The potential risks of a trade war, quantitative tightening, peak profits and a yield curve inflection are all reasons for investors to remain cautious, according to Bank of America Merrill Lynch.
With some analysts and investors increasingly warning that the end of the market cycle is nearing, it may seem prudent to review portfolios.
Despite the bears growling louder, however, markets have continued to grind upwards albeit in a less synchronised fashion.
But analysts at the Bank of America Merrill Lynch (BofA ML) believe there is still reason for caution with a number of challenges facing investors.
Below, FE Trustnet takes a closer look at the bank’s ‘Charts of Darkness’.
Quantitative tightening
Of all the warning signs currently flashing in markets, quantitative tightening seems to have been the most flagged.
After a decade of ultra-loose monetary policy following the global financial crisis, central banks have made no secret that they intend to slow down and begin reversing the quantitative easing programmes.
The scale of the programmes was unprecedented at the time of the crisis and was instrumental in recapitalising the banks and restoring the financial system.
However, it was always understood that stimulus would one day be withdrawn once the economic environment strengthened.
As the chart shows, central banks of the three largest economies have already begun to normalise policy.
Source: Bank of America Merrill Lynch
“Year-to-date G3 central bank asset purchases of $125bn [are] well below [the] $1.5tn run rate of 2017,” BofA ML’s analysts noted.
“We estimate liquidity growth turns negative in six to eight months; Fed tightening always triggers an event.”
Trade war
The second ‘Chart of Darkness’ highlights a relatively recent concern for markets as US president Donald Trump has followed through on campaign pledges to renegotiate international trade deals – such as the North American Free Trade Agreement (NAFTA) – he deems unfair.
The imposing of tariffs on steel and aluminium imports from neighbouring Canada and Mexico and the EU for reasons of national security has been met with outrage.
Retaliatory measures have been introduced on culturally significant items, such as bourbon whiskey, motorcycles and peanut butter, raising concerns over a tit-for-tat escalation.
Indeed, investors have one eye on negotiations with China and how a trade war might affect markets and global growth.
Source: Bank of America Merrill Lynch
“New US tariffs set to boost US protectionism to highest level since mid-1970s; further action on China ($200bn), autos ($350bn), NAFTA ($690bn) would raise tariff revenue as a per cent of total imports to levels not seen since 1946,” according to the bank.
“Our own view is 2018 ‘trade war’ really just [the] first stage of [a] new arms race between US & China to reach national superiority in technology, and protectionism inevitably on rise to address inequality.”
Peak profits
One of the key drivers in markets has been a rise in global earnings in recent years, however, there are signs that the indicators are now beginning to weaken, as represented by South Korea exports data and its correlation to global earnings per share.
Source: Bank of America Merrill Lynch
While the global earnings per share growth forecast for 2018 remains robust at 15.5 per cent, for 2019 it has slipped from 10.4 per cent in April to 9.4 per cent.
German fiscal stimulus
Another cause for bearish sentiment is the continued fiscal austerity in Germany, which is continuing to drag on the wider euro area, as the current account surplus remains at 8 per cent of GDP. Indeed, the issue has been highlighted by several economists.
“Each country can do more to promote sustainable trade and reduce excessive global imbalances,” said Mitsuhiro Furusawa, deputy managing director of the International Monetary Fund, last month.
“Germany could use its excessive savings to boost long-run growth by increasing investments in physical and digital infrastructure.”
BofA ML’s added: “We believe European Central Bank tightening is doomed to fail as has been case in Japan past 30 years.
Source: Bank of America Merrill Lynch
“Until Italy, migration, trade wars force Germany to capitulate on fiscal austerity a case cannot be made for European banks.”
Yield curve
Finally the spread between the 10-year and 2-year US Treasury yield has also started some worrying signals to the market, the bank’s analysts noted.
The yield curve has reached its flattest since the September 2007 and is just 36 basis points away from its first inversion since 2007, according to the bank.
BofA ML analysts noted that curve inversions have preceded each of the seven prior US recessions since 1970 by four to five quarters.