The Fed pause and market risks

From BofAML:

• Fed confirming “deflationary recovery” (Chart 1); risk can rally but sell into strength; upside for risk assets constrained by growth outlook, downside protected by Fed. Fragile Wall Street + perilous China = “tactical delay” in Fed hike according to our economists; BofAML say Dec hike likely; but if no autumn risk rally despite ultra-dovish Fed & bearish sentiment = markets hinting “recession” and/or “default” imminent.

• Short-term tactics: negative for US$, banks. EM>DM, resources>banks, gold>US$, REITs>cash, growth>value decent tactical trades.
• Deflationary recovery means “growth”, “yield”, “quality” remain structurally bid; we stay long US$, volatility, real estate & stocks>bonds; but SPX>2040-2070, GT30>3.2%, DXY>97 needs stronger global growth in Q4.
• Bearish risk = deflationary bust: Asia banks indicate crisis; Q3 EPS recession. FMS says Discretionary, Banks, Tech & Eurozone most at risk should peak liquidity coincide with EPS recession…

The Fed left rates unchanged at 0% to 0.25%. Thoughts…

1. Fed admits China/Wall St threatens to reverse Main St recovery; Fed confirming “deflationary recovery”; risk can rally but sell into strength; upside for risk assets constrained by growth outlook, downside protected by Fed.

2. Stay of execution for “liquidity era”: nonetheless liquidity has peaked (Chart 2). And peak in liquidity = peak of excess returns = trough in volatility: annualized returns between start of QE1 (3/9/2009) & end of QE3 (10/29/2014)…stocks 20%, HY 18%, REITs 31%…(Table 1); since end of QE3, returns much, much lower, volatility higher & flash cashes (oil, UST, CHF, bunds, SPX) more common.

3. No hike, no rally: fragile Wall Street + perilous China = a “tactical delay” in Fed hike according to our economists; but if no risk rally despite ultra-dovish Fed & bearish sentiment = markets hinting “recession” and/or “default” imminent: allocation to risk hindered by growth fear (China, global PMIs), default fear (EM, commodities, Wall St), and liquidity fear (bonds/stocks “untradable” right now). Stronger global growth best antidote to fear: US payroll/retail sales & Chinese exports now key data (nb latter has tough comps next 2 months).

4. Short-term tactics: negative for US$, banks. Stocks>bonds but SPX>2040-2070, GT30>3.2%, DXY>97 needs stronger global growth; EM>DM, resources>banks, gold>US$, REITs>cash, growth>value all good tactical trades.

5. Big picture = deflationary recovery: Fed confirming “deflationary recovery” status quo (Chart 3); no recession/bankruptcy thanks to low rates/oil/unemployment; but expansion remains deflationary thanks to debt, tech disruption, demographics.

Deflationary recovery means “growth”, “yield”, “quality” remain structurally bid. We stay long US$, volatility, real estate & stocks>bond, but upside for risk assets now constrained until unambiguous handoff from liquidity to growth.

6. Bullish risk = reflationary recovery: if the Fed’s failure to hike does not lead investors to completely abandon hope on growth and scurry into gold, cash & volatility, “barbell of 1999” could reemerge: Über-growth & Über-value massive outperformers post-Asia crisis.

7. Bearish risk = deflationary bust: Asia banks indicate in coming weeks markets at early stage of crisis; Q3 EPS shows recessionary global economy. Crowded Discretionary, Banks, Tech & Eurozone (Chart 4) most at risk should peak liquidity coincide with EPS recession, SPX<1870, GT30<2.8%, DXY<93…at least until new extreme policies introduced (Fed QE4, China QE1 or a G7 shift toward fiscal policy stimulus).

• SPX<1870, GT30<2.8%, DXY<93…at least until new extreme policies introduced (Fed QE4, China QE1 or a G7 shift toward fiscal policy stimulus).

Could not have put that better myself though China can’t do QE without blowing up. It’s cash rate is still 4.6% and any move to QE would destroy the US dollar peg.