2022 is exposing ‘freaky post-QE financial system plumbing,’ BofA says

The third quarter is officially a wrap, and the stock market saw the Dow (^DJI) post 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 The Nasdaq Composite (^IXIC) is now in the red for three consecutive quarters for the first time since the global financial crisis.

And as investors prepare for the historically volatile (and crash-prone) month of October, some on Wall Street are rallying around the idea that stocks are on the cusp of a significant rally. Two key questions remain: How far can the stock rally? And, “The low” is in?

BofA Securities’ global research team, led by Michael Hartnett, has navigated the curveballs thrown at 2022 far better than most. In its latest missive, Hartnett & Co. reflects on the “strange broken post[Quantitative Easing] financial system plumbing” and throw down the gauntlet to the folks at the bottom.

“We’re tactical bears,” says BofA, which recommends betting on lower stock prices and higher returns (especially over the two-year period) on Halloween.

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

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

They cite the recent actions of the Bank of Japan and the Bank of England as evidence that central banks are adopting ad hoc policy responses doomed to failure. The moves in London were particularly dizzying: British authorities aggressively raised rates to fight inflation (restrictive), then proposed tax cuts to ease the pain of the working class (stimulus), and then, in the face of pension funds that they were on the brink of collapse. — pledged to buy an unlimited amount of bonds for a period (also stimulating).

The situation may not be as dire in the US, but cracks are emerging that reveal financial markets are creaking under the strain of massive and often incongruous policy responses.

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



Meanwhile, investors are facing a generational shake-up in the market regime, which necessarily requires time and patience to navigate. BofA painted a clear 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, fiscal panic, QT, high rates, high taxes, [and] inclusion,” the analysts wrote.

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

Until then, BofA sees the S&P 500 sinking further toward the numerically symmetric target of 3333. Rounding to the nearest hundred, its advice is “bite 3600, bite 3300, gorge 3000.” The S&P 500 closed Friday at 3585.62, a fresh 2022 low, suggesting a light snack of broken large-cap stocks for those willing to deploy cash on the sidelines.

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

BofA stressed that investors should not expect to achieve anything close to the historic 10% annualized returns, let alone the 14% returns achieved over the final decade, and simply be aware of “the more limited upside of the assets of risk”.

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

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