Markets could sell off in the third quarter of 2021, Bank of America strategists have warned, as investors react to the risk that economic growth and corporate earnings might start to splutter before the end of the year.
Despite the coronavirus pandemic hammering the global economy in 2020, markets had a strong run last year thanks to masses of fiscal and monetary stimulus.
Robust performance continued in 2021, as confidence over the roll-out of effective vaccines buoyed economic growth and led to gains for risk assets such as commodities and stocks.
Performance of asset classes in 2021
Source: FE Analytics
Bank of America pointed out that the past 15 months has seen $30trn of stimulus announced across the globe but some $14trn of debt is still trading on negative yields. The average yield on 10-year government bonds across G10 is just 0.3 per cent.
The bank’s strategists argued that a combination of a US Federal Reserve that is unwilling to upset the market and poor levels of yield in areas like bonds is the key reason why investors continue to be believe ‘there is no alternative’ to risk.
However, they warned that this could change in the coming months.
Bank of America’s outlook for the pandemic, price, positioning, policy, profits (which is calls the Five Ps) suggest a “sharp slowdown” in global GDP and earnings per share (EPS) in the final quarter of 2021. This suggests stocks, credit and commodities will turn negative in the third quarter as investors price this in.
Pandemic
More than 3 billion doses of the various Covid vaccines were administered over the opening half of 2021, which Bank of America strategists noted was “very bullish” for risk assets.
“But further gains in daily cases and especially hospitalisations in highly vaccinated populations will cause downward pressure on 2021 and 2022 elevated GDP and EPS expectations,” they added.
Daily UK hospitalisations rising >1000 = negative
Source: BofA Global Investment Strategy, Bloomberg, John Hopkins
The bank highlighted the UK, which is currently going through a third wave of Covid as said a rise in daily hospitalisations to above 1,000 would be negative for the market.
Price
The S&P 500’s trailing price/earnings ratio has averaged 15x sine 1901 but currently stands at 30x – its highest ever – and raises concerns of excessive valuations.
Added to this, Bank of America said, is the fact that 2021’s first half was the fifth best for both global stocks and commodities over the past 100 years while being the fourth worst for government bonds.
“Wall St boom/bubble needs breather and one of world's best risk appetite lead indicators, the Brazilian real, has failed to corroborate H2 risk-on consensus,” its strategists said.
Brazilian real has not corroborated risk-on in H2
Source: BofA Global Investment Strategy, Bloomberg
Positioning
Bank of America has its own gauge of market sentiment - the Bull & Bear indicator – which it monitors various inputs to determine when appears to be an opportune time to buy or sell.
This BofA Bull & Bear Indicator currently sits at 6.4 (where 0 is ‘extreme bearish’ and 10 is ‘extreme bullish’), so is not flashing a sell signal at the moment.
However, the bank added that 2021’s opening half witnessed “remarkable inflows” into stocks, index-linked bonds, financials, materials and infrastructure funds while allocations to ‘late-cycle’ assets like commodities and banks last month reached their highest in 15 years.
But over the past month, value stocks – which have led the market for much of 2021 as investors eye higher inflation and a strong economy – have fallen behind the growth style.
Performance of value and growth stocks over 1 month
Source: FE Analytics
“Nobody is long bonds and short stocks,” Bank of America strategists said. “But everyone is a) bailing on value versus growth and b) believes US tech the Q3 hiding place rather than defensives.”
It added that the third-quarter “pain trade” would be the S&P 500 index moving below 4,000 (it’s currently around 4,300) after being led downwards by tech stocks.
Policy
The bank noted that global banks have bought around $10bn of bonds and the US federal government has spent $20bn on every day of 2021 so far, providing a supportive backdrop for risk assets.
However, it warned that this ultra-loose environment could be about to get tighter as concerns shift to the likelihood of higher inflation. It suggests that the US, Canada, the UK, Australia, New Zealand, Sweden, Norway, Brazil and Russia are among those that could taper or tighten policy, following China’s recent move to tighten.
“Thus far China government policy is to not allow tech billionaires to run their country, PBOC policy is to not allow speculative bubbles to worsen wealth inequality,” it added.
Profits
Another reason why the next few months could bring more volatility for risk assets is declining profits.
Bank of America’s global EPS model suggest a deceleration in profit growth from around 40 per cent in April 2021 to below 20 per cent in August.
“But the most obvious reason for a negative Q3 for assets is a negative Q4 for macro (after three-four quarters of stunning, abnormal growth),” the strategists continued.
“Wall Street leads Main Street so re-pricing lower of overvalued stocks and credit leads to drop in business and consumer confidence and added downside risk.”
Should 2021’s third quarter bring a market sell-off, Bank of America’s strategists said investors should consider defensive stocks over tech and cyclicals, as well as investment grade bonds over high yield.
However, it listed a number of “bull catalysts” that could keep markets buoyant over the coming months and lure investors back into areas such as small-caps and value.
These include: the US infrastructure package regaining momentum, China easing aggressively and/or intervening in domestic stock and credit markets, US yield curve beginning to bull steepen as Fed hikes priced-out or a “blockbuster” US payrolls print.