While valuations and its tactical models are signalling a more pro-risk environment, Bank of America Merrill Lynch investment strategists argue that there is need for greater improvement in macroeconomic conditions for stronger growth to emerge.
Strategists James Barty, Ronan Carr and Jack Iacovou said that market signals were much more improved at the start of 2019 from where they had been 12 months earlier.
“This time last year the data was great and earnings revisions were sky high, as was investor confidence,” they said. “Yet our models were flashing warning signals and global equities peaked for the year on 26 January.”
However, after the fall in equity markets at the end of 2018 and with earnings revisions having experienced their worst slide in 30 years amid increased investor bearishness, the bank’s models have been triggering buy signals “across the board”.
As the most recent edition of the bank’s Global Fund Manager Survey revealed, investor bearishness has manifested itself in weaker growth and earnings per share expectations for the coming 12 months, as shown below.
Source: BofA ML Global Fund Manager Survey
Taken together, current market conditions and the bank’s models are now signalling a more risk-on approach.
“The tactical signal came at a time when global equity markets had significantly de-rated, with the MSCI AC World index 12-month forward P/E [price-to-earnings ratio] dropping below 13x at the lows,” the strategists said.
“Global equities have only really been significantly cheaper over the last 30 years in the global financial crisis and the eurozone crisis.
“The peak-to-trough de-rating was some 27 per cent, something only exceeded in those two episodes and the bear market that followed the ‘tech bubble’ of 1999/2000. In other words, we have priced in a growth scare but not a full-blown recession.”
Indeed, given the more volatile market backdrop, the bank’s US strategists believe valuation dispersions in the S&P 500 have reached their highest levels since the financial crisis, something that has “historically provided more alpha opportunities for stockpickers”.
As such, they have begun to favour US stocks where they see the best earnings growth potential, although a resolution to the US-China trade dispute is likely to be a deal-breaker.
“Our view has been that both sides want a deal and president Donald Trump's tweets have certainly been more positive of late,” said Barty, Carr and Iacovou. “We also think given the weakness of the Chinese economy there is pressure on president Xi Jinping to compromise too.”
However, key issues such as intellectual property and state subsidies will need to be tackled when the next round of negotiations begin at the end of the month.
For global growth to pick up there will need to be more positive resolutions to several other longstanding issues.
In China, more easing is likely to be required to stop the economy from slowing, although another drop in the reserve requirement ratio – the amount of capital Chinese banks must hold – and tax cuts should be positive.
Elsewhere, in Europe more fiscal stimulus could help the flagging eurozone economy, although it would need to avoid the shock of a ‘no deal’ Brexit.
However, the BofA ML strategists believe that the risk of a no deal Brexit are falling, particularly after prime minister Theresa May’s deal was defeated.
“We fully expect MPs to make clear that they will not support and no deal Brexit and likely force the prime minister to ask for an extension of Article 50,” they said. “Where we go after that is not entirely clear, but the obvious routes would seem to be towards either a softer Brexit or a second referendum if parliament cannot decide.
“In our view, as this becomes clear, more of the ‘no deal’ risk premium will need to come out of sterling and UK inflation expectations.
“The latter are also affected by the risk of a Jeremy Corbyn-led Labour government, but current opinion polls show little prospect of Labour winning the type of outright majority that would allow them to enact their more radical policies.”
And in the US, the Federal Reserve will also likely have to pause its rate-hiking programme, although that outlook remains uncertain currently.
“While chairman Jerome Powell and colleagues have definitely blinked, saying that the Fed needs to be patient and that it will respond to shifts in the outlook for the economy, our economists believe that the risks on rates remain firmly on the upside,” said Barty, Carr and Iacovou. “Given the tightness of the US labour market, as evidenced by the steady rise in US average earnings, the barrier to the Fed cutting rates is certainly high.”
The bank's economists are currently forecasting global growth of 3.6 per cent for 2019, said the three strategists, slightly higher than the 3.5 per cent predicted by the International Monetary Fund in its latest World Economic Outlook.
“The more growth dips below 3.5 per cent, the more likely it is that global earnings growth will fall to zero and even below," they explained. “Growth at the rate that our economists forecast is consistent with around 5 per cent earnings growth, which is only a modest decrease from the 7 per cent currently assumed by the consensus. Put earnings growth at zero and we are in a much more difficult situation for markets.”
In addition to the long-US position, the strategists favoured long emerging markets and Asia where valuations are bear markets lows and companies should be the biggest beneficiary of a softer dollar and progress on a US-China trade deal.
“For now we stay on the sidelines in Europe and Japan at least until there is more of an all-clear signal on the global cycle,” they added.
“Europe screens particularly beaten up after months of outflows. Nevertheless, without evidence of renewed global reflation and regional political uncertainties not yet fully resolved, we prefer the risk/reward in the US.”
While the bank is now running with the new year rally, it continues to employ protection on all its long-equity positions in via put spreads in the event that a US-China deal fails to materialise and noting how sudden shifts in sentiment have been recently.
Within its US equity position, the BofA ML strategists prefer industrials despite the sector's correlation to the global cycle and trade war risks, as they believe it should prove more resilient given its high-quality characteristics.
“Balance sheets are much stronger than on average historically and return on equity has risen in absolute and relative terms,” the said. “Moreover, earnings volatility in industrials is the second-lowest of the major sectors in the US after staples.
“The sector de-rated over the past year despite long-term growth expectations ramping higher, which historically has tended to support valuations.”
In addition, sentiment in the sector has also collapsed representing a net 11 per cent underweight in allocators’ portfolios, according to the latest Global Fund Manager Survey – the lowest allocation since February 2016.