Something odd is going on in global markets: in recent months a huge divergence in the performance of risk assets has opened up which previously has only been observed during recessions.

As the S&P 500 marched towards its record bull market and a new all-time high, EM equities, copper and European banks were experiencing bear markets, while EM FX carry has unwound almost all of its post-2016 gains. As a result, according to Bank of America, the key question for investors as we move into the latter part of 2018 is "whether they should use the pullback in non-US risk assets as a buying opportunity or not". 

As an indication of just how stretched this divergence is, BofA notes that non-US equities have underperformed the US by the most since the GFC and EM equities are back sub-11x earnings, or as BofA puts it, "the underperformance of non-US equities to US equities is reaching levels normally only exceeded in bear markets".

(Click on image to enlarge)

Similarly, the bank's "Risk-Love" metric for emerging markets is now in a panic territory, again at levels normally only exceeded in bear markets.

(Click on image to enlarge)

Investors are further confused because those bear markets are almost always associated with recessions, so "the key decision investors have to make is whether a recession is looming or whether the cycle has a good deal further to run".

Here BofA notes that the unwinding of risk this year is not particularly abnormal, and as reference, it shows the path of global equities since the peak in its Global Wave, which looks very similar to previous paths, although the question is whether it diverges to the top side, as it did every year ex the bubble bursting years of 2000 and 2007, or if it slides as the global asset bubble pops (more on that below).

(Click on image to enlarge)

As an aside, at the start of June, we noted that BofA's "Global Wave" indicator (shown in the left chart above) just peaked for only the tenth time in 25 years, as five of the seven components deteriorated including confidence, market, and real economic indicators. The "global wave" is an advance indicator for global economic expansion and contraction, with virtually every peak in recent decades resulting in either a recession or a sharp market drop: of which, the last two took place just before the European sovereign debt crisis and around the time of the Chinese post-devaluation turmoil.

Of note: previous downturns in the Global Wave averaged 12 months, although some downturns were brief; Previous negative-but-brief signals occurred in 2002 after President Bush introduced steel tariffs, and in 2005 when PMIs fell quickly before recovering.

Still, the facts are adverse for global stocks, as subsequent to previous peaks in the Global Wave, the MSCI All Country World Index averaged -3.4% in the next 12 months, and defensive regions (the US), defensive sectors (Telecom, Health Care, Consumer Staples) and defensives styles (Quality, Dividends) outperformed, on average.

That said, BofA notes that it is not unusual for higher beta assets such as EM to underperform in such periods, and while the outperformance of the US market is "perhaps a little more marked than usual", that likely reflects the robustness of the US economy and US earnings.

So going back to the original question, "is now the time to buy non-US assets", a broader question that has to be answered is how close are we to the end of the cycle?

Whether it is the performance of markets post a Global Wave peak or post a panic reading in the EM Risk-Love indicator, the key is whether the reading is associated with just some form of pause/moderation in the cycle or whether it precedes a recession. The good news for bulls is that currently, the MSCI ACWI in chart 4 (below) is following the non-recessionary path, which seems sensible given the US economic data and the consensus view of economists that, ex a shock, the US economy will grow above 3% for the remainder of 2018 and next year.

(Click on image to enlarge)

"This is the big call investors have to make", according to BofA and summarizes as follows:

"Is it right to continue to anticipate strong global growth and therefore buy risk assets into this pullback? Or are we sufficiently close to the end of the cycle that they should be switching into more defensive assets and selling into any rally?".

The bank shows two charts that sum up the situation. In its latest Fund Manager Survey, the bank asked investors where they think we are in the cycle. Since January there has been a marked rise in the proportion saying we are late cycle to around 80% now. Yet compare this with the right-hand chart of the Global output gap from the OECD, which was updated to the end of this year using the bank economists’ forecasts, which shows the output gap will have only just closed by year-end.

(Click on image to enlarge)

Historically the peak in the cycle is somewhere between 1.5% and 3% positive, as it normally requires some inflation to get central banks to hit the brakes. Even reaching the lower end of that band would require three more years of 3.75% global growth. While the US is more advanced, the picture is similar, with BofA economists thinking that the US output gap has probably just closed. Again, historically it has taken a positive output gap (and hence rising inflation) to get the Fed to tighten enough to send the economy into a recession.

And while the cycle may indeed be late, there is another consideration: missing out on the last melt-up in the market. Here are BofA's thoughts:

Equity markets and risk assets in general tend to peak only six months or so before an economic downturn, which would suggest this pullback in risk assets is one that investors should buy into. If you want to compare with the last cycle, perhaps May 2006 is a good comparison: a sharp pullback in markets (around 12% for MSCI ACWI) was followed by a rally that eventually peaked some 34% later in October 2007. You could have sat that last rally out, but it would have been pretty painful to do so. It wasn’t until the Lehman crisis of October 2008 that the MSCI ACWI properly took out the May 2006 low.

The risk, however, is that markets are underestimating the Fed's resolve to keep hiking, something which became less of an issue last Friday, according to conventional wisdom, Jerome Powell turned dovish at Jackson Hole with his "gradualist" speech invoking Alan Greenspan's "go slow" rate hike policy of the late 1990s.

Michael Hartnett, BofA's Chief Investment Strategist, rightly points out that when the Fed is tightening there are often market accidents and the sell-off in EM this time around has been pretty bloody, with Argentina and now Turkey the key victims. Nevertheless, it is also often the case that risk assets recover from those accidents until the Fed finally punctures the cycle, at which point it is game over and all investors have to head for defensive assets.

(Click on image to enlarge)

In other words, those who still are on the fence whether the cycle is about to end, and - if not -whether to buy EM assets, should answer the following question: what would Jerome Powell do during every FOMC meeting next year, and whether he will keep hiking at a time when the strong dollar is already crushing emerging markets around the globe even as US stocks keep hitting all-time highs.