DJ Don't Be Afraid of Stocks Now. But Next Year Is Another Story. -- Barrons.com

By Daren Fonda

A rough month for stocks in August shouldn't scare investors from so-called risk assets for the rest of this year, though 2020 could prove much more challenging.

That perspective comes from Michael Hartnett, chief investment strategist at Bank of America Merrill Lynch. In a note out Wednesday, he and his team outline a scenario in which stocks and other risk assets do well for the rest of 2019 before things take a turn for the worse in 2020.

"We are bullish on stocks, bearish bonds, bullish commodities...and bearish the U.S. dollar," he wrote. Despite the trade war heating up, returns on equities, bonds, and commodities have been strong, he added, as "bullish monetary policy" has trumped a weakening macroeconomic outlook.

But the 2020 outlook doesn't look so strong. "We are bearish on risk assets in 2020," he writes, as a confluence of economic, policy and financial market risks induce a "big top" in credit (corporate bonds) and equities. Translation: Lower rates and tax cuts may be of limited use in preventing a recession and keeping the bull market going as the trade war continues to hammer business confidence and investment.

We won't know for a while if Hartnett's predictions pan out. of course. This year is delivering another lesson in how strategists' forecasts can be wildly off the mark. Long-term Treasury bonds are one of the best-performing assets, for instance, gaining 21% and beating the S&P 500's 16.9% return so far this year. Real estate investment trusts have also been big winners, gaining about 26%. Those weren't exactly consensus views on Wall Street a year ago.

Indeed, Hartnett himself predicted in 2018 that a "bear market vibe is likely to continue into 2019" as investors face "a backdrop of rising rates and falling earnings." Rates have instead fallen sharply, and the stock market has rallied more than 16%. Hartnett added in his forecast that he expected to turn tactically bullish in the spring of 2019. That turned out to be a bad call, too -- the market rallied in the first four months before sliding sharply from May to June.

Nonetheless, Hartnett and his team throw out some eye-popping statistics to illustrate the notion that we are in an unprecedented financial era, offering both risk and opportunity.

They write that the 2020s "will begin with the lowest interest rates in 5,000 years." Yes, you read that right: Back in 3000 B.C. -- the Bronze Age of civilization -- rates were higher than they are today, according to data they provide. Today's low rates are needed to sustain a weak global recovery, they write, and they're being fueled by deflationary factors such as aging populations, savings surpluses, and technological disruption.

Low rates also illustrate the fragility of the global economy and the potential for more market pain. Hartnett expects there to be a "coming bust" in fixed income that will lead to "extreme pain on Wall Street," ultimately transmitting to the economy more broadly.

There's a growing risk that the Fed and other central banks have run out of policy tools to avoid a recession -- what Hartnett calls "policy impotence." A jump in rate volatility -- rapid shifts in the 10-year Treasury yield, for instance -- could signal the end of a bullish decadelong combination of low rates fueling maximum corporate profits.

Hartnett doesn't expect asset prices to peak right away. "The moment of error and impotence has yet to arrive," he writes. Indeed, he notes that bearish investor sentiment is now so high that it has triggered a strong contrarian buy signal, the first one since January 2019.

Among his investment recommendations, Hartnett suggests buying foreign stocks, notably shares listed in Hong Kong, South Korea, and Germany, along with European banks, emerging market currencies, and low-rated junk bonds.

Investors can gain exposure to these assets through exchange-traded funds, such as iShares MSCI Hong Kong (ticker: EWH), iShares MSCI South Korea (EWY), Franklin FTSE Germany (FLGR), iShares MSCI Europe Financials (EUFN), WisdomTree Emerging Currency Strategy Fund (CEW), and SPDR ICE BofAML Broad High Yield Bond (CJNK).

Hartnett also recommends buying gold as protection against a selloff in bonds and rising inflation expectations. The SPDR Gold Trust ETF (GLD) would do the job, and it's done well this year, up about 20%.

For U.S. equity exposure, it may be best to stick with high-quality stocks (companies with strong balance sheets, returns on equity or invested capital, or other measures of quality). August was a good month for such stocks, according to BofA Merrill Lynch quantitative strategist Savita Subramanian, and she expects quality to continue to outperform as market volatility increases. The iShares Edge MSCI USA Quality Factor ETF (QUAL) has been a winner this year, gaining 19.9%, edging the S&P 500.

Write to Daren Fonda at daren.fonda@barrons.com

(END) Dow Jones Newswires

September 05, 2019 05:59 ET (09:59 GMT)

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