Investors have to start preparing for a regime change in markets and look to rotate their portfolio out of the winners of the post-financial crisis rally, according to analysts at Bank of America Merrill Lynch. 
In a recent note, the bank’s strategists warned that ‘QE winners’ such as tech stocks and emerging market debt will come under pressure and said investors should be considering a rotation into more defensive or stagflation plays such as cash and commodities.
Bank of America Merrill Lynch (BofA ML) expects to see investors positioning, corporate profits and policy stimulus come to their peaks during 2018; in turn, this will mean peak financial market performance.
“We expect low, volatile 2018 returns, limited equity outperformance of bonds, frequent market reversals and a rotation in coming months out of QE-winners (tech, emerging market debt, high yield, investment grade) to defensive/stagflation plays (cash, commodities, bond sensitives),” the note said.
In the following article, we look at seven charts that Bank of America Merrill Lynch is used to support its argument.
The end of “I'm so bearish, I'm bullish”
Source: BofA ML, Bloomberg
The decade since the global financial crisis has seen a strong bull run in equity markets, leading to many indices reaching record highs. In the US and many other countries, this has been down to ultra-loose central bank policy and strong corporate profits.
While Wall Street has surged, Main Street – or the overall economy – has struggled because of factors such as globalisation, tech disruption, ageing demographics, excess debt and bank deleveraging.
Bank of America Merrill Lynch argues that this dynamic looks under threat: “But in 2018 the bull market tailwinds are reversing… we forecast a regime change in volatility and credit markets, big top in equity markets.”
Second longest US equity bull market of all time
Source: BofA ML
The above chart demonstrates just how strong the past decade’s bull run has been. The S&P 500 has made a 325 per cent total return since the financial crisis bottomed out in 2009, compared with an average bull market performance of 174 per cent.
On 26 January 2018, the ongoing bull market in the S&P 500 became the second longest of all time and will become the longest ever if it continues until 22 August this year.
If equities outperform bonds across 2018, it would be the seventh year running this has happened; the longest winning streak for stocks since 1928, according to BofA ML.
A deflationary bull market
Source: BofA ML, Bloomberg, MSCI, Global Financial Data
However, the bank’s analysts added: “The bull market leadership has been in assets that provide scarce ‘growth’ and scarce ‘yield’.”
The above chart shows how deflation assets – which include government bonds, investment grade bonds, high yield bonds, consumer discretionary companies and growth stocks – have enjoyed a meteoric rise since the financial crisis.
Inflation assets such commodities, index-linked bonds, banks and value stocks, on the other hand, have witnessed much weaker growth over the same period as investors flocked to other parts of the market.
Bubble trouble
Source: BofA ML, Bloomberg
Bank of America Merrill Lynch uses the above chart to show how ultra-low interest rates of recent years have driven equity valuations higher. “Lowest interest rates in 5,000 years guaranteed ‘melt-up trade’ in risk assets…the ‘Icarus Trade’,” its analysts said.
They singled out e-commerce stocks as one area that has surged over recent years and argued that this looks to be the third largest bubble of the past 40 years. The Dow Jones Internet Commerce index – which includes the likes of Amazon, Facebook, Google parent Alphabet, Twitter, eBay and Facebook – is up 617 per cent.
The only two bubbles that have been bigger than this are the tech boom of the early 2000s and US housing in the run-up to the financial crisis. E-commerce has risen higher than bubbles such as biotechnology and gold in the late 1970s/early 1980s.
Private client equity allocations high
Source: BofA ML
The bank’s global wealth & investment management team noted that private client asset allocations remain biased to equities, with 61 per cent of assets in stocks and 33 per cent in bonds and cash.
Top exchange-traded fund holdings show private clients are positioned for equity outperformance of Europe, Australasia and the far east, the US, value, emerging markets and tech.
BofA ML’s Bull & Bear Indicator – which is a cross-asset barometer of sentiment – also shows continued bullishness across all investors. The indicator moved from extreme bearish in February to extreme bullishness by January 2018; the sell-offs of 2018 have since this dip somewhat but sentiment remains in bull territory.
The end of the ‘Liquidity Supernova’
Source: BofA ML, Federal Reserve
Much of the bull market gains explored in the previous charts have been driven by ultra-loose monetary policy but BofA ML said this ‘Liquidity Supernova’ has now peaked and markets will be entering the era of quantitative tightening.
Central bank quantitative easing programmes were making purchases of $4trn in 2016 and 2017 but this will drop to $400bn in 2018 and liquidity growth will turn negative by the end of the year.
The European Central Bank is expected to start tapering its own quantitative easing programme from September 2018 while the Bank of Japan is forecast to raise the level of its “yield curve control” mechanism in the third quarter.
Regime change
Source: BofA ML, Bloomberg
All of the above means that BofA ML is forecasting a regime change in volatility and credit markets in the future.
It noted that 2018 started with the Merrill Lynch Option Volatility Estimate Index – which is the bond market’s equivalent of the Vix – started 2018 at 50-year lows while credit spreads were at their tightest since the financial crisis; both have since normalised as liquidity support from central banks wanes.
“The ‘glue’ for the bull market in financial assets is credit and it is cracking… worst start for investment-grade corporate bonds since 1994: -2.9 per cent YTD 2018 versus -3.1 per cent by end-March 1994,” analysts said.
“The ‘glue’ for the bull market in equities is US tech; it is yet to crack [but] when it does, the potential leadership is invisible.”