If 2017 has had a surreal feel to it, it is because it has so far been a "perfect encapsulation of 8-year QE-led bull market" according to BofA's chief investment strategist Michael Hartnett, a "bull market" which has turned financial logic and fundamental economic relationships on their head, and replaced everything with copious money creation as the only marginal price setter.
What are the characteristics of this "bull market": Hartnett describes them as i) Lower-than-expected rates, ii) higher-than-expected EPS, iii) non-existent inflation = big cyclical returns for asset prices (e.g., EAFE equities & industrial metals); but thematic leadership of “scarce growth” (e.g., tech stocks) & “scarce yield” (high yield and EM debt) which remains the heart of the bull.
In order to spawn and rear this artificial bull market, central banks have unleashed an unprecedented degree of extraordinary monetary easing in recent years, revealed by lowest interest rates in 5,000 years. As BofA further calculates, we have seen 698 global interest rate cuts since Lehman bankruptcy, as well as $11.1 trillion purchases of financial assets by central banks since Lehman.
However, if it was central bankers' intention to boost Main Street at the expense of Wall Street, they failed - as we warned would happen in 2009 - and as everyone now realizes. They did succeed, however, in created the biggest Wall Street boom in history: since the Global Financial Crisis ended in 2009, US equity market cap has risen $17.8tn…far, far outpacing the $2.6tn gain in US real personal income
However, like every other artifical, man-made thing, this "bull market" too, will come to an end. Here, the structural reasons are three, and all go contrary to what the inflation that the Fed is desperate to spawn: these are Debt, Demographics, and Disruption, and combined result in Deflation.
According to Hartnett, who first coined the equality, the 3 “Deflationary D’s” (excess Debt, aging Demographics, tech Disruption) cap inflation: "the slowdown in the growth of the working population is deflationary, as are new biotechnologies that may extend human life"
Here, BofA also points out that technological disruption is also deflationary via an increased supply of labor, energy, services, financial, consumer products. Furthermore, the number of global robots by 2020 is expected to rise to 2.5 million, up from 1 million in 2010. According to the bank, US urban workforces most at risk of automation are in the Midwest, Florida, south California; less at risk in San Francisco, Seattle, Boston, NY,
The combination of record debt, record deflation and record (old) demographics means that deflation assets have massively outperformed inflation assets at the same time as US equities have massively outperformed non-US equities.
This euphoria, in turns, leads to one bubble after another.
According to Hartnett, the structural risk is that the era of excess Liquidity & wage Disruption by AI ends with a tech & credit bubble, one which will force the Fed to pop it - this is Jay Powell's "biggest nightmare." But before he does, the 30-year UST would go to 2%, according to Hartnett, while HY spreads would drop to 100bps and the Nasdaq would hit 10,000.
Yet as the world careens to this final, mega bubble burst, the liquidity supernova is already ending.
Yet while the market is aware of this, what it does not believe is that the one thing that can stop the party - inflation - will appear. Indeed, according to Bank of America, inflation is the single biggest risk for asset prices in 2018.
In this context, Hartnett calls 2018 a "one-decision market" : either inflation returns (bearish) or it doesn’t (bullish):
risks to “Goldilocks” consensus: 1. “inflationary boom” = rates up = flash crash a la 1987/94/98…best trade = long CRB, short CCMP; 2. “recession” via Quantitative Tightening + lower EPS = bear market…best trade…long T-Bills & gold, short HY & EAFE.
Hartnett concludes by looking at the fate of the "Icarus Rally" which he first defined one year ago, and says that "the only reason to be bearish is there is no reason to bearish."
But even that, almost a decade into the most insane market period in history, is coming to an end: