‘Tis the season for Wall Street "Year Ahead" previews.
This is the time of year when everyone gets together and pens 100-page tomes, chock-full of recos that, while based on a set of ostensibly reasonable assumptions and models, will almost invariably fail to play out.
One thing everybody has going for them headed into 2018 is that the consensus take on risk assets rests on the now ubiquitous “Goldilocks” narrative, the pillars of which are synchronized global growth but still subdued inflation in developed markets.
There are a lot of reasons to suspect that narrative may indeed end up approximating reality, not the least of which is that if it doesn’t, things could go to hell in a handbasket.
That’s not so much an attempt at hyperbole as it is a statement of fact. Central banks have put themselves in a position where the very thing they’ve spent nine years trying to engineer cannot - must not - actually materialize to any significant degree.
Sure, the Fed, the ECB, and certainly the BoJ wouldn’t mind if inflation rose sustainably to target, but if it turns out that the deflationary impulse created by all of those factors which have been summarily dismissed as “transitory” (e.g. technology) evaporates at the same time the post-crisis regulatory regime is dismantled in the U.S. and if that’s compounded by looser fiscal policy (i.e deficit spending), well then all that “missing inflation” could come calling at once. If oil prices were to rise at the same time, we could end up in a situation where everyone (including and especially central banks) is caught woefully behind the curve. That would necessitate rapid tightening and a disorderly unwind of the bond trade. From there, it’s curtains. Plan and simple.
So circling back, the only way this doesn’t go off the rails is if inflation remains muted, thus providing cover for central banks to stick to a gradualistic rollback of accommodation, characterized by an ongoing dialogue with markets. Because after all, that’s what forward guidance is - a consultation with markets that helps policymakers determine ahead of time what the likely reaction would be in the event they were to do [XYZ].
The consensus for U.S. stocks is that robust earnings growth (supercharged by tax cuts) will play out against that “Goldilocks” backdrop. That’s pretty much the long and the short of it (no pun intended) when it comes to how most desks are looking at this.
Goldman was out on Tuesday with their 2018 S&P outlook which they’re calling “rational exuberance”, something I’ve variously mocked as an oxymoron. One cannot be completely rational and exuberant at the same time. Inherent in the word “exuberance” is some degree of irrationality. Anyway, here’s a fun chart that juxtaposes the “rational” with the “irrational”:
And make no mistake, Goldman is hardly the most “exuberant” shop on the Street.
Lurking in the background in each and every one of these outlook pieces is a palpable sense of angst regarding what would happen in the event inflation did suddenly show up and force central banks’ to move more aggressively. Albert Edwards has been warning about this a lot lately (when he’s not busy warning about something else). The notion that if central banks finally get what they want it could paradoxically be the death knell for the risk rally hangs over everyone’s forecasts like smog over Beijing on a particularly dirty morning.
Implicit in that is the flipside (because the flipside of something is always implicit). If the “transitory” factors keeping inflation subdued turn out to be structural, endemic and more powerful than anyone anticipated, well then it’s possible that inflation could decelerate, necessitating still more easing and still more dovish forward guidance. In that scenario, it’s feasible that risk premia could compress even further and stocks could blast off into the goddamn stratosphere.
Ok, so if you follow BofAML’s Michael Hartnett you know that he’s pretty keen on pushing the hyperbole envelope as far as it can be pushed in research that presumably has to be vetted by compliance.
Personally, I love Hartnett’s stuff. It’s colorful (figuratively and literally if you’ve seen the charts), it’s engaging, the format is super-fun, and his notes serve as a reality check in that kind of way where reality isn’t conforming to Hartnett’s warnings, but you know that on some level he’s probably right.
Well, Hartnett’s year ahead piece is called “The Big Top” and while he concedes that risk assets are likely to remain buoyant in H1, he also lays out a series of nightmare scenarios the last of which sounds like something out of the opening sequence from Terminator 2.
“The Big Top” comes in H1 as “the last flames of QE, US tax reform and robust EPS incite full capitulation into risk assets.”
Nothing particularly novel about that. But then it gets interesting.
“The Big Long” is volatility. Since at least August 24, 2015 (that would be the morning when the implications of the Chinese yuan devaluation finally dawned on the world all at once and triggered a nauseating wave of selling that culminated in a 1,000 drop at the open on Wall Street), there’s been a chorus of doomsayers warning that systematic, vol.-sensitive strats might one day be forced by an acute bout of volatility to deleverage into a falling market, thus triggering a flash crash of catastrophic proportions. Here’s Hartnett on that:
Volatility...peak positioning, profits, policy = peak returns and trough volatility; 50-year low in stock volatility, 30-year low in bond volatility likely to be followed by flash crash (à la ’87/’94/’98) in H1.
Next is “The Big Short”. For Hartnett that’s corporate bonds and his punctuation-filled “equation” amounts to the same worry outlined above: namely that the sudden emergence of inflation on the scene could prompt central banks to abruptly cancel their “consulting” agreement with investors in the interest of moving aggressively to catch up. Here’s Hartnett:
Corporate bonds...higher inflation, higher debt, higher bond volatility and end of QE era most damaging for corporate bonds; game-changer = wage inflation shatters Goldilocks consensus (no fear of Fed/ECB) via higher credit spreads.
But believe it or not, none of that is the scary part. Recall what we said above about what happens in the event inflation actually decelerates meaningfully. To wit:
If the “transitory” factors keeping inflation subdued turn out to be structural, endemic and more powerful than anyone anticipated, well then it’s possible that inflation could decelerate, necessitating still more easing and still more dovish forward guidance. In that scenario, it’s feasible that risk premia could compress even further and stocks could blast off into the goddamn stratosphere.
If you follow Michael’s notes, you know how to translate that from Heisenberg into Hartnett. That scenario would be “Icarus unleashed,” a reference to Michael’s long-running characterization of the relentless runup in equities as something akin to Icarus and his wax wings. To wit, from Hartnett:
Tech bubble...AI/robots cause wage deflation extending era of excess liquidity, bond yields fall, Nasdaq exponential; “Icarus unleashed.”
That sounds “good” in theory for anyone who’s long risk assets and especially for anyone who took Josh Brown’s advice and “just bought the damn robots.”
But Hartnett thinks you might want to consider the possibility for that scenario to create actual class warfare. The idea, I guess, is that everyone who was previously satisfied with the extra $20k they made in their E*Trade account will suddenly realize that when Icarus is “unleashed” and flies off into the wild blue yonder, it necessarily means that people like Jeff Bezos have become trillionaires and that the already gaping wealth divide in America has been transformed into a chasm that approximates a thousand Grand Canyons.
That’s when the torches and pitchforks come out. Here’s Hartnett one more time:
Bubble could end in 2019 with bear market on hostile Fed hiking, Occupy Silicon Valley and War on Inequality politics.
That’s when Josh Brown’s “just buy the damn robots” reco will be commandeered by the downtrodden masses and modified into a battle cry as the peasant hordes descend on Silicon Valley shrieking “Just murder the damn robots!”
So if you’re inclined to ask “what could go wrong?”, just make sure you want the answer.
And while the world burns, Janet Yellen will be sitting quietly somewhere sipping chamomile, knitting a sweater and whispering to herself: “Free at last, Free at last, Thank God almighty I am free at last.”
Catch more Heisenberg over at Heisenberg Report.