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The single biggest factor driving this rally may go up in smoke

The George Washington statue in front of Federal Hall on Wall Street is engulfed in a cloud of steam.
Gary Hershorn | Getty Images
The George Washington statue in front of Federal Hall on Wall Street is engulfed in a cloud of steam.

From the Federal Reserve chair on down, expectations have been building along with equity valuations. Forecasts and kudos have been handed out based on the S&P 500's runup. We see fresh monies in the hundreds of billions chasing flows into equities.

So what's conducting this cacophony? We believe it's the reflation trade.

Many have heard what they wanted to hear and declare the noise a symphony. We hear the noise and sense the conviction; beyond that, we see thick haze. There's been a nearly $1 trillion decline in fixed income assets, pushing rates higher. Commodities took this trip up and then back down. Yet despite the lack of surviving commodity price pressure, reflation remains. Equity excitement — U.S. equities particularly — seems everyone's favorite reflation play. Rising rates on U.S. Treasurys, pushed up as bonds are sold down, are the other side of the same story.

Reallocation to assets positioned for higher growth and higher inflation is the portfolio expression of reflation — unless those assets are oil and other commodities. Selling traditionally less volatile positions and buying traditionally more volatile assets generally pushes up indexes and sends a reflation signal to those who infer a trend from equity markets. As such, reflation becomes a cause and effect of asset appetite.

We have seen the market rally since September 2016. Ironically, the pre-election rally was thought to be based on Hillary Clinton winning the presidency — but following the Donald Trump surprise, we have seen a four-plus-month rally boosting the S&P by 9 percent.

The rally is based on offers of lower tax rates for individuals and corporations. Reductions of up to 50 percent in corporate rates, mentions of estate tax repeal, cuts in capital gains and repeal of the alternative minimum tax float around. Export subsidies, tariff walls and $1 trillion in infrastructure spend are said to be on their way. Reflation confidence is based on extrapolation of campaign promises.

Meanwhile, mounting tensions within the Republican Party and setbacks on immigration and health care have not shaken confidence.

The usual macro suspects, like spiking wages and commodity prices, do not presently explain reflation expectations. Instead, the market appears to be working off the following assumptions:

1) Unpassed legislation
2) Phasing of effect from future legislation
3) Net macro impact from legislation passed
4) Effect of higher interest rates
5) No unintended effects that reduce growth and optimism

Unfortunately, these amount to conjecture heaped upon conjecture. Estimating compound political and economic effects out into the future and then properly discounting them back to the present is a fool's errand. We believe there is little reason — aside from optimism — to believe that we will see all that is hoped for and priced in from Trump.

Legislative processes are slow, opaque and subject to swings in opinion. Market price movements are opaque and subject to swings in opinion — but markets move quickly. Single party political rule in the U.S. was alleged to offer clarity on legislation. The recent misadventure in repealing and replacing the Affordable Care Act suggests otherwise.

Expectations remain elevated for policy-driven reflation to deliver what markets have spent four months pricing. Legislation is more likely to deliver disappointment than expectations and market trends have suggested. We see commodity and U.S. dollar weakness signaling that expectations are slowing down toward legislative speed and success probability.

Only time will tell if we are in an actual reflation cycle or just a reflation expectation binge. The endings to these two tales are dramatically different. Expectations are ahead of legislative progress, despite the recent market pause. It looks like big momentum is snowballing money and sentiment into equities. Growing apprehension about disappoint is disturbingly absent.

Story-based investment cycles, however, do not permit participants to write their own endings.

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Brian Sullivan

Brian Sullivan is co-anchor of CNBC's "Power Lunch" (M-F,1PM-3PM ET), one of the network's longest running programs, as well as the host of the daily investing program "Trading Nation." He is also a frequent guest on MSNBC's "Morning Joe" and other NBC properties.

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