Bank of America's Michael Hartnett is back with another controversial note overnight, reminding readers that "it ain't a normal cycle" for one overarching reason: central banks. As Hartnett explains, the catalyst for bull in equity and credit markets since 2009 was the "revolutionary monetary policy of central banks" who, since Lehman, "have cut rates 679 times and bought $14.2tn of financial assets." And, once again, he warns that this central bank “liquidity supernova” is coming to an end, as is "the period of excess returns in equities and corporate bonds, as is the period of suppressed volatility"...
With an entire generation of traders having grown up "trading" in centrally-planned markets, few can make sense of the fundamentals that accompany the market. As a result, Harnett writes that "risk markets continue to climb a wall of worry, defying bearish structural trends in the financial industry, taunting skittish skeptics by paraphrasing Margaret Thatcher; ”You turn if you want to. The market’s not for turning.”
Demonstrating how insane just the past year has been in markets, Hartnett reminds us that just eight months ago belief in debt deflation & secular stagnation induced lowest interest rates in 5000 years.
- On July 11th 2016 Swiss government could have issued 50- year debt out to 2076 at a negative yield (of -0.035%)
- and in 1989 the Imperial Palace in Tokyo worth more than all real estate in California
- and in March’2000 the market cap of Yahoo was 25X greater than market cap of Chinese equity market (MSCI)
- and in 2008 the combined assets of Iceland’s three biggest banks were 14 times the size of the nation’s GDP
- all manias, all over now...
While the current mania almost ended in early 2016, it was once again China that was responsible for the latest leg higher:
- The current rally was kick-started by China, commodities and credit (the “3C’s”) in February 2016: since then stocks are up 31%, commodities 27% and HY bonds 23%.
- Watch the 3C’s; China, commodities, credit.
- We believe commodity prices must rise to maintain equity outperformance versus bonds; BofAML forecast oil at $57/b in Q2.
Note commodity/claims driver hooked lower last month or two.
And yet, this period of great confusion is slowly coming to an end: what happens next is split into two phases - the famous "Icarus Trade" popularized by Hartnett several months ago, which the BOFA strategist believes will send the S&P above 2,500 and the yield on the 30Y to 3.5%, before the next "Great Fall" trade emerges.
First, a look at the near-term forecast:
We believe we are closer to the highs than lows in risk markets. But tops are a process; lows are a moment. The hubris, monetary tightening and macro peak that normally ends a strong bull trend feels H2 not Q2. So our base case unchanged heading into spring:
- Long stocks, commodities, US dollar; short bonds; we see double digit returns for Japan, Europe, UK stocks, oil in 2017, single digit returns for US stocks, commodities, US$ and EM, and low/negative returns for bonds
- Q2 combo of bullish but light Positioning, fiscal Policy expectations, “hard” Profit data keeps our Icarus Trade targets alive; SPX 2500, GT30 3.5%, DXY 110
For those who wish to trade this last, marketwide blow-off top, Hartnett has several "favorite Q2 trades": the US$, sterling, oil and banks.
We think Q2 driver will be stronger growth expectations; tactical contrarians would play via long US dollar, long sterling-short EM FX, long oil, long EAFE banks-short US tech.
The risk to our bullish Q2 call is the price action of 3C’s (China, commodities, credit) deteriorates and signals synchronized global Profit top, on back of PBoC tightening. Commodity prices must rise to maintain equity outperformance versus bonds: BofAML forecast oil @ $57/b in Q2. EPS resilience required for stocks to continue to outperform bonds.
Hartnett also presents "a nice Icarus stat": "should the S&P500 exceed 2540 in conjunction with a 3% yield on the 10-year Treasury bond then US stocks will reach an all-time high versus US bonds, exceeding the prior tech bubble peak reached in March 2000"...
Still, all great, if abnormal and fake, bull markets and manias come to an end eventually, and Hartnett warns that what follows the final, Q2 "Icarus" rally will be far less enjoyable, because that's when the infamous "great fall" is set to take place.
“Great Fall” potentially comes in H2 as hubris, synchronized monetary tightening, EPS peak coincide; buy long-dated puts in anticipation; we believe best time to sell would likely be after a pop induced by a US tax reform bill (March Fund Managers Survey showed only 10% of institutions expect US tax reform passed before summer recess).
And yes, the Fed will likely try to step in again with more rate cuts to prevent a crash, although this time it won't work at least according to Hartnett, because after the "Great Fall" comes the Long View, which Bank of America describes simply as: Manias, Panics, Crashes
Longer-term, we continue to remind ourselves it’s not a normal cycle. “Normalization” from 5,000-year low in rates, 70-year low in G7 fiscal stimulus, 35-year high in US-German rate differential, all-time high US stocks vs. EAFE, 75-year low in bank stocks is unlikely to be peaceful.
- Humiliation remains one of the best assets to buy.
- In Feb 2009 the 10-year rolling return from US large-cap stocks humiliatingly dropped to -3.4%, lowest since 1930s.
- Since then S&P 500 up from 676 to 2368; now second longest bull ever (longest ever if runs past August 22nd 2018), and becomes 3rd largest ever at 2467...
*) His conclusion is two fold.
On one hand, "our Longest Pictures argue for a treacherous period of potential manias, panics or crashes as policy makers try to normalize policy."
On the other, the response will be the same one we have said since day one will ultimately take place: runaway inflation as central banks literally throw everything at the next mega crash, or as Hartnett calls it, "further outperformance of inflation assets versus deflation assets."
And this is how to trade it:
- The beneficiaries of rising inflation and rates are many.
- The long-run price relative of real assets (real estate, commodities, and collectibles) to financial assets (stocks and bonds) is at its lowest level since 1926.
- Bull markets in real assets have coincided with war and fiscal stimulus programs in 1940s, rise of inflation in 1960s and 1970s, and 9/11 & China accession to WTO in the early years of this century.
- Higher inflation and interest rates are consistent with real assets outperforming financial assets: since 1970, relative performance of real assets 83% correlated with inflation...
His best trade recommendation?