On Wednesday, Bank of America Merrill Lynch's global investment strategy team, led by Michael Hartnett, released a report based around a simple equation:

Peak Liquidity + Peak Globalization + Peak Inequality = Big Rotation (also, Peak Returns)

The way the bank sees it, the current deflationary era has been defined by the "omnipotence" of central banks; the free movement of people, goods and capital; and stimulus that has gone towards bond-buying rather than fiscal measures—and it is coming to an end.

The "winners" of the current cycle will accordingly give way to a new set of social groups, sectors, policies and -isms that define the coming inflationary cycle. We will see a "big rotation" from Clinton to Trump (whether BAML means a literal election victory for the Republican or a broader shift in the political climate is unclear), from capitalism to socialism, monetarism to Keynesianism, globalization to protectionism, and so on down the line:

RIP Deflationary Cycle

The world economy is currently defined by low interest rates, low inflation, high inequality and high asset prices, a situation BAML pins on a set of secular trends:

Central Banks

Since Lehman Brothers toppled in September 2008, central banks have cuts rates 671 times—blasting right through the supposed zero lower bound in some cases—in an effort to nudge the global economy towards recovery, but their efforts have not convinced corporations and households to splash out. Instead, they have driven up asset prices and made borrowing cheaper for the rich, fueling inequality. The reality of "qualitative failure," in BAML's view, has dawned on monetary policymakers: the Bank of Japan and European Central Bank are "walking back" their negative interest rate policies, and the Federal Reserve appears set on tightening, if slowly. (For more, see: Case Study: The Collapse of Lehman Brothers.)

As the experiment in radically accommodative monetary policy comes to an end and with it "excess liquidity and QE," we have the first term of BAML's equation, "peak liquidity." As monetary stimulus shifts to fiscal stimulus, as we're already seeing in Japan and Europe and may soon see in the U.S., BAML expects higher rates, faster economic growth, giving the third term of the equation: "peak inequality."


BAML places the start of the current era of free trade, capital mobility and openness to immigration in 1981, presumably because that was the year Reagan was elected. (Ironically, it was also the year Bernie Sanders began his political career as mayor of Burlington, Vermont.) Today voters across the world are becoming increasingly skeptical of open borders, leading to calls for curbing trade and immigration. Advocates of capital controls are less vocal. (For related reading, see: The Economics of Labor Mobility.)

The report cites a number of recent events as evidence of a fading spirit of cooperation: Brexit, the EU's tax fight with Apple, the Department of Justice's threat to fine Deutsche Bank into the ground, and the bill—which Congress overrode Obama's veto to pass—allowing the families of 9/11 victims to sue Saudi Arabia. In terms of data, global trade growth is projected to lag GDP growth, at 1.7% and 2.2% respectively, "a rare event without a recession." (For more, see also: IMF Says Protectionism Will Curb Global Growth.)

The second term of the equation: "peak globalization."

Technology, Debt and Demography

BAML does not see every single deflationary pressure disappearing in the near future. Technology has made a wide range of goods and services cheaper, a trend that's likely to continue. Similarly, aging populations and a growing global debt pile will not suddenly cease to impact the trajectory of the world economy. But the turn against monetary stimulus and open borders, in BAML's estimation, will be enough to usher in the "Big Rotation." (For more, see: 4 Global Economic Issues of an Aging Population.)

Revenge of the "ZIRP Losers"

By BAML's reckoning, the sum of peak liquidity, peak globalization and peak inequality is peak returns. The bank expects outperforming equities and bonds to cool off, following a couple quarters of "slim returns;" they are long stocks and commodities, but short bonds. (For more, see: A Bond Bubble: CFAs Say We're In One.)

For what's left of 2016, BAML says "buy what central banks buy," meaning Japanese stocks, EU and UK credit and emerging market debt. For 2017, it expects action in the beneficiaries of fiscal stimulus: commodities, small caps and "Main Street." Other "ZIRP losers"—areas of the global economy that have not reaped the benefits of zero interest rate policy—include emerging market, European and Japanese equities; the bank expects these to log "double-digit returns." (For more, see: Get Japanese Equity Exposure with EWJ ETF.)

The "yield" trade, on the other hand, has become too crowded, with dividend, investment gradeREIT and emerging market debt funds attracting $1.1 trillion of inflows since 2009. The ZIRP losers have drawn in just $329 billion over the same period. It's not clear whether ZIRP losers and inflation winners are meant to be synonyms; the report gives only the overlapping, but not totally identical examples we've reproduced above.

Putting those questions aside, though, the broader theme is clear enough: time is running out for areas of the global economy that have prospered in an era of deflationary pressures, powerful monetary policymakers, porous borders and widening gaps between rungs on the income ladder. Areas of the economy that have struggled under these conditions may soon see their day in the sun.

Betting on Convergence

Another potentially exploitable imbalance shows up in U.S. versus global equity valuations: the former trade at 2.9 times book value, compared to 1.6 times for the latter. Buying non-U.S, equities represents a "convergence" bet on global value.

To bet on inflation returning, investors can purchase Treasury inflation-protected securities (TIPS). Finally, they can always "buy what nobody else owns," such as banks, value stocks, and UK and Japanese equities (again). 

Wild Cards

BAML has laid out a pretty tidy summary of current trends and how to play them, but acknowledges the possibility that reality won't cooperate. One potential risk is that the Fed passes up on a December rate hike, which the bank sees inducing a "tech bubble." Another is a "Wall St. systemic event," leading to a spike in bond yields, a collapse in gold prices and widening credit spreads. There is the chance that putting the breaks on globalization leads to a recession. Or the Chinese property bubble could pop: residential building prices in first-tier cities have shot up 28% year-over-year, and second-tier cities are not too far behind at 10%.

Finally, the election is a growing concern: BAML's global fund managers survey has shown a Trump presidency topping the list of tail risks for the three months to September, supplanting Brexit (May and June), qualitative failure (March and April), a U.S. recession (February) and four months of a Chinese recession.

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