April 9, 2018
Michael Hartnett, the chief investment strategist at Bank of America Merrill Lynch, said investors will shift their holdings as the realization sinks in that the Federal Reserve is committed to raising interest rates until a major event compels the central bank to reverse course.
That means investments that had strong gains during a decade of quantitative easing – a way for central banks to stimulate the economy by buying government and corporate debt – will lose out to strategies that have been out of favor since the last recession.
“We believe investors will slowly rotate from QE winners to QE losers, but the pace will be contingent on how quickly profit growth slows,” Hartnett said in an April 8 report. “Year-to-date returns indicate that the rotation has begun.”
QE winners include the U.S. equity market, technology stocks, U.S. and European high-yield bonds, emerging markets. QE losers have been cash, commodities, government bonds and volatility.
“If the first quarter was about volatility, the second quarter will be about rotation within a big, fat trading range, rotation specifically from levered cyclical plays to liquid defensive plays,” Hartnett said. “Peak positioning, peak profits, peak policy stimulus imply peak asset returns and a trading mantra of sell-the-rip, not buy-the-dip.”
Stocks, Valuations Rise
The Fed is expected to raise interest rates at least two more times this year, and the European Central Bank and Bank of Japan have indicated they will scale back their stimulus programs.
The Fed started this process in 2014, when it ended its QE programs that left the central bank holding $4.5 trillion of U.S. Treasurys and mortgage debt. It has raised its target rate five times since the end of 2015 and is letting its balance sheet shrink as its debt holdings mature.
While the Fed gradually withdrew monetary stimulus, stocks got a renewed boost from the possibilty of greater fiscal stimulus after Donald Trump unexpectedly won the U.S. presidency. He ran on a pro-business platform of cutting taxes and regulation, boosting job growth and spending $1 trillion on infrastructure like roads and bridges.
The S&P 500 stock index climbed 34 percent between the election on Nov. 8, 2016, and late January 2018, a month after Trump approved a sweeping tax overhaul.
Since then, investors have paid more attention to the possibility of a trade war between the United States and China, the world’s two biggest economies. President Trump slapped tariffs on imported steel and aluminum, and has threatened to target billions of dollars of Chinese goods for levies. China has responded with its own threats. The back-and-forth has led to sudden sell-offs and rallies with each new pronouncement about trade talks.
Stocks fell as much as 12 percent from the January peak before trading in a range between the 50-day and 200-day moving averages, two significant indicators of market trends. If the 50-day moving average crosses below the 200-day moving average, many investors will read the signal as a major warning of a bear market.
Investors will next want to see solid earnings results from U.S. companies and optimistic guidance for future sales growth. Key valuation measures remain elevated, indicating that stocks are expensive compared with historical norms.
As of March 31, the forward consensus price-to-earnings ratio was about 16.3 times, or 7 percent higher than the historical average of 14.3 times, excluding the distortion of the tech bubble in the 1990s. The Shiller P/E ratio that adjusts for longer-term earnings trends was about 32.8 times, or 95 percent higher than the long-term average of 16.8 times.
BofA’s Hartnett said investors need to pull back on their tech holdings because of several warning signs, such as extended valuations and the possibility of greater regulation.
Tech stocks have been a key driver of the stock rally, with the so-called “FAANG stocks” – Facebook, Apple, Amazon, Netflix and Google (and Microsoft) – showing some of the strongest gains. Without the tech industry, the S&P 500 would be at current level of 2,000 points, or 24 percent lower than its current level of about 2,643.
Tech stocks may lose that leadership position as the tech industry faces more intense scrutiny from government regulators, Hartnett said. Stricter rules may hamper tech stocks the way that the tobacco and biotech industries were similarly affected in the past.
“The sector’s growth, power and visibility make it extremely vulnerable to increased regulation and taxation, most especially if recession wrecks government finances,” he said. “Tech and e-commerce companies currently account for almost one-fourth of U.S. earnings per share.” That level is rarely exceeded and is typically associated with bubble peaks.
Facebook, Apple, Amazon and Google have received greater government scrutiny for a variety of reasons.
Facebook currently is embroiled in a data privacy scandal that likely will result in stricter regulations if the company is found to have violated a 2011 consent decree with the Federal Trade Commission. Google last year was fined a record $2.9 billion by the European Commission over alleged anticompetitive businesses practices; the search giant has appealed the decision.
Apple agreed to pay $15.4 billion in back taxes to Ireland, which is appealing a decision by the EC to collect the tax.
Finally, President Donald Trump has repeatedly targeted Amazon for criticism, alleging that the company doesn’t pay its fair share of taxes and exploits the U.S. Postal Service. Whether the criticism results in more regulations for the e-commerce giant remains to be seen.
“The vulnerability of tech to increased regulation and taxation, most especially as economic slowdown in coming quarters wrecks government finances, means investors should reduce tech allocations in 2018,” BofA’s Hartnett said.