15 Jun 2015
Strategy, tactics and Asset allocation into upcoming Fed rate hike – BAML
FXStreet (Barcelona) - The BofA-Merrill Lynch Team, shares the convictions on tactics, strategy & asset allocation in light of the upcoming Fed hike.
Key Quotes
“1. The Fed’s exit from zero in 2015 will prove far less dramatic than in 1937: investors today have been raised on a dovish not a hawkish Fed; inflation is perceived to be under control, underscoring Fed credibility; and investor faith in economic recovery is bolstered by a virtuous cycle of rising housing activity, bank lending and small business activity.”
“2. Our tactical view is that until the US macro is unambiguously robust enough to allow the Fed to hike safely, investors will be cursed by mediocre returns, vicious trading rotation & flash crashes. Investors should hold a little more cash and own volatility. Our tactical Q2 targets of 0.2% for the 5-year bund, 2% for Italy 10-year, 20 on VIX, 2000 for S&P500 remain intact.”
“3. We would also own some optionality to SPX upside in H2; in our May FMS US equity allocation slumped to its lowest since Jan’08 and the relative positioning of US vs rest-of-world was at its most extreme level since Nov’07. As Greece risks mount and investor concerns peaks, the contrarian play will soon be to add risk in Q3 via SPX calls.”
“4. We continue to believe that investors should watch bank stocks as the “policy mistake” barometer. Rising rates & rising bank stocks = good; rising rates & falling bank stocks = bad. Thus far the banks stocks say it’s safe for the Fed to hike.”
“5. We remain structurally bullish the US dollar, bullish stocks, bearish rates & opportunistic in EM. We believe forthcoming regime change to Lower Liquidity-Higher Growth will ultimately prove positive for banks, large cap cyclicals, Europe, Japan, value>growth, and negative for high PE stocks, high DY stocks, high yield bonds & EM debt. The ultimate catalyst for the Great Rotation is a Fed hike & stronger global growth. David Woo recently reiterated his bullish view on the US dollar.”
“6. We believe developed market banks are the best structural equity play on Fed tightening. US, European & Japanese banks will rally sharply as bond markets acknowledge the end of deflation. European strategist James Barty thinks EU stocks currently present a favorable risk-reward profile following the recent plunge in the DAX. European downside risks are limited and the ECB would intervene if Greece threatens contagion. James recommends Eurozone banks.”
“7. We believe bond exposure should continue to be minimized. Market highs always take longer to form than market lows. Nonetheless we believe a major bond top is forming. Within the asset class a number of our strategists have turned cautious. Chris Flanagan recommends reducing MBS exposure as spreads widen in H2. Hans Mikkelsen remains bearish on HG corporate bonds as the Fed hike coincides with an expected pick-up in issuance, elevated bond dealer inventories and likely duration-triggered outflows. And Michael Contopolous remains bearish on high yield corporate bonds.”
“8. Finally, the best trading opportunities are likely to be found in EM as fears of dollar strength cause investors to exit the asset class. Yet price action in EM FX has been robust, testament to the high yields found in the asset class. Brazil remains very contrarian.”
Key Quotes
“1. The Fed’s exit from zero in 2015 will prove far less dramatic than in 1937: investors today have been raised on a dovish not a hawkish Fed; inflation is perceived to be under control, underscoring Fed credibility; and investor faith in economic recovery is bolstered by a virtuous cycle of rising housing activity, bank lending and small business activity.”
“2. Our tactical view is that until the US macro is unambiguously robust enough to allow the Fed to hike safely, investors will be cursed by mediocre returns, vicious trading rotation & flash crashes. Investors should hold a little more cash and own volatility. Our tactical Q2 targets of 0.2% for the 5-year bund, 2% for Italy 10-year, 20 on VIX, 2000 for S&P500 remain intact.”
“3. We would also own some optionality to SPX upside in H2; in our May FMS US equity allocation slumped to its lowest since Jan’08 and the relative positioning of US vs rest-of-world was at its most extreme level since Nov’07. As Greece risks mount and investor concerns peaks, the contrarian play will soon be to add risk in Q3 via SPX calls.”
“4. We continue to believe that investors should watch bank stocks as the “policy mistake” barometer. Rising rates & rising bank stocks = good; rising rates & falling bank stocks = bad. Thus far the banks stocks say it’s safe for the Fed to hike.”
“5. We remain structurally bullish the US dollar, bullish stocks, bearish rates & opportunistic in EM. We believe forthcoming regime change to Lower Liquidity-Higher Growth will ultimately prove positive for banks, large cap cyclicals, Europe, Japan, value>growth, and negative for high PE stocks, high DY stocks, high yield bonds & EM debt. The ultimate catalyst for the Great Rotation is a Fed hike & stronger global growth. David Woo recently reiterated his bullish view on the US dollar.”
“6. We believe developed market banks are the best structural equity play on Fed tightening. US, European & Japanese banks will rally sharply as bond markets acknowledge the end of deflation. European strategist James Barty thinks EU stocks currently present a favorable risk-reward profile following the recent plunge in the DAX. European downside risks are limited and the ECB would intervene if Greece threatens contagion. James recommends Eurozone banks.”
“7. We believe bond exposure should continue to be minimized. Market highs always take longer to form than market lows. Nonetheless we believe a major bond top is forming. Within the asset class a number of our strategists have turned cautious. Chris Flanagan recommends reducing MBS exposure as spreads widen in H2. Hans Mikkelsen remains bearish on HG corporate bonds as the Fed hike coincides with an expected pick-up in issuance, elevated bond dealer inventories and likely duration-triggered outflows. And Michael Contopolous remains bearish on high yield corporate bonds.”
“8. Finally, the best trading opportunities are likely to be found in EM as fears of dollar strength cause investors to exit the asset class. Yet price action in EM FX has been robust, testament to the high yields found in the asset class. Brazil remains very contrarian.”