Turbulent Market Summer Could See `Mini-TARP' Jolt, BofAML Warns

  • Market turbulence may be needed to force U.S. tax reform ahead
  • Emerging markets could get hit particularly hard, analysts say

With stocks remaining near record highs and bond yields lingering below historical averages, here’s another warning that investors are complacent about economic and policy risks.

This time, Bank of America Merrill Lynch has a neat historical reference: the meltdown in U.S. stocks that occurred after Congress rejected the Bush administration’s request for a $700 billion rescue fund in the midst of the financial crisis in 2008. A smaller scale of that may be in the offing, triggered by a collapse in investor confidence that the business-friendly tax reforms President Donald Trump has promised will get done.

"We don’t think the market has priced in adequately the downside risk to growth associated with the heightened uncertainty around tax reform and political standoff," BofA Merrill Lynch analysts led by David Woo in New York wrote in a June 8 note. "If we are right the risk is for a repricing in volatility and a correction in risky assets."

While U.S. economic growth has disappointed, economic gains in the rest of the world have helped tide investors over when it comes to American equity valuations, according to the U.S. bank’s narrative. China’s expansion rate is set to slow, in the views of most observers, however. And though many analysts are upbeat on prospects in Europe, BofA Merrill Lynch economists see a moderation in the second half of 2017.

The bank also flagged the panoply of political risks that have so far generated figurative shrugs from traders -- dangers on the Korean peninsula, tensions in the Persian Gulf and corruption in Brazil among them.

Where’s the Reform?

The key, though, may be the U.S., where signs are that overhauling taxes is on hold, with Gary Cohn, the head of Trump’s economic council, saying earlier this month the White House wouldn’t send its detailed plan to Congress until September. "The uncertainty around tax reform itself is possibly dampening U.S. growth," according to BofA Merrill Lynch.

"We have come to think that a combination of brinkmanship and a correction of risky assets may be necessary for tax reform to get done," Woo, head of global rates, foreign-exchange and fixed income strategy and economics research, and his colleagues wrote. "This is why we now see limited upside for the dollar and U.S. rates until late September or early October."

Here’s how the team suggests investors position "for this coming mini-TARP moment":

  • Emerging markets are likely to get hit "particularly hard," so investors who are long on EM assets should consider "accumulating risk reversal as a hedge."
  • Dollar bulls should stay on the sidelines until there’s greater clarity on tax reform, potentially in September or October.
  • Further in the FX market, investors could buy a four-month 102-107 dollar-yen put-spread; where a 90 yen contract could yield a 5.5 maximum payoff -- the gap between 107 and 102 yen.
  • In fixed income, consider buying a three-month straddle on two-year/10-year interest-rate swap spreads. The tactic would offer investors returns if the gap between the two-year and 10-year rates significantly widens from current levels -- as would happen in scenarios ranging from a pickup in U.S. growth or a scaling-back in Federal Reserve interest-rate hike expectations.

— With assistance by Mark Cranfield

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