Last week we noted that something odd was going on in global markets: in recent months, a near record divergence has opened up in the performance of risk assets, which previously was only 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.

This brings to mind a topic that Morgan Stanley's chief equity strategist, Michael Wilson had been discussing for much of the past year, namely the idea of "rolling bear markets" in which one specific asset class is slammed even as the rest of the market remains surprisingly stable. For context he used the vol shock in early February and the sharp sell-off in Italian BTPs in May which "stand out as perhaps the best examples of what investors have had to deal with this year. Amazingly, neither of these events led to a broader, more systemic de-risking of portfolios. Instead, prices reset quickly in the affected assets and investors simply moved to higher ground", he said in a July note.

Further to this idea of a "rolling bear market", Wilson described it as feeling "awful at times in specific places, but not everywhere at once."

Perhaps it’s easiest to see when comparing regions, sectors or specific stocks. In other words, the damage below the surface is much worse than if you simply look at the broad indices. However, the higher ground is getting scarcer, with few completely dry areas.

Wilson then proceeded to lay out a dire outlook, which culminated with a downgrade of tech and small-cap stocks, noting that "global risk markets have absorbed a lot of bad news this year, not to mention meaningfully tighter financial conditions. We think that our rolling bear market narrative has captured this unusual dynamic quite well."

Since these observations two months ago, the financial tightening around the globe as a result of the ascendant dollar coupled with global tariff concerns, has only made the "rolling bear markets" worse and according to Bank of America's latest note. In particular, in Emerging Markets, BofA notes that its "Risk-Love" indicator has entered panic mode, while some of the defensive sectors in equity markets have hit record overbought readings.

Furthermore, the sell-off in EM has also pushed valuations back to levels last seen during the Chinese devaluation panic of February 2016, with EM equities now trading at a sub-11x P/E...

... and as a result, non-US equity markets have underperformed the US the most over a 3-month period since the GFC .

What is even more bizarre, is that according to the bank, "the underperformance of non-US equities to US equities is reaching levels normally only exceeded in bear markets."

Yet what is making investors that Bank of America has spoken to especially confused is that at the same time as the US stock market continues undaunted to new record highs, spurred by the ongoing US economic growth and stellar corporate earnings, the abovementioned 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", or in other words - how close are we to the end of the cycle ?

"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.

And while the cycle may indeed be late, there is another key consideration investors need to keep in mind: missing out on the final meltup of this cycle:

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.

Meanwhile, another major risk for US investors - as demonstrated rather clearly by non-US assets - is that markets are underestimating the Fed's resolve to keep hiking, something which became less of an issue during Powell's somewhat dovish Jackson Hole speech.

Still, as Michael Hartnett, BofA's Chief Investment Strategist, rightly points out 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.

The key question for investors then boils down to this: will the Fed keep hiking beyond the 2 and change rate hikes priced in by the market until the divergence between the US and the rest of the world finally snaps, or "will Powell throw in the towel", as previously requested by the head of the Indian Central Bank, and put a stop to the Fed's tightening cycle.