Bank of America’s Hartnett: Contrarian Investors Await Two Key Signals, Ready to Shift to Risk-Off Mode

Before the two key signals are triggered, he believes the market will continue its "grinding higher" pattern without a leading sector.

Written by: Dong Jing, Wall Street Journal

Michael Hartnett, Chief Investment Officer at Bank of America, warns that despite the current market sentiment being extremely bullish, contrarian investors are preparing for a sudden shift in market sentiment and are ready to pivot their portfolios to a "risk-off" mode.

In the latest Flow Show report, Hartnett states that the core of this potential shift hinges on two upcoming key signals: a potential compromise in the U.S.-Iran conflict and the upcoming U.S. midterm elections. Any sudden easing of geopolitical tensions or unexpected political power shifts could quickly disrupt the fragile consensus supporting the leadership-less rise of risk assets.

The report notes that market funds have begun to hedge against the risk of fiat currency depreciation, with safe-haven assets experiencing a massive influx of capital. Recent data shows that gold and cryptocurrencies attracted over $10 billion in funds in a single week, while the U.S. stock market faced significant outflows, highlighting the underlying currents of capital and investor defensive psychology beneath the apparent prosperity.

Meanwhile, the bond market is vying for dominance in global asset pricing. Hartnett believes that whether policymakers can successfully suppress long-term Treasury yields is not only crucial for the financing environment of AI capital expenditures but also a decisive factor in whether the current risk appetite in the stock market can be sustained.

Two Flip Signals: The Waiting List of Contrarian Investors

Hartnett clearly outlines two "flip risk" opportunities that contrarian investors are waiting for in the report:

First, a de-escalation in the U.S.-Iran situation and the final drop in oil prices. If there is a substantial easing of the U.S.-Iran conflict, oil prices will face one last round of downward pressure, at which point the market's optimistic sentiment regarding EPS expectations may peak, providing an entry point for shorting risk assets.

Second, the results of the U.S. midterm elections. Hartnett explicitly points out that if the Republican Party loses its Senate seat or the governorship of Texas, it will have a negative impact on the market. The logic is that:

Voters are indicating through their ballots that affordability and controlling inflation take political priority over tax cuts, deregulation, or boosting stock prices, which will fundamentally undermine the policy foundation of the current market consensus.

Before these two signals are triggered, Hartnett believes the market will continue its "grinding higher" pattern without a leading sector, while contrarian investors remain highly vigilant, ready to switch to risk-off mode.

Capital Flows and Sentiment Indicators: Safe-Haven Assets Encounter Buying Frenzy

In the recent market turbulence, capital flows have shown a strong "anti-devaluation" characteristic.

According to Bank of America’s report, funds are being withdrawn en masse from traditional risk assets and flowing into alternative safe-haven assets.

Specifically, gold recorded an inflow of $7.3 billion, and cryptocurrencies saw an inflow of $3.2 billion, both marking the largest scale since October 1998.

In stark contrast, the U.S. stock market faced an outflow of $4.4 billion, marking the first time in five weeks; high-yield bonds also recorded an outflow of $700 million. Although the technology and materials sectors still saw inflows, the overall capital landscape has shown a defensive tendency.

Additionally, the Bank of America Bull Bear Indicator rose further to 9.7 last week, nearly reaching a historical high.

Hartnett believes this extreme bullish indicator is primarily driven by the broadening of global stock indices and the increase in hedge funds' long positions in gold and short positions in VIX. Despite the S&P 500 index slightly rising after triggering a "sell signal" on May 26, the extreme positioning has laid the groundwork for a potential correction.

Bond Market Pricing Power: Yields Become the Core Battleground

Michael Hartnett candidly states in the report that it is currently "bond trading information, stock trading ideology." In the AI investment frenzy, AI bonds are seen as leading signals.

The report indicates that only when the 30-year Treasury yield falls below 5% will the underperformance of AI spenders (MAGS) and AI builders (SOX) relative to AI adopters end, but this goal seems difficult to achieve in the short term.

Hartnett believes that the new Fed Chair Waller's speech at Jackson Hole attempted to balance inflation and the yield curve. Although the yield curve between the 2-year and 30-year yields flattened significantly after the speech, and the dollar rebounded, broader risk appetite did not recover as expected, with Treasury yields even breaking the critical intervention level of 4.7%.

Michael Hartnett believes that the policy combination of Bostic and Waller must prevent U.S. Treasury yields from rising further; otherwise, long-duration trading will face immense pressure.

Policy and Positioning: Central Bank Shift and the Collision of "No Landing" Consensus

From a market positioning perspective, investors are currently immersed in a perfect consensus of "no macro landing, the Fed not raising rates, AI capital expenditures not being cut, and the Democrats not sweeping." Asset allocation shows characteristics of going long on stocks, going long on investment-grade bonds, and shorting government bonds and the dollar.

However, to hedge against this highly consistent consensus risk, Michael Hartnett insists on going long on gold and global natural resources as commodities.

On the policy front, global central banks are quietly changing course. The report notes that in the past three months, global central banks have raised rates 13 times, exceeding the 12 times they have cut rates, and Bank of America expects a scenario of 17 rate hikes against 4 cuts by the end of the year.

Hartnett believes that central bank rate hikes help coordinate the U.S. Treasury's bond and foreign exchange interventions to suppress long-end yields—this is crucial for financing the AI capital expenditure boom and preventing consumers from increasing precautionary savings due to concerns over $40 trillion in national debt. Notably, the U.S. Treasury's bond repurchase program will end on November 4, just one day after the U.S. midterm elections.

On the political front, Trump's economic approval rating (35%) and inflation approval rating (28%) have declined again.

Hartnett points out that a swift end to the U.S.-Iran conflict is the quickest way to boost approval ratings, which is also the core logic behind contrarian investors closely monitoring the situation in Iran.