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Merrill’s Hyzy: Trade War Fears Overblown as ‘Buffalo Market’ Lumbers On

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A buffalo market is a horse of a different color: Neither the typical bull nor a bear, it’s big, heavy, roams about and sharply reverses course when it bumps into deterrents. That has characterized the stock market since 2016 but this year the volatile buffalo is “hairier, heavier” and more prone to fatigue, Christopher Hyzy, chief investment officer for Merrill Lynch and U.S. Trust tells ThinkAdvisor in an interview.

However, once earnings season is over, stability should return, he forecasts. Then, get ready for another plunge triggered by midterm elections.

As for a potential trade war, Hyzy thinks actual policy may turn out to be far less harsh than the recent verbal threats traded by President Donald Trump and the Chinese Commerce Ministry.

Other issues financial advisors should be watching, says Hyzy: the potential for robust wage growth that could bring more frequent interest rate hikes and oil prices that ascend to $90 or above and hold.

In the interview, he reveals the sectors that Merrill Lynch pegs to be this year’s market leaders, and others for which the firm also holds high expectations.

ThinkAdvisor talked by phone with Hyzy on April 5. The focus was on economic reality, which the CIO views as a potent reason for optimism.

Here are highlights of our conversation:

THINKADVISOR: What’s your view of the current market?

CHRISTOPHER HYZY: The market overall is trying to find a bottom. We’ll continue to try to bounce off these lows until we get through earnings season by mid-May which becomes the catalyst that ultimately stabilizes the market and from which we can rise. Earnings should show that the economy isn’t falling down and is actually gathering a little bit more momentum than was believed.

What did the February correction accomplish?

We’ve corrected the excess that was built into the market. Now it’s time to get back to more normal gains through earnings season. The next pullback is likely to be due to worries over the midterm elections.

What are the main market headwinds right now?

A real concern is protectionism and a trade war/tariff tantrum that what has been spoken about is going to become policy. That would be detractive from growth and could undo some of the benefits of tax reform. Our view, though, is that this is the negotiation phase of more equal trade policy, especially a more palatable trade policy with China. The market threw a tantrum when there was an announcement that tariffs were going to be applied to specific goods. We expect that once all the negotiations take place, the trade policy may not look as arduous as what the words [threats] suggest.

What other issues should financial advisors be watching?

They should look for signs that wage growth is getting to levels that worry the Federal Reserve that is, 4% or higher. This would likely increase the number of interest rate hikes over the three we’re expecting for 2018 and what the market is technically ready for.

What else should FAs be on the alert for?

If oil prices rise about $80 a barrel, stay there and get closer to $90 or higher, that’s hurtful to consumers. In the past, when we’ve gone into recession, the Fed had a tightening policy at the same time that we had high oil prices.

Do you think the Fed is increasing interest rates too aggressively in a short time span?

No. It’s right in line with what the market expects. They’re going up, but slowly. The level of wage inflation in the broader economy shouldn’t rise sharply enough to induce a policy error in the short term by raising rates too fast, too much.

Two years ago you described the market as a “buffalo market.” Are we in one today?

We’re still in a buffalo market within the bull market. The buffalo is a different type of bull market. This year, the buffalo market is hairier, heavier and gets more tired than its cousin, the bull. When it sees something that it doesn’t recognize, it tends to run the other way [pulls back].

Where do you see investing opportunities?

They’re still in the equity markets large cap U.S. The most attractive opportunity is in emerging markets, which are still early in their cycle and have both valuations and growth that are attractive.

What other sectors do you like?

We think the financials are the next market-leading sector. They had some levels of leadership last year and earlier this year, but they weren’t the leader. We think they become the leader and as a tag team with them, technology. The technology sector is now back to valuation levels on a par with the broader market but growing substantially more than the broader market.

What about the retail sector?

It’s going through a metamorphosis and becoming very nichey and low cost a value-buying spree on the part of most consumers. At the same time, retail needs to create an experience for the consumer when they buy goods or services that something is being done especially for them. For example, buying sneakers or athletic leisure[wear] or even cell phone cases. All those can be customized to the individual’s liking. So it becomes an experience versus just owning something.

Why did you call the February pullback a “torque correction”?

It was a fast, aggressive, powerful repricing of risk and that equals torque. We had gotten to valuation levels that were a little too high.

Most people didn’t see that correction coming.

Most people don’t see 10% corrections coming. There needs to be a real fundamental catalyst that makes a correction last. We just don’t see that fundamental catalyst negative enough to have that happen the correction lasting and then ultimately turning into a bear market.

How long should a healthy correction be?

Usually a correction lasts two to three months. It gives investors an opportunity to reposition portfolios and add to positions that are attractive. That’s why we think corrections are normal.

What’s your forecast for bonds?

We expect bond yields to start to splinter up. We expect them to be anywhere between 3% and 3-1/4% on the 10-year and another 50 basis points on the federal funds rate. So, for those who have had gains in fixed income recently, we’ll be rebalancing into equities. We’ll be putting the cash to work in our preferred equity areas, such as large cap U.S. and emerging markets.

But what about pre-retired or retired investors, who are income-oriented?

They’re having a little bit longer duration and a higher quality exposure in bonds.

But, generally, bonds are seen as risky right now.

Bond yields grinding higher, which is what we expect, is still a fine environment for fixed income because it represents a hedge on equity exposure. It also produces the cash flow you need. So we think that bond yields going up doesn’t necessarily mean that bonds will be in the red for the year.

What areas are you underweight?

One that hurts is bond proxies in the equity market REITs, telecom, utilities. Also, long-duration assets in fixed income typically underperform in this type of environment. So we’re underweight bond proxies in equity-land as well as the more defensive sectors, like consumer staples.

Is now a good time, then, to reposition a portfolio?

Yes. We’re doing that now. Areas that have underperformed versus the broader markets, like technology and financials, are attractive to add to.

Do you see continued volatility ahead?

Yes. The volatility we’re experiencing right now feels sharper and more painful and abnormal because last year was a record low year [for volatility].

You told me about a year ago that “we need to be realistic at all cost.” How are you being realistic now?

Some people think that all that’s happened recently around trade, tariff tantrums and the potential for policy change is going to stop economic expansion [meaning] when’s the next recession? But the real economy is humming along and actually gathering momentum. The tax reform package will add about $800 billion to the broad economy. The profit cycle is alive and well. The Federal Reserve is removing the ultra-accommodation and is normalizing policy.

But that last one increases volatility.

Yes, when you have a change in interest rate policy, you always have an initial spike of higher volatility before it settles down to normal volatility, which is exactly what we’re experiencing right now.

Is there anything to be concerned about investing-wise by President Trump’s attacks on big companies, like Amazon or Verizon?

The most important thing about a company is their current earnings and whether or not future earnings are going to be affected by their normal course of business. What matters most is that the tax-cut stimulus is coming into play, the ability to bring back repatriated capital and the fact that unemployment is down to 4%. We still have an emerging middle class that loves to buy American goods. So what’ going on in the real economy what’s happening in the restaurants, airports, stores everywhere commerce is flowing optimistically.

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