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”.

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.

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).

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.