Merrill Lynch’s X Asset Views 2018: Higher, but Harder

Supportive macro backdrop so far makes the case for investing in risky assets, but valuation-wise, harvesting decent returns on a risk-adjusted basis is harder. At least, that’s BofAML’s strategists views.

Summary quotes from a note dated Dec 1st:

« Global growth momentum strong into 2018

Our economists have raised their GDP forecast for 2018 to 3.8%, but current growth rates top even that. US consumer confidence is at a 17-year high, Ifo is at a 48-year high, Euro PMI stands at 60, and the Richmond Fed is at a 24-year high. The global wave has been rising for 18 months and looks set to remain elevated.

Double-digit earnings – long Asia ex, Japan, Europe

Plug the above into any earnings model and it points to double-digit earnings growth again in 2018. Years where earnings are at, or above, consensus (currently 10% for MSCI ACWI) have tended to be good ones for equities. We see no reason to trim our longs. Asia has the best prospects in our view, with Asia ex earnings expected to be up c20% and Japan 11%. We remain long both. Even Europe should deliver 11% with the Euro drag lifted.

Rising inflation the risk – short rates in the US/Japan

Our economists think inflation will rise modestly and central banks exit gradually – hikes to the dot plot in the US, the end of QE in Europe, and an upward shift in Yield Curve Control (YCC) in Japan. If correct, equity markets would perform and credit squeeze tighter still. The risk is that inflation rises more rapidly and central banks exit faster. We see little of that priced into rates. We add to our short rates positions via a 1y1y OIS US/UK widener and a 1×2 1y20y Japan payer spread to hedge Fed/BoJ.

Tax reform risks USD/rate spike – add to USD longs

If the tax reform passes, which looks increasingly likely, we think it could trigger a sharper sell-off in rates. Our strategists target US 10Y at 2.85% by end-Q1should this happen. Higher US rates plus repatriation should give the USD a bid. They target 1.10 EUR/USD, 120 USD/JPY. We go long USD/CHF as a result. In FX we also add a long ZAR/MXN trade on improving South Africa risks vs NAFTA risks.

China/credit other risks – add AUD/JPY put, close US IG

We see two other key risks. First, a sharper slowdown in China as financial conditions are tightened further. This is not our central scenario but we add an AUD/JPY 6M put to provide a hedge. Second, credit spreads just look too tight – we close our US IG position. We prefer to use vol to hedge tail risks though, so roll our current hedges forward. »

Key risks include inflation, China, Credit. Per Merrill’s report

« In our view inflation is probably the biggest single risk because it would potentially push a gradual unwind of monetary accommodation into something more aggressive. The US is front and centre of this debate. The lack of inflation this year has been a surprise to most – not least the Fed. There are some signs that inflation is picking up as the chart on CPI below shows. That is also reflected in a higher prices paid balance in the ISM’s. Where there has not been any pick up yet has been in wage inflation, which has broadly gone sideways over the last 18 months. Our economists think that with growth coming in around the 2 1⁄2% mark for 2018, the labour market will continue to tighten and wage inflation will rise from current levels. They have the US output gap fully closed by 2019, which will push inflation on the Fed’s preferred measure picking up to 1.8% by the end of next year and 2% by end 2019. »

Some charts in the report: 

And the reason why European earnings have a positive outlook: