Fund manager positioning and further policy action suggests a spike in volatility could be seen in markets by the end of the first quarter, according to the latest findings from the Bank of America Merrill Lynch (BofA ML) Fund Manager Survey.
In the bank's first survey of the year, fund managers have moved to their highest equity positions for two years and have also become more bullish in their corporate earnings outlooks.
While some had expressed concerns over the longevity of the equity bull run in the December poll and predicted markets would peak during the second quarter, most investors now believe there will be no peak in equity markets during 2018.
Indeed, as the ‘most hated bull run in equity markets’ continues, fund manager exposure to equities hit a two-year high in January to a 55 per cent overweight, with many now expecting markets to peak sometime in 2019 or beyond.
Source: BofA ML Fund Manager survey
This month’s survey also revealed that 44 per cent of respondents believe corporate earnings will improve while the profit outlook for cyclicals has exceeds defensive stocks, highlighted by the fund manager positioning.
However, the bullish outlook is tempered somewhat by the expectation of rising rates in markets and the withdrawal of stimulus, which could lead to a spike in volatility at the end of the first quarter.
Michael Hartnett, chief investment strategist at BofA ML, said: “By the end of Q1, we expect peak positioning to combine with peak profits and policy to create a spike in volatility.”
The survey found that just 4 per cent of respondents believe interest rates will be lower in the next 12 months, with 78 per cent anticipating higher rate environment.
The expectation of higher rates is reinforced by a change in leadership of the biggest tail risks to markets expected by fund managers, as well as a record high for the percentage of respondents who think fiscal policy is ‘too easy’.
While concerns over policy mistakes by the Federal Reserve or European Central Bank (ECB) dominated the fund manager survey at the end of last year, in January this was no longer the biggest tail risk for investors.
Inflation and/or a crash in global bond markets was highlighted by 36 per cent of respondents as the biggest tail risk for investors in the first fund manager survey of the year.
The top three tail risks were rounded out by a policy mistake by the Fed/ECB, highlighted by 19 per cent, while concerns over market structure worry 11 per cent of respondents.
Despite the bank’s forecast of a volatility spike at the end of the quarter, the most crowded trade currently is ‘short volatility’.
The trade has overhauled the ‘long Bitcoin’, ‘long Nasdaq’ and ‘long US dollar’ trends that dominated for much of last year as the most crowded.
Performance of VIX over 1mth
Source: FE Analytics
Short volatility was identified as the most crowded trade by 28 per cent of the survey’s respondents – which collates responses from 183 participants managing $526bn in assets under management.
With fund managers having moved to their biggest equity positions for two years, there was a corresponding drop in month-on-month cash levels from 4.7 per cent to 4.4 per cent – a five-year low.
However, this was not a sufficiently sharp enough fall to trigger a ‘sell signal’, although the bank’s ‘cash rule’ has indicated that equities have now entered neutral territory.
While the expectation of volatility has risen among fund managers at the start of the year, the level of hedging against a near-term correction in markets has fallen to its lowest level since 2013.
It appears that warnings over the end of the bull market in bond markets have been heeded as allocations to bonds fell to four-year lows, with a net 67 per cent
Indeed, the bank noted that investors are have moved most overweight equities relative to government bonds since August 2014.
But it should be noted that the percentage of fund managers who believe bond markets are overvalued fell to 79 per cent, compared with recent highs of 85 per cent in October.
As mentioned above, within the equities space fund managers have moved to pro-cyclical stocks with defensive areas being sold out of.
Source: BofA ML Fund Manager survey
Among the biggest moves in January was more buying activity in technology, industrials and emerging markets, which remain among the most popular positions relative to the history of the survey. Indeed, global investor prefer technology, banks, industrials and energy over consumer staples, telecoms and utilities stocks.
Allocations to US equities remain underweight, while allocation to eurozone and emerging markets are strong overweights among respondents.
Fund managers remain most pessimistic towards UK equities with 36 per cent underweight, close to post-global financial crisis era lows and is the industry’s consensus short position.