BofA Sees ‘Impossible Trinity’ in Markets as Risks Underpriced

Commodities, stocks and bonds are sending conflicting signals on the health of the global economy, an “impossible trinity” that may end with a surge in market volatility, according to Bank of America Corp.

The S&P GSCI Spot Index of 24 raw materials has retreated 10 percent in the past two months, while the Standard & Poor’s 500 Index (SPX) rose 1.4 percent and bond yields in emerging markets and so-called peripheral European nations declined.

Commodities are signaling a slowdown in global growth, while stocks reflect expectations of strong U.S. consumer spending and credit markets anticipate greater demand from Japanese households for high-yielding assets, David Woo, the head of global rates and currencies research at Bank of America Merrill Lynch, wrote in a note dated yesterday. It’s unlikely all these markets will prove correct and investors are underestimating the risk of a “major re-alignment” of prices, Woo said.

“Something will have to give,” Woo wrote. He recommended a three-month risk reversal on Australia’s dollar, an options trade that would benefit if the currency weakens against the U.S. dollar. The strategy offers “cheap insurance against the possibility of a synchronized global slowdown,” Woo said.

Investors may be overestimating China’s scope for stimulus, the economic tailwinds from a U.S. housing recovery and Japan’s appetite for riskier overseas assets, the New York-based strategist wrote.

China Stimulus

Economic growth in China, the world’s biggest consumer of metals, missed estimates in the first quarter as industrial production and fixed-asset investments in March fell short of forecasts. At the same time, new home prices rose in all but two cities tracked by the government last month, limiting scope for monetary stimulus as policy makers seek to prevent a real-estate bubble.

While new-home construction in the U.S. climbed last month to the highest level in almost five years, the real-estate recovery may not be enough to boost consumer confidence as America’s government tightens fiscal policy, Woo wrote. U.S. retail sales dropped in March by the most in nine months and the Thomson Reuters/University of Michigan gauge of consumer sentiment declined this month, reports showed last week.

Japan’s unprecedented monetary easing has spurred speculation the country’s investors will put their money in higher-yielding investments in emerging markets and indebted European nations, Woo wrote. The yield on JPMorgan Chase & Co.’s GBI-EM Global Diversified Composite Index of local currency debt in emerging markets tumbled to a record low of 5.32 percent yesterday, while Spanish five-year note yields reached 3.26 percent on April 18, the lowest level since November 2010.

Capital outflows from Japan may be limited by the country’s shrinking current-account surplus during the past two years and the already large holdings of foreign assets by Japanese pension funds and insurance companies, Woo said.

“To the extent that these themes reflect market expectations of reality, there seems to be three different versions of reality right now,” he wrote. “It is unlikely that all three markets will prove to be right. In this respect, we are concerned that the current market equilibrium may not be a stable one.”

To contact the reporter on this story: Michael Patterson in Hong Kong at mpatterson10@bloomberg.net

To contact the editor responsible for this story: Darren Boey at dboey@bloomberg.net

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