2022 exposes ‘the bizarre plumbing of the post-QE financial system’, says BofA

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The third quarter is officially over, and the stock market has seen the Dow Jones (^ DJI) posted its worst September performance in two decades – down nearly 2,800 points, or 8.9% for the month – while the S&P 500 (^GSPC) and Nasdaq Composite (^IXIC) are now in the red three quarters in a row for the first time since the global financial crisis.

And as investors brace for historic volatility (and accident prone) October, some on Wall Street are uniting around the idea that equities are on the cusp of a significant rally. Two key questions remain: how far can equities rally? And, is “The low” in it?

BofA Securities’ global research team, led by Michael Hartnett, has navigated far better than most curveballs launched by 2022. In their latest missive, Hartnett & Co. reflect on “the shattered post-war and weird”.[Quantitative Easing] plumbing the financial system” and throwing the gauntlet to the crowd of lows.

“We’re tactical bears,” says BofA, recommending bets on lower stock prices and higher returns (especially in the two-year duration) through Halloween.

This image of US dollars flowing through pipes was created by Yahoo Finance using DALL·E AI software. (OpenAI)

They cite the recent Bank of Japan and Bank of England stocks as evidence that central bankers adopt ad hoc policy responses that are doomed to failure. The moves in London were particularly dizzying: British authorities raised rates aggressively to fight inflation (restrictive), then offered tax cuts to ease the pain of the working class (stimulant), then – in the face of pension funds on the verge of collapse — committed to buying an unlimited number of bonds for an (also stimulating) period.

The situation may not be as dire in the United States, but cracks are appearing that reveal financial markets are creaking under the pressure of massive and often incongruous policy responses.

Central banks have tightened financial conditions to the point where the plumbing in global financial markets could burst, BofA said, having already drained $3.1 trillion from their balance sheets through quantitative tightening (QT).

BofA:

BofA:

Investors, meanwhile, are grappling with a generational shift in the market regime, which necessarily takes time and patience to navigate. BofA painted a grim picture of the dramatic transition.

“The bullish deflationary era of peace, globalization, fiscal discipline, QE, zero rates, low taxes, [and] inequality” is slowly giving way to an “inflationary era of war, nationalism, tax panic, QTs, high rates, high taxes, [and] inclusion,” the analysts wrote.

At the same time, authorities must respond to day-to-day realities – often without the luxury of waiting. BofA believes global authorities are likely to come together and coordinate policies if the carnage continues at a critical G20 meeting in mid-November.

Until then, BofA sees the S&P 500 dipping further toward the numerically symmetric target of 3333. Rounding to the nearest hundred, their advice is to “nibble 3600, bite 3300, gorge 3000.” The S&P 500 closed at 3585.62 on Friday — a new 2022 low — suggesting a slight snack of bruised large-cap stocks for those rushing to deploy cash on the sidelines.

Looking ahead to 2023, BofA expects the “Big Low” to be hit in the first quarter as recession and credit shocks peak. From there, the bank expects the “23 trade” to be short on the dollar while going long in emerging markets, small caps and cyclical stocks.

BofA stressed that investors should not expect to achieve historic annual returns of 10% – let alone the 14% returns achieved over the past decade – and simply be mindful of “the more limited upside in assets to risk “.

After what’s shaping up to be a remarkably turbulent year for investors, perhaps a “limited upside” will be a welcome change in 2023.

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Don F. Davis