly overweight in equities and underweight inrnbonds.  The latter market has seen a nearlyrn$1 trillion inflow of funds since 2000 while equities have seen $388 billion inrnliquidations over the same period.  Thernauthors say that while “the structural position in bonds and leverage is a riskrnskewed towards fixed income, central banks do still control the bond market.”</p

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Emerging markets may also be arnbright spot for those with a long-term perspective.  “An improving long-term risk-reward trade-offrncould make EM the comeback asset class of 2014,” the authors say.

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