BofA’s Simple Answer for Sideways Stocks Amid Stellar Earnings

Bank of America Merrill Lynch has a disquieting solution to this vexing mystery: Why are markets struggling despite blockbuster earnings growth?

Because before long the economy will be struggling, too.

“It’s late-cycle, profits are peaking, and the Fed is tightening,” according to a team led by chief investment strategist Michael Hartnett.

Investors are too optimistic about the global expansion and the ability of economies to handle rising rates, Hartnett wrote in a May 6 note. And while an old saw holds that stocks have predicted nine of the past five corrections, markets have a better record than economists when it comes to forecasting global growth.

To bolster its observation, Bank of America highlighted a key chart that suggests the narrative of global synchronized growth has passed its best-before date: South Korean export growth — a canary in the coal mine for global earnings per share — is now falling on an annual basis.

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“Our model suggests global earnings per share will slow from 20 percent to 6 percent in coming quarters as Asian export growth slows and global purchasing managers’ indexes normalize, as predicted by the yield curve,” said Hartnett.

But for now, the world’s largest economy has remained immune from this concerning trend from Asia.

“We’re struck by how well U.S. factories have been holding up relative to their South Korean counterparts,” Neil Dutta, head of U.S. economics at Renaissance Macro Research. wrote in a May 4 note. “This should be a reminder that U.S. domestic demand is far more important for factory production than demand outside the U.S.”

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Hartnett said he doesn’t see a bear market brewing in 2018, but contends that it’s now time to move into “more conservative trades,” such as:

Long the ABCDs: AAA-rated high-quality assets, Treasury Bills, Chinese equities and the U.S. Dollar;Short the EFH: Emerging-market debt, FAANG stocks and High-yield bonds.

“Few are bearishly positioned for lower growth, lower yields, and lower cyclicals,” he concluded.